April 26, 2010
Looking Back, Looking Forward
As of last week, our most comprehensive measure of market valuation reached a price-to-normalized earnings multiple of 19.1, exceeding the peaks of August 1987 (18.6) and December 1973 (18.3). Outside of the valuations achieved during the late 1990's bubble and the approach to the 2007 market peak, the only other historical observation exceeding the current level of valuation was the extreme of 20.1 reached just prior to the 1929 crash. The corollary to this level of rich valuation is that our projection for 10-year total returns for the S&P 500 is now just 5.3% annually.
While a number of simple measures of valuation have also been useful over the years, even metrics such as price-to-peak earnings have been skewed by the unusual profit margins we observed at the 2007 peak, which were about 50% above the historical norm - reflecting the combination of booming and highly leveraged financial sector profits as well as wide margins in cyclical and commodity-oriented industries. Accordingly, using price-to-peak requires the additional assumption that the profit margins observed in 2007 will be sustained indefinitely. Our more comprehensive measures do not require such assumptions, and reflect both direct estimates of normalized earnings, and compound estimates derived from revenues, profit margins, book values, and return-on-equity.
That said, valuations have never been useful as an indicator of near-term market fluctuations - a shortcoming that has been amplified since the late 1990's. The lesson that valuations are important to long-term investment outcomes is underscored by the fact that the S&P 500 has lagged Treasury bills over the past 13 years, including dividends. Yet the fact that these 13 years have included three successive approaches (2000, 2007, and today) to valuation peaks - at the very extremes of historical experience - is evidence that investors don't appreciate the link between valuation and subsequent returns. So they will predictably experience steep losses and mediocre returns yet again. Ironically, before they do, it also means that investors who take valuations seriously (including us) can expect temporary periods of frustration.
I've long noted that the analysis of market action can help to overcome some of this frustration, as stocks have often provided good returns despite rich valuations so long as market internals were strong, and the environment was not yet characterized by a syndrome of overvalued, overbought, overbullish, and rising yield conditions. In hindsight, the stock market has followed this typical post-war pattern, and we clearly could have captured some portion of the market's gains over the past year had I ignored the risk of a second wave of credit strains (which I remain concerned about, primarily over the coming months).
It is important to recognize, however, that even if we had approached the recent economic environment as a typical, run-of-the-mill postwar downturn, we would now be defensive again, as a result of the current overvalued, overbought, overbullish, rising yields syndrome. I do recognize that my credibility in sounding a cautious note would presently be stronger if I had ignored further credit risks and captured some of the past year's gains. But the awful outcome of this same set of conditions, which we also observed in 2007, should provide enough credibility.
Looking Back, Looking Forward
Last year, in the August 31 market comment A Tale of Two Data Sets, I observed "If we had a reasonable basis to believe that the recent economic downturn was an ordinary run-of-the-mill post-war recession having no lasting structural impact, and believed that the record profit margins observed in 2007 (about 50% above the historical norm) could be recovered and sustained, we would infer an average return/risk profile for the market that is still much less favorable than we have normally observed following bear market lows, but strong enough to warrant the removal of a good portion of our hedges outright, with a willingness to remove another portion of our hedges on market weakness.
"On the other hand, using the same essential measures of valuation and market action, but including periods of major economic dislocation into the dataset, produces average return/risk inferences that are substantially less favorable. Indeed, the reason we were somewhat “burned” during the fourth quarter of 2008 is that we expected – too early, in hindsight – a powerful rebound from the extremely oversold conditions we observed, based on normal market behavior. The larger dataset also includes periods of similarly powerful rebounds – but the attempt to participate in them is less appealing due to their lack of predictability as well as their sometimes abrupt and costly endings."
Given that valuations and market action have generally been a useful guide to setting investment exposure in normal post-war market cycles, it may be helpful to detail how these factors behaved during the period between 1929 to 1935, which represents the greatest period of credit strains observed in U.S. data. Though not all of the data we use in our market and economic analysis is available for this period, some of it can be estimated and proxied enough to allow us to characterize the key results. The results below are specific to methods we actually use, but I expect that they could be broadly replicated using any basic combination of valuations (say, Shiller PEs), and market action (say, moving averages or breadth measures).
