All contents copyright 2000, John P. Hussman Ph.D.
Excerpts from these updates should include quotation marks, and identify the author as John P. Hussman, Ph.D. A link to the Fund website, www.hussmanfunds.com is appreciated.
Thursday Morning December 28, 2000 : Special Hotline Update
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The Market Climate is characterized by extremely unfavorable valuations and modestly unfavorable trends. On Monday, I noted that the Treasury yield curve had become more "normally" sloped, with short term interest rates dipping below long term rates. In general, that's a healthy sign. Tuesday's bond market trading quickly reversed that, however, with short term Treasury yields soaring back above long-term yields. That condition is consistent with a further slowing in the economy and a deeper ultimate market decline.
Shorter term, however, I increasingly suspect that this bear market could see several weeks or even a few months of consolidation before resuming a strongly downward course. The main reason for that suspicion is that market internals have improved significantly in recent days. Most notably, the advance decline line has firmed, and higher grade corporate bonds are also holding up better. We still haven't seen a move to favorable trend uniformity, but market internals are clearly moving in the right direction.
If market conditions do shift to a favorable trend status, we expect to move to a still-hedged but significantly more constructive position. Extreme valuations, an inverted yield curve, high bullish sentiment, continued insider selling, and likelihood of an oncoming recession strongly argue against an unhedged position. So I would consider any move to favorable trend uniformity as indicating a likely consolidation or stabilization within a bear market, rather than a bullish outlook.
Our investment stance remains defensive for now, but we are not raising our strike prices or increasing our hedge positions in any way in response to market strength. We'll allow market action to dictate any shift in the Market Climate, and there's no need to second-guess whether we'll see such a shift or not. Again, if we do shift to favorable trend uniformity, it would indicate a likely consolidation within a bear market, rather than a bullish outlook. We have no intention of holding an unhedged market position given the backdrop of market negatives, but we would not be averse to a somewhat more constructive stance if trend uniformity allows.
With the Fed likely to ease at its January meeting, the market will face two opposing forces. On the positive side, lower interest rates, and on the negative side, a continued and nearly inevitable slowing in earnings growth. Those two opposing forces may allow price/earnings ratios to hold up somewhat longer, which would be consistent with a consolidation or counter-trend rally. Even if we did see such a climate, I would ultimately expect slower earnings growth to reveal the absurdity of market valuations, so the bear market would be likely to reassert itself despite any Fed moves that might be forthcoming.
In short, we're currently defensive, but are making no moves to add to that stance. We are prepared to move to a still-hedged but somewhat more constructive position in the event that trend conditions improve further. No need to second guess if or when. We'll know if and when it occurs, and that will be the appropriate time for any shift in market posture.
Monday December 25, 2000 : Hotline Update
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Merry Christmas!
The Market Climate is characterized by extremely unfavorable valuations and modestly unfavorable trends. The main thing to note: the bond market started screaming something last week, and we're paying close attention. Specifically, short term interest rates declined so significantly that the yield curve began to normalize, and market breadth also improved. Now, there's certainly little possibility of a new bull market from current conditions, and we continue to expect earnings problems as weakness in the economy pressures profit margins. But yields are currently being pressured lower, and that argues against the strong upward spike in stock yields that would have to occur in a crash. So at this point, there's an increasing likelihood that this bear market will be drawn out somewhat.
Think of it like this. Stock prices are simply the product of earnings and the price/earnings ratio. While earnings growth is likely to slow, and even drop to negative levels for technology stocks, a market crash always exhibits a sharp collapse in price/earnings ratios. Historically, that has occurred with much more regularity in environments of rising interest rates than in environments of falling rates. Given the extent of the damage to the market so far, it's also not out of the question that if trend conditions improve further, we could see what you might call a "counter-trend rally" - something on the order of several weeks or even a few months. We're not expecting that yet, but our trend models are designed to pick up improved trend conditions sooner rather than later if they improve.
In short, although I do believe that stocks remain in a bear market, and my opinion is that high P/E technology and banking stocks should still be strongly avoided, our discipline places great importance on the signals conveyed by market action. Right now, bond market action has improved enough to move away from a Crash Warning. It's always possible that a crash could still occur, especially given the need to satisfy margin calls from as recently as last Wednesday, but it's no longer so likely as to put it on a "Warning" status.
Bottom line: We're in a bear market and market conditions remain negative overall. The appropriate position remains defensive, but we've eased our expectations regarding crash risk. If the market can generate even better bond market action and more favorable breadth, we may even see a favorable trend condition and be able to capture a counter-trend rally with a less hedged position. We're not at that point yet, but if our models were to identify more favorable trend uniformity we would shift to a still hedged but more constructive market position. Our job is to identify shifts in the market environment and position ourselves accordingly. We're seeing some better bond market action, and it's important to mention that. With our trend models still negative, we're not shifting our position at this point, but we are softening our tone. For now, we remain appropriately, but not aggressively defensive.
Friday Morning December 22, 2000 : Special Hotline Update
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The Market Climate remains on a Crash Warning, but there's a strong likelihood we'll shift to an "extremely unfavorable" condition at the end of the week. In our most aggressive managed accounts, we rolled our OEX put options from the February 700 strike to the February 680 strike on Thursday morning for a nice credit. We still hold the same number of puts as before, but we've taken a good deal of profit off of the table to allow for the ever-present possibility of a bounce. My opinion is that we won't get much sustainable upside, because margin calls have been going out. Wednesday's calls will have to be satisfied by Tuesday of next week. So my opinion is that we could see some real pressure develop then. That said, we don't invest on my opinions, so we've rolled our strike prices down. We're still quite defensive, but we like to take opportunities to lock in profits on our options when the market gets particularly oversold. Thursday morning gave us a nice opportunity.
I've been watching the NYSE Composite. It has found support 3 times now at the 625 level. A close much below that level would be a good sign that the overall market is going to start looking more like the Nasdaq.
A great comment from Richard Russell today: "What's wrong with this market? Here it is in a nutshell. General Motors has $17 billion in sales, it's market capitalization is $28 billion. Juniper Networks has a market capitalization of $31 billion. It has sales of $102 million - that's million. Is JNPR overpriced? You do the math. JNPR has already dropped from 244 last October to 100 today. What's the stock really worth? Damned if I know, but it's not worth more than GM."
I have to agree. Even though people are talking about values and bargains and finding a bottom, the basic fact is that value isn't determined by how far a stock has fallen from its highs. Value is based on the relationship between prices and properly discounted cash flows. The darlings of the Nasdaq are still ridiculously overpriced in my view. There are certainly areas of emerging value, and in the broad market, even some very favorable ones. But among the largest capitalization stocks that drive the major indices, there is more room for downside than investors might imagine.
Just a thought. Historically, markets bottom about the midpoint of very well recognized recessions. At that point, investors aren't talking about the market finding a bottom. They're panic stricken that there is no bottom. Once it is widely agreed that the economy is in recession, it's well recognized that business conditions are bad, but it's also expected that they'll turn worse. That's when you can start talking about a bottom. And I'm fairly certain that we won't see the number of bearish investment advisors still under 30%, as it is today.
Another thought. Does anybody doubt that the Fed will ease in January? Anybody? [Pause] I didn't think so. My impression is that it's already priced in, for exactly that reason. At this point, the only kick the market can hope for is if the Fed cuts by 1/2% rather than 1/4%. I have little doubt that that's the next line the market analysts will be tossing out to investors looking for hope.
As for our position, we're still on a Crash Warning, and likely to move to an extremely unfavorable climate at the end of this week. That keeps us in a defensive position. If we get better breadth, broader trend uniformity and an improvement in corporate bonds, we'll quickly become more constructive. We'll know it when it happens, and that is precisely the point at which we'll shift our position. Until then, we remain appropriately defensive.
Thursday Morning December 21, 2000 : Special Hotline Update
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The Market Climate remains on a Crash Warning, though my expectation is that the climate will shift to an "extremely unfavorable" condition at the end of this week. That doesn't actually imply a change in our investment position, but it at least allows for the possibility that this bear market will be drawn out and churning. For now, we remain on a Crash Warning.
There are several important developments that we're watching. The first is the action in Treasury bonds, with yields in a downtrend. The yield curve is still inverted, however, and that has historically been a profound negative for stocks. A profile of declining bond yields and an upward sloping yield curve (long term yields higher than short term yields) would be a more convincing positive. That's just not the case here, and it's one of the reasons why strong bond market action alone can't be expected to underpin stocks here.
As expected, Cisco, Sun Microsystems, and the financials have finally submitted to the bearish trend. With capital spending turning lower, and defaults on the rise, I noted in recent weeks that it would be illogical to expect those stocks to remain strong. With the weakness in those bellwethers, the bear market has now taken force in earnest. But bear markets are difficult to navigate if you don't fully prepare yourself for monster rallies that can emerge from time to time. So even though I believe we're still in the early part of a bear market, I am as usual completely agnostic about short term action.
Two main areas of concern here are the U.S. dollar, about which I've written extensively, and the potential for margin calls here. The dollar continues to be pressured lower, and the real question here is whether we'll start seeing foreign sales of U.S. Treasuries. Remember that foreigners hold well over a third of the public float in Treasuries, and with yields now quite low and the dollar sliding, there is little incentive for foreigners to hold them on the basis of return-on-investment. If there's one thing that could make the recent decline in interest rates reverse dramatically, that would be it. And I don't believe we should rule it out. Moreover, a plunge in the dollar would make Fed easing a much more difficult task, and would certainly reduce the aggressiveness with which the Fed could go about it.
Finally, margin calls. I noted several weeks ago that the market was nearing the point where margin calls could become a significant issue. I believe we're here. So while there's a good possibility that we could get some attempts to buy the dip here, there's also a growing spectre of forced selling. In other words, we're now at about the point where we can reasonably expect that investors may start selling out of necessity rather than choice. That's one ingredient for a crash.
So that's where we are. I strongly believe that stocks are in an ongoing bear market, and now that comment doesn't seem nearly the stretch that it may have seemed in early September. Interest rate trends and a clearly oversold market condition allow for the possibility of typical fast and furious bear market rally. On the negative side, the yield curve is inverted, which has never sustained good bull moves. The dollar is under pressure, raising the possibility of foreign liquidation of U.S. securities. And margin debt is likely to trigger some forced liquidation here, seemingly out of nowhere. Yet even with those opposing forces, our investment stance is simple and clear. The Market Climate remains on a Crash Warning for now, and we are appropriately defensive.
Finally, a reminder. I realize that every analyst on CNBC wants to tell you where they think this market is going. But really, it's not useful to think in terms of forecasting the market, or to base your investment plans on my opinions or anybody elses. I certainly do hope that my comments are useful in interpreting what's going on in the markets, but be assured our investment discipline is not about making forecasts and then hoping they are right. It is about identifying the Market Climate that is currently in effect and holding a position consistent with that climate until a shift is objectively identified. That takes a lot of the hoping, praying, worrying, second-guessing, and general emotion out of what we do, and for one, I like it that way.
I want to wish all of you a very Merry Christmas, and a happy Hanukkah. I always appreciate your business, but as you probably know, I am most grateful for your trust. I'll do everything possible to treat it well.
