All contents copyright 2001, 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.comis appreciated.
Thursday Morning March 29, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable market action. Cisco closed at 15 3/4 today. Not that we'd buy it here. Wait till it reports an earnings loss. Oracle, Sun and EMC have also lost over half their value since our January issue, but there's still plenty of room between current levels and median price/revenue ratios, even using median bull market valuations. I have little doubt that the "Four horsemen of the Internet" will ultimately see their prices below 10 dollars a share, which is what happens when you split your stock incessantly during a market bubble.
All opinion, of course. Educated opinion, but unlike many investors, we don't need the market to prove us right in order to survive. We're defensive based on the objective evidence from our Market Climate approach, and we'll shift our market position when the Market Climate shifts. All of our commentary is meant simply to paint a picture consistent with what the analytical evidence suggests. But it's the objective evidence that drives our positions. The recent volatility has given us great opportunities to manage our stocks and hedges, and we constantly try to take those opportunities. For example, as far as is practical, we routinely try to sell lower-ranked holdings that have experienced short-term strength and replace them with higher-ranked candidates that have experienced short-term weakness. That simple "swap rule" is more effective in managing positions than any stop-loss rule we've tested (and we've tested a lot). I don't like to sell on declines, except in the occasional instance that we get a shift in Market Climate as the market is falling. When that Market Climate shifts, we try to pull the trigger immediately. Better to be wrong and take a whipsaw than to be right and not have acted on it. As I mentioned yesterday, investors had the opportunity to use the recent rally as a selling opportunity. I'm not convinced that many actually did so.
It almost makes me sad to watch CNBC these days. An obviously nervous woman called into one of the program segments, saying that she owned Cisco at an average cost of $55 and asked whether she should sell some of it. Forget the fact that I think tech is still overvalued. In my view, the correct answer is to ask how much of her portfolio Cisco represents. A small position could be viewed as a speculation. But to the extent that she wants to own the stock, yet could not financially tolerate a substantial further decline, the proper advice would be to sell down the position until she could ride the stock out through thick or thin. Instead, the guest analyst didn't even ask the size of the position. He simply suggested buying more, to decrease her average cost. I would have toppled out of my chair, but luckily, the fist I had slammed into the TV set broke my fall.
Another comment on CNBC this morning was that Wednesday's decline had retraced about 50% of the recent rally, so on a technical basis, the market was free to advance again. Look. The recent rally was the retracement. On a technical basis, the market is now free to decline. Wednesday's decline wasn't a retracement of a prevailing uptrend. More likely, it was a continuation of the prevailing downtrend.
In any event, time will tell. Maybe the bulls will be right, we'll take a whipsaw, and we'll end back in a constructive position. Maybe our expectation of a profit collapse and recession will be accurate, and the market will plunge another 30-40%. Our current investment position relies on neither outcome. The nice thing about writing these updates is that I don't have to be right. And as long as your positions are appropriate to your risk tolerance, you don't even have to agree with me. I realize that many investors read these updates who are not actually invested in our approach. If you're still holding a lot of stock here, and you can ride out the position if you're wrong (meaning a further market decline of 30-40%), then good luck to you. I'm concerned for you, but I wish you well. Nobody should be nervous here except those investors who need the market to prove them right in order to survive. Unfortunately, a terribly large number of investors are still in that camp.
Wednesday Morning March 28, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable trends. Over the past three days, we've seen a typical bear market rally - fast and furious, expected, and most likely, prone to failure. When we're defensively hedged as we are now, our position tends to do best when the broad market is strong, and we can pull back during rallies where the broad market trails the major indices. Sustained rallies and new bull markets nearly always show broad strength early on (often with advancers outpacing decliners by 10-to-1), which is one of the factors that can move our trend models to a positive condition. The failure of the market to show broad strength in the past few days suggests that this rally really is nothing more than short-covering and a knee-jerk buy-the-dip response in the glamour stocks. Despite Tuesday's huge move in the Dow, advancers outpaced decliners by less than 2-to-1 on the NYSE, and only about 5-to-4 on the Nasdaq. Breadth fell far short of what would be expected on a move of this size. While we can take a little bit of pressure while they last, such rallies should always be expected to punctuate a bear market downtrend.
On Tuesday, the Conference Board reported that March Consumer Confidence bounced to 117. The media preferred the verb "soared." As in, "The dead cat soared several inches into the air after hitting the pavement." In reality, the March figure was only slightly above January's awful figure and far below last year's peak. The "current situation" figures hardly budged. Moreover in order to be counted, the surveys had to be received by the Conference Board on March 21st, so it's safe to say that the figures did not reflect any change in consumer attitudes in the face of the market's latest swan-dive. Still, for a market crying for hope, the Consumer Confidence figures were hope. And that hope gave the market a chance to clear its oversold condition with a rally. I continue to view the latest rally as a good selling opportunity. Unfortunately, many investors refuse to take such opportunities. Rallies bring hope. And investors who have been well conditioned to buy on dips during the bull market don't realize that the rule during bear markets is to sell on rallies.
For now, the Market Climate holds us in a strongly defensive position. As always, if the Market Climate shifts to a more constructive trend condition, my views about the market's overvaluation and the economy's vulnerability will not prevent us from moving back to a constructive position. My views are opinions. Educated, I think, but opinions nonetheless. And we don't manage money on opinion. If the necessary objective evidence shows an improvement in market internals, we will act on it. For now, we're positioned in alignment with the existing Market Climate - and strongly defensive.
Tuesday Morning March 27, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable trends. Our investment position remains strongly defensive.
We would certainly allow for the possibility of a further advance to relieve the oversold condition of the market, but even the advance we've seen should be treated as a selling opportunity. As usual, I have no opinion about short-term direction. On the favorable side, the market is well below short and long-term moving averages, so there's room to bounce even in the context of an ongoing bear market. On the unfavorable side, the next couple of months are the most likely point that we'll see unequivocal evidence of a recession. We've just entered heavy earnings warning season, and the actual releases begin in mid-April. Also, it's typical for job creation to turn negative on a quarterly basis early into a recession, so there is a good chance of negative new job figures in the next few employment reports. So the next couple of months are the most likely point that reality will diverge sharply from the still-upbeat expectations of investors. And that surprise is likely to lead prices much lower.
Bottom line, anything is possible in the short run, though we would take even the current rally as an opportunity to execute any desired sales. Looking even a couple of months out, I expect further market damage. If the Market Climate shifts, of course, we'll shift our position as well. But here and now, all of the most reliable evidence suggests an ongoing bear market and an emerging recession.
Sunday March 25, 2001 : Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable trends. Believe me, I would love to be the guy telling investors to hold on and that the market was near a bottom - the guy to offer hope, and to be right about it. But I'm not that guy, because anybody offering that sort of hope is just not likely to be right about it.
Frankly, I've found (sometimes the hard way) that it's usually best to give up "hope". By that I mean that anytime you find yourself "hoping" in regard to an investment position, you're probably positioned against the trend, and there's a good chance that you're taking more risk than you will ultimately be able to tolerate. It's best to avoid hope, and instead to focus on strategy, discipline, and a realistic assessment of both market risk and your tolerance for it. If you find yourself in a position that has the potential to generate an unacceptable loss, you should immediately shut down at least 40% of what is excessive and try to work out of the rest at the earliest opportunity. It doesn't matter who thinks the investment will go up, or who thinks it will go down. Opinion is useless and irrelevant when you're carrying a position where one of the potential outcomes is an unacceptable loss. If your position is "heads I win, tails I lose", fine. But if it's ever "heads I win, tails I'm wiped out", then shut down the excess risk immediately. Don't be one of these investors who takes every bear market rally as a sign of "hope", and finally sells at the bottom when the losses have become intolerable. In my view, that bottom is still nowhere in sight. More on that below.
Similarly, I've learned that in order to manage market risk, what is required is not an accurate assessment of where stocks will be tomorrow, but simply an accurate assessment of what the Market Climate is today. Both favorable valuations and favorable trend uniformity tend to either accompany or lead major moves. So by attending to the prevailing Market Climate, a lot of the secong guessing and forecasting is taken out of the investing process. The reason I believe that our Market Climate approach is sufficient in this regard, is that the dimensions we consider are directly related to total return, by definition. By definition, stocks can only provide gains through dividends or through capital gains. When stocks are undervalued, current dividend yields are usually attractive, and there is significant room for future capital gains. When trend uniformity is positive, the market is in a condition which favors current capital gains. The best of both worlds is when both are true, but so long as one of those factors - valuation or trend uniformity - is positive, then some component of "total return" is favorable. Not surprisingly, the market has historically generated attractive returns on average when at least one dimension of the Market Climate has been positive. If you're a long term investor, and you can, on average, participate in periods of attractive returns and, on average, sidestep major losses, that's all you need. All that's necessary is to accurately gauge the Market Climate in effect, and to hold a position consistent with that Climate until a shift takes place.
There are three reasons that I don't believe that this bear market is near a bottom. First valuation. The S&P 500, after all of it's recent pain, still trades over 20 times record earnings. That's a higher level than at the 1929, 1972 and 1987 peaks. I'm not saying that the market can't enjoy a good bear market rally. Those should always be considered as possible. But in terms of an important bottom, you could only get one at these valuations if the market was still in a bubble mentality. In 1998, that was true. That is no longer the case. And for those investors hoping for the bubble to come back, one thing is clear from the history, all through time and around the globe. Bubbles are a lot like Humpty Dumpty.
Second, trend uniformity. In general, the final phase of a bear market decline is accompanied by "positive divergences". In effect, there is a tendency for various components of our trend models to firm, or even buck the downtrend, even before the market bottoms. Currently, exactly the reverse is true, last week, we continued to see important market sectors breaking into new downtrends. Financial stocks have been a key example, but there are a number of others. It's not impossible for the market to bottom when market internals are weakening, but it's certainly not typical, and at these valuations, with trend uniformity negative overall, the benefit of the doubt goes to the bear. That's particularly true because I expect earnings warnings in the next several weeks to be utterly ruthless.
