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September 14, 2009

Conditional Expectations and September Seasonality

John P. Hussman, Ph.D.
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One of the arguments we've seen a lot lately is the idea that September and October have historically been the worst months for the stock market, coupled with rebuttals by bullish analysts along the lines that the discussion of this historical tendency by the bears makes it likely that nothing bad will happen this time.

Being reasonably defensive at present (though with a “contingent” index call position amounting to about 1% of assets in the Strategic Growth Fund), I might be expected to rush to the side of the September-October bears, but as I've noted before “if you give me a dozen opportunities to mine the data in ways that have even a modest probability of coming up with an interesting superstition, it's almost certain that I'll come up with an interesting superstition.”

The fact is that yes, on average, the combined September-October period has historically produced slight declines for the S&P 500 whether you look back since 1870, 1900, 1940 or 1970. But the variance around that slightly negative return is large enough that it's really misguided, in my view, to base predictions on it. All you can say is that maybe in a repeated game of 20 or 30 years, you might find that avoiding stocks in September and October slightly reduces risk without surrendering long-term returns.

Saying “September and October are the worst months for stocks” simply isn't all that scary, because again, the average change in the S&P 500 is just slightly below zero, and the average total return including dividends is still slightly positive (though generally less than T-bills).

While a two-month period with an average historical return of zero is interesting, what is more interesting is the variation in those returns. Investors rarely operate in a vacuum, so a given piece of data really matters only in the context of other pieces. As investors, we are very much interested in “conditional return,” which requires that we base our analysis on a wider context than a single indicator.

With regard to September-October performance, Jim Stack of Investech points out that if you restrict the set of Sep-Oct periods to only those that followed the end of a bear market, the returns for the S&P 500 during that subset have been positive by a couple of percent, on average. The difficulty, from my perspective, is that the close of a bear market isn't an observable variable, except with the benefit of hindsight. Better to use “conditioning variables” that can be measured directly.

For example, at any point in time, we can observe directly where the S&P 500 Index is in relation to its 6-month moving average. Using this variable to measure the recency of a market weakness or strength, we find that Jim is still right, but he's right in an interesting way. Specifically, if you look at the set of periods where, at the end of August, the S&P 500 was more than 10% below its 6-month average, it turns out that the S&P 500 has indeed advanced by an average of about +2.5% during the subsequent September-October period.

On the other hand, if you look at the set of periods where the S&P 500 was more than 10% above its 6-month average (as it was at the end of August this year), we find that the September-October returns have been clearly negative, averaging a -5.6% decline for the S&P 500.

The lesson here really is much broader than September-October seasonality, which is interesting in the same way horoscopes are interesting, but not something I consider useful for investment management. The important point is that what investors believe are “average” tendencies for the stock market are actually very dependent on the prevailing context, be it valuation, market action, overbought/oversold conditions, sentiment, economic considerations, or other factors. The implications of September-October seasonality are largely dependent on the position of the market at the end of August. So knowing only that September-October has arrived is not particularly helpful information taken by itself. Similarly, it is not helpful to say, look, we think this is a recovery, and in a recovery stocks do “X” – without coupling that analysis with a whole set of other conditioning variables that shape the outcome (or call the recovery itself into question).

As for me, I generally avoid making forecasts, even in extremely pointed market conditions, (see for example A Who's Who of Awful Times to Invest). Normally speaking, whatever forecast you can make is absolutely overwhelmed by day-to-day, week-to-week, and even year-to-year noise. Instead, the best approach is to accept market risk in proportion to the average return/risk profile that can be expected in the context of all that conditioning information. If the expected return is low enough in relation to probable risks, we move to a fully hedged stance, but we don't go short.

Investing isn't about specific forecasts, but about repeated actions and long-term discipline. By taking greater risk in periods where the average return/risk profile is strong, and avoiding risk where the average return/risk profile is weak, we can certainly miss individual instances that would have been profitable (sometimes strongly so), and can get hit with individual instances of loss (though we can sometimes mute them). What we focus on, however, is the “weighted averaging” that comes from repeated discipline.