Tuesday Morning December 19, 2000 : Special Hotline Update
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The Market Climate remains on a Crash Warning. In our most aggressive accounts, we moved our OEX put options down to the February 700 strike for a good credit, keeping our defenses intact, but reducing the amount of put value exposed to a possible bounce. We certainly aren't positioning ourselves in anticipation of such a bounce, but we have to allow for the possibility of the usual fast, furious bear market rallies that can occur after the market becomes oversold. And though we have to allow for a possible rally, we also have to allow for the possibility that the market responds badly if the Fed's policy statement doesn't heavily emphasize recession risks. In short, near term direction is a coin toss, but the next few days could involve a sizeable move one way or another. Overall, our position remains defensive, but we're managing our risks in a way that accomodates the possibility of a bounce.
It's unfortunate, in my view, that investors have so much faith that a monetary easing can and will bail out the economy and the stock market. My view is fairly simple - the economic boom we've enjoyed has been driven by an inordinate amount of leverage, much of it of very poor credit quality, and by capital spending financed through the import of foreign savings. In an environment where demand for new capital investment was strong, easy bank credit and ample foreign savings fed extremely good economic growth rates. But I believe we are past that point here.
First, much of the frenzy for capital spending, particularly on information technology, was driven by a desire of companies to keep up, and avoid falling behind the competition at any cost. Now, it's much clearer that companies can and perhaps should move more slowly, and that has caused a rash of order cancellations and slowing sales that we observe daily in new earnings warnings in the tech sector. I doubt that the demand for this sort of IT spending will rebound even if credit becomes more available.
Second, the banking sector has become much more aware of credit risk in recent months, so again, even if the Fed eases, it's not clear that this will translate into nearly the same boost to bank lending as we saw in recent years. A Fed easing works only if there is unsatisfied demand for loans to make new investments, and then only if banks are willing to make those loans. In the current economy, both the demand for new investment, and the willingness to make loans are compromised.
Third, there is growing pressure on the U.S. dollar. The U.S. dollar index has broken down from a very clear double top. With the economy weakening and U.S. interest rates headed lower, while U.S. inflation remains in a rising trend, we have the combination of an overvalued dollar in an unfavorable trend environment. Just as those conditions are negative when they occur in stocks, they are currently putting significant downward pressure on the dollar. And if the dollar does fall hard, it's going to make easier money and interest rate cuts much more difficult for the Fed.
In short, the boom was driven by strong investment demand, a strong willingness to take on leverage, a willingness of bankers to provide it, and eager inflows of foreign savings. The economy is now in what is known as a "deleveraging cycle" - investment demand is weakening, corporations are increasingly eager to reduce leverage and cover loan losses, banks are less willing to extend credit to risky borrowers, and foreign savings flows are softening (which is evident in the weakening dollar). All of these factors make the Federal Reserve much less powerful than investors, and perhaps even Alan Greenspan may believe.
As for investment strategy, we remain defensive, but are positioned to accomodate a bounce if it occurs. Broader market action and better corporate bond action would move us to a still-hedged but more constructive position. For now however, we remain on a Crash Warning.
Sunday December 17, 2000 : Hotline Update
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The Market Climate remains on a Crash Warning here. While interest rates have been behaving much better of late, corporate yields, and of course, stock yields, are still acting less than favorable, so the overall trend of yields continues to be hostile. Valuations remain extreme, and on a price basis, trend uniformity is also unfavorable. Continued improvement on the interest rate front could move us off of a Crash Warning in the weeks ahead. That would still leave us in an extremely unfavorable market climate, but one which might be expected to generate a prolonged bear market slide rather than a sudden crash. For now, a Crash Warning still remains in effect.
Bank stocks have now joined the cascade of earnings warnings, and my expectation is that credit problems will become much more pronounced in the coming months. It's clear that the Fed should and will indicate that inflation and recession risks are equally balanced this week. It's impossible to rule out a statement that recession risks are dominant, but I doubt it. To do so would signal either that the Fed is behind the curve, or that business conditions are collapsing, which the Fed would never want to indicate even if it was true. The worst thing possible, from the Fed's perspective, would be a loss of business confidence in which businesses were unwilling to make new investments even if credit was available. That's a situation that makes Fed easings completely ineffective, and the Fed would never want to explicitly or implicitly trigger that. Even with a "balanced" bias (a term which I prefer to "neutral"), the Fed would still have the flexibility to cut rates in January, so there's nothing to be gained from a more aggressive statement of risks. As for the possibility of an actual rate cut, Greenspan's recent remarks underscored that current conditions are not at all like 1998, when the crisis in global financial markets (and the exposure of banks to those markets) made immediate interest rate cuts desirable. I doubt that Greenspan would take such pains to point out the distinction between now and then if he believed that an immediate rate cut was appropriate here.
One statistic that underscores the complacency of investors - the Investors Intelligence survey indicates only 25.9% of advisors are bearish here, which is a reading that you tend to see at tops rather than bottoms. Despite the clear difficulties with earnings and technical action, advisors are evidently focused on the prospect of Fed easing and on weak seasonal patterns. The low level of bearishness suggests that there's a lot of selling that could be drawn out of this market, and not a lot of buying to be induced.
In short, yield trends are improving, but the Market Climate remains on a Crash Warning here. Valuations and unusual bullish sentiment allow for the possibility of significant selling pressure ahead, but a more favorable yield environment could allow this to occur more gradually than a vertical crash. A sustained improvement in market breadth, market internals, and corporate bonds would be required to restore favorable trend uniformity. That doesn't appear likely at this point, but we will respond to any change in Market Climate if and when it occurs. We have no inclination to guess what the next Market Climate will be, or when a shift will occur. For practical purposes, there is no need to do so. For now, the climate remains a Crash Warning.
Friday December 15, 2000 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. There's a possibility that the climate could shift from Crash Warning to "extremely negative" depending on how much follow through we see to the recent decline in interest rates. Such a shift wouldn't make us particularly less defensive, but it would move us from expecting a compressed crash to expecting a more prolonged bear market slide. Keep in mind that when we use the term "crash" we are referring specifically to a decline of 15%-30% in prices over a period of a few days. Moving off of a Crash Warning, if it occurs, would simply reduce the possibility of that sudden a collapse. But unless we actually were to achieve favorable trend uniformity, we will retain a significantly defensive position. In any event, the current climate remains a Crash Warning, and since our job is to identify the climate rather than make guesses about future shifts, our position remains on full defense here.
Retail sales came in very weak on Wednesday, but Producer Prices were also fairly modest, which reinforced hopes of a Fed easing early next year. Some recent academic research has focused on why inflation has been so restrained in recent years. The strong conclusion is that this experience of low inflation has not been due to productivity growth, but can largely be traced to a slowdown in benefit costs, particularly health care prices, and restrained import prices. Benefit costs appear to be on the rise again, so it's effectively the strength in the U.S. dollar that has helped to restrain inflation. That said, the U.S. dollar has been churning lately, rather than making significant new highs, and higher oil prices have also been filtering through the economy. As a result, I continue to expect inflation pressure despite a significantly slowing economy.
Chase and J.P. Morgan issued earnings warnings on Thursday. Many of the analysts seem to be terribly surprised at the recent weakness in bank stocks and financials. Meanwhile, I can't imagine how they didn't see this coming. There's this amazing sense of denial that stocks are actually in a bear market, and that the weakness in the economy will actually spill over into problems in earnings and credit risk. This slowdown in the economy has not been particularly abrupt or steep. What makes it seem steep is just that investors have been in total denial, so the warnings continually catch them off guard and trigger sharp selloffs in stock prices. But from an economists point of view, and from the Fed's, it is not at all clear that a monetary easing is appropriate.
People seem to think that the economy simply produces one good and the only issue is to stimulate demand for it. On the contrary, I've long argued that recessions are periods when the mix of goods supplied becomes poorly matched to the mix of goods demanded. And in that environment, which I believe we're in, stimulating aggregate demand through monetary easing isn't going to solve anything. You really only want to ease if you're concerned that banks are denying credit to productive and sound borrowers, and we're not seeing that yet. So while I wouldn't rule out a Fed easing, it's certainly not the panacea that investors seem to think it would be, and I'm also not convinced that the Fed wants banks to ease credit when all they seem to do with good money is to make more risky loans of poor credit quality.
The bottom line, there is a strong likelihood that the economy is moving toward recession. The knee-jerk response of investors seems to be that the Fed will ease and everything will be rosy again. I don't place much faith on that belief being correct, particularly because credit easing doesn't respond to the main problem in this economy, which is that capital has been misallocated, and those bad investments are, well, going bad. Higher oil prices and wage pressures don't help. Monetary easing doesn't dig you out of all that. In fact, we tried it in the seventies, and got both inflation and recession. There just isn't any easy solution that bails you out of overinvestment in capital goods, overfinancing of garbage stock offerings, and overlending to poor credit risks. Bad investments go bad. In my opinion, that's the lesson that will eventually be learned, but so far, investors have been in denial every step of the way.
As always, though, we don't base our investment position on anybody's opinion, including our own. Our discipline is fairly straightforward. On the stock side, build a portfolio dominated by stocks exhibiting favorable valuation and market action. On the risk allocation side, identify the Market Climate, and remain positioned accordingly until there is objective evidence that the climate has shifted. For now, we're strongly defensive. No guesses, forecasts or opinions required.
Sunday December 10, 2000 : Hotline Update
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The Market Climate remains on a Crash Warning here. Although bonds are acting better lately, there is still not enough positive uniformity in yield trends to move our models from a full featured Crash Warning to an extremely negative condition. Of course, both are bearish conditions, but a Crash Warning is more unusual and immediate. No relief from market action yet.
The latest election developments underscore why I view short term action as a coin flip. No opinion at all. As far as economic reports go, the data have been well in line with our own expectations, if not with the consensus view. First time unemployment claims are in a well defined uptrend here, and the labor report showed slower job growth and more wage inflation than consensus expectations. The wage inflation wasn't quite enough to prevent investors from concluding that the Fed will ease, so we got a market rally on Friday anyway. Investors also yawned when Intel disappointed yet again, and that complacency was viewed as a sign that the tech selloff has bottomed - a view that will persist only until fresh warnings come from companies that haven't warned before. That's not likely to be far off.
The market increasingly sees the economic outlook as "neutral" in the sense of no inflation risk and only small recession risk. If anything, traders are viewing a January easing as the next likely move. This week will be important in nailing down the market's expectations. Wednesday gives us retail sales, which I expect to be weaker than expected, Thursday and Friday give producer and consumer inflation, respectively, which I expect to be higher than consensus. By the end of the week, I would expect that the markets will view the current situation more in line with how we view it: recession and inflation risks are balanced, but only because we have both. That would make a Fed cut less likely.
Main risk here: the U.S. dollar. I've written about this extensively in our research reports, and I do believe that pressure on the dollar is becoming very strong. The dollar doesn't do well, in general, when it is overvalued and supporting trends are unfavorable. For the dollar, the main supporting trend is that of real interest rates. When U.S. interest rates are falling and inflation pressures are not, the real interest rate is, by definition, moving down, and that doesn't support an overvalued currency. I doubt that investors in U.S. Treasuries realize how vulnerable long term bonds could be, even in an emerging recession, if the dollar heads south in a hurry. So I wouldn't rule out the possibility that the recent decline in Treasury yields turns out to be a spike bottom, followed by an upward spike if and when the dollar weakens. I don't want to give the impression that this must occur over the very short term, but the pressures are in that direction.
The bottom line for us is simple. The Market Climate remains on a Crash Warning for now, and we are appropriately defensive. There are certainly a lot of developments that we are watching, but the only one that governs our market position is that Market Climate.