Finally, we've repeatedly noted that bear market lows tend to occur in the midst of well recognized recessions. The key phrase here is well recognized. We've seen a number of analysts racing to call a bottom because of bearish covers on popular news magazines. But look closer. Time magazine's cover has the headline, "Looking Beyond The Bear". That line alone is enough to indicate a lack of concern. Indeed, the bear in the picture is nicely dressed and carrying a bag, as if it's just visiting Grandma for a few weeks. But the subhead goes further, saying "Yes, it's scary out there, but recession isn't a sure thing." U.S. News & World Report's cover says "Bear Trap", but the story inside is headlined "Young or old, just sit tight." Newsweek's cover asks "How Scared Should You Be?" But inside, the subhead is "The markets may seem hazardous to your health, but for long-term investors, the diagnosis is actually much improved."
In short, the spectre of recession is anything but well recognized, and the news coverage certainly contains none of the dejection seen at previous bear market lows. At those lows, the tenor of news reports has always been something to the effect that "conditions are bad, expected to get worse, and there is no end in sight." When the news reports are uncontroversial in reporting that the U.S. is in recession, when they suggest that there is worse news ahead, and when they indicate that nothing seems to be helping, that is when the market is more likely to register its low. We just don't see it here.
As I always stress, my hope is that this commentary and analysis is useful. But in the end, it's filler. What matters is this. The Market Climate remains unfavorable, and we remain defensively positioned.
Thursday Morning March 22, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable market action. I am seeing a lot of lip-service about the pain of investors and the brutality of this market slide, but every news report is accompanied by advice to hold on, ride it out, and to think of this decline as a great opportunity. Over the short term, bear markets can produce fast and furious rallies, and that sort of action should be expected from time to time. The crucial factor is that you view those rallies not as "hope" to keep you in, but as gifts to get you out. I continue to believe that the opportunities are on the sell side. During a bear market, you sell on rallies, and you don't aggressively buy or cover short sales on declines, and this remains a bear market poised to get much worse. If this is the final low, our trend models will dictate a shift in Market Climate soon enough. Until that point, we will remain strongly defensive.
Please keep in mind that the Dow has not even declined 20% from its highs. Frankly, I find the perpetual hope offered up by analysts and the media to be both mindless and superstitious. Unless there is an analytical reason to believe that prices will advance, there is no point in hoping for it. And there are only two ways that prices will advance: either earnings advance or the price/earnings ratio advances.
First, earnings. All of the analytical evidence suggests that earnings are likely to decline sharply, particularly given the well-established and powerful effect of slowing economic growth on profit margins. Over the past 3 months, consumer confidence has plunged, which has a strong correlation with profit margins. But since profits are quarterly, we will not actually see the corresponding profits until earnings are released beginning about mid-April. The final week of a quarter is typically a heavy pre-announcement time, so expect the earnings warnings to explode here.
Second the price/earnings ratio. It's still above 20 on the S&P 500! That's the P/E that we saw at the 1929, 1972 and 1987 peaks. The assertion that stocks are cheap just because they've declined is terribly dangerous when stocks are declining from an extremely overvalued position. If you're jumping out of a plane, the distance you have left to fall has nothing to do with how far you have already plunged. The only thing that matters is where the ground is, and at a P/E of 20, the broad market is nowhere near the ground.
Again, expect powerful rallies to punctuate this bear market. Recognize that if a bottom is near at hand, our trend models are likely to pick up any new bull trend early enough to participate in the major trend. But right now, the major trend is down, and there is no fundamental support for the market. The historical median P/E for the S&P 500 is 14 times record earnings. Bear markets typically end at a P/E ratio of about 11. The brutal ones such as 1973-74 and 1982 have taken the P/E below 7. We're still above 20, which is generally associated with tops, not bottoms.
Again, again, again. If you know you're taking more risk than is appropriate for your financial goals, and if your financial security could not tolerate a substantial and prolonged market decline, then do something. I always advise selling off a bit less than half of an undesirable position immediately, and then work it down from there. Even if you're a "buy and hold" investor, if your long term strategy is to always hold 60% of your funds in stocks, but you've actually let it creep up to 90%, that extra 30% is not appropriate. Don't wait for a rally. Just shut down 12-15% of the portfolio now, and then try to use rallies to whittle down the position until you're actually at your target of 60% in stocks. This is not about market timing. It's about risk management.
Stated simply, risk management requires immediate action. If you know you're not holding an appropriate position, the worst thing to do is to hope it will turn around. Because I guarantee, the next rally will make you comfortable again. Comfortable enough to do nothing. And that sets you up to lose even more when the position drops to a new low. This is how bear markets inflict their damage - by producing brief and powerful rallies that keep investors hoping enough to hold on, and to allow the bear to rip into their wealth again. If you wonder how investors could have held Cisco on margin from 82 to 19, that's how it happens.
The bottom line, expect, but do not rely, on the possibility of brief and strong rallies to punctuate this bear market. The most important thing is not where prices are headed, but whether you are taking an appropriate level of risk. If you're taking too much, direction doesn't matter. Shut down the excess risk. Doing that doesn't require you to make price forecasts.
When you hear analysts with their hopeful talk of "riding out the storm", "capitulation", "bottoming", and "bargain prices", just ask which are they expecting: growth in earnings, or growth in P/E ratios. If they can't answer why either should occur, they have no business suggesting that prices cannot go lower. Value is determined by the relationship between prices and fundamentals. We can always find individual stocks we like, so long as we can hedge away the market risk if we choose. But on the major indices, we're nowhere close to a bargain. The Market Climate remains strongly defensive, and that, not my opinion or outlook, is what determines our position. As always, every other comment here is filler.
Wednesday Morning March 21, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable market action, which places us in a strongly hedged position. As usual, I have no opinion regarding short-term market action, and knowledge of the current Market Climate is really all we need in order to position ourselves appropriately. That said, I do view stocks as being in an ongoing bear market, and have unfortunately none of the glib optimism about a bottom that the analysts on CNBC keep expressing.
An attractive feature of our Market Climate approach is that we don't need to make forecasts to position ourselves properly. That allows us to avoid the need to make bold forecasts about what lies ahead. In one respect, though, that's a problem. As much as I've written about the market, I continue to receive questions from people who are over their heads in stocks and paralyzed from doing anything, thinking that it's bad investing to sell stocks out of their portfolio. The truth, however, is that for most investors, it was bad investing to get into stocks at anything close to current valuations, and at this point, the job is to minimize the damage from those bad decisions.
As I've said before, if you are ever convinced that an investment position is not appropriate to your goals or risk tolerance, the proper approach is to immediately liquidate 40% of the position, lock in an acceptable level of regret, and then work out of the remainder, taking as many opportunities to sell on rallies as possible. I don't really like to make forecasts, but if it will place the current market into better perspective, I'll share one view: I expect that the market still has a loss of nearly 40% ahead. That sort of decline would not even take the dividend yield on the S&P 500 to 3%, nor would it take the P/E ratio below the historical median. Investors are confused here, because they see stocks declining, and they keep saying "This must be enough". Maybe. But on a historical basis, there is zero evidence of it.
On Tuesday, the Dow broke 9796.03, making this the first time since 1982 that the Dow has even broken the low of the previous year. It's just fascinating to me that the news coverage treats this as a panic already. We are so far above the levels where stocks could ultimately trade. At the same time, I still see no evidence that the average investor has done anything to reduce stock holdings or risk levels. Investors certainly want the decline to end, but they continue to want that without the necessity of doing anything. As I've said, bear markets don't end when investors are still holding on, asking "How much lower can it go?", or "No, really, how much lower can it go?" Bear markets end when investors are screaming "Sweet Mother of Joseph! How much lower can it go?" and "I don't care, just get me out!"
The Fed did what it should have done on Tuesday, cutting rates by 50 basis points. In doing so, Greenspan implicitly made a statement that he would not protect investors from the consequences of bad investment decisions. Greenspan is well aware of what economists call "moral hazard" - the tendency to engage in risky behavior when one is protected from the consequences. While the market certainly didn't like losing the so-called "Greenspan put", the Fed's willingness to ignore demands for 75 basis points showed that the FOMC understands the long-term risk of protecting investors from themselves. The Fed's job is not to provide bull markets, and it can't force banks to make loans or borrowers to demand them. The Fed can provide enough liquidity so that banks are able to make appropriate loans. And the Fed did its job again today. In my view, the only mistake the Fed has made in recent years was to ease monetary policy too far after the Asian crisis in 1998, which set up the bubble that is now collapsing on itself.
The bottom line, this is a bear market, and as we approach the end of the first quarter, profit warnings are about to accelerate. I view the current environment as extremely risky, because while the hope of Fed easing is now behind us for a while, the likelihood of collapsing profit reports is directly ahead. As usual, the Market Climate is all we really need to analyze, and we're appropriately defensive here.
Tuesday Morning March 20, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable trends. That is not a forecast but an identification of the current Climate. As much as I tend to write on the subject of the economy and the possible market outlook, it's important to remember that all that discussion is "background." What determines our willingness to take market risk is not what we think will happen tomorrow, but the Market Climate that we identify today, based on objective evidence that is already available. If the Climate shifts, we'll shift our position, and no forecasting is required. There is a great advantage in that discipline, because it avoids the need to constantly make second-guesses based on every piece of data that comes in. For our part, we position ourselves in line with the prevailing Market Climate. For now, we're defensive.