By accepting a larger investment weight in conditions that have historically been associated with strong return/risk characteristics, and establishing small investment weights in conditions associated with weak returns or elevated risk, we attempt to achieve a weighted average return per unit of risk that significantly exceeds that of a passive buy-and-hold approach over the complete market cycle.

Presently, we remain well hedged, with a 1% allocation to index call options to allow for further speculative pressures. September-October seasonality isn't a particularly favorable portent for the market given its current overbought status, but it doesn't prompt us to liquidate our call position or make forecasts about future market direction. Suffice it to say that the probable return/risk profile here is not compelling, on average, but as usual, we have no forecast about short-term market direction in this particular instance.

Market Climate

As of last week, the Market Climate for stocks was characterized by moderately unfavorable valuations and mixed market action – still very strong for breadth and major indices, but with a continuation of dull volume sponsorship, elevated bullish sentiment, strenuous overbought conditions, and other factors. Overall, we can't rule out a further advance on speculative enthusiasm alone – hence our index call exposure of about 1% of assets, but the recent advance is now looking tired and aged, and we should certainly not rule out the alternative of a significant correction.

With mortgage delinquencies and foreclosures still pushing new records, and little reason from employment data (and particularly temporary hiring) to suggest a turnaround in job creation, it appears very likely that we will observe further deterioration in the balance sheets of major financials over the coming quarters. My impression is that significant balance sheet losses are already mounting unreported (but don't show up in gleeful “operating profits” because of weakened mark-to-market rules earlier this year). Eventually, push will come to shove, but it's not clear when, so it's not particularly useful to sit at the edge of one's seat waiting for the other shoe to drop. It might very well take until next year. In any event, the likelihood is strong in my view that the credit crisis is not over. I believe it is a large mistake to treat current economic conditions as if we are in a typical post-war economic recovery.

In bonds, the Market Climate last week was characterized by relatively neutral yield levels and modestly positive yield pressures. The U.S. dollar has hit fresh lows against a number of currencies, which has pushed up the U.S. dollar prices of precious metals and other commodities (think of it this way – if a globally traded good like gold or oil is trading at a given level in terms of foreign currency, and foreign currency gets more expensive – that is, the dollar depreciates – then the prices of gold and oil will rise as well, due to the “pass through” effect of the exchange rate change). While inflation concerns based on expectations of an economic recovery may be some part of that dollar depreciation, the primary reason is fairly straightforward – a huge issuance of new U.S. government liabilities by the Treasury, coupled with a reduced “safe haven” demand for those U.S. government liabilities.

My impression is that the reduction in safe haven demand is not likely to be sustained, as new cracks appear in the smooth plastic veneer that has been laid over a still deteriorating credit market. There is some talk, of course, of yet another stimulus plan, but this would be like laying a fresh band-aid over a growing infection. Out of necessity, we'll eventually get to talking about major debt restructuring in the mortgage and banking sector, but until we do, as Nobel economist Joseph Stiglitz has noted, our policy makers will just be pursuing a solution that says “let's kick the can down the road a little bit.”

So while I continue to believe that major dollar weakness and eventual inflation pressure (a few years from now) will be the unavoidable outcome of trillions of dollars of U.S. government liabilities that have been issued to defend bank bondholders, I also expect that we'll observe fresh safe-haven demand for those liabilities over the intermediate term. That may make it more difficult for the precious metals and currency advances to get continued traction. As a result, we've modestly added to our Treasury exposure, moving the average duration of the Strategic Total Return Fund just over 3 years (still quite conservative), and we've clipped our exposure to precious metals and foreign currencies to only about 8% of the Strategic Total Return Fund, with about 4% of assets invested in relatively high-yielding utility shares with reasonable dividend coverage.

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