Thursday Morning November 7, 2000 : Special Hotline Update
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The Market Climate remains on a Crash Warning. Wednesday's decline was clearly in line with our thinking - more earnings warnings. On the technology side from Apple, and now it's getting interesting - an earnings warning from Bank of America, citing loan losses. We're still seeing a wide divergence in internal action, so the technical picture is still negative, as are sentiment, valuation, and economic indications.
On the interest rate front, the picture is very unclear. On the negative side, it's likely that we're about to see a significant downward move in the U.S. dollar, which tends to be a negative for bonds. But we've also got an undertone of serious economic weakness. As I've noted before, Friday's employment report is likely to be surprisingly weak, reflecting an emerging recession. Unless we also see a wage jump (which is likely but not certain), bond investors could be at least temporarily encouraged about the possibility of easier monetary policy. That could also potentially give us another stock market bounce before failing again.
The bottom line, being on a Crash Warning, we're not at all inclined to trade in and out of the market, because it would risk missing a market plunge that we've diligently prepared for. At the same time, we have to be prepared for virtually any type of move over the short term. All of which underscores why we're generally agnostic about short term action, and attempt to always be positioned in line with the prevailing Market Climate. Currently, that climate is negative, and we remain defensive.
Wednesday Morning December 6, 2000 : Special Hotline Update
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The Market Climate remains on a Crash Warning, and the market enjoyed a bear market rally on Tuesday - fast, furious, and most probably prone to failure. The reason I tend to be agnostic about short term action, particularly in a bearish trend, is that anything is good for a few days of rally when the market is oversold. Alan Greenspan hinted that the Fed was likely to move to a neutral bias, which is what I noted last week, the election came one step closer to being finalized, and John Chambers of Cisco did a nice dance, which also helped. More on that later.
Tuesday's rally continued to give deliver a wide internal divergence, with a large number of both new highs and new lows. Breadth was better, in terms of the number of stocks advancing, but there was still a profound divergence in the sense that gains were heavily concentrated in the glamour technology stocks, while stocks not carrying the New Economy banner showed much more modest gains. Needless to say, all the talk is that we've seen the bottom. Opinion here - given the hope attached by investors to this rally, a break below the recent lows would be the most likely point for a crash to occur.
A fair question is this: what if this was a bottom? The answer is simple - there's a lot of room between here and new bull market highs, and if we're headed at all in that direction, I would expect our trend models to pick up on a uniform trend fairly quickly. What is really required is a further broadening of this rally, and a further improvement in bond market action, preferably in corporate bonds as well as Treasuries. So if the market can indeed produce sufficient uniformity to move our trend models back to a favorable position, we'll quickly become more constructive. But that's not where we are now, and as usual, there is absolutely no historical evidence to suggest that we can or should pre-emptively become constructive before such a signal is actually in hand. Frankly, I think that earnings warnings will get the better of the market before that occurs.
Alan Greenspan made it clear that current conditions were not like 1998, which was another way of telling the markets not to expect any surprise easings. As I've said earlier, it's fairly clear that the Fed should move to a statement that inflation and recession risks are equally balanced. Some call that a "neutral bias", but I'm more inclined to think that there's risk of both inflation and recession. It's just that those risks are equally large. Now, I expect that we'll see a surprisingly weak employment number on Friday, and that may prolong this rally a bit if we don't see the jump in wages that I'm also expecting. In any event, a shift in the risk statement by the Fed will no longer be a surprise when it occurs, so the main surprises to watch for now are on the employment front, and on the inflation front. Upward price pressure is the most significant negative to watch for, because that's what would tie the Fed's hands from easing, even in the face of an emerging recession.
A word on Cisco's analyst meeting. The comments from Chambers were so transparent I was surprised that nobody seemed to catch on - virtually every time he talked about revenue growth, he mentioned acquisitions. Cisco isn't enjoying 50% core revenue growth - it's simply buying the existing revenues of other companies with overpriced toilet paper. As long as the price/revenue ratio of the acquired company is lower than Cisco's price/revenue ratio, per share revenues grow. And because Cisco's valuation is so skewed in relation to its acquisition targets, the company can manufacture as much "growth" as it chooses. But that growth rate is meaningless unless you partition the growth contributed by each acquired component - similar to how retail analysts gauge the health of a chain-store by looking at growth in same-store sales. Cisco never does that, for fairly obvious reasons.
The bottom line - the Market Climate remains on a Crash Warning for now, and we have zero inclination to pre-empt that based on a textbook bear market rally. If trend uniformity is on its way to turning favorable, we'll know soon enough, and will respond accordingly. Short term action is a coin flip, but I still strongly advise investors to shut down part of their risk now if they are financially unprepared for a follow-through to what is most probably an early bear market. We'll take any shift in the Market Climate as it comes. For now, the climate remains very negative, and we are appropriately defensive.
Tuesday Morning December 5, 2000 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. Monday's rally was very messy internally: decliners beat advancers on both the NYSE and the Nasdaq, and we're still seeing very wide internal dispersion, with large numbers of both new highs and new lows. That sort of internal dispersion is typical of market tops and early bear markets, and not surprisingly, that's where we believe the market is. Monday's rally was clearly focused on "old economy" stocks, following a favorable article in Barron's over the weekend. But again, the internal action showed no relief. In our most aggressive accounts, we did move our OEX put options to the February 720 puts for a slight credit, in order to reduce our sensitivity to time decay as we watch market conditions unfold.
In recent weeks, I've noted that insider sales have been unusually heavy, and that remains the case. And even in light of the decline we've seen, the percentage of bearish advisors is still under the important 30% level. I say important because that's an unusually low percentage that is often seen at market tops. Bearishness at market bottoms is typically double that percentage. While there's a lot of talk about relatively high mutual fund cash positions, there are two things to point out. First, cash positions typically increase when interest rates are higher, so the majority of this increase in cash positions is a response to risk-free T-bill yields over 6%. Second, the portion that is unexplained by higher risk-free rates is simply an attempt to brace for investor withdrawals. So even with those mutual fund cash positions, the statistical evidence is clear that sentiment is still overly bullish, and that's a contrary indicator.
What's clear from all of this is that investors really haven't accepted the notion that stocks are actually in a bear market. They are still overloaded in technology and stocks in general, but rather than lightening up, they are constantly listening for the next analyst to tell them that the market is close to a bottom. And of course, that's what CNBC has been dishing out. As I said on Sunday, that's very sad, because many of these investors risk literally being wiped out if those guesses turn out to be wrong. We haven't seen the margin calls yet, but we're close. Remember that while brokers will let you borrow $1 for every $1 of equity in your portfolio, they don't give you a margin call until you owe more than $2 for every $1 of equity. If you're on 100% margin, a 25% drop in the security will trigger a margin call. Most investors aren't using full margin, but even assuming less aggressive margin, the decline we've seen is close to triggering margin calls for a whole lot of tech investors. And once that happens, investors no longer have a choice of whether to sell or not. They have to sell, or their broker decides for them. With the personal savings rate negative, very few of these investors have the money to meet those calls.
The bottom line is simple: the Market Climate remains on a Crash Warning, and we are appropriately defensive. As always, everything else is filler.
Sunday December 3, 2000 : Hotline Update
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The Market Climate remains on a Crash Warning, which we continue to take seriously. Now, as I stress constantly, our defensive position is based on the current Market Climate, objectively measured, so we don't need to make forecasts in order to support our position. If the Climate shifts, our position will shift, and it's not necessary to guess whether such a shift will happen a week from now or a year from now. The current Climate is a Crash Warning, and we're accordingly defensive.
That said, a number of you have asked that I share my opinions anyway. So here goes. One of the things that strikes us is how universally investors are expecting a bounce here. Most of the distinction between analysts is whether or not such a bounce would be sustained. This is not analysis but hope. Investors need a rally, as do the analysts and portfolio managers who appear on CNBC and the like. In the past week, I've received some of the saddest calls I've ever heard, from investors who have lost literally decades of retirement savings in the Nasdaq this year. A few of them were, and frighteningly still are, on heavy margin. The fact that they've lost so much has paralyzed them from selling, even as they helplessly watch their life savings disappear. This is so damned sad, because these people keep saying things like "so and so says that we've hit a bottom" or "they say that we could recover after the Fed meeting". Then they ask me what I think. I just tell them that if they want to hear something hopeful, I'm the wrong guy to ask. And then I tell them this. Don't listen to my opinion about where the market is going. Don't listen the opinions of people on CNBC. Don't listen to anybody who tells you where they think the market is going to go next. Right now, you're taking a coin flip: heads you win, tails you're literally wiped out. That coin flip is one you should never take. Shut down 40% of your position now. Expect to regret it either because you sold some and the market goes up or because you didn't sell everything and the market goes down. But lock in some regret, and put yourself in a position where you're not wiped out regardless of what happens. They say thank you. And then I bet they do nothing. Human nature. My opinion is that the market is likely to crash vertically. And that's my reason. Too many people are depending on a rally to bail them out, but so many of them are also under so much pressure to liquidate and cut their losses that the selling is likely to persist, and at some point, the camel's back will break and these poor people will finally hear themselves saying "sell everything".
A few words about the market backdrop. I'm expecting job growth to be decidedly weak in Friday's report. Early into most recessions, the 3-month change in nonfarm payrolls turns negative. With weekly claims for unemployment suddenly surging, I am expecting weak job growth to show in the monthly numbers here. That won't raise the unemployment rate by much, and I would expect that optimism about slow job growth will be offset by a larger than expected jump in wages. If wages don't jump, Friday's employment report might be worth a rally for a day or two.
Though I do think it would be appropriate for the Fed to drop its "inflation bias" and admit that risks are now equally weighted between inflation and recession, a moment's thought should convince you that this is not a good thing. My guess is that we're likely to see inflation and recession. Despite another drop in the NAPM index, the Prices Paid component was up. The CPI is also due for a pop, as are wages, and if there's one thing worse than recession risk, it's recession risk that the Fed is powerless to do anything about. In short, my impression is that as this month progresses, it will become clear to investors that the Federal Reserve has much less flexibility to cut rates than they would like. That said, anything is good for a couple of upside days. But our models are firmly defensive here, and our most aggressive accounts continue to hold OEX put options. To defend our stock positions, we've moved our Russell 2000 puts to the March 500 series.
There are two areas I expect to weaken next. First, nearly everybody in tech believes they have been at least slightly bailed out by the relative strength in Cisco and Sun Microsystems. But it's just not logical to expect core revenue growth for these companies to hold up in the face of a clear economic slowdown centered on deteriorating tech spending. Cisco meets with analysts on Monday. We'll see how well they can dance. The other area is financials - bank stocks in particular. Credit quality is literally plunging, and default rates are clearly rising. In fact, on Friday, Moody's downgraded Xerox corporate bonds to junk status. That's not isolated, but part of a very broad trend that we've written about at length in the past year. Again, it's just not logical to expect lenders to be unscathed by the credit deterioration of their borrowers, particularly when the FDIC is accelerating the pace of bank downgrades.
In short, we don't need opinions or forecasts. Our Market Climate is based on objective measurement of current market conditions, and until that Climate changes, we're appropriately defensive. But since some of you have asked my opinion, now you have it. I hope I've given you the reasoning behind those views. But for the purpose of setting our position, my opinion is irrelevant. The Market Climate is on a Crash Warning. That's not a "maybe we're in a bear market warning", or a "maybe the market might pull back a little more before rallying warning", or a "maybe you shouldn't use quite as much margin warning". It's a Crash Warning. Our models have never advised a more defensive position. Everything else is just analysis and commentary.
