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October 19, 2009

The Stock Market Has Never Been This (Intermediate-Term) Overbought

John P. Hussman, Ph.D.
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If you spend a great deal of time analyzing market data, there are some dates that are easy to remember – October 29, 1929, March 23, 2000 (the date of the 2000 bubble peak in the S&P 500), August 12, 1982 (the 1982 low), October 19, 1987, and so forth. Certain years are memorable of course, marking the beginning or end of recessions, major market movements, major economic events, and the like. But individual dates are generally forgotten unless they represent some sort of outlier.

At any given time, there are a good number of historical points where market data have been generally similar in terms of broad valuation and market action, and these references provide specific examples that we can look at as we evaluate the distribution of likely market returns and risks.

In reviewing the status of the market late last week, the condition of the data was something of an anomaly in that regard. On the valuation front, stocks are presently overvalued, but to levels that we've observed at least several times in history. The anomaly relates to market action, where we can no longer find a single historical instance where stocks were more overbought on the combination of short- and intermediate-term measures we respond to most strongly. Indeed, only one instance comes close, which is November 28, 1980.

Now, if that date doesn't ring a bell, I have to admit that it didn't resonate with me either at first. On that date, the stock market was just a few months into a fresh economic recovery following the 1980 recession, employment conditions were just beginning to improve, capacity utilization was picking up, the Purchasing Managers Index had just moved back over 50, and stocks were certainly not overvalued on the basis of normalized earnings or cash flows. Indeed, the P/E multiple of the S&P 500 was just over 9, on the basis of both trailing and normalized earnings. Advisory sentiment was not strenuously bullish either, so there was little to identify it as a date to remember.

As it happened, however, November 28, 1980 was the peak of the furious advance in S&P 500 driven by enthusiasm over "less bad" economic news, though with little proven economic strength. It was the last day of the 1980 bull market. The economy later proved to have been in a short lull within a double-dip recession, taking stocks to their final lows in 1982.

One of the notable features of extreme overbought conditions is that investors rarely have much opportunity to get out, just like the fast and furious advances that clear oversold conditions tend to occur too quickly to capture unless one has already established a position. As for the present, we have rarely seen 90% of stocks suspended above their 50- and 200-day moving averages for as sustained a period as we have now observed.

This concern extends beyond intermediate-term technical conditions. On the valuation front, even if we assume that the historical growth of earnings continues unabated, without any lasting impact from the recent credit crisis, our standard methodology projects unsatisfactory total returns for the S&P 500 averaging 6.1% annually over the coming decade. More persistent economic difficulties would lower that figure, but it is already at or below the level at which every bull market since the Great Depression has ended, save for the bubble period between 1995 and 2007 (which has produced disappointing overall returns for the S&P 500), and one other instance – January 1937, which was followed by a brutal one-year loss of more than 50%.

That said, investors clearly are approaching the current market with every belief that the extreme valuations of 2007 represent the sustainable norm to which stocks should return. This despite the fact that the 2007 peak reflected rich valuation multiples against earnings that were themselves inflated by abnormally elevated profit margins. Last week, Bill Hester reviewed the evidence that forward earnings estimates presently assume a return to record profit margins observed just before the market turned down. If the expectations of investors and analysts are heavily anchored to those 2007 levels, as seems to be the case at present, then the fact that stocks are richly valued on the basis of sustainable, normalized earnings and cash flows may not be sufficient to give investors pause.

The anchoring of investor expectations to a period of rich valuations and unusually wide profit margins may not be reasonable, but it prevents any ability to “forecast” a significant near term decline, much less a sustained downtrend. At the same time, we do have sufficient evidence to indicate that market risk is not worth taking on the basis of average outcomes from the combination of valuation and market action we currently observe.

The foregoing should not be interpreted as a "call" or forecast about sustained market direction. Rather, it outlines some of the factors are behind our defensive stance. As always, we align our investment position with the prevailing Market Climate, which does not require large or extended forecasts. I would be less than forthright, however, if I didn't admit that I suspect the current overbought condition may be cleared somewhat violently.

Projected Foreclosures

A few weeks ago, the Center for Responsible Lending testified before the Joint Economic Committee of the U.S. Congress regarding prevailing conditions in the housing market. The CRL is a non-partisan organization focused on consumer protection. Among their main objectives is the establishment of a Consumer Financial Protection Agency to prevent abusive and deceptive lending practices.

Among these practices in recent years was a form of mortgage broker compensation called a “yield spread premium.” The YSP was an extra payment that brokers received for delivering a mortgage with a higher interest rate than one for which the borrower would usually qualify. The mortgages were then packaged up and securitized to satisfy the demand of yield-hungry lenders. The yield spread premiums typically encouraged brokers to offer “no doc” loans even when borrowers could verify their income, but also generally require the mortgage to have a prepayment penalty. A lot of these non-standard mortgages (Alt-A, Option-ARM) were written during the late stages of the housing bubble. These are precisely the mortgages that are beginning to reset, and will continue to be reset into 2012. And there is a mountain of them.

Several facts are worth noting. In September 2007, about a month before the stock market peaked and well before credit strains were obvious, the CRL testified to Congress about the wave of coming subprime foreclosures, encouraging Congress to act before the crisis escalated. “As it turned out,” the CRL noted in its latest testimony, “our predictions – dismissed by some as pessimistic – actually underestimated the dimensions of the crisis.”

This is important, because here is what the CRL is saying now. First, over 1.5 million homes have already been lost to foreclosure in the sub-prime category, and another 2 million subprime mortgages are currently delinquent.