We expected a bounce above Dow 10,000, and Monday was a good start. There's no particular reason that a rally has to fail immediately, but with Monday's bounce satisfying the need for a "knee-jerk" rally, I have moved back to having no view about near-term action. On the positive side, the market is oversold, though bear markets can sustain that condition for a great while. On the negative side, we're in a well-defined bear market, with no reason to expect that it is even near completion. Interest rates on both bonds and Treasury bills rose on Monday, and there's not much assurance from the futures markets that the Fed will move more than 50 basis points. That would be a clear disappointment to the stock market. All of the proclamations by Fed governors over the past several weeks were along the lines of the economy not being in particularly bad shape. So although we wouldn't rule out the possibility of a more aggressive move, 50 basis points is still the most probable outcome.
Sunday March 18, 2001 : Hotline Update
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The Market Climate is characterized by extremely unfavorable valuations and unfavorable trends. That places us in a strongly defensive position here. It's interesting to hear all the talk about stocks bottoming here, given that the P/E ratio of the S&P 500 is still above the multiple of 20 times record earnings that accompanied the 1929, 1972 and 1987 pre-crash peaks. Meanwhile, our main trend model has formally moved to a negative posture, suggesting, if anything, that this bear market is about to take a turn for the worse. As I noted last week, if this is indeed a bottom, I would expect our trend model would move to a favorable condition relatively quickly, at which point we would take a brief loss on our hedges and move back to a constructive position. I doubt that such an outcome will occur.
You should fully allow for a move back above 10,000 on the Dow, if for no other reason than knee-jerk buying. At the same time, you should not count on such a move. As Richard Russell of Dow Theory Letters points out, it's striking that investors could believe that this bear market is nearly over when the Dow has not even broken the low of last year. That low was set on March 7, 2000 at 9796.03. Indeed, the Dow has gone since 1982 without once breaking the prior year's low. As Russell notes, a close below Dow 9796.03 would usher in a market environment that most investors have no experience to deal with.
ABC News This Week devoted much of the show to the market decline, and promised an "exclusive interview with Warren Buffett". When the time came to introduce it, Cokie Roberts noted, "perhaps no one is more qualified to discuss the recent action of the stock market than Warren Buffett. Of course, he realizes that his comments can move the market, so he won't be talking about it. Instead, we talked with him about campaign finance reform..." That in itself was enough to know exactly what Buffett thinks about the market. Cokie might as well have said, "Of course, Mr. Buffett notes that the Romans used to toss the bearer of bad news to the lions..."
In case you are interested in Buffett's current views, you can read his February 28th letter to Berkshire Hathaway shareholders at berkshirehathaway.com. His letter includes comments like: "We remain awash in liquid assets", "The long-term prospect for equities in general is far from exciting", and "There are no 'bargains' among our current holdings." He also notes "acquisitions will at best provide us only reasonable returns. Really juicy results from negotiated deals can be anticipated only when capital markets are severely constrained and the whole business world is pessimistic. We are 180 degrees from that point", and finally, "I would wager you a very significant sum that fewer than 10 of the 200 most profitable companies in 2000 will attain 15% annual growth in earnings-per-share over the next 20 years." You'll also find the same distinction between investment and speculation that we drew in our February 26th letter, as well as an emphasis on properly discounted cash flows. So it's nice to see our views corroborated by somebody like Buffett. It's safe to say that he would have had nothing comforting to offer investors had he discussed the market on Sunday morning's show.
In short, we were largely hedged even prior to last week, but the Market Climate formally shifted into a fully defensive mode on Friday. We can't rule out a whipsaw, and we would certainly allow for a brief move back above Dow 10,000. But I continue to view stocks as being in a bear market. With the Market Climate now objectively negative, the likelihood is that market action is about to become worse rather than better. As a sidenote, the Fed is certain to cut rates this week. 50 basis points are probable, with an outside chance of 75 basis points. Anything may be good for a bounce to relieve the current oversold condition, but this market should be treated strictly as a bear market. As I've noted before, during bull markets, you buy the dips, but you usually shouldn't attempt to sell the rallies. In a bear market, you sell the rallies, but you usually shouldn't attempt to buy the dips.
Thursday Morning March 15, 2001 : Special Hotline Update
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Techs and financials leading the market lower. Who could have possibly guessed?
The Market Climate is characterized by extremely unfavorable valuations and unfavorable market action. On Tuesday morning, market internals deteriorated enough to ensure a negative trend condition from our primary trend model. We were largely hedged even before this signal, but had given the market the benefit of the doubt before establishing a more complete hedge. Even though our main model is weekly, the fact that a sell signal was ensured in the weekly data meant that immediate action was appropriate. The additional hedging helped us to escape the effects of Wednesday's plunge. We also made modest additions to speculative put option positions in our most aggressive managed accounts.
Keep in mind that because we are long stocks and short indices, yet hold very little in the technology or financial sectors, we have a tendency to see very strong gains on days when both technology and financials are weak, and can endure pullbacks during tech-centered rallies such as Tuesday, when tech drives the major indices higher without participation from the broad market. As the valuation and market action of techs and financials improve, we may find ourselves adding positions in this area, but we have not yet seen sufficient improvement. As usual, our allocation to various market sectors is driven by a very disciplined strategy, so our current underweighting of tech and financials is very intentional.
The talk on CNBC is of "capitulation" and "bottoming". Maybe. If this is a bottom, we'll get a quick whipsaw in our trend models, move back to a constructive position, and that will be that. We follow our discipline. Period. That said, I have zero faith in the possibility that this bear market is ending. As Al Pacino's character remarked in Scent of a Woman, "Am I finished? Nah, I'm just gettin' warmed up!" Again, if this is a capitulation, we'll know quickly enough. We're willing to accept a whipsaw in order to defend ourselves against major losses, but there's nothing in our trend models that would prevent us from moving back to a constructive position if the market was to launch a new bull leg.
The S&P 500 is still priced at over 21 times record earnings. Keep in mind that the 1929 peak, the 1972 peak (prior to the 73-74 collapse) and the 1987 peak all occurred no higher than 20 times record earnings. So it's safe to say that the market decline from this point forward will probably be no worse than 1929, 1973-74 and 1987. I suspect that this isn't of much comfort.
I realize that the entire tenor of market commentary here is "A good investor rides out the storms. Hold for the long term and you'll be fine." The problem is that market participants stopped being investors when they accepted the notion that stocks are always attractive regardless of the price paid for them. And the simple fact is that stocks are still priced to deliver very poor long-term returns. Look, over the past century, as well as the past 10 and 20 years, S&P 500 earnings have remained in a well defined growth channel of less than 6% annual growth when measured from peak-to-peak. It's reasonable to assume that this will continue. So if the P/E ratio on the S&P stays constant at current levels, we're looking at 6% long term price growth as well. Kick in a 1.2% dividend yield, and you're up to a long-term return on stocks of 7.2% IF the P/E on the S&P 500 stays above 21 forever. But let it go back to its historical median of 14, or the typical bear-market low of 11, or the 1974 and 1982 troughs of 7 times earnings, and stocks are going to return a whole lot less than 7.2%, and probably less than T-bills over the next decade. Individuals holding a heavy position in stocks here may be short-term speculators, but they are most definitely not investors in any meaningful sense of the word.
We're in good company with that assessment. As Warren Buffett states in his February 28th letter to Berkshire Hathaway shareholders, "Another negative (which has persisted for several years) is that we see our equity portfolio as only mildly attractive. We own stocks of some excellent businesses, but most of our holdings are fully priced and are unlikely to deliver more than moderate returns in the future. We’re not alone in facing this problem: The long-term prospect for equities in general is far from exciting."
So again, if we're wrong, and this is a capitulation, we'll take a whipsaw in our trend models and find ourselves back on the constructive side fairly soon. But if, as I expect, corporate profits are likely to crater, and several major tech leaders are about to generate not just earnings shortfalls but outright losses, I doubt that market participants will remain willing to attach such high P/E ratios on the market.
As I've mentioned before, anytime you have a position that you know is beyond your true tolerance for risk, the proper response is to shut down 40% of the position immediately. Lock in an acceptable level of regret. If the market moves higher, you'll regret you sold 40%, but you still have the majority of your position, and if you're still uncomfortable you can work it down from there. If the market moves lower, you'll regret not having sold more, but at least you've limited your losses, and you can work down the rest of your position until it is consistent with your ability and willingness to bear long-term risk. Though prices have moved down rapidly, I have not seen much evidence that investors have actually reduced their exposure. Yes, they feel pain, but they're hoping that the pain will end without the necessity of doing anything. Again, the real problem is that they have no concept of value. They're looking at how far prices have declined, and have decided that this must be enough. But unless they understand value, they do not realize how much lower prices would have to decline just to attain median historical valuations.
The bottom line, we're on a fully defensive signal now. Both valuations and trend conditions are negative. If this is a bottom, our trend models will bounce back, we'll take a quick whipsaw and move back to a constructive position. I doubt that this will occur. With the Dow still near 10,000, P/E ratios still extreme by historical measures, and corporate earnings likely to register a stunning shortfall, here is an important reminder. Value is not measured by how far prices have declined, but by the relationship between prices and properly discounted cash flows. On that basis, the market could have a deep follow-through ahead. We'll take our signals as they come. For now, we're fully defensive.
Tuesday Morning March 13, 2001 : Special Hotline Update
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The Market Climate is characterized by extremely unfavorable valuations and essentially neutral trends. As our trend model is driven primarily by weekly data, we do not have a formal negative trend signal at present. Our current position is so slightly constructive that we may as well call it neutral for all practical purposes. Since we are fully invested in favored stocks and have largely avoided high P/E technology and financial stocks, even a partial hedge allows us to enjoy gains when those high P/E stocks plunge. The reason is that the tech selloff drives the indices lower without affecting our favored stocks as strongly, so we gain on our hedges without losing as much on the stock side. As always, our allocation to various industries is driven by objective data, not opinion. So our underweighting of tech and financials here is strategic and very intentional.