Friday December 1, 2000 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. I had expected the decline in the market during November to reduce the level of bearishness in our econometric models, but the technical deterioration has been so severe that the models have actually become more negative. Historically, that's rare, and also ominous. As always, I have absolutely no projection for what the market will do over the very short term. And with our strategy, we don't need forecasts or projections. We deal with what is, and until conditions change, valuations, trend uniformity, and yield pressures remain negative. That gives us a Crash Warning, and we are accordingly defensive.
The expansion of new lows in recent days is notable. Richard Russell also points out that the last three days have generated the "Hindenburg" signal that we've discussed in the past. Essentially, there is an unusually extreme divergence in market action, with large numbers of both new highs and new lows. When that has happened with a weak advance-decline line and negative trend uniformity, it has often preceded nasty downside follow-through. So although the damage in the Nasdaq has been severe, we're not particularly inclined to look for or attempt to play a rebound.
We'll quickly change our stance if there is a shift in our objectively measured Market Climate, but our subjective view is that the market is far from a real bottom. Far too many investors jumped on the New Economy bandwagon and are still holding stocks like Cisco, Sun, Oracle, Dell, Lucent and others. Those stocks were considered "no brainers" earlier this year, and my impression is that despite recent declines, investors are still holding on to those stocks in hopes of a rebound. While we certainly will see intermittent rallies along the way, a real bottom will be marked by a thorough capitulation and disgust with these issues. Even investors in Lucent haven't been shaken out, in my view. The stock has plunged from 84 to 15 and change, and investors are still holding on for the rebound.
As I've noted before, in a bear market, the psychology moves from "buy on dips" to asking "How much lower can it go?" to "No, really, how much lower can it go?" to "Sweet Mother of Joseph! How much lower can it go?" The simple fact is that the Nasdaq could fall in half yet again and still be at only the average valuation of the past decade. And those have been bull market valuations. Remember, value is measured not by how far stocks have declined, but by the relationship between prices and properly discounted cash flows. On that basis, the Nasdaq is still outrageously overpriced.
Average investors here are sickened by the losses so far, but don't want to sell, because they feel that stocks might rebound. Yet if the market does rebound, they won't want to sell then either, because they'll figure that stocks are recovering. For many investors, the only thing that will get them to sell is a truly catastrophic decline. That's why investors tend to hold stocks all the way through a bear market until the losses are so revolting that they cry "Just get me out!" For investors who are fully prepared to ride out a bear market through what may very well be a 40% drop from here, fine, and good luck. But for investors who are in the market with money they really can't afford to lose, there's a simple strategy I always advise. If you have friends who are helplessly watching their portfolio lose value, and they can't really afford to ride out extreme losses, feel free to share this strategy with them. And here it is:
Sell 40% of the portfolio immediately. That's it. Guarantee yourself an acceptable level of regret. If the market rallies, you'll regret having sold 40%. If the market declines, you'll regret not having sold everything. But instead of gambling, and risking an unacceptable level of regret, lock in an acceptable level and be done with it. Expect in advance that you'll actually experience that regret, because I guarantee you will. But it's a lot better than risking truly catastrophic regret if the market crashes, which remains possible and even likely. Look, if the market rallies and you still want out, sell another piece off. If the market declines, at least you took some action, and you can always sell off another piece on the next rally. The worst thing you can do is to know that you are taking far too much risk, and yet do nothing.
In the early part of a bear market, which I believe is where we are, that's probably the best comment I can offer.
Thursday Morning November 30, 2000 : Special Hotline Update
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Just a note. Barring a 100 point Dow move on Thursday, the next update will be on Sunday evening.
The Market Climate remains on a Crash Warning here. Wednesday's market action displayed surprisingly weak market internals, with new lows expanding, and virtually no lead by advancers over decliners. The Nasdaq was far worse, with significant negative breadth on yet another yearly low. In the accounts we manage, we've been pleased to see our stocks holding up relatively well, particularly compared to the Russell 2000 and OEX, which is what we use to hedge. That has produced some satisfying gains in recent weeks. We have a strong bias toward value and yield, as opposed to high P/E and dividend-less stocks driving the major indices, so we tend to do best when those overvalued leaders are hit, and investors seek the safety of dividends, lower P/E's and established industries. With valuations still well twice their historical norm, we clearly hope to see more of that sort of action in the months ahead.
Regardless of day-to-day action, the Climate remains on a Crash Warning here, and that's really all we need to know from a hedging perspective. The Nasdaq looks oversold, but bear markets can produce persistent oversold conditions, and we have no inclination to trade in-and-out in any event. The bottom line; the deterioration in market internals is somewhat alarming. The Nasdaq has been the focus of recent selling pressure, but with the overall economy now showing much more tangible signs of a hard slowdown, I expect the blue chip indices to experience more notable pressure as this bear market unfolds. As usual, you should expect intermittent bear-market rallies to be fast and furious. With a Crash Warning in effect, they will also continue to be prone to failure, and the risk of a free-fall crash remains very real.
Sunday November 26, 2000 : Hotline Update
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The Market Climate remains on a full-featured Crash Warning, with extreme valuations, unfavorable trend uniformity, hostile yield trends, unswaying bullish sentiment (a contrary indicator), slowing economic growth, rising inflation, peristent earnings warnings, and weekly unemployment claims suddenly accelerating.
Short-term action is a coin-toss, and I don't place much expectation on the sustainability of a rally once the Presidential race is finalized. It's not the declaration of a winner, but a concession by the loser that will end this, and that doesn't seem to be in the works. Even when that ultimately does occur, the backdrop of negative market conditions is really what holds sway on the primary trend. Right now, the evidence remains strong that stocks are in the early phase of a bear market.
Tuesday Morning November 21, 2000 : Special Hotline Update
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The Market Climate remains on a Crash Warning, so a strongly defensive posture continues to be appropriate. The market isn't quite back to an oversold condition, so there's no particular pressure for a bounce here. As always, we're agnostic about short term action, but I do consider it important that new lows expanded considerably on Monday. It's important because severe declines are generally preceded by what technicians call "downside leadership" - basically, a surge in the number of stocks hitting new lows. That's a rough way of measuring a breakdown in trend uniformity. While our own methods are more precise and reliable, it's reinforcing to see confirmation from simpler measures such as new lows and the advance-decline line. As for other measures of trend action, after an unusual series of whipsaws, Richard Russell's Primary Trend Index (www.dowtheoryletters.com) has also moved to the bearish side.
There's a general view that once the election is decided, the market will soar. Maybe. But if I had to guess, I would expect it to soar for about 2 days before failing. The fact that market participants expect a rally generally indicates they have already made purchases or deferred sales on that expectation. So aside from initial reactions, I'm not convinced that a resolution to the election will garner much follow-through. All of this churning is taking place in a backdrop of an economic slowdown, and a gradual realization that capital spending, profit margins, and earnings are all under more than temporary pressure. That's why the selling pressure keeps coming back in on every bounce. And we may very well be close to the point where investors react simultaneously. As usual, no guessing is required. The Market Climate is on a Crash Warning, which is associated with an unusually negative return/risk profile on average. That puts us in a strongly defensive position, which will change when valuation, trend uniformity or yield action shifts.
Sunday November 19, 2000 : Hotline Update
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Just a note, the latest issue of Hussman Investment Research & Insight was mailed on Friday, and is available for download on our website. Also, the Hussman Strategic Growth Fund now has a NASDAQ ticker. Beginning with Wednesday's close, it will be reported under the symbol HSGFX. You can also obtain the daily net asset value of the Fund on our Fund website, www.hussmanfunds.com .
The Market Climate remains on a Crash Warning. One of the interesting developments over the past several weeks has been a sharp increase sales by corporate insiders, at the same time that public sentiment readings remain highly bullish. In recent weeks, insider sales have moved to a 2-to-1 ratio relative to insider purchases, even while the AAII survey of individual investors has reported the lowest percentages of bears in history, save for a single lower reading that was registered in August 1987. Needless to say, when corporate insiders and individual investors disagree, the historical tendency has strongly favored insiders being correct. And right now, the disparity in these gauges is wider than we've ever seen it. That's very consistent with the kind of market action we've been seeing. On one hand, we have a real persistence to selling pressure here, as evidence mounts that the slowdown in earnings is getting teeth. At the same time, we have a public that has become conditioned to view every selloff as a buying opportunity. Our view is relatively simple: buy on dips works fine when trend uniformity is favorable, but is the road to ruin when the Market Climate has shifted to a Crash Warning. Given that most observers fail to recognize the profound shift in market conditions since early September, I expect that investors are increasingly viewing these failed rallies with great confusion as to why "buy on dips" isn't working lately.
One observer that finally gets it right on technology earnings is featured in the November 20 issue of Barron's - Nancy Lazar, chief economist at ISI Group. Based on ISI's own indicators, as well as a weekly comprehensive industry survey similar to the NAPM, Lazar notes that the emerging economic slowdown is likely to be "weaker, longer, everywhere". A few other comments: "Near-term, earnings expectations are still too high. As global growth slows, those expectations will have to come down more and more, and that is going to create indigestion for the stock market. I believe very strongly we are experiencing a cyclical slowdown in tech, which will last longer and be potentially deeper than expected. A simple point to make is that tech is cyclical. If anything, tech is more cyclical today than in the past. It's a bigger share of capital spending. The level of capital expenditures has been rising faster than the level of cash flow. And that corresponds with this surge in debt growth. A lot of the junk-bond problems are tech-related. So, the fact that tech cap-ex is now such a big part of cap-ex, and that a lot of it has been leveraged make tech a more, not less, cyclical industry. It is cyclical to start with, it moves with the business cycle, but it has just been a long time since we've had a slowdown. The slowdown is here."
In our most aggressive accounts, we are now holding OEX January 730 puts for the "bearish" portion of our hedge, and December 530 puts on the Russell 2000 to hedge our stock positions. We expect to move our Russell hedge to January expiration in the next couple of weeks, but intend to keep that portion of our hedge deep in-the-money.
As usual, no expectation for short term action. For now, the Market Climate remains on a Crash Warning and a defensive position remains warranted by current conditions. Have a great Thanksgiving.
Wednesday November 15, 2000 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. Probably the most important thing to keep in mind here is that stocks move in cycles and the probability is overwhelming that stocks are now in the bear portion of that cycle. Primary moves tend to go far beyond the expectations of most market participants. In the past two days, at least three analysts have used the phrase "rock solid support" on CNBC when talking about current levels in the stock market, which is one of the things that drives the idiot-meter way into the red zone. It's fine to talk about support, but when you attach any form of the word "rock", you've wandered into Fantasyland. Irving Fisher used exactly the same words in 1929, about a week before the Crash. Historically, a market value of anywhere between 7 and 11 times record earnings has been somewhere close to the bottom. At nearly three times that level, it's not rock solid support the market is standing on - it's quicksand.
Moreover, there is strong evidence that the economy is likely to slow sharply, and with it, corporate profit growth. Our most reliable indicators are on a rare recession warning, and as we discuss in the upcoming issue of Hussman Investment Research and Insight, a recession is also increasingly likely ahead.
In a bull market, buying the dips is an appropriate strategy, and though it's not really optimal to sell the rallies, you have to have some tolerance for brief selloffs when they do occur. In a bear market, exactly the opposite is true. Selling the rallies is the appropriate strategy, and though it's not really optimal to buy the dips (or cover short sales on dips), you have to have some tolerance for brief rallies. In a bear market, bounces from oversold conditions tend to be fast, furious, and prone to failure. That's really what we're expecting from Tuesday's advance as well. There is certainly no requirement for rallies to be limited to only a day or two, but very little importance should be attached to any advance that does not restore favorable trend uniformity. At present, the market is far from achieving that, so a strongly defensive posture remains appropriate.