But even this figure pales in relation to their data on projected foreclosures of all types. For 2009, total foreclosures are estimated to be 2.4 million. But coupling state-by-state delinquency rates and foreclosure starts (as reported by the Mortgage Bankers Association) with other data, the CRL projects that for most states, foreclosure totals will more than triple over the coming 4 years, for a total of 8.1 million foreclosures, with only about one in ten of these being saved thanks to court-supervised modifications. These figures are consistent with the reset data I've repeatedly presented - it appears to be wishful thinking to believe that the credit crisis is over. Most likely, what we've witnessed in recent months is little more than the combination of a lull in the reset schedule coupled with a wholly unsustainable burst of deficit spending amounting to over 7% of GDP.

My impression of the U.S. banking system is that it is quietly going insolvent, in a manner that will become evident only when the slack for “significant judgment” (provided by the FASB earlier this year when it altered mark-to-market rules) is taken up so tightly that the rope snaps. Presently, this slack has allowed banks some time, but the question is, time for what? The rules encourage banks to neither modify loans nor foreclose, both which would trigger a restatement of value on the mortgage asset. Meanwhile, banks are reluctant to allow “short sales” in lieu of foreclosure (where a homeowner sells a home to avoid foreclosure, but at a price less than the residual loan value, so the bank has to essentially eat the loss). This again defers the restatement of asset values for a while, but makes business sense only if home prices are expected to recover faster than the foregone interest that could be earned on new loans.

So if you talk to people who oversee these assets, including people who work with the FDIC, you'll hear that there is an inventory of unrecognized losses being built up, in hopes that the underlying mortgages will turn around without the need for loss reporting. In view of the CRL foreclosure projections, all we can think is – fat chance.

The FDIC itself is already essentially broke, and is looking at options like taking premium prepayments to try and shore up its own books. Last week, an FDIC spokesman offered the interesting assurance that “our ability to raise premiums essentially means that the capital of the entire banking industry -- that's $1.3 trillion -- is available for support.”

So the banking system, which is most likely quietly undergoing its own erosion of capital, can expect to see its capital tapped by the FDIC to pay for, well, the erosion of capital in the banking system. Still, don't blame the FDIC. Our policy makers bailed out bank bondholders instead of focusing on debt restructuring. The bad assets are still in the banking system, millions of families will still lose their homes, the Treasury and Fed have jointly issued trillions in new government obligations, but the bondholders of Bear Stearns will still get 100% of their principal and interest.

Despite the current enthusiasm of Wall Street, this story has probably not ended, and the evidence suggests it will end badly.

Market Climate

As of last week, the Market Climate for stocks was characterized by unfavorable valuations. Major indices and breadth were marked by generally positive recent trends, but intermediate-term and short-term market action is so strenuously overextended that the overall combination indicates negative expected returns. On that basis, the Market Climate shifted from mixed to negative last week.

Again, I have to emphasize that I am not "forecasting" that a near-term or extended market decline is a necessary outcome of present conditions. A decline certainly should not be ruled out, and may be more likely at this point than a near-term or extended advance, but our primary focus here is that the expected return for stocks is negative and the risk appears unusually high. Accordingly, the Strategic Growth Fund is fully hedged, for now. In response to market strength in recent sessions, I have placed a great deal of attention on the question “what is threatened?” In response to that question, we have clipped our positions in many stocks that have become fully valued, or have demonstrated weakening price/volume sponsorship, or have simply grown to more than about 2-3% of Fund value.

Always, our objective is to add to high-ranked candidates on short-term weakness, and clip lower-ranked holdings on short-term strength. The Fund presently has just over 85% of assets in stocks, with a hedge of similar size (when we sell stocks outright, we also reduce our hedge proportionately), so we are holding more cash as a percentage of assets here than is typical. We rarely have less than 90-100% of assets invested in stocks (since we can hedge their market risk), but at present, many of our most interesting candidates are also overbought and vulnerable to “spike” declines. I expect that we'll get opportunities to shift into higher ranked candidates on weakness reasonably soon, if not because of market-wide losses, then on the basis of day-to-day variability in individual stocks in any event.

In bonds, the Market Climate remained characterized by modestly unfavorable yield levels and moderately positive yield pressures. The general conditions in the precious metals market have taken us largely out of our gold stock positions in recent weeks, so the Strategic Total Return Fund currently has only about 1% of assets in that group. Though I don't want to draw too many parallels to November 28, 1980, it is interesting that gold prices had doubled in the 18 months leading up to that date, which marked a high in precious metals and precious metals shares. Over the following 18 months, gold dropped by about half, and gold shares by an even greater amount. Again, that isn't a statement of expectation in this case, since monetary conditions in particular are very different, but I did think it was an interesting feature of that period.

What I do think is important here is the potential for the U.S. dollar to strengthen in response to fresh credit concerns, as investors may still be inclined to seek U.S. government liabilities (currency and Treasury securities) as default-free safe havens. I certainly believe that over the longer term, the profligate deficit spending of the U.S. government, particularly the trillions in monetary base and Treasuries that have been issued to bail out troubled financials, will ultimately result in dollar erosion and sustained inflation. But as I've noted before, that is a problem that is likely to be expressed over a decade or so, with most of the pressure coming several years out. There is generally an “ebb and flow” in day-to-day and quarter-to-quarter events that can hold off these longer-term pressures from time to time, and fresh credit concerns would fall into that category.

NEW from Bill Hester: This Earnings Season, Watch Sales


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