Flip a coin, and you'll have my expectation for short-term market action. The market is clearly oversold and the Fed is certain to cut rates next week, but earnings warnings are likely to persist and even worsen. So I have no expectation about short-term direction. Of course, our strategy requires no forecasting at all - it is sufficient simply to identify the Market Climate in effect at any given time. As for my personal view, I believe that stocks are fairly early in a bear market.
Investors evidently want to believe that now that the S&P has suffered a 20% decline, we can call this a bear market and promptly get on with a new bull market. But the S&P still trades at 23 times record earnings. The Dow is still well over 10,000. My personal view is that by the time this bear market is over, both the Dow and S&P will have declined by roughly 40% from current levels. That would take stocks to median historical valuations, from which point investors could reasonably expect long-term returns of about 10%. Currently, stocks are priced to deliver less than Treasury bills over the coming decade.
So regardless of short-term action, all of the evidence suggests that stocks are relatively early into a bear market. Indeed, if and when our trend models register a formal sell signal, I would expect price action to turn decidedly more hostile. Again, the Dow is still over 10,000, and that's one of the reasons that investors have been so complacent even in the face of a ravaged Nasdaq. I expect that the bear market will be more fully recognized, and acted upon, as the blue chip indices begin to follow the Nasdaq more closely. Given our expectation for collapsing profit margins and earnings, that may not be far off.
That said, my opinions or expectations do not drive our investment position. Our profitability does not depend on the economy being in recession or the blue chip averages indeed falling another 40%. We are currently defensive based on objective valuation and trend conditions, and our position will change as that objective evidence changes, regardless of personal opinions. That's our definition of strategy and discipline, and it is what separates our approach from those that act based on analyst ratings, hunches, opinions, greed, fear, and hope. If our trend models formally move to a negative condition, we will fully hedge our portfolios, and establish bearish positions in our most aggressive managed accounts. For now, we're essentially neutral.
Sunday March 11, 2001 : Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and tenuously favorable trends. I continue to view stocks as being in a bear market, and the economy as being in a recession. At the same time, it is important to understand that these views have very little to do with our current investment position. The valuation and trend action of individual stocks determines the particular investments that we hold, and the objective valuation and trend condition of the market determines the extent to which we accept or hedge away market risk. My comments here are offered as a way of placing the data in context, to interpret market events, and to offer some expectation of what may lie ahead. I hope that those comments are useful. But again, our investment position does not rely on forecasts, opinions, or scenarios. We let the market dictate our position to us through valuation and trend action. We don't listen to a single analyst recommendation, rumor or "hot tip" - every stock we hold "comes to us" by exhibiting specific characteristics. Our sell decisions are equally objective. In short, our investment stance is based on what is, not on our views (or anybody else's) about what might be or should be.
That said, Friday's employment report seemed to shift investors away from the belief that the U.S. is at risk of a recession. In my view, that conclusion is terribly incorrect. The February employment report did show much stronger-than-expected overall job creation, though manufacturing employment continued to plunge. The problem is that even if we take the February number at face value, total non-farm payroll has grown by less than 1/2% over the past 6 months, a rate that has never been seen outside of recessions. Even stripping out manufacturing, total non-farm, non-manufacturing employment has grown by less than 1% over the past 6 months, again, never seen outside of recessions. The NAPM employment index has plunged to 37.2, indicating a strong contraction in planned hiring, once again, a level never seen outside of recessions. Aggregate hours worked have also declined, which is always accompanied by sharp economic slowdowns, nearly always recessions.
Moreover, the January and February employment numbers look, for lack of a better word, fishy. Indeed, if you correlate total employment with factors such as the NAPM indices and hours-worked, the non-farm employment figure has shot in the wrong direction by about 500,000 workers over the past two months. That's a large and unusual error, and because the employment figures can be subject to large revisions, I just don't trust these ones. I doubt that the Fed will either, which means that a rate cut on March 20th is still nearly assured. Again, though, even taken at face value, the February numbers already spell recession. As you know, I hope that I am wrong, and that a recession can be avoided. Nothing in our investment stance requires a recession. I just expect one.
In the meantime, earnings and profit margins are likely to continue lower. Cisco is evidently feeling cost pressures, in view of its surprising layoff announcement late Friday. For many companies, a large portion of quarterly revenues are always booked in the last few weeks of the quarter, as sales representatives aggressively work to close sales and make their quota. So it's only now that a lot of these companies will even realize that they are likely to miss revenue and earnings estimates. I expect that to translate into a relentless string of warnings in the next few weeks.
Finally, most of the real damage of this bear market has been focused on the technology sector. It's important to remember, though, that the S&P 500 still trades at nearly 25 times record earnings, versus a historical norm of close to half that level. So far, large "Old Economy" stocks have been the beneficiaries of selling in the "New Economy" sectors, because investors have had the impulse to rotate rather than abandon stocks. In view of earnings pressure here, that impulse is likely to change. For that reason, I expect that the Dow and S&P will begin to participate more fully in this bear market in the months ahead. The Nasdaq has already plunged by 60%, but investors have really not retreated. I do expect that sort of retreat ahead.
Even in view of current conditions, I constantly hear investors saying "I have to be in stocks! Where am I going to put my money? T-bills?". There are two answers to this. First, it is possible to invest for growth and still defend against capital loss in unfavorable markets, which is what we try to accomplish. Second, the fact is that if earnings continue to grow within their well-defined channel of the last 1, 2, 5, and 10 decades, stocks are priced to deliver poor long-term returns. That's unfortunate, but the recent decades of outsized gains have brought us to this point. You can't force stocks to deliver good returns just because you need those returns. And there's no sense getting all upset over a fact. Regardless of short-term direction, I expect a buy-and-hold approach on the S&P 500 to underperform Treasury bills over the next decade. And for buy-and-hold investors who need long returns for their financial security, that's just unfortunate. That's really all you can say.
Again, our investment position is currently well-hedged, and so slightly constructive that we may as well call it neutral. That position is based on current conditions, not my views or expectations. But given those views, I am certainly comfortable with a defensive posture.
Friday Morning March 9, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and tenuously favorable trends. Given the employment report on Friday, my inclination is to expect a good bounce, which we would expect to use as an opportunity to increase our hedges modestly. The reason is that earnings are likely to continue to be surprisingly weak, so a particularly strong rally would represent a good selling opportunity in my view. Barring such an advance, we'll remain with our well-hedged but very slightly constructive position.
Thursday Morning March 8, 2001 : Special Hotline Update
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Just a note, the semi-annual report of the Hussman Strategic Growth Fund is now posted to the Research & Insight page of our Fund website www.hussmanfunds.com
The Market Climate remains characterized by extremely unfavorable valuations and tenuously favorable trends. That places us in a very slightly constructive position, but for practical purposes we should call it neutral - not particularly bullish nor bearish. In a broader context, I continue to view stocks as being in a bear market with the potential for further market losses of about 40%. That sort of decline would bring stocks back to historical valuation norms. We don't even want to contemplate the decline required to reach valuations typically seen at bear market lows. While we still have not moved to an aggressively defensive position in any of our portfolio strategies, we are already hedged enough to avoid concern about a further market breakdown.
The next few weeks are going to be interesting. On the potentially "bullish" side, I am expecting a brutal employment report on Friday. The Fed gets a 1-day advance release of this, so it's difficult to completely rule out a surprise rate cut on Thursday or Friday. A cut at the regular meeting on March 20th is still most likely, but I would not attach a zero probability to an earlier move. If that does occur, the ensuing rally will probably be a good opportunity to increase our hedges. We'll see what develops.
On the "bearish" side, the next few weeks are likely to bring a relentless string of earnings warnings. I expect that at least a few will involve high profile "New Economy" companies warning not only of slowing earnings but of actual operating losses ahead. And that could get the market moving to the downside again. On the credit front, Moody's reported another decline in credit quality during February, "that could soon pose problems in the bank loan and short-term debt markets." Moody's also stated that "ratings reviews indicate more credit weakness ahead."
The bottom line, we try not to pre-empt shifts in the Market Climate, so for now, we're relatively neutral. We expect to increase our hedges if we see a strong near-term rally, but even in our most aggressive managed accounts, a strongly bearish posture awaits more deterioration in market internals. We would rather not attempt to guess when that will occur, and our strategy doesn't require it. Our stocks are acting well, and we're comfortably defensive for now.
Sunday March 4, 2001 : Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and tenuously favorable trends. Probably the most favorable trend recently has been the action of the advance-decline line. Unfortunately, much of this advance has been due to preferred, interest sensitive, and high-yield stocks, as well as small value stocks. This is due both to lower interest rates and to a reallocation of money away from technology and toward value.
While these trends certainly could continue, they are not the stuff that will keep the major, capitalization weighted averages from futher declines. So while we're very comfortable with our value-oriented stock selections, we are very cautious about interpreting the uptrend in the advance-decline line as positive for the major indices. Buying interest is likely to continue to wane in the large-cap stocks that drive those indices. The only question is whether buying interest continues in the value area. In short, while smaller value stocks will probably continue to outperform large growth stocks, the strength in value should not be taken as a positive for the overall market, nor should we become complacent about risk.
There's a good chance that the Fed will ease on Thursday or Friday of this week, if the employment numbers are as negative as I expect. That may give us a good short-term bounce, which I would view as a welcome opportunity to increase our hedges. Regardless of the Fed move, the next month is likely to generate a seemingly endless string of earnings warnings, with some so-called growth companies actually projecting sudden losses. Since the Fed has its scheduled meeting later this month, there's no question we'll see an easing this month in any event. It's just that easing is fully expected, and collapsing profit margins are not.
In short, I am expecting a rather sudden collapse in earnings expectations in the next several weeks. In the latest issue of Hussman Investment Research & Insight, which is available online and is now in the mail, there is a chart depicting the surprisingly strong correlation between Consumer Confidence and economy-wide profit margins. The Consumer Confidence figures are monthly, and have suffered the worst quarterly plunge since the last recession. The profit figures are quarterly, and the numbers for the first quarter are still forthcoming. When you combine the action of Consumer Confidence with the recent data on producer cost pressures and revenue shortfalls, the decline in profit expectations is likely to be very abrupt.
