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December 21, 2009

Clarity and Valuation

John P. Hussman, Ph.D.
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Last week, the dividend yield on the S&P 500 dropped below 2%, versus a historical average closer to double that level. While part of the reason for the paucity of yield in the current market can be explained by the 20% plunge in dividend payouts over the past year, as financial companies have cut or halted dividends to conserve cash, the fact is that current payouts are not at all out of line with their historical relationship to revenues, and even a full recovery of the past year's dividend cuts would still leave the yield at a paltry 2.5%. The October 1987 crash occurred from a yield of 2.65%, which was, at the time, the lowest yield observed in history, matched only by the 1972 peak prior to the brutal 1973-74 bear market.

Those two periods had a few other things in common. In the weeks immediately preceding the market downturn, stocks were overbought, had advanced significantly over prior weeks, bond yields were creeping higher, and investment advisory bearishness had dropped below 19%. All of those features should be familiar, because we observed them at the 1987 and 1972 peaks, and we observe them now.

On the basis of normalized profit margins, the average price/earnings ratio for the S&P 500, prior to 1995, was only about 13. Higher historical “norms” reflect the addition into that average of extremely high “recession P/Es,” based on dividing the S&P 500 by extremely low, but temporarily depressed earnings. For example, the P/E for the S&P 500 currently is 86, because earnings have been devastated, but it would be foolish to take that figure at face value, and equally foolish to work it into a historical “average” P/E. The pre-1995 norm of 13 for price-to-normalized earnings is important, because at present – and again, we are not using current depressed earnings, but properly normalized values – the S&P 500 P/E would currently be over 20. That's higher than 1987 and 1972, and about even with 1929. Of course, valuations have been regularly higher in the period since the late 1990's (and not surprisingly, subsequent returns, even after the recent advance, have been dismal overall, with the S&P 500 posting a negative total return for the past decade).

So overvalued, check. Overbought, check. Overbullish, check. Upward pressure on yields, check. Market internals? – certainly mixed, but not bad – and there's the wild card. Historically, markets featuring a combination of these other risks have been vulnerable even without clear deterioration of internals. What the mixed internals (rather than clearly negative) buy you is variability in the timing of subsequent weakness. Sometimes the market plunges immediately, but often it bounces around for a while and continues to make marginal new highs. More often than not, what the syndrome produces is an abrupt plunge within a window of about 10-12 weeks. Not a forecast, just a regularity. This time might be different, but we wouldn't risk a great deal hoping it will.

It's important to recognize that when I quote probabilities, I am generally using a form of Bayes' Rule. So when I say, for example, that I estimate a probability of about 80% of fresh credit difficulties accompanied by a market plunge over the coming year, that figure is based on various combinations of historical evidence, and what has (and has not) happened afterward, and how often. As a side note, a “market plunge” in this context need not be a “crash.” In the context of a credit-driven crash and rebound (which is what I believe we've observed), a typical post-rebound correction would be about -28%, but even that would take stocks to less than 20% above the March lows.

Probabilities, however, are not certainties. If the probability of a given event is “p”, then the probability of “not that event” is (1-p). This, in my view, is what makes probabilities and average outcomes different from forecasts. When people forecast, they say “this or that is going to happen,” and very often they establish investment positions that will do them a great deal of harm if they are incorrect. What we try to do is say, “on average, these conditions have been associated with this typical outcome, as well as a range of other possible outcomes (risk) that is this wide.” The larger the typical outcome is, compared with the possible range of outcomes, the larger a commitment we are willing to make. But if the average outcome is weak, and the range of outcomes is wide, we'll defend against the risk.

Unfortunately, a wide range of possible outcomes necessarily implies, well, a wide range of possible outcomes. Some of those can be quite bad, but some can be quite good. Still, if the average expected outcome is poor, we'll forego the possibility of those quite good outcomes in order to avoid the quite bad ones. That can be difficult during periods when speculative (and even dangerous) risk is temporarily working out nicely, while we're standing defensive. But long-term returns are based on repeated discipline, not single hits or misses (except for investors who take excessive risks that wipe them out).

What produces strong risk-adjusted returns over a complete market cycle is to accept more risk, on average, when the return per unit of risk is likely to be strong, and avoid risk, on average, when the return per unit of risk is likely to be weak.

So when will we accept more risk? Easy – when the expected return from accepting risk increases, or when the expected range of outcomes becomes narrower. Presently, two things would accomplish that. One is clarity, the other is better valuation.

