March 29, 2010
Possible Outcomes: A Typical Post-War Recovery, or a Perfect Storm
As of last week, the S&P 500 was priced to achieve an estimated average annual total return of just 5.83% over the coming decade, based on our standard methodology. Prior to 1995, the lowest implied 10-year total returns priced into the S&P 500 in post-war data were:
November 1961: Implied 10-year total return 6.26%.
October 1965: Implied 10-year total return 5.89%.
November 1968: Implied 10-year total return 6.19%.
August 1987: Implied 10-year total return 6.29%.
Note that in the 1987 case, the unusually strong 10-year return reflects a move to the extreme bubble valuations in the late 1990's, which have in turn been followed by 13 years of market returns below Treasury bill yields. Once the market becomes overvalued, further gains are ultimately paid for by a period of sorry returns later. To expect normal or above-average long-term returns from current prices is to rely on the market bailing out the rich overvaluation of today with extreme bubble valuations down the road.
While investors can hope that today is similar to August 1987, a moment's reflection about the market crash that occurred shortly after August 1987 might dampen that hope a bit, particularly because that instance also featured overbought, overbullish and rising-yield conditions.
As I emphasized last week, even if we had no concern at all about a second wave of credit strains, we would still be fully hedged here based on the present combination of rich valuations, overbought conditions, overbullish sentiment, and hostile yield pressures. Presently, we are also at the peak of concern about the potential for fresh credit difficulties to emerge, as we move into the first portion of the Alt-A / Option ARM reset schedule.
We will respond to the data as it emerges. This allows several possibilities. In my view, the most likely outcome is that we will indeed observe serious credit strains in the months ahead. That possibility adds to an already unfavorable syndrome of overextended market conditions, and this mix of factors courts a great deal of potential risk. The CBOE volatility index - a measure of expected market volatility - dropped below 17 last week, while mutual fund cash levels have dropped to a historic low (and are depressed even after adjusting for the low level of interest rates). Given the extreme complacency of investors here, we may have the elements of a perfect storm.
Alternatively, if we do not encounter fresh credit strains in the coming months, we will gradually apply increasing weight to the "normal post-war" dataset, so that by year-end we will be operating entirely on that basis. Even here, that means that if we were to experience a market correction or yield reversal sufficient to clear the current overvalued/overbought/overbullish/yield-pressure syndrome without a material deterioration in market internals, we would expect to remove a moderate portion of our hedges.
Regardless of whether we view the market within the framework provided by past credit crises in the U.S. and internationally, or we instead view the market within the framework of a typical post-war recovery in which further credit risks have been bailed out and eliminated, the present configuration of evidence holds us to a defensive stance.
On the subject of record low cash levels in equity funds, juxtaposed against a seeming mountain of "cash sitting on the sidelines" in money market funds, I should note that cash levels in equity funds are a sentiment indicator, not a liquidity indicator. See, in the equity market, every share of stock that has been issued must be held by someone. The only question is whether the shares are held by individual investors, hedge funds, pensions, mutual funds, or another entity. To the extent that mutual funds buy stock, some other holder must sell that stock. Somebody has to own it in any case, and it is simply not true that money "flows" between "cash" and "stocks" as if water is being poured from one cup to another. Every share of stock has to be held by someone, as must every debt security issued. Only the holders change. So mutual fund cash is not a measure of potential money available to "flow" into stocks. The shares that the mutual fund might buy are already held by someone, and the cash that the mutual fund might dispose of must also be held by someone. Depressed levels of mutual fund cash are a specific reflection of bullish sentiment among mutual fund managers as a group.
At the same time, what is counted as cash on the sidelines, whether in money market funds, or as tiny balances in equity funds, is nothing but a mountain of short-term debt securities, mostly Treasury bills, that have been issued and must be held by somebody until they are retired. To the extent that a particular investor wishes to dispose of this "cash on the sidelines," another investor must be found to hold it, and it will remain counted as cash on the sidelines. At present, more than one-third of the publicly held float in Treasury debt is financed at maturities of less than a year and at yields well below 1%. Between the refinancing of existing debt and new deficits, the Treasury will have to issue about $3.5 trillion in debt this year. What is not a problem in an environment of credit concerns (where there is a great deal of demand for default-free securities) will become a major hurdle down the road. The rollover financing and interest costs of this debt will begin to create fiscal stress at the point where yields rise even moderately.
As challenging as the "two data sets" uncertainty has been over the past year, this is not uncertainty that will persist indefinitely. The coming months will help to better define the framework within which we set our analysis. I am not at all convinced that the satisfaction of the markets in recent quarters will prove to be durable, and suspect that we'll observe an excruciating bout of inflation beginning in the second half of the decade. But that is a longer-term concern. The primary uncertainty here relates to whether or not the recent easing of credit difficulties will prove to be durable, or simply a temporary lull. We will obtain a significant amount of clarity over the coming months.
As of last week, the Market Climate for stocks remained characterized by strenuous overvaluation, overbought conditions, overbullish sentiment, and hostile yield pressures. The Strategic Growth Fund remains fully hedged, with the same "staggered strike" position we had at the 2007 peak, which strengthens our defense against potential market losses by raising the strike prices of our defensive put options, at a cost of just over 1% of assets in additional put premium (which is relatively inexpensive with the CBOE volatility index currently at about 17).
In bonds, the Strategic Total Return Fund continues to carry an average duration of about 4 years, primarily in straight Treasuries of 10-year maturity and shorter. While I would expect downward pressure on Treasury yields in the event of fresh credit strains, we are not inclined to increase our portfolio duration until (unless) we observe a spike in the 10-year yield toward 4% or higher. Presently, even a 4 year duration is a sufficient amount of interest-rate exposure given the still relatively low profile of yields.
On a final note, a shareholder kindly forwarded me a video link in response to last week's market comment. It features the band OK Go with an amazing Rube Goldberg machine put together by Mindshare, a community of students and engineers. It's worth watching.
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