Sunday November 12, 2000 : Hotline Update
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We'll keep this brief. The Market Climate remains on a full-featured Crash Warning. That's not a forecast as much as an identification of the current condition of the market. Now, the fact is that this particular climate has occurred less than 4% of the time in history, and both major crashes (1929 and 1987) as well as a host of less memorable crashes all emerged from this condition. On average, the market has lost a great deal of value in this climate, so we are very defensive here. While the market may very well crash over the short-term, a short-term market forecast isn't necessary to justify our position. All we need to know is that the market on average has suffered in this climate. The reason I say this is to underscore that we are positioned based on what the market is already doing. If the market begins doing something different, namely, displaying uniform trend action, our models should pick that up fairly quickly, and we will become more constructive. For now, we're highly defensive.
Tuesday Morning November 7, 2000 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. In a sense, that's really all we need to know. Everything else is analysis, detail, and elaboration. But the Market Climate is what defines our market stance, and current market action places us in a very defensive mode. Unless yield trends turn downward, favorable valuations are restored, or the market establishes favorable trend uniformity, that defensive position will remain appropriate.
Cisco released a very upbeat earnings report after the close, and the stock got whacked in early after-hours trading before clawing its way back to a modest loss. Cisco's chief financial officer gave guidance of 50-60% growth for the coming year, which investors seemed relieved to hear. It's really the same story. Give a company a stock with a P/E of 150 and let it use that as currency to make dozens of acquisitions a year, and you can construct nearly any growth rate you want - for a while. I hate to say this, but my daughter's goldfish could produce 50% earnings growth from acquisitions if it could get its fins on a P/E of 150.
With favorable seasonality behind us, we have the election on Tuesday, and a probable pickup in trading volume once that's over. Interest rates rose again on Tuesday, and our gauges of yield pressures are suggesting higher stock yields ahead. At a dividend yield of just 1%, even a minimal upward movement in stock yields could translate into severe downside price action. But again, that's all analysis, detail and elaboration. Really, the only thing we need to know is that we remain on a Crash Warning here.
Sunday November 5, 2000 : Hotline Update
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The Market Climate remains on a Crash Warning here. The typical period of favorable month-end seasonality ends on Monday, and I expect trading volume to pick up after Tuesday's election. As usual, there is no need to second-guess short-term market direction. As long as the overall profile of market conditions remains on a Crash Warning - that is, extreme valuations, unfavorable trend uniformity, and upward yield pressures - a strongly defensive posture remains appropriate.
The October NAPM figures fell further below 50, and combined with a number of other indicators, that reiterates the recession warning that we first saw in September. Those other indicators are 1) a widening in credit spreads, 2) a relatively flat yield curve (the current curve is actually inverted), and 3) the S&P 500 index below its level of 6 months earlier on a monthly closing basis. In addition, I noted last week that Treasury bill yields had moved decisively above 6% after averaging less than 6% over the past year. That occurrence has always been followed by poor market action. So not only do we have a Crash Warning, we also have a series of other bearish indications.
One fact is particularly interesting. I went through all of the post-war recession warnings, and it turns out that except for the one we saw in 1998 - the only one which was not followed by a recession - every one of the previous post-war warnings occurred with Treasury bill yields over 6%. In the latest issue of Barron's, Joseph Carson of UBS Warburg notes that prior recessions have all been preceded by a collapse in liquidity growth (including real M2, consumer and business credit growth, etc). That was not evident in 1998, but it is very evident today. In short, the current recession warning is also supported by factors which have been reliably bearish for economic growth.
The bottom line, despite the recent bounce in the major indices, a strongly defensive posture is still warranted. In the event we do see favorable trend uniformity, we will move to a still hedged but more constructive position. But here and now, we're comfortable with a tightly defensive stance.
Wednesday Morning November 1, 2000 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. As I've noted in prior updates, investors appear to have latched onto the belief that all negative market outcomes end in October, and clearly were almost frantic to get in on the market as we move into November. Now that investors have done their buying on that thesis, the question is, "Now what?"
Seasonally, we're still in a mildly favorable seasonal period that runs through Monday of next week. So as usual, I am agnostic about short term action. But my impression is that a lot of buying plans have been exhausted, and that the underlying tone of slower growth remains with us. The Chicago Purchasing Managers Index slipped notably, and we'll be watching the national PMI on Wednesday for further clues. Meanwhile, I should mention that corporate insiders have turned substantially to the sell side. The insider sale/purchase ratio has shot up dramatically in recent weeks, which may reflect a shift in expectations toward weaker business results, but in any case is not good.
The bottom line, if we see enough strengthening in trend uniformity, we will quickly move to a more constructive position, but the evidence thus far is inadequate. The market has clearly worked off its oversold condition, and renewed weakness over the near term would strengthen the prospects of more serious follow-through. For now, a defensive position remains appropriate.
Tuesday Morning October 31, 2000 : Special Hotline Update
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The Market Climate remains on a Crash Warning. Despite the pressure on the Nasdaq, my impression is that the market is enjoying two benefits. First, mutual funds generally end their fiscal year on October 31st, so there has been a tremendous amount of tax-loss pressure on secondary stocks. That is now behind us, so the broad market may enjoy a better tone. As it happens, though, the vast majority of stocks have very little effect on the major indices, which are capitalization weighted. Given the continued evidence that stocks are in a bear market, what we're really expecting is that value stocks may hold up generally better than the major indices, and that would certainly be good for all of our portfolios, even the most defensively positioned ones.
Second, I suspect that there is a short-term rush to get in on the market in order to take advantage of ostensibly favorable seasonality now that October is out of the way. As I noted on the Sunday update, the longer term evidence of that is much weaker than is generally believed, and we certainly wouldn't rely on weak seasonal patterns in the face of a complete Crash Warning. But as usual, I am completely agnostic about short-term action. So a bit more piling into stocks would not be surprising. On the other hand, if we see renewed weakness after Monday's bounce, it will feed into that "relentlessness" that investors are experiencing, and that would sustain the risk of a near-term market crash. With the models still on a Crash Warning, there's no need to second-guess short term action. We're defensive, and that's that. If trend uniformity becomes more favorable, we'll quickly shift to a more constructive tone. But here and now, we remain on a Crash Warning.
Sunday October 29, 2000 : Hotline Update
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The Market Climate remains on a Crash Warning. In the past, market crashes have typically been preceded by a 9-15 week decline from an intermediate peak which takes the Dow about 14% below its high. That's just the pre-crash action. My impression remains that there needs to be a certain relentlessness to such a decline in order to trigger a concerted wave of selling. For that reason, I'm more inclined to expect a near-term crash if rallies emerge simply to clear oversold conditions, followed by renewed losses. That's clearly been the case thus far. Investors seem to be pinning inordinately high hopes on seasonal patterns that are in fact relatively weak historically. Specificially, the notion that market declines magically end in October is controverted by numerous historical instances. Most of the support for this idea focuses on the period since 1982, but that period has been marked by 18 years in which the Dow has never violated the low of the prior year. That's an environment in which a lot of spurious patterns can be drawn out of the data. Moreover, the fact that everybody believes that things will get better once October is out of the way means that they will have acted on that belief in the next two days. Then what? Seasonally, one might expect typical mildly favorable month-end seasonality through this week. But with our models on a clear Crash Warning, the risks are far too great to rely on such weak seasonal assurances.
The OEX did decline significantly enough last week to offer us a surprisingly good opportunity to roll our strike prices down, and in our most aggressive managed accounts, we rolled from the OEX December 760 puts to the December 730 puts at a net credit of 20 points. I suspect we'll see more opportunities to roll our strikes down for strong credits in the weeks ahead, but as I've noted several times, we are in no hurry to take put option profits simply because we have them. Our interest is in being positioned in line with the current Market Climate, and a significant hedge remains appropriate.
One of the most significant items we've been watching in recent weeks: the lowly Treasury bill. Historically, when the yield on the 3-month Treasury bill has moved above 6% after averaging less than 6% over the prior year, the market has suffered significant losses. The reason, I believe, is that over time, earnings, revenues, dividends, cash flows and GDP have been well-contained in a 6% long-term growth channel. When competing risk-free yields rise above that 6% rate, likely capital gains become insufficient to compete, and investors begin to demand higher risk premiums. In other words, the yield on stocks begins to be pressed higher, and the only way to drive stock yields up quickly is to drive stock prices down. Here are the prior instances we've seen a break of that 6% level on risk-free T-bills:
January 1969 (near the beginning of the 1969-70 bear market)
April 1973 (near the beginning of the 1973-74 bear market)
November 1977 (followed by a year of flat returns, despite a 5% dividend yield and a
market P/E of just 9)
September 1987 (no elaboration required)
October 2000.
In short, we've got a Crash Warning. Our models continue to view stocks as a poor investment on the basis of valuation, and as a poor speculation on the basis of trend uniformity and yield pressures. Even beyond the set of criteria we use to define the Market Climate, we've seen at least a dozen other features which are consistent with unusual risk. These include extreme sentiment, major earnings warnings, deteriorating credit quality, rising inflation trends, yield curve inversion, a recession warning from our 4-indicator composite, important and independent technical warnings from Peter Eliades, Richard Russell, Lowry's, the Pitbull Crash Index, and Investech, and yield competition which has historically signaled bear market trouble.
Wednesday Morning October 25, 2000 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. Despite the popular view that the market has already set a short-term bottom and is due to work its way higher, I'm not at all convinced of that. In any event, the only thing that drives our hedging stance is the Market Climate condition. With the exception of modestly favorable trends in utilities and long-term Treasuries, the overall climate could not be worse. My impression is that those two favorable trends in utilities and Treasury bonds reflect a flight to safety, particularly given the virtual collapse in the riskier high-yield debt market. Overall, this climate is still very amenable to a market crash, and until we see more uniformly favorable trend developments, a strongly defensive position is warranted. Frankly, we're not quite as hedged as we could be, but we are very sensitive to the risk of losses from a larger hedge, if the market was to advance significantly. So our current position is the most effective compromise that is reasonable, but it's certainly enough. Our models have not advised as aggressive a hedge since mid-August through late-October of 1987, and before that, July-August 1981, and late 1973-mid 1974. There is absoutely zero chance that we would reduce or shift-down our current hedge for the probably temporary satisfaction of taking a few put option profits here. Particularly in our most aggressive accounts, the required discipline is a full-cycle perspective, not a day-trader's horizon.
After the close on Tuesday, Nortel, Compaq and Amazon all released earnings above expectations. But due to soft revenues and weak guidance for the 4th quarter, Nortel plunged on the news in after-hours trading, and Compaq lost about 10% of its value. Amazon did better though, rising by about 10%. Speaking of earnings and revenues, GE was in classic form, using its vastly overvalued stock as currency to buy Honeywell, one of the few remaining large-cap stocks with a low price/sales multiple. I'm sure the guys at Cisco are kicking themselves. Had Cisco made the same purchase of Honeywell with Cisco stock, it would have been able to report a doubling of revenues per share, and a 40% jump in earnings per share, without a bit of real growth. Which goes to show you how absolutely meaningless the quarterly per-share figures are when hot companies are actively making acquisitions using their overvalued stocks as the currency. Well, you'll know that Cisco is getting desperate to pad their revenue numbers if they try to buy General Motors or Caterpillar...