Thursday Morning March 1, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and tenuously favorable trends. On one hand, the selling is beginning to take a relentless tone, which could deteriorate into a panic situation, but on the other hand, the market is so deeply oversold that another "fast and furious" bounce is an equal possibility. That should give you a good idea why we generally have no opinion at all about short term action. Our only real concern is the Market Climate, and that's so mildly constructive that we might as well call it neutral. That may seem like a cop-out, but in fact, "neutral" is as much a stance as "bullish" and "bearish" are. In recent days, we've seen significant deterioration in our measures of uniformity. While we don't have a formal negative signal yet, we're inclined to use market rallies to move toward an even more neutral exposure. If we do see that formal negative signal, we'll also shift our more aggressive accounts to a bearish posture.
One of the things that could get us a sharp rally in the major indices, though equally prone to failure as other recent rallies, would be an inter-meeting Fed easing. In my view, that's a strong possibility. If we get one, it would most probably occur on one of three days. The first would be today (Thursday) if the NAPM indices are substantially weaker rather than stronger. The other possibilities would be next Thursday (March 8) when the Fed gets a 1-day advance release of the February employment report - a report that I expect to be brutal - or next Friday (March 9) when that report is actually released. I really do believe that such a rally, if it occurs, will be a last-chance opportunity to sell, while investors still have hope, but before some really ugly earnings and economic results become evident. That sort of jump in the major indices would be an excellent opportunity to move to a fully neutral position, or in some accounts even bearish positions, particularly if market internals remain relatively weak.
In short, we're seeing more deterioration in market internals as well as in the major indices. While we could very well see a rally in the major indices to clear the oversold condition of the market, we certainly don't have any inclination to "play" such a rally by relaxing our hedges. To the contrary, if we do see a strong rally, that's exactly the point at which we would put a more complete hedge in place. For now, the Market Climate is as close to neutral as it can become. We remain very modestly constructive but hedged enough to have little concern about actual direction. That's a good thing, since we're likely to see a lot of volatility in the market, and ultimately little return.
Tuesday Morning February 27, 2001 : Special Hotline Update
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Just a note: the latest issue of Hussman Investment Research and Insight will be available online by 5:00 P.M. Eastern Time today.
The Market Climate remains characterized by extremely unfavorable valuations and tenuously favorable trends. Monday's advance certainly qualifies as a "fast and furious" bounce, which we fully anticipated. Though there were new profit warnings after the bell, the oversold condition of the market still hasn't cleared, so we certainly could have a few days of follow-through. It's not as strong an expectation, but it wouldn't be at all surprising to see a further bounce. Being in an very modestly constructive position, it would still be good to see the market rally even if it turns out to be short lived.
Monday's rally was fairly broad, on hopes that the Fed would make an intermeeting rate cut this week. I wouldn't rule it out, as the evidence is compelling that the economy has already entered a recession. It's just that we're also in an economic situation where loose monetary policy is likely to be fairly ineffective in stimulating growth. More on that in the upcoming letter.
So even allowing for the probability of further rate cuts, possibly even this week, I continue to view stocks as being in an ongoing bear market which will be very unfriendly to earnings, and by extension, stocks with very high price/earnings ratios. Shorter term, I wouldn't be surprised to see the market work off its oversold condition (though I wouldn't count on it either). It will be important, in any event, to monitor whether any bounce remains broad, or whether it narrows to a smaller set of market sectors.
Sunday February 25, 2001 : Hotline Update
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The latest issue of Hussman Investment Research and Insight will be posted online by Wednesday evening of this week. The printed version will be mailed on Thursday morning. Since we're still completing that issue, we'll save the bulk of our comments for that letter.
The Market Climate remains characterized by extremely unfavorable valuations and tenuously favorable trends. Our trend model has moved to a "hot" condition, which means that we have become very sensitive to any further deterioration in market trends. Given the extreme oversold level of this market, there's actually a good chance of a fast and furious rally to relieve that condition. But we'll be watching internal market action.
A market bounce that fails to substantially lift the advance-decline line, retail stocks, brokerages, transports, utilities and other key sectors would be a warning sign. Specifically, a strong tech-centered rally could potentially drive the major indices up and still trigger a negative shift in our readings of trend uniformity. That's actually what we would prefer to see, even if such a rally puts temporary pressure on our investment position. It's always good when you can take a negative signal and increase your hedges (such as put options) on a market rally. If instead we get a negative trend signal on a market break, we'll act on it just the same. Time will tell. For now, we're just slightly constructive, but very sensitive to further deterioration in market internals.
Thursday Morning February 22, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and tenuously favorable trends. It's interesting that the reality of stock pricing remains fairly simple. The only way for a stock price to go up is either for the earnings to rise or for the price/earnings ratio to rise. Unfortunately, when investors with implausibly high earnings expectations have driven stocks to extravagantly high price/earnings ratios, any whiff of falling earnings can cause those P/E ratios to contract. And suddenly all those bullish arguments about favorable November-April seasonality and Fed easing become worthless. In short, falling earnings expecations and contracting P/E ratios are no way to run a bull market.
I continue to view the economy as having entered a recession, something which is still not materially discounted into stock prices. Interest rate cuts, on the other hand, have been fully discounted into prices, and with recent inflation news, the Fed will not be able to be quite as aggressive as it otherwise would. Now, I have no doubt that further interest rate cuts are ahead, but that's already priced into the market. The real problem with the recent inflation figures is that they indicate accelerating cost pressures, particularly in areas such as energy, health care and benefit costs, and other production-side costs. That puts further pressure on profit margins. Again, again, again: the main difficulty ahead - one that we hear virtually nothing about yet - is that profit margins are likely to crater in the coming months. And when earnings are actually falling, which I expect, it becomes very difficult to sustain the extreme P/E ratios that stocks have maintained.
As I've noted before, value is not determined by how far a stock has declined, but by the relationship between prices and properly discounted cash flows. From any historical perspective, stocks remain breathtakingly overvalued.
Over the short term, however, I have no opinion about stock price direction. Large moves are more likely than small ones. That's about all I can offer. The reason is simple: on one hand, bear markets tend to be punctuated by brief corrective rallies that are fast and furious. On the other hand, there's a real risk that after two years of stagnant stock prices, investors may be inclined to move some funds off the table. And anytime a lot of investors get the same idea at the same time, the price moves tend to be large. So expect some wild movement, both up and down, over the coming sessions. On days when the news offers a glimmer of hope, that "same idea" will be that the worst is over. Soon enough, however, new recessionary evidence will appear again, and that "same idea" will be to liquidate.
As for trend conditions, they're becoming increasingly tenuous, but we're still clinging to a favorable reading. New lows have begun to expand again, and bellwether groups such as brokerage and retail are showing sudden weakness. More evidence is required to move us to a strongly defensive posture, but even with a modestly constructive market position, the fact that we're avoiding technology has had a positive effect on all of our portfolios.
Monday February 19, 2001 : Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and moderately favorable trend conditions. This places us in a hedged, but modestly constructive position overall. We are, however, seeing some early signs of deterioration in market internals. While we maintain a modestly constructive position, we are inclined to reduce positions in stocks with higher P/E ratios on advances, and to raise defenses incrementally on such rallies. The reason is that the market is looking at best as a trading range, and at worst like the calm before the storm.
Historically, bull markets have a strong tendency to begin in the midst of well recognized recessions when the Fed is easing. The moderately favorable technical action of the market, combined with this fact, has led a number of good technicians to become more optimistic about the market's prospects. There are several reasons we are skeptical, and unwilling to take on more than a modestly constructive position.
First, it's true that market internals have acted well enough to move us to a modestly constructive position in recent weeks, but when we look closely at those internals, a pattern emerges. The favorable action of the advance-decline line in recent months has been largely driven by strong action in interest sensitive stocks, preferred stocks, and convertibles. Outside of these groups, we see few signs of robust trend strength. That's why we've never been able to describe trend conditions as anything more than "moderately favorable".
Second, the reason that bull markets tend to emerge during well-recognized recessions is that stock prices are generally already quite depressed, and at the bottom, the economy is not only weak but expected to become considerably worse. We just don't see that sort of expectation today. In fact, the vast majority of economists, including Alan Greenspan, openly argue against the possibility that the economy is at risk of recession. Interestingly, Alan Greenspan never has correctly identified a recession. The most notable example was his "unqualifiedly bullish" outlook just before the worst economic decline since the Great Depression, in 1973-74. Most bull markets begin somewhere between 7 and 11 times record earnings. Currently the S&P is at 25 times record earnings.
Third, earnings expectations are still extremely bullish, and do not reflect the risk of contracting profit margins which is always part and parcel of an economic slowdown. Analysts were almost unanimous in arguing that the huge jump in the Producer Price Index on Friday would not prevent the Fed from easing again. But that's not the problem. Though Fed rate cuts are virtually assured, and already priced into the market, analysts have not stopped to consider the impact of soaring producer prices on profit margins. Just do the math. On the revenue side, we have slower economic growth, slower capital spending, and slower revenue growth economy-wide (particularly in the technology area). On the cost side we have continued wage pressures, accelerating benefit costs, and rising producer price inflation. Now, if profits are the difference between revenues and costs, it should be clear that profit margins are in trouble. Add to that the historical fact that profit margins always retreat when the economy slows, and it's extraordinarily difficult to imagine what analysts are thinking when they fail to account for this.
Bottom line: we're still tenuously constructive, but certainly not unhedged. Nothing in recent data offers compelling evidence that stocks have completed this bear market. Again, at best, I believe that stocks are in a trading range. At worst, this is a brief calm before another storm. We're not bearishly positioned, but we certainly aren't inclined to take on much market risk.