At the outset, I should note that overall, our general criteria of valuation and market action would have been quite helpful during the Depression. When we apply the methods that we developed for post-war data to Depression-era data, we find that there was clearly sufficient evidence from valuations and market action to warrant a strong avoidance of risk during much of that period, and eventually to establish a significant exposure to market fluctuations.
But here is the difficulty. The primary benefit of the market action criteria was in avoiding risk, while nearly all of the gains from applying our approach would have been attributable to the valuation considerations we use. While applying post-war criteria would have resulted in an overall gain between 1929 and 1935, the bulk of that gain was driven by market exposure accepted during periods of exceptionally low valuations. Negative market action was a powerful signal to avoid market risk, but except when valuations were extremely favorable, positive market action contributed nothing on its own.
What is most striking about Depression-era data between 1929-1935 (and post-credit crisis data more generally) is that when we examine periods when one would generally grade market action as favorable on the basis of major trends and market internals, we find that taking positive exposures would actually have resulted in a net loss. This is due to the abruptness of trend reversals, so even periodic gains of 30-50% would have been largely erased through a combination of abrupt initial losses and subsequent whipsaws. While the compound net loss from periods of "trend following" over the full period was tolerable (about a -25% drawdown), that figure represents a combination of large individual gains and losses - substantial volatility, with a negative overall contribution to returns.
Partitioning the data provides a clearer picture. When valuations exceeded even 12 times normalized earnings (on our most comprehensive measure discussed above), seemingly "favorable" market action was followed by profound losses averaging -69.8% on an annualized basis (generally reflecting a few weeks of vertical losses until enough damage was done to kick the market action measures negative). Once the initial damage was done coming off of the uptrend, valuations over about 12 were still hostile, but were associated with slightly less profound losses averaging -37.7% annualized.
In contrast, only when valuations became quite depressed did the combination of favorable valuations and market action produce positive subsequent returns. Multiples below 12, coupled with favorable market action, were associated with annualized returns of 12.5%, while multiples below 12 coupled with unfavorable market action were associated with further mild losses averaging -4.5% annualized.
In 2009, we observed only a few weeks in March when the S&P 500 was priced at less than 12 times normalized earnings (again, on our best measure). At that time, indicators of market action were still negative. Faced with two possible data sets, one assuming further credit strains and one assuming that the problems had been solved, I noted "even giving the two possibilities equal weight is harsh, because as I've repeatedly noted, post-crash markets have included advances as large, and larger, than we've observed since March, but with devastating follow-through." Needless to say, sharply negative return figures don't "average in" very well.
How to respond?
Which brings us to the present. As of last week, even from a strictly post-war standpoint, a defensive investment stance is warranted, based on a syndrome of overvalued, overbought, overbullish and rising-yield conditions. Equally important is how to respond appropriately as these conditions change.
First, my primary concern with regard to fresh credit strains would be the period of recognition. We may very well have a multi-year period over which the full effects of deleveraging is actually felt, but the most damaging declines often occur where reality departs materially from expectations. The past year has been seen an easing of credit strains even as the volume of delinquent loans has hit new records, partially because of the abandonment of mark-to-market accounting, and partly because mortgages are long-term assets and it's possible to kick the can down the road with mortgages that aren't being serviced. It's unlikely in any event that these problems have actually been solved, because we can't reconcile the quantity of delinquent loans with the tamer figures for foreclosures and writedowns. Still, we need several more months of data before we can start relying on "extend and pretend" to dispense with the problem through an extended period of chargeoffs and Fannie/Freddie bailouts. Meanwhile, I remain concerned.
The economy and the markets have enjoyed a great deal of positive effect from the enormous deficit spending of the past 18 months (if it doesn't seem that the economy has benefited, consider the dismal the profile of GDP and personal income when stimulus spending and transfer payments are excluded). It's not at all clear that these effects are durable, and it's also not clear to what extent bank assets have been marked up, passed off to Fannie and Freddie, or otherwise obscured.
Here is precisely how we plan to approach the current uncertainties.
First, over the next few months, we are continuing to allow for uncertainty as to whether we should assume a "typical post-war" cycle or a "post-crash, credit strained" environment. As noted above, the primary distinction between these data sets is how the market responds to valuations and market action. Accordingly, the main strategic difference between "post-war" and "credit-strained" criteria is that valuations take a larger role relative to market action in a deleveraging cycle.