In short, the Market Climate remains on a Crash Warning. That's a warning, not a certainty, but in any case, a strong defense is still in order.
Sunday October 22, 2000 : Hotline Update
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The Market Climate remains on a Crash Warning here. The S&P 500 closed out last week with a gain of 1.7% for the week, while the Dow did somewhat worse and the Nasdaq somewhat better. With the market down in each of the 6 preceding weeks, the bounce was just enough to clear an oversold condition in the market. There is great hope among market analysts that last week was the bottom. From our standpoint, we continue to view stocks as being in a bear market, but if indeed we are to see a near-term crash, we would expect to see the market weakening again fairly quickly. Panic declines tend to occur between 9-15 weeks off of an intermediate peak, and we would mark that peak as having been September 1st. My impression is that you need a sense of relentlessness to a decline in order for investors to panic, so the status of Crash Warning will probably be sensitive to how the market acts in the next several weeks.
Barron's had an interesting article reviewing what they call "creative accounting" at Cisco, which is following in the mold of the glamour performance stocks of the late 1960's. I included the lengthy quote about this in the Ticker section of the October letter because I strongly expect this sort of creative accounting to be recognized and eventually punished in coming quarters.
Another condition that is showing up on our radar; mass layoffs appear to be surging, virtually from nowhere. In the past few weeks, we've seen layoff announcements from Dana, Ingersoll Rand, Unisys, Imation, Qwest, Textron, and Georgia Pacific, not to mention countless web companies such as WebMD and others. Apart from the separate announcements, I haven't seen one word written about in the papers yet. Certainly not anything recognizing it as an emerging trend. So in addition to slower revenue growth, soft capital spending, and pressure on profit margins, keep your eye out for a trend toward higher layoff announcements. The corporate bond market is reeling from credit concerns, and this may be a related indication of economic weakness ahead.
The bottom line - there's no need to forecast or second-guess short term direction. Market action will effectively tell us what we need to know. We would certainly not rule out several days of churning or even further upside, but if we are going to see a market crash, I would expect to see renewed weakness setting in relatively soon. If that does not occur, we will still view stocks as being in a bear market, but we may move out of a Crash Warning. In that case, we would back off somewhat on our put positions in our most aggressive managed accounts. Either way, unless we actually see a resumption of favorable trend uniformity (which is unlikely in the near term), we do expect to remain well hedged against what we believe to be an ongoing bear market. As usual, our job is to keep our position in line with the Market Climate. We still have a Crash Warning here, but if that condition changes, we will respond accordingly.
Friday Morning October 20, 2000 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. As I noted last Sunday, the market has had 6 consecutive weeks of decline, so it is reasonable to expect a break in that pattern. Even so, Thursday's rally showed a characteristic frenzy for big-name large-capitalization tech stocks, while the broader market was more subdued on an unweighted basis. The rally was clearly driven by a handful of techs such as Cisco, Sun, and Microsoft, which vaulted 10-20% in the belief that all the bad news is behind us. Even in a market-neutral position, that difference in behavior between the big names and the broad market can cause a bit of day-to-day pressure, but it's clear that the explosive performance of the big-cap techs was a frenzy to buy from oversold levels, rather than a performance which can be sustained day after day over any extended period. The market has shown a clear tendency to resume its decline after clearing an oversold condition. That still allows for a modest amount of further upside, but I doubt that the next earnings disappointment is far away. Regardless of short term action, we remain positioned in line with the current Market Climate, which is a fairly unmitigated Crash Warning.
In our most aggressive managed accounts, we are staying with the current strike prices in December options. When you hold short-dated options, you accept a relatively high rate of time decay in return for greater option sensitivity, and it is optimal to change strike prices frequently. The reason we are holding longer dated December options is specifically because we do not intend to roll the strike prices back and forth frequently. Our objective is to give the market time to express a decline more fully, and to limit the decay of time premium while we hold our position. As we move through the coming weeks, we will probably change our strike prices once or twice, but our strikes and expirations are strategic choices which are consistent with the current Market Climate, and we currently elevate patience during this Crash Warning over a quick profit based on day-to-day fluctuations, especially when taking a quick profit would expose us to a great deal of time decay on the remaining position.
A final comment: the trade figures showed a narrowing of the trade deficit in today's report. It's often believed that this should boost GDP growth. The fact, however, is that a smaller trade deficit by definition means less foreign capital inflow into the U.S., and the typical result is a 1-for-1 drop in domestic capital spending. Why nobody seems to know this fact is beyond me, but it's obvious in the data. That's not good news for the industry that is most heavily dependent on continued strength in capital spending. And that happens to be the technology industry.
Thursday October 19, 2000 : Special Hotline Update
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The Market Climate remains on a Crash Warning on this 13th anniversary of the 1987 crash. I'll say it again: the names are getting bigger. Today, we got a fresh earnings disappointment from IBM, and once again, investors reacted to the selloff by buying the dip and hoping that this morning was the bottom. I doubt it, but regardless of my personal opinions, the more important factor here is the current Market Climate. And on that basis, we continue to be tightly hedged. It's tempting to try to trade in and out around a bearish position, but the risk of a crash remains significant. While stocks are significantly off their highs, that is not what creates value. What creates value is the relationship between the price of a security and the discounted stream of cash flows it is likely to generate in the future. On that basis, we see absolutely no reason why the major indices could not (and indeed, should not) lose more than half their value from current levels.
There's no need to make forecasts however. All we need to know is that the Market Climate is severely negative based on current conditions. If trend conditions were to firm uniformly, we would shift to a more constructive tone, but our measures are actually getting worse rather than better. Tuesday's bounce off the lows proved little else but that investors have been well trained to buy on dips, and that they don't recognize that the basic character of the market has shifted.
As I noted yesterday morning, even on days where the Nasdaq is down modestly, the internal action is terribly divergent, with a handful of stocks down 20-80% in a day, significant damage to second-tier stocks, and enough strength in the largest capitalization stocks to conceal the devastation. It's clear that investors are retreating to a narrower and narrower strip of "quality", focused on the largest names. Not surprisingly, those stocks are also the most overvalued, so when they disappoint, as IBM, Intel and others have, even that strip of quality becomes vulnerable.
Based on the after-market action of stocks releasing earnings on Wednesday afternoon, the Nasdaq should have an upward bias on Thursday morning. Beyond that, I am, as usual, agnostic about short term action. The Market Climate is on a Crash Warning, and we are appropriately hedged.
Wednesday Morning October 18, 2000 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. I noted last week that we had seen 5 consecutive declines in the NYSE Composite on significant downside leadership from new lows. That condition certainly isn't always followed by market crashes, but when the market has crashed previously, that condition has often preceded the crash by a few weeks. When valuations have been high and trends weakening, it has generally been a good idea to fully hedge or liquidate no later than the Monday following that signal, which would have been early this week. We'll see.
As I noted on Sunday's update, with the market having endured 6 consecutive weeks of decline, there's certainly room for some upward movement. But this being a Crash Warning, there is no way on Earth that we would speculate against that warning. From Tuesday's action, my personal inclination is to believe that rally attempts are likely to fail quickly. The reason is the striking lack of uniformity in market internals. When we see a down-day of say, 2% in the Nasdaq, it doesn't happen as a modest and orderly process. Rather, we see lots of high-profile but second-tier stocks being hit for 5-7%, a handful of stocks down 20% to as much as 70% in a single session, and just enough strength in the largest cap stocks so that the relentless internal damage is relatively hidden. Over the past several months, the names have been getting bigger and bigger, and at this point, it looks increasingly as if the damage will finally hit those huge stocks that dominate the capitalization weightings. At that point, the major indices will begin to reveal the same kind of damage that's already so evident in the broad market. The recent break in Jim Stack's "Gorilla Index" of high profile stocks (click here for Jim's "Chart of the Week") suggests that this pressure is increasing markedly.
Again, that's my personal inclination, and our positions are not driven by those views. Even if my inclination was more positive, we would still remain tightly hedged. The only thing that determines our hedging stance is the condition of the Market Climate. Right now, we're on a Crash Warning, and I really do implore our clients to take that condition seriously.
Sunday October 15, 2000 : Hotline Update
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The Market Climate remains on a Crash Warning here. Friday's strong bounce was clearly not unexpected, but was surprisingly tepid in terms of overall breadth. With the decliners having outpaced advances persistently day after day, we should have seen somewhat more strength in advancing issues on Friday. As it happened, advances led decliners by 1613 to 1255. That's another way of saying that the rebound was largely focused on the large-cap glamour stocks that dominate the major indices, rather than the rank-and-file.
We've had 6 consecutive down weeks in the S&P 500, so it's reasonable to allow for a further rebound. At the same time, market internals didn't act well on Friday's rally, and that raises the possibility of a fast failure. If that sounds like I'm completely agnostic about short term action, you're exactly right. And as you know, our current position has absolutely nothing to do with short-term forecasts. The Market Climate is on a Crash Warning, and for hedging purposes, that's literally all we need to know. I realize that I say that often, but it's important to underscore how unimportant short-term movements are to our investment stance. Even with the market technically "oversold", we wouldn't dare speculate against this Market Climate. So we'll let market action unfold. There is an unusually strong risk of a market crash ahead, but there's no reason why it has to occur without a further bounce. We just wouldn't bet on a bounce actually happening.
Friday Morning October 13, 2000 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. We've now seen 5 consecutive declines in the NYSE Composite, with significant downside leadership by new lows, and that condition has an odd tendency to shortly precede market crashes. Certainly, we wouldn't place much weight on that event alone, as we wouldn't place much weight on Peter Eliades "Sign of the Bear" alone. But currently, we have a Crash Warning and the most negative econometric projections in history from our own models, some of the most extreme sentiment readings in history, a proliferation of earnings warnings, a recession warning, and bearish signals from advisories we respect: from Richard Russell, a renewed Dow Theory bear market confirmation as well as a sell signal from his Primary Trend Index, and from Jim Stack, a bear market distribution signal as well as a head-and-shoulders break in his "Gorilla Index" of super-large cap stocks. None of this assures a market crash, but we don't like the probabilities.
Clearly, we reject the notion that Thursday's difficulties were much related to the tensions in the Middle East. In a bear market, the market focuses on bad news and shrugs off good news, while the opposite is true in bull markets. It's not worthwhile to focus on the myriad items of bad news. The main difficulties are clear: stocks are under pressure because valuations are extreme, capital spending and profit margins are likely to come under pressure, and market action has lost favorable trend uniformity. The Middle East tensions have driven oil prices higher, and that's the news of the day that investors are focusing on. But we expect the downside pressure on the market to become particularly strong if the U.S. dollar comes under pressure. That's likely to occur as soon as there is any palpable easing of those Middle East tensions, because the rush for a "safe haven" will diminish. So again, in a bear market, all news tends to be bad news.
The market is clearly "oversold", but as usual, we have absolutely nothing to say about short term direction. We would allow for a potentially sharp bounce, as often happens to relieve an oversold condition, but we would also allow for a continued plunge. As always, our only interest is in being positioned in line with the Market Climate, and that condition remains on a Crash Warning.