Thursday Morning February 15, 2001 : Special Hotline Update
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This update is brought to you by the letter V.
The Market Climate continues to be characterized by extremely unfavorable valuations and moderately favorable trend uniformity. That uniformity is weakening however, and it's possible that we may move back to a strongly defensive position in the weeks ahead. In general, it is not profitable or advisable to move pre-emptively. It's best to wait until the objective evidence of a Climate shift is in hand, but at least we're aware of the possibility. On Wednesday, leadership on the Nasdaq reversed, with new lows once again outpacing new highs. In another sign of deteriorating internals, we're also seeing softness in sectors such as retail and brokerage. For now, something to watch. We're already largely hedged, but we do maintain a modest positive exposure to the market here.
As far as I can conclude, the bullish case rests on the assumption that the Fed will continue to panic, and make sharp interest rate cuts out of concern over a weak economy, but that the economy will not actually weaken, and will instead grow strongly in the second half of this year. This fascinating scenario requires that we have enough economic weakness to panic the Fed into further cuts, but that the economy will respond quickly and reliably to those cuts. Or in the dreadful Sesame Street analysis that passes for economics these days, investors are expecting the economy to follow a V, rather than a U, or worse yet, an L.
While that sort of outcome is not impossible, it rests on a razor's edge, and any number of alternate outcomes are possible. For instance, the economy might show only modest signs of slowing, in which case, the Fed would not cut rates aggressively, but we would still see corporate earnings crater. Remember, contraction in profit margins is the main factor that drives earnings down in an economic slowdown (even one that is short of a recession). In any environment less than 5% real GDP growth, a narrowing in recent record profit margins is inevitable. As an alternate possibility, and the one that we espouse, the economy may actually lapse into a recession in which capital spending is not responsive to interest rate cuts. In that event, we would indeed see the Fed cutting aggressively, but corporate earnings would be so dismal that even those lower rates could not sustain the kind of extreme P/E ratios still evident in the S&P and Nasdaq stocks.
In short, it's dangerous to rest one's financial security on a very narrow assumption, when small variations could be disastrous. Mathematicians call that kind of assumption "non-robust". In order to work out, reality has to conform to your assumptions very precisely. If it doesn't, things more or less blow up. There's no robustness to holding overvalued tech stocks in a market where earnings are collapsing, and your only hope is that Alan Greenspan will panic about a recession, and that his panic will ultimately turn out to be unfounded. But that's what investors are evidently banking on.
In the meantime, for us, there's a nice robustness to holding stocks with good value and trend strength, while having the majority of our market risk hedged. A lot of things can happen and we can still expect stability. We're comfortable with that position here.
Tuesday Morning February 13, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and moderately favorable trends, placing us in a still-hedged but modestly constructive market position.
Not much news today except that the pure denial is palpable. Every funding source for capital expenditure is drying up, including the IPO market (where new issues are being cancelled), the corporate debt market (where Lucent's bonds were just downgraded to near-junk status), and the bank credit market (where both loan demand is the weakest and lending standards now the tightest since the last recession). We're increasingly hearing that companies believe that their internet "buildout" is nearly complete - another way of saying that the boom in capital spending was largely a one-time burst rather than a sustainable and never-ending flow. More like the flush of a toilet than the steady rush of a waterfall.
Too cynical? This just in. Internet consulting firm MarchFirst just reported a $6.8 Billion dollar loss last quarter. That whooshing sound you hear is $6.8 Billion dollars swirling down the drain. The stock is 97% off its high. But that doesn't make investors think twice about buying Cisco or the other glamour techs. As I say, the denial is palpable.
Bottom line, stocks are still in what might be considered a pause within an ongoing bear market. We're comfortable with a modestly constructive position. But it would be dangerous, in my view, to take the technical and monetary conditions as bullish without considering the context of extreme overvaluation and an oncoming but largely undiscounted recession. Historically, the Fed has eased strongly when prices have already been beaten down and recession is fully recognized. The fact that the Fed is being pre-emptive has certainly supported this bear market pause, but the market remains vulnerable to what is sure to be strong disappointment over earnings and growth prospects. At these valuations, that's a real danger. As I've said before, the main difficulty ahead is deterioration of profit margins. Expect to hear more about that as the next couple of months develop. For now, we're modestly constructive, highly skeptical, and ready to move to a fully defensive position if and when objective evidence advises it.
Sunday February 11, 2001 : Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and moderately favorable trends. Strategically, that places us in a slightly constructive, though still-hedged market position. In terms of stock selection, we continue to favor groups exhibiting both favorable valuation and favorable market action, which leans us toward health care, defense, apparel, and utilities, among other groups, and keeps us decidedly away from technology, where both valuation and market action indicate crash risk in this sector. As a sidenote, the Hussman Strategic Growth Fund is now tracked by Morningstar, and you can punch us up on most charting and quote services (such as Excite) under the Nasdaq ticker symbol HSGFX.
The relative firmness of the broad market in the face of tech weakness has allowed our favored stocks to perform well, even while we see erosion in the major indices. That's likely to continue, particularly when it becomes evident that profit margins are under extreme pressure. The sharp jump in mass layoffs that we've seen in recent weeks is an early indication of this margin pressure. It should be clear from these layoffs that even though companies aren't admitting it openly yet, there is a panic to defend profit margins by cutting costs, capital investment and employment (or as the guys with green eyeshades call it, "aggressive management of headcount").
As always, market action and valuation drive our strategic position, which is mostly hedged, but allows a modest constructive exposure to the market. My guess is that we'll end up shifting to a fully hedged and defensive position in the coming weeks, but guesses don't drive our position, and we'll have to wait for objective evidence before we shift our market stance. The reason for my suspicion is the conviction that the U.S. is now already in recession and that the market has not discounted this into stock prices. Normally, we would expect something of a lull once the earnings season slows down, but with the SEC's new disclosure regulations, we're likely to see new warnings and lower guidance on first quarter earnings beginning just a few weeks from now.
In the meantime, as always, we'll continue to take any attractive opportunities in individual stocks as they arise, and we'll monitor market action for a shift in the overall Market Climate. Again, for now, we're avoiding high P/E technology and banking stocks, modestly constructive, but certainly not aggressive or unhedged.
Tuesday Morning February 6, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and moderately favorable trends. That puts us in a modestly constructive position, still well hedged, but willing to take a very modest amount of market risk here. Though I continue to view the economy as in recession, and the current period as a pause within an ongoing bear market, the current Market Climate drives our modestly constructive position at present, and there is not sufficient evidence of trend deterioration to justify an outright bearish position. The current trend uniformity suggests that correctly or incorrectly, investors have become somewhat more tolerant of risk, and without pressure on the risk premium, you just don't get much of a market crash.
Though our investment position will change only when the objective evidence is available, my suspicion is that investors have not nearly discounted the probability of a recession in either stocks or bonds. For stocks, that means much more disappointment ahead. For bonds, it means a further move to lower rates. It is important that in the current economic climate, falling stock prices and rising bond prices are not inconsistent. Stock prices are determined by three factors, interest rates being one, risk premiums being the second, and expected future cash flows being the third. Stocks fall either by a shortfall in expected cash flows (earnings disappointments), rising interest rates, or rising risk premiums (both which reduce the discounted value of those cash flows). At present, interest rates are secondary to how stocks are priced. The main factors which have driven stocks over recent years have been relentless increases in expected earnings growth, and a relentless decline in the risk premium demanded on stocks.
Very simply, at current valuations, a shortfall in earnings growth, or even a modest increase in risk premiums toward normal levels, would drive stock prices lower regardless of interest rate action. We're not seeing pressure on risk premiums yet, but shocks to the risk premium tend to come rapidly, so we have to defend against complacency.
On the economy, we have this: manufacturing in a sharp contraction, evidenced both by the NAPM figures and the employment data, the extent which has always been associated with recession. Consumer confidence in a dive, the extent which has also always been associated with recession. Capital spending clearly slowing, with access to capital slowing on nearly all fronts: IPO's slowing, corporate bond issuance slowing, and foreign capital flows slowing (which again will be evident as a shrinking trade deficit). The Fed is desperately attempting to keep access to capital open through the banking sector, but banks already have enough bad debt on their books that the easy lending of the last few years is unlikely to be revived, regardless of Fed easing. In a nutshell, the economy faces pressure in both consumer and business spending. Given that, a recession remains the most probable outcome here. As I've said before, I'll be pleased if I'm incorrect about that, and little in our investment positioning depends on it. That view does, however, make us cautious to avoid areas vulnerable to falling profit margins and rising credit risk. And it keeps us vigilant about the possibility of a trend deterioration. For now, we're modestly constructive, but still avoiding vulnerable areas of technology and banking.
Sunday February 4, 2001 : Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and moderately favorable trend uniformity. We are currently holding a modestly constructive position in all of our management strategies, but continue to strongly avoid technology stocks at high P/E and price/revenue ratios, as well as most banking stocks. That positioning tends to be very favorable on days like Friday, when glamour technology stocks are hit hard while the broad market holds up, and slightly unfavorable on days when technology roars higher without participation by the broad market. Overall, there continues to be a tendency toward liquidation of technology stocks, which is likely to continue in an environment of deteriorating profit margins.
On the economy, I believe that the U.S. has entered a recession, a determination made clearly by our most reliable leading indicators. The best coincident indicator, the NAPM Purchasing Managers Index, plunged again in January, and is at levels which have never been seen except during recessions. Friday's strong employment report was driven by upward seasonal adjustments in a month that was uncharacteristically devoid of seasonal tendencies. For instance, rather than a sharp drop in construction jobs, which is what you normally see in January, construction jobs surged because of much better weather (anecdotally, the contractors we hired in October had repeatedly been put off by bad weather, and finally fixed the hail damage to our own roof in January). Government employment showed the same tendencies. But manufacturing employment, which is much less subject to weather influences, was very obvious in its continued plunge. Accordingly, it's our expectation that the February employment report will be beyond awful.
In the past two weeks, our models have become quite favorable on longer maturity fixed income, so those of you who have a portion of your assets in bonds may wish to move part of your portfolio to longer maturities between 10 and 30 years. We're not so aggressive as to advise zero coupons or anything very volatile. Zero coupon bonds make more sense when yields are beginning to fall from very high levels. But even at today's interest rates, there is likely to be enough downward pressure on yields to justify having some portion of a fixed income portfolio in longer maturities. Moderation is advisable, but again, the outlook suggests a good total return over the next year or so on longer maturities.
Overall then, we're modestly constructive on stocks, but certainly not aggressive or unhedged. We won't fight a market uptrend if it emerges, but we're hedged enough to avoid concern over any sudden downward reversal in market direction. We view the economy as being in recession, and doubt that the market has discounted that. So despite the relatively constructive trend condition at present, we are very adamant about avoiding high valuation stocks that are vulnerable to deteriorating profit margins. That's a particularly real danger for most of the glamour technology stocks. In fixed income, we still like having moderate exposure to European bonds, and also see longer maturities as attractive for a portion of fixed income portfolios.
Wednesday Morning January 31, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and moderately favorable trends. There is virtually no doubt that the Fed will cut rates by 1/2% on Wednesday, which leads to the question of whether the cut is fully priced into the market. Regardless of the initial market reaction to the Fed move, I continue to expect earnings to be a continued area of trouble for the market. The market may very well have discounted further Fed easings, but it certainly has not discounted a recession. And our indications are that a recession is now in progress. As I've noted in recent updates, the current economic situation is not likely to be redressed by easy money.
There's little more to say about monetary policy except that the Fed will retain an aggressive easing mode. At current valuations, that's likely to help less than it usually has, because Fed easings have historically helped the market by driving the P/E ratio higher, a much greater feat when the S&P already has a P/E over 25. The main factor is going to be earnings disappointment, driven partly by softer revenue growth, but primarily through declining profit margins.
In the next few months, we're expecting a virtual panic by businesses to contain and reduce costs. It's that sort of panic this week alone that has prompted the auto companies to announce mass layoffs, not to mention technology and telecom companies, and of course, Tuesday's layoff announcement by Amazon.com. Those mass layoff announcements are an early warning that corporate profits are likely to come under much more pressure than is commonly assumed.
Everybody seems to believe that the Fed has bought a market bottom, and that the current economic slowdown is "old news". We're skeptical. Modestly constructive, but skeptical. Mainly because the current economic downturn is coming off of a capital investment boom financed with a great deal of leverage. We believe that the economy is in the early phase of a "deleveraging cycle". Investors who believe in the omnipotence of the Fed have evidently forgotten phrases like "liquidity trap" and "pushing on a string", which are ways that economists describe the failure of easy money to stimulate the economy when capital spending is sluggish. Well, that's what we're likely to get.
Bottom line: we're still modestly constructive, but certainly not aggressive or unhedged. Wednesday's probable Fed cuts are most likely fully discounted in current prices, so we view market direction after the move as a coin toss. The main surprises for the market are likely to be earnings disappointments, and specifically downward pressure on profit margins. That pressure is already triggering a jump in mass layoffs. We won't shift to a heavily defensive position until and unless trend uniformity deteriorates, but while we're constructive for now, we're not compelled to be very bullish.
Sunday January 28, 2001 : Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and modestly favorable trend uniformity. That combination has historically been moderately favorable for the market, overall. So while this Climate persists, we continue to hold a modestly constructive market position - that is, one that we would expect to benefit from a market advance. We are not, however, aggressive or unhedged, because we are unwilling to risk much in the event that the market turns quickly lower.
It is a foregone conclusion and a near certainty that the Fed will cut interest rates again this week. While we are modestly constructive in our investment position, we are also skeptical that much benefit will come from the rate cuts, either for the stock market or for the economy generally. The very certainty of investors that the Fed will cut rates means that such a cut is already very well priced into the market. In fact, investors are counting on a whole string of cuts to follow. So the real surprises will remain on the earnings side. On that front, downward pressure on profit margins is likely to produce much weaker earnings results in the coming quarters than consensus earnings estimates currently project. With the large-cap stocks in this market still at extreme price/earnings multiples, stocks will be much more sensitive to earnings disappointments than they typically have been when the Fed is in a cutting mode. Prior Fed easings have occurred at an average market price/earnings ratio that is half of current levels.
Moreover, the notion that a Fed easing will naturally boost the economy is also dubious. It ignores the nature of the current slowdown. In most of the post-war slowdowns we've seen, economic weakness has been largely the result of weakened demand, and credit risk, though high, has not been profound. This slowdown is different on both counts. It is driven not by a measurable pullback by the consumer, but instead by a major shift in the profile of capital spending. Stated simply, the problem is not that overall demand is weak, but that the mix of goods and services demanded is not the same mix that we have the capacity to produce. The U.S. has overinvested in capacity such as telecommunications, where credit defaults have accelerated, and has underinvested in capacity such as energy production, where there are increasing shortages and inventory rundowns. This is not a situation that is easily remedied by easy money.
If the current slowdown was simply a matter of slack demand, investors' confidence in interest rate cuts might be well placed. But what we have here is a situation where investors and corporations alike are betting on the Fed to bail them out of bad investment decisions that are, in fact, going bad.
We certainly do hope that the Fed can pull off a recovery. Not only because our own position is modestly constructive, but more because this economic downturn involves real people with real jobs, families and portfolios at risk. The economy is forgiving of small misallocations of capital, but unfortunately not very forgiving of enormous ones. The misallocations of the past several years are likely to require further layoffs, restructurings and friction. The belief that easy money fixes everything is likely to be a terrible disappointment.
Bottom line. Expect the Fed to cut interest rates again. We're just not convinced much good will come from it.
Sunday January 21, 2001 : Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and modestly favorable trends. Overall, that's a climate which leads us to be modestly constructive, but certainly not aggressive or unhedged. Since the end of December, when the Market Climate shifted to a more favorable tone, the main disappointment has been the rather weak follow through in our measures of trend uniformity. The clear targets of investor enthusiasm have been those sectors with the most extreme price/earnings and price/revenue measures. Unfortunately, while those stocks have been successful short-term speculations, the evidence continues to suggest a contraction in profit margins ahead, and the main casualties of contracting margins are invariably those same high P/E and high price/revenue stocks. On the cost side, the prices of labor, employee benefits, energy and imports are all trending higher, and that could work through to significant profit difficulties as this year continues. The main risk to earnings is not so much that revenues grind to a halt, but that profit margins contract moderately from current record levels. As I've noted before, this margin contraction is likely to blindside analysts who fail to partition earnings growth into the separate influences of revenue and cost.
Meanwhile, the best areas of value in this market remain small and mid-capitalization stocks with solid records of earnings and revenue growth, generally favorable price and volume trends, and relatively low valuation multiples. Stocks at lower valuation multiples are likely to be much more reslient in the face of profit disappointments ahead. But at least in the past three weeks, these are exactly the stocks that nobody seems to want. We've seen particular pressure on groups such as healthcare, insurance, defense, and of course utilities. The recent backing away has not reduced our favorable view of valuation and market action for these stocks, but it has moved a significant number of our stocks to the lower portion of their generally rising trend channels. That's another way of saying that we may be setting up for a nice rebound in these groups. I am also expecting significant relative strength in these groups as the year progresses. That relative strength is likely to be particularly attractive in comparison to sectors that are vulnerable to contraction in profit margins. We still advise that you avoid stocks having high P/E and price/revenue ratios, including a large proportion of technology stocks, financials, and even most of the large-cap pharmaceutical companies.
The bottom line: we continue to have a modestly constructive market climate, but the lack of follow-through in trend uniformity is disappointing and may place this constructive tone in danger in the coming weeks. The main risk to the market is the likely contraction in profit margins, and I've yet to hear any comment at all from analysts in this regard. It's important to pay attention to the coming stream of earnings reports. Keep an ear out for comments about cost and margin pressures. My expectation is that we're about to hear a lot of that. For now, we're modestly constructive, but mindful that further internal weaknesses could cut short this cautiously favorable tone.
Wednesday Morning January 17, 2001 : Special Hotline Update
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We'll keep this brief. The Market Climate remains characterized by extremely unfavorable valuations and modestly favorable trend uniformity. Defensive stocks, however, continue to act poorly. One positive aspect of this is that many of our highest ranked stocks are in the lower part of their rising trend channels, and that often results in favorable moves. Overall, then, there are certainly attractive stocks in the market, but we are still largely hedged, and we have to be increasingly tentative about the favorable trend status of this market. Until we actually have a shift in the objective evidence, we will maintain a modestly constructive position. A shift to a negative climate would place us in a fully-hedged position, and would move our more aggressive managed accounts to a moderately bearish posture. For now, we're closely monitoring market action, skeptical about the Fed's ability to forestall recession, concerned about the likelihood of poor earnings, but in the end, modestly constructive for now, and hopeful for a more sustained and uniform follow-through.
Monday January 15, 2001 : Hotline Update
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Just a note: the latest issue of Hussman Investment Research & Insight was mailed on Thursday, and is also available for download on our website.
The Market Climate remains characterized by extremely unfavorable valuations and modestly favorable trends. Two aspects of the market are of concern here. First, defensive stocks have not been acting well at all so far this year. This is clearest in the utilities, which are in some ways a special case due to the emerging crisis in natural gas, but we're also seeing weakness across groups such as consumer goods, insurance and health care, among others. The second concern is the upcoming earnings season, which we expect to be a disaster. Those two factors, as well as the general overvaluation of the market, extremely high credit risk, and the very real possibility of a more widespread crisis in energy, make us unwilling to take significant market risk based on the current constructive trend uniformity. We certainly do not intend to fight any emerging uptrend, and we do want to have a modest positive exposure to market movements, but we would not want to be aggressive or unhedged here.