Over the course of 2010, absent very clear (i.e. crisis-level) additional credit strains, our weighting toward "post-war" criteria will increase in an approximately linear way. If we don't observe a significant second-wave of credit strains this year, I am comfortable with our standard post-war criteria to address any residual risks. If we do observe such strains, my primary concern would be the initial period of recognition. We would still gradually move our weights toward "post-war" criteria, but at a slower rate.
Based on the convexity analysis that I discussed late last year, my impression is that it is more appropriate to weight investment positions rather than expected returns from the two possible data sets. For example, if we weight expected returns, it is nearly impossible to give any weight at all to a credit strained environment and still justify a positive investment position, because of the size of the losses that can emerge in credit-strained conditions. In contrast, if the investment position would be zero based on "credit strained" criteria and 60% based on typical post-war criteria, a 60/40 weighting, respectively, would result in a weighted exposure of 24%.
Presently, if the Market Climate was to improve based on our standard post-war criteria, we would move 40-50% in the direction of that exposure. For example, if the market declines enough to clear the overbought, and overbullish components of present conditions, or if yields decline sufficiently to remove the present upward pressures we observe, and provided that market internals do not deteriorate notably, we would be left with a strenuously overvalued market, but with favorable market action and no negative syndromes. That wouldn't warrant a fully invested position in any event, but we would become decidedly more constructive.
What if the market simply moves higher? It is safe to say that at current valuations, a continued extension of overvalued, overbought, overbullish conditions, with no reprieve from interest rate pressures, would keep us in a hedged stance. The Strategic Growth Fund is not appropriate for investors who wish to speculate under that specific set of conditions, because we have no historical evidence that it is sensible to take market risk, on average, once that syndrome emerges.
Ideally, any removal of the current overvalued, overbought, overbullish, rising-yields syndrome would involve a substantial improvement in valuations, an initial deterioration in market action, and then an eventual firming of internals. That outcome would allow us much greater latitude in accepting market exposure.
In short, accepting a greater level of market exposure will require, at minimum, that we clear the present syndrome of overvalued, overbought, overbullish, rising-yield conditions. The quickest way to a more constructive investment stance would be a meaningful improvement in valuations (which would most likely be associated initially with a deterioration in market action), and no further credit strains. That would allow us to establish a strong market exposure on early evidence of improved market action. If we do observe significant fresh credit strains, our valuation criteria will be more demanding, particularly in the initial recognition phase. In any event, however, we will gradually transition toward standard "post-war" criteria as we move through 2010 - slower if we observe credit strains, but otherwise in a roughly linear way as we move through the year.
Presently, the market is strenuously overvalued, faces a syndrome of overextended conditions that has historically proved hostile, and relies on the absence of further credit strains to an extent that strikes me as incredible. Our investment objective continues to focus on outperforming our benchmarks over the complete market cycle, with smaller periodic losses than a passive investment strategy. We've achieved that objective since the inception of the Funds, and I'm comfortable that we have the tools to achieve that objective as we go forward. I frankly don't know which direction the market is headed here, but I hope I've made it clear how I expect to approach the evidence, and why.
As of last week, the Market Climate in stocks remained characterized by an overvalued, overbought, overbullish, rising-yields syndrome that has historically produced periods of marginal new highs, slight declines, and yet further marginal highs, followed somewhat unpredictably by nearly vertical drops. I've often accompanied the description of this syndrome with the word "excruciating," because the apparent resiliency of the market and the celebration of each fresh high, can make it difficult to maintain a defensive stance. Interestingly, the analysts at Nautilus Capital recently noted that the most closely correlated periods in market history to this one were the advances of 1929 and 2007. While exact replication of those advances would allow for a couple more weeks of further strength, we've generally found it dangerous to expect history to do more than rhyme. These hostile syndromes have a tendency to erase weeks of upside progress in a few days.
In bonds, the Market Climate last week remained characterized by relatively neutral yield levels and unfavorable yield pressures. While we would be inclined to increase the duration of the Strategic Total Return Fund modestly if the 10-year Treasury yield was to push beyond 4% or so, we are comfortable with our current duration of just under 4 years. For now, I continue to be concerned about potential credit strains, which may provide the opportunity to accumulate precious metals, TIPS, and possibly foreign currency exposure on associated price weakness.
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