Thursday Morning October 12, 2000 : Special Hotline Update
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I'll keep this brief. The market continues to be hit by earnings disappointments, and some of the abrupt losses in individual stocks are stunning. With the glamour stocks still at breathtakingly high valuations, the decline we've seen so far is likely to pale in comparison to the subsequent retreat to more reasonable multiples. When trend uniformity was favorable, the impulse of investors to buy on dips was typically well rewarded. But that impulse here is likely to be disastrous, and I doubt that investors recognize that the underlying character of the market has shifted so profoundly. Shorter term, the market is clearly oversold, but as always, we have no interest in attempting to time short term action. Our models are collectively more negative than at any time in history, and the Market Climate is on a clear Crash Warning. The possibility of violent short-term rallies always exists during bear market declines, but our focus remains on maintaining a position in line with the prevailing Market Climate. One thing I am watching over the short term: if the NYSE Composite is down on Thursday, it will be the fifth consecutive decline on significant negative leadership (as measured by the number of new lows). Historically, that pattern has often preceded market crashes by about 2 weeks. That's not a signal that I would put much weight on by itself, but if it does occur, it would tend to underscore the generally negative tone from our formal models.
Sunday October 8, 2000 : Hotline Update
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Just a note - the latest issue of Hussman Investment Research and Insight is now available for download. The print version was mailed on Friday.
The Market Climate remains on a Crash Warning here. We have no changes in our recommended hedges here. At this point, all of our put options are in-the-money, and given the pronounced negative condition of both our Market Climate and econometric models, our intent is to allow those puts to become quite deep in-the-money before we shift strike prices. Of course, that also means we are not taking put profits off of the table here. The reason is that our models indicate a good chance of substantial downside follow through, and in that environment, you typically prefer to allow the put options to run further in-the-money.
We found the Presidential debates amusing, particularly the part about what to do with the "surplus" being run by the Federal Government. The fact is that the "surplus" is an illusion of accounting. When Social Security takes in more than it pays out, the balance gets spent by the Treasury, and the Treasury gives the Social Security Trust Fund some Treasury bonds and a kick in the pants. Ditto for the interest earned by the Social Security Trust Fund. That money from Social Security is considered part of the "revenue" that allows the government to report a surplus. But since it is really being taken from Social Security in return for Treasury bonds, the amount of government debt rises. The simple fact is that the Federal government has more debt outstanding now than last year, the year before, or any time in history. So when you watch the next debate, laugh with us. Or cry. But don't imagine that the Federal debt is actually going down.
We're coming out of a period of favorable month-end seasonality, though you wouldn't know it from last week. When the market can't sustain a rally during a seasonally favorable period, coming off of an oversold condition, it's in bad shape. And we're getting more signals from advisories that we respect. Most notably, Investech's "Gorilla Index" of super-large cap stocks has broken deeply out of a long head-and-shoulders top formation (www.investech.com), and Investech's Negative Leadership Composite has just shifted to a "bear market distribution" mode. Meanwhile, Richard Russell's "Big Money Breadth Index" has plunged to new lows (www.dowtheoryletters.com), while Russell's Primary Trend Index is close to delivering a sell signal on even a single additional day of market weakness. We review a number of other major signals in the latest issue of Hussman Investment Research & Insight. Most importantly, from our standpoint, our price-trend model has been negative since September 1st, and we moved to a Crash Warning in mid-September. As usual, we have zero interest in trying to predict or "time" this market over the short term. Our primary focus here is to be positioned in line with the prevailing Market Climate, and that position remains decidedly defensive.
Monday Morning October 2, 2000 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. In the past several weeks, our econometric models have been generating bearish readings that are almost bizarre. In fact, even if we disable all valuation criteria (which fits the past few years somewhat better), the models still generate a projection that the market will lose over a quarter of its value in the year ahead. In other words, the extreme projections are not uniquely due to valuation, but are supported by technical, monetary, economic and sentiment conditions. Leaving the valuation criteria in place, the forecasts are almost so negative as to defy credibility (except that the projected decline would barely take the market P/E ratio to its historical norm).
Now, as a practical matter, those econometric forecasts have absolutely zero effect on our Market Climate approach. The Market Climate does not forecast or project the market. Instead, it is a tool to identify current conditions, with no concern for whether or not those conditions will change next week, next month, or next year. We are strongly hedged here, not because we are forecasting a crash, but because market conditions have in fact already deteriorated now. It's a subtle distinction, but a crucial one. The Market Climate approach is a way of setting our positions on the basis of what the market is doing, not on the basis of what it should or is expected to be doing. If the market was to generate sufficient trend uniformity, we would quickly move to a still-hedged but generally constructive position, regardless of valuations or econometric forecasts. The fact that the econometric forecasts are so extremely negative simply adds to our comfort in being positioned as we are.
The main numbers of importance in the coming week will be the NAPM Index on Monday morning, and the labor report on Friday. Given the bounce in the Chicago NAPM index reported last week, we wouldn't expect the national NAPM to remain below 50. If it does, we'll have not only a Crash Warning, but a recession warning as well. We're getting signs of a significant slowdown in other survey figures, but that Chicago NAPM number suggests that we may very well defer a recession warning for a bit longer. As for Friday, a particularly slow rate of job creation would be an immediate economic concern. The markets might like such a figure in the short run, but in terms of measuring recession risk, a slow jobs number would be a negative development. In any event, the only consideration that is crucial here is to keep ourselves positioned in line with the current Market Climate, and on that basis, a strong hedge remains appropriate.
Friday September 29, 2000 : Special Hotline Update
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Just a note. The next update will be available on Monday morning, October 2nd, about 2 hours before the market opens. Also, in our more aggressive Managed Accounts, we moved on Wednesday from the OEX November 770 puts to the December 760 puts. In the event of a serious downturn, we would expect to let those 760 puts become significantly in-the-money before changing the position further.
The Market Climate remains on a Crash Warning. We've been anticipating a bounce for several days to relieve the oversold condition of the market, and Thursday fit the bill nicely. We continue to see the signs of capitulation that were discussed in the August issue of Hussman Investment Research & Insight. Value and income stocks have displayed good strength, with the Dow utility average hitting a new high on Thursday, while we're seeing increasing pressure on technology and high valuation sectors of the market.
The Nasdaq was certainly strong on Thursday, which we viewed as a typical oversold bounce, but no sooner did the market close than Apple Computer issued a warning about upcoming earnings. Apple, which closed at 53 1/2 in regular trading, was promply given the heave-ho in after-hours trading, losing 45% of its value, to 29 3/8. There wasn't quite as much contagion as we saw when Intel warned, so there's only about 1% downside pressure on the Nasdaq for Friday morning, based on after-hours trading. But it's clear to us that these announcements are part of the cyclical downturn in technology earnings which we continue to expect, and discussed at length in the August issue. Unlike Intel, which blamed an easy target - European sales - Apple was more forthright, indicating "a business slowdown in all geographics".
On the economic front, we'll be watching the NAPM indices closely on Monday. If the Purchasing Managers Index comes in below 50 again, we'll have all of the conditions which have historically been associated with the onset of a recession. An attentive client forwarded an article to me which indicates that historically, anytime the 3-month change in non-farm payrolls has been negative, the economy has been entering, or already in, a recession. That signal actually arrived last month, though the effects of census workers and the telecom strike suggest that more confirmation would be useful. A signal from our own criteria would be one such confirmation, particularly if payroll data are weak in the September report as well.
In short, we've seen the oversold bounce we've been anticipating. Favorable month-end seasonality runs through the better part of next week, so we're fairly agnostic about short-term action. What matters most, as usual, is that we are positioned in line with the prevailing Market Climate. On that front, a very defensive position remains appropriate.
Wednesday Morning September 27, 2000 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. The main news of the day is that our gold model has moved to a strong buy signal. We've got several conditions in place which have historically been very favorable for gold, and gold stocks are typically best bought on dips, rather than on rallies, moving average breakouts or the like. With the XAU currently below 49, prices are unusually depressed here. Last year, we published an analysis of conditions which favor gold stocks, and we've reprinted that in the Research & Insight section of our Fund website, www.hussman.net (click here). In general, the outlook for gold stocks is better when the NAPM Purchasing Managers Index is below 50, but even if it bounces back above that level in the next report, due October 2nd, the depressed level of gold prices is sufficiently compelling here. We're not advising large positions, because of the volatility of gold stocks, but some exposure in this area may currently be appropriate as part of a diversified portfolio.
The market took another hit on earnings warnings, this time from Eastman Kodak among others. At this point, the major indices are significantly oversold. We've noted that even in very negative market environments, the market often works off oversold conditions by rallying briefly before continuing lower. Market breadth, as measured by advances and declines, has been persistently negative day after day, so we would certainly allow for a short-term bounce. That said, our interest is never in trying to time short-term action, and is always in making sure that our position is consistent with the overall Market Climate. Given the very negative climate in effect here, a strongly defensive position remains appropriate.
Sunday September 24, 2000 : Hotline Update
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The Market Climate remains on a Crash Warning here. As I noted in the August newsletter, we've been expecting a significant increase in earnings warnings and disappointments over the next several months, and Friday gave us a fairly preliminary taste of that. After the initial panic on Intel's warning, tech investors evidently, and I believe mistakenly, concluded that the problem was isolated, and took the selloff as a buying opportunity. That's all well and good, until we get the next surprise, which isn't likely to be far off. In the meantime, we noted last week that a number of important trend breaks had occurred in the S&P and the Dow, and that such breaks are often followed by a bounce before continuing lower. As we've seen in the past, once the market gets significantly oversold, it often rallies briefly to work that off. So the early part of next week is a coin toss, and the sentiment that "nothing can keep this market down" may be worth at least a good rally on Monday. It's not something we would try to trade, but it's not something which would surprise us either.
Of course, we have no interest in trying to time short term market movements. Instead, our discipline requires us to position ourselves in line with the prevailing Market Climate, and that climate is currently on a Crash Warning. So whether or not the market has a brief bounce here is inconsequential to the main focus, which is that stocks are vulnerable to a Crash here. Keep in mind that by "Crash", we don't just mean a decline like we saw in the summer of 1998, or earlier this year in the Nasdaq. For our purposes, a Crash is best defined as a period of about 5 days in which the market drops by 20-30%. In both 1929 and 1987, the market was already down about 14% in the 10 weeks before those plunges occurred. Again, we have no interest in short term timing, but we do want to make it clear that "Crash" is not just a figure of speech.
In the coming bear market, there's only one group that we think will be devastated more than U.S. investors in Nasdaq stocks. And that's European investors in Nasdaq stocks. Over the coming year, we expect those investors to be hit by both losses in the stocks, and losses in the value of the U.S. dollar. Our econometric models are currently generating the most negative Nasdaq projections in their history, eclipsing previous bearish records in October 1969, October 1973, August 1987, and March 1998. Moreover, the euro is at about the same level as it was a few months ago, when our models indicated one of the deepest undervaluations of European currencies in post-war data. We've updated our chart of the euro's valuation, which is available in the "Research and Insight" section of our Fund website, www.hussman.net (click here). From a European investor's perspective, an advance in the euro is a decline in the value of the dollar. A probable decline in the Nasdaq, coupled with a drop in the U.S. dollar, has the potential to produce particularly gruesome returns to those investors.
In summary, the short-term outlook is clouded by an oversold condition, and the potential for a bounce to clear that condition. On the negative side, our models are on a clear Crash Warning, and we have no intent to trade out of defensive positions for any length of time under these conditions. The market remains vulnerable to further earnings warnings in the weeks ahead, further earnings disappointments as reports are released beginning in mid-October, and pressure on the U.S. dollar, which has the distinct potential to carry long-term bonds down with it. In all, this is an extremely unhealthy market environment, but one in which investors will take a slap in the face, a punch in the gut, and are still willing to come back for a kick in the pants.