If we do lose favorable trend uniformity in the weeks ahead, we expect to raise our defenses aggressively. Most likely, we are in a bear market rally or consolidation, and historical norms of value are still half of current levels. The Fed is going to ease aggressively, but as noted in the latest issue of Research & Insight, Fed cuts have historically exerted their positive effect on the stock market by raising the P/E ratio of the market, and with the P/E at 25 times record earnings (double what it usually is when the Fed cuts rates), the response of P/E ratios may be tepid. Moreover, risk premiums have soared in the bond market. In fact, the spread between the Dow 20 corporate bond yield and the 10-year Treasury yield has never been wider, while stocks continue to be priced at historically low risk premiums. So there continues to be potential downward pressure on P/E ratios even if the Fed cuts rates, something that typically hasn't been the case when the Fed has eased in the past.
A final thought is this. The market is clearly split into distinct tiers, with many of the smaller stocks in the broad market reasonably priced, while the large cap stocks that dominate the major indices still sport extreme P/E and price/revenue ratios. I should also note that neither the Dow, S&P or Nasdaq are in favorable trends, so the favorable trend uniformity from our models is coming from other market internals such as breadth, sector action, bonds, and other components. One possible outcome is that we could see continued pressure on the major indices as earnings disappointments continue, while the more favorably valued broad market holds up better. Normally, in a bear market, large and small stocks decline together. But so long as our readings of trend uniformity hold up, we could see a more unusual outcome. A loss of favorable trend uniformity would suggest a more typical market plunge, and we would accordingly raise our defenses aggressively.
Bottom line: we continue to have favorable trend uniformity, which appears to favor the broad market more than the major indices, which are driven by overvalued large-cap stocks vulnerable to earnings disappointments. Defensive groups are acting poorly, and that could reverse our constructive trend climate and put us in a highly defensive position. But while favorable uniformity persists, we are inclined to keep a modest positive exposure to the market. Certainly not aggressive or unhedged, but modestly positive until market conditions give us objective evidence to shift our position.
Sunday January 7, 2000 : Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and moderately favorable trends. We certainly wouldn't touch glamour technology names like Cisco, Sun, EMC or other high valuation techs, nor would we hold banking stocks here. Yet despite the pressure on the large-cap indices, we actually saw a strengthening of trend uniformity last week. Defensive stocks started to hold up moderately better on Friday, which I view as necessary and important here. There's still a reasonable chance of a whipsaw back to unfavorable uniformity, so we certainly would not hold an aggressive or unhedged position here. Moreover, 4th quarter earnings reports will start being released in the next couple of weeks, and we could see some real bombshells.
So while the broader market is showing some favorable uniformity to which we want some exposure, we also want to avoid any emphasis on the overvalued large-caps that drive the major indices. Accordingly, we're happy with the broad list of secondary stocks that populate our own portfolios, and continue to be hedged against weakness in the major indices. Depending on the portfolio strategy, we're doing this using cash positions, moderate put positions in the Russell 2000 and S&P 100, or short sales on those indices against the portfolio of stocks we own. Regardless of the strategy, our hedges are sufficiently defensive that we are comfortable with the possibility that the market could turn down unexpectedly, but they are also sufficiently limited that we would expect portfolio gains if the current constructive Market Climate is indeed followed by a rising market.
In an industry that whines for analysts to take an all-out bullish or bearish stand, we will have none of it here. We've got an extremely overvalued market, yet trend conditions which have historically been constructive for the market. That's a very specific climate which has a very specific market position associated with it. And the appropriate position is to be largely hedged, but with a modest positive exposure to market movements. As usual, no opinions or forecasts required. At this point, the most likely events that would move us back to a defensive stance would be further weakness in defensive stocks, particularly utilities, and a loss of favorable market breadth and leadership, as measured by weakness in advances vs. declines, and new highs vs. new lows. Since it would be difficult for a sustained downtrend to assert itself without one of those measures turning weaker, we're comfortable in a modestly constructive position until at least some negative trend evidence actually emerges.
Thursday Morning January 4, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and favorable trends. The favorable trend uniformity that emerged last week proved to be well-founded on Wednesday, with the major indices leaping on a surprise Fed rate cut. I'll have more to say on this in the upcoming issue of Research & Insight, which we expect to publish late next week. Clearly, though, the Fed is concerned about the probability of a recession. And at this point, our trend models are positive, so despite terribly high valuations, we are reasonably constructive here.
One disturbing feature about Wednesday's rally was the tremendous gap between glamour growth stocks and value stocks. The Nasdaq 100 index soared 18%, but the Dow Utility average actually plunged by 6%. In the broader market, there was also a definite tone of weakness in value stocks, which we shouldn't really see in a sound market rally. Bond prices were also clobbered, with long term interest rates rising. If this kind of disparity in market action continues, it would threaten to throw the market back into an unfavorable status and potentially even a fresh Crash Warning. For now however, we'll stick to both a constructive position, but with a continued bias against technology and banking stocks. Certainly tech stocks could rally further, given the extent of their prior decline, but tech earnings are still likely to fall in any economic environment short of 4-5% growth. And even with Fed cuts, I don't expect that. So regardless of the constructive market tone currently in effect, I continue to view tech and banking stocks as vulnerable. The upbeat market tone would be significantly enhanced if we see value stocks join a general uptrend in the days ahead. A failure to do so would be an early warning sign. For now, however, we remain constructively positioned.
Wednesday Morning January 3, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and favorable trend uniformity. I continue to view stocks as being in a bear market. Also, with our best set of indicators on a recession warning, I continue to view the economy as being in the early part of what will ultimately be recognized as a recession. The plunge in the NAPM purchasing managers index to the lowest level since the 1991 recession underscores that view.
At the same time, however, the market has quietly recruited enough internal trend uniformity to push us to a constructive position. That's definitely not an aggressive or an unhedged position, but it is also not a position that would fight a rally here. It's interesting to note that only 28 stocks hit new 52-week lows on the NYSE on Tuesday, and decliners led advancers by just 17 to 13. So the internal action of the market was more a pullback from a short term high, rather than a plunge to a new low. Too bad for the herd that the same can't be said for overvalued techs like Cisco and other components of the Nasdaq 100.
That's not to say that stocks didn't decline broadly on Tuesday. But while Tuesday's decline indiscriminately hit both the overvalued techs and more favorably valued stocks, many of our favorite stocks are now at the bottom of their rising trend channels - a situation which often makes for very good rebounds when the market eventually bounces. In any event, our portfolios held up relatively well on Tuesday, particularly compared to the Nasdaq and Russell indices. As for hedges, in our most aggressive accounts, we currently hold 1 Russell 2000 March 460 put for every $50,000 of portfolio value, and 1 OEX February 670 put for every $70,000 of portfolio value. That's a position that would allow the portfolio to gain if the market was to rally strongly from here, while avoiding significant losses if the market declines, and still allowing significant gains if the market was to crash. A crash is currently something we don't expect, but we wouldn't hold a position that requires a crash to be avoided.
In short, the Market Climate is constructive here, so we are positioned accordingly, but we strongly advise against an aggressive market position. We're sufficiently hedged to avoid any particular concern about a market crash, and constructive enough to take advantage of favorable trend uniformity. While we're still almost certainly in a bear market, that favorable trend uniformity makes us relatively upbeat about the prospects for a corrective rally.
Monday January 1, 2000 : Hotline Update
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Happy New Year!
The Market Climate is characterized by extremely unfavorable valuations and favorable trends. In the past few weeks, yield trends have become more constructive, and last week market internals recruited enough uniformity to move our trend models to a tenuously favorable position. While I strongly believe that the major trend remains an ongoing bear market, there is sufficient trend uniformity now in place to sustain a consolidation or even a counter-trend rally. In any event, the expected return/risk profile of the market is currently moderately positive. We don't need to ask whether or when that will end. Our strategy requires only that we position ourselves in accordance with the climate currently in effect.
We certainly would not hold stocks without some level of hedging, but it is currently appropriate to move to a partial rather than full hedge. In our most aggressive accounts, we are reducing our OEX put position by half, and moving it further out of the money, to the February 670 strike price. We are also rolling our Russell 2000 puts from an in-the-money to an out-of-the-money position, from the March 500 strike most probably to the March 460 strike. In short, while the major trend is still most probably a bear market, and partial hedging remains appropriate, the Market Climate has improved enough to take a moderately constructive position. Even in the face of fundamental negatives, the market currently has the "tape" on its side, in the form of positive trend uniformity. Most likely, the market will also have the Fed on its side in a few weeks. In general, you don't want to fight both the tape and the Fed, though we would rapidly become defensive again if trend uniformity was to deteriorate, even if the Fed was easing rates. Our models are currently fairly hot to take a negative trend signal if one emerges.
For now, trend uniformity is positive, and it's a good possibility that the bear market will take at least a short breather here. Valuations remain extreme, and we view a slowdown in earnings as inevitable regardless of Fed action, so there's little prospect of a new bull market. We're really talking about a pause in a bear market. We don't believe any sort of aggressive position is appropriate here, but we also don't want a position that would fight an uptrend. We want a position that will participate in any emerging uptrend, without risking significant losses if the market was to turn down abruptly. We rule out neither possibility, but the current climate leans toward the positive side. Accordingly, a modestly constructive position is optimal.
| Past performance does not ensure future results, and there is no assurance that the Hussman Funds will achieve their investment objectives. An investor's shares, when redeemed, may be worth more or less than their original cost. Investors should consider the investment objectives, risks, and charges and expenses of the Funds carefully before investing. For this and other information, please obtain a Prospectus and read it carefully. The Hussman Funds have the ability to vary their exposure to market fluctuations depending on