First, and foremost, we have to get through the next 5-6 months, which is where we will at least begin to see the extent to which “second wave” credit risks materialize. We emphatically don't need to work through all of the economy's problems. What we do need, however, is for the latent problems to hatch, so we can have more clarity about what we're dealing with. I'm specifically referring to the second round of delinquencies and foreclosures tied to Alt-A and Option-ARM loans, the requirement beginning in January that banks and other financials bring “off balance sheet” entities onto their books (which, as Freddie Mac observed in a recent footnote, “could have a significant negative impact on its net worth”), and the disposition of a mountain of mortgages that have been increasingly running delinquent, but where foreclosure has been temporarily delayed.

It's clear that financial institutions have made a mad dash to repay TARP money in hopes of being able to pay year-end bonuses, but what is not so clear is what happens after the year actually ends. Various policy makers (particularly Ben Bernanke, who is currently up for reappointment) have begun to take on a self-congratulatory tone, suggesting that the recent crisis is not only behind us, but that it has been resolved at a profit. What is not evident from these comments is how small these “profitable” inflows have actually been, in relation to what has been spent.

I will be convinced that the crisis has been resolved at a profit when the Fed disgorges the $1.5 trillion in Fannie Mae and Freddie Mac securities it has bought for us, and if the U.S. government does not end up having to bail those securities out because the cash flows from the underlying mortgages prove inadequate. Having no such assurance, the smug “mission accomplished” remarks of Bernanke and Geithner are reminiscent of a veterinarian who walks out of the operating room saying “I saved the life of your rabid dog … by giving it the vital organs of your children.”

Again, we don't have to deal with and correct all of these problems, but until it is clear that the markets are more aware of them, the range of potential market outcomes will be extremely wide – and in my estimation, tilted toward the downside. As we learned from the various bubbles of the past decade, discounting a risk means more than simply paying lip service to it. Major risks are not discounted by talking about and dismissing them. Risks are discounted when it is taken for granted that they will get worse. Positives are discounted when it is taken for granted that conditions will continue to improve. From my vantage point, we are much closer to having fully discounted the positives than we are to even scratching the surface of the second wave of negatives.

From current valuations, durable market returns appear very unlikely. As I noted last week, whatever merit there might be in stocks is decidedly speculative. That doesn't mean that the returns must be (or even over the very short term, are likely to be) negative. What it does mean is that whatever returns emerge are unlikely to be durably positive. Market gains from these levels will most probably be given back, possibly very abruptly.

Still, we will get to the other side of these uncertainties, many of them within months, not years. I expect that we'll resolve the “two data sets” issue as we move through 2010, which itself will narrow the range of possible outcomes and – especially if valuations come in – allow us to accept greater amounts of market risk in response to improvements in valuations and market action. As an optimist and a realist, I've had to play the realist much more in recent years. I don't expect that it will ever be appropriate to abandon that realism, but I'm looking forward to much greater optimism as we move through 2010.

Market Climate

As of last week, the Market Climate for stocks was characterized by unfavorable valuations and mixed market action. As noted above, present conditions contain the general features of overvaluation, overbought conditions, overbullish sentiment, and moderate upward pressure on yields. This combination tends to have what statisticians would call a “fat left tail.” That doesn't mean that a decline is certain – it must means that there is an above-average probability of quite bad outcomes, large enough to produce a clearly unfavorable return/risk profile. The Strategic Growth Fund continues to be well hedged overall, with a fairly small range (generally less than 10%) of market exposure in response to short-term fluctuations. At the point we observe a greater deterioration in market internals (beyond the moderate divergences we observe at present), we expect to shift to a full and complete hedge.

In bonds, the Market Climate was characterized last week by relatively neutral yield levels and moderately unfavorable yield pressures. My impression continues to be that fresh credit concerns are likely to trigger something of a “flight to safety” in default-free Treasuries, possibly as we move into next year. Accordingly, we are very gradually adding to our Treasury positions on yield spikes, but our overall duration remains fairly restrained at about 3 years at present. The Strategic Total Return Fund also currently has about 2% of assets in precious metals, about 2% in foreign currencies, and about 4% in utility shares.

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“He placed His hand on the shoulder of humanity and said, ‘You're something special.'”

Max Lucado

Wishing you a Merry Christmas, a bright and happy Hanukkah, and the blessing of knowing your blessings. Always, I am grateful for the trust you've placed in me.

Peace, joy, love

- John

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