Thursday Morning September 21, 2000 : Special Hotline Update
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We'll keep this brief. The Market Climate remains on a Crash Warning here. We've also got some important breakdowns in a number of trends. These include the rising trendlines in the S&P going back to last October, and the Dow going back to March. Jim Stack of Investech also keeps track of what he calls "Gorilla stocks", and his index appears close to breaking a head-and-shoulders top, as does Richard Russell's "Big Money Breadth Index", tracking the advance/decline action of super large-cap stocks. That said, trend breaks in an oversold market are often followed by knee-jerk rebounds before continuing lower, so we're very agnostic about short-term movement here. It's just as likely that we'll get a sharp bounce as it is that we'll get immediate downside follow-through, so this is a market where you position yourself properly and then let the market determine your next move. Again, the very short term outlook is a coin toss, and we're not really interested in timing short term movements. All we need to know is that given the current Market Climate, the proper position is highly defensive.
Tuesday Morning September 19, 2000 : Special Hotline Update
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The Market Climate remains on a Crash Warning. Monday's action was decisively negative, with declining issues leading advancers by a 3-to-1 margin on both the NYSE and the Nasdaq. The damage in the broad market was deep and abrupt, and its extent was understated by the less severe declines in the capitalization weighted indices. Moreover, new lows blew past new highs on both exchanges, with NYSE new lows topping 100 for the first time in weeks. Needless to say, Monday's action also satisfied the criteria to complete Peter Eliades' bear market signal, which we take as ominous in the context of our own Crash Warning.
To its credit, our main price trend model turned negative on September 1st at the peak of the recent market rally. On Friday of last week, our models moved to a fresh Crash Warning. And seemingly out of nowhere, we are seeing earnings warnings, oil prices threatening $40 a barrel, negative leadership from new lows, and a rare technical breadth signal which has invariably preceded deep market plunges. If the S&P closes September below 1500 and the NAPM Purchasing Managers Index stays below 50 for the month, we will also move to a recession warning. Now, that doesn't mean that prices have to continue lower immediately, but the next 6-8 weeks do appear particularly vulnerable given earnings reporting season and the probability of disappointing earnings guidance for the 4th quarter. We're treating this as a confirmed bear market, and at these valuations, one that could prove to be historic. Unless valuations or trend conditions shift measurably, the appropriate position is strongly defensive here.
Sunday September 17, 2000 : Hotline Update
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The Market Climate has shifted to a new Crash Warning this week. This indicates that market conditions are characterized by extreme overvaluation, unfavorable trend uniformity, and hostile yield trends. Last week's selloff in bonds and the S&P 500 combined were enough to tip the scales, given the prevailing trend of rising yields in Treasury bills, commercial paper, and corporate bonds. It is not impossible for the market to whipsaw back to a favorable yield environment, but our discipline requires us to respond to Market Climate shifts without second guessing them. And right now, the combination of valuations and trend conditions could not be worse. Last week, in our most aggressive Managed Accounts, we increased the number of our OEX November 770 puts to about 1 for every $25,000-30,000 of portfolio value.
As we've discussed extensively, corporate earnings are likely to come under significantly more pressure than is commonly expected, and we saw a glimpse of that last week. Even Oracle, which posted blowout earnings numbers, sold off sharply following the report, because revenues were softer than anticipated. We're not even in the heart of earnings warning season yet. Moreover, earnings reporting season really begins about mid-October, and even if Q3 figures are good, it's only then that we'll start seeing guidance for the 4th quarter. Needless to say, we're expecting a lot of downward pressure on earnings expectations over the next 6-8 weeks, and that concern is consistent with the fresh Crash Warning that we've received.
Another feature of market action that has our attention is the narrow range in the advance/decline ratio we've seen in recent weeks. Historically, major declines are often preceded by about a month of extreme complacency, where the daily advance/decline ratio fails to make a sharp move in either direction, followed by a sharp 2-3 day break that completes the bearish signal. In 1998, Peter Eliades wrote an article in Barron's detailing a measure of this, which he calls the "Sign of the Bear". He defines this as a period of 21 to 27 consecutive days where the advance/decline ratio is no greater than 1.95 and no lower than 0.65 on any day. The signal is complete if that flat period is followed by a 2-3 day market break where the average advance/decline ratio is below 0.75.
When Eliades wrote that Barron's article, there had only been 5 times in history that the signal had been triggered: August 1929 (-89% drop), December 1961 (-29% drop), January 1966 (-27% drop), October 1968 (-37% drop) and December 1972 (-47% drop).
Eliades wrote that the signal had been triggered on April 6 of 1998, which at the time was several weeks before the summer 1998 market plunge began. As it happened, the S&P subsequently lost close to 20%, while the Nasdaq and Russell 2000 were each whacked by over 30%.
On Friday of last week, after 23 consecutive days of narrow market breadth, the market finally generated an advance/decline ratio of 0.59. Accordingly, the market will generate Eliades' signal if the NYSE advance/decline ratio on Monday is below 0.90, or if the average ratio on Monday and Tuesday is 0.83 or less. Again, with our own models on a Crash Warning, it doesn't matter much to us whether this signal emerges. Nonetheless, it would be a particularly rare, and somewhat compelling confirmation of what our own models are telling us.
In short, the Market Climate has moved to a Crash Warning, which is consistent with a deteriorating earnings outlook and rare technical market action. While that warning is in place, we have to be at least temporarily braced for unusual trouble.
Sunday September 10, 2000 : Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable trends. The only thing missing from a Crash Warning is a deterioration in either long-term Treasury bonds or the S&P 500 Index itself. If we're going to get a crash signal quickly, it would probably come from the S&P 500 dropping to the 1400 level. That's only a few percent away from current levels. Such a decline would simultaneously trigger a recession warning. Neither signal is in hand yet, but we're watching closely.
With the Fed probably on hold through the election, there's a real complacency among investors regarding the risk of a market plunge here. I'm well aware of the seasonal pattern: historically, in election years, the market has been very stable between mid-summer and election day. But it's another thing all together to believe that this ensures stability. Pinning a bullish case on election year seasonality isn't analysis, it's superstition. With the S&P 500 at 29 times record earnings, our price-trend model on a sell signal, and the most extreme sentiment readings since 1987, we have the elements for a bear market well in place. We haven't seen these kinds of conditions in prior pre-election markets, so we're not about to dismiss the risk of a plunge on the basis of election-year seasonality.
We noted in the August issue that the AAII sentiment survey showed just 11.5% of investors bearish. Jim Stack of Investech notes that the past 10 weeks have seen 2 such readings below 12%, and the last time we saw that was in August 1987. Also, the CBOE volatility index has hardly budged from its lows, and complacency among options traders is also a typical occurrence at market peaks. Finally, we remain convinced that the earnings outlook will turn out to be much less favorable than is generally believed, if only because of the cyclicality of earnings in technology companies. The economy is clearly slowing on the production side, but cost pressures remain strong, leading us to expect continued inflation pressures. Slowing revenues and upward cost pressures just aren't conducive to good earnings reports, and we're just entering the earnings warning season.
All of which suggests continued caution. This has been a long and drawn-out top formation, and though complacency is tempting given the benign outlook on Fed policy, there is a long list of reasons to be defensive here.
Monday September 4, 2000 : Hotline Update
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The Market Climate is characterized by extremely unfavorable valuations and unfavorable trends. Our Price Trend model, which has been correctly favorable in recent weeks, has just signalled unfavorable trend uniformity. That may seem odd with the major indices strong, but this model also turned bearish the week of the 1987 top. Remember that the model measures internal uniformity, and it's there that the market is suddenly showing problems. Much of the internal weakness we're seeing is in economically sensitive areas: retail, transports, corporate bonds, and so forth. Together, we would take that as a signal that corporate earnings may soften much more ahead than is commonly expected. Indeed, the NAPM Purchasing Managers Index came in at a 49.5% reading for August, which now gives us 3 of the 4 signals which have invariably signalled an oncoming recession - the fourth signal being a decline in the S&P 500 below its level of 6 months earlier. That said, a recession signal is still not in, and we don't want to second-guess that.
At the same time, we would take the latest price trend sell as a bear market signal, and we do want to respond to it. It's not a Crash Warning, so we're not changing the number or strike prices of our OEX puts, but in our most aggressive Managed Accounts, we are immediately raising the strike of our Russell 2000 puts in order to defend our stock holdings against downside risk. In those Managed Accounts, we moved from the Russell 2000 December 490 puts to the December 520 puts on Friday afternoon. Those puts are still out-of-the-money. But with the trend model negative, we don't want to allow much of a decline before those puts offer a solid line of defense. The two questions to ask are "What is the opportunity?" and "What is threatened?". At this point, the main threat is to our stock holdings to the extent that our put options are out-of-the-money, and the main opportunity is the relatively cheap cost of rolling the Russell strikes higher in response. Again, because we do not yet have evidence of a Crash Warning, we don't want to take an aggressive position by raising the number or strike price of our OEX puts, but we do want to defend our stocks against a sustained market decline.
The bottom line, our best trend model has shifted from constructive to negative here, and we're taking that as a cue to defend our stock holdings against a likely bear market decline. Though we wouldn't rule it out, there's still not enough upward pressure on yields to anticipate a crash. For now, the market outlook is uniformly negative. With prices still elevated, this appears to be a particularly good opportunity to defend against downside risk.
Thursday Morning August 31, 2000 : Special Hotline Update
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Just a note - barring a 100 point Dow move on Thursday, the next update will be on Monday evening at 8 PM Pacific Time.
The Market Climate remains characterized by extremely unfavorable valuations and tenuously favorable trends. I say tenuously, because there is a good chance that our price trend model is moving to a sell signal here. We use weekly data because they give somewhat more reliable signals than daily data, but we've already seen enough deterioration in market internals to suggest a likely sell signal. We're seeing internal weakness in economically sensitive groups such as retail, transports, and lower rated corporate bonds, and the advance-decline action of operating companies (ignoring preferred stocks, convertibles, and the like) has also deteriorated. So even with the major indices appearing relatively strong, the internal action of the market is weakening. There's no chance of a Crash Warning here until long term interest rates move higher or the S&P 500 actually weakens below about the 1400 level, but already the weight of the evidence is shifting to the bearish side. We won't raise any strike prices until we get a signal in weekly data, and we would add modestly to the number of our put options only on a Crash Warning, so we're still in a "wait and see" position for a couple of days.
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The Hussman Strategic Growth Fund has the ability to hedge market risk by selling short major market indices in an amount up to, but not exceeding, the value of its stock holdings. The Fund also has the ability to leverage the amount of stock it controls to as much as 1 1/2 times the value of net assets, by investing a limited percentage of assets in call options. The Hussman Strategic Total Return Fund has the ability to hedge the interest rate risk of its portfolio in an amount up to, but not exceeding, the value of its fixed income holdings. The Fund also has the ability to increase the interest rate exposure of its portfolio through limited purchases of Treasury zero-coupon securities and STRIPS. The Fund may also invest up to 30% of assets in alternatives to the U.S. fixed income market, including foreign government bonds, utility stocks, and precious metals shares. The Market Climate is not a formula but a method of analysis. The term "Market Climate" and the graphics used to represent it are service marks of the Hussman Funds. The investment manager has sole discretion in the measurement and interpretation of market conditions. Except for articles hosted from the web domains hussman.net or hussmanfunds.com, linked articles do not necessarily reflect the investment position of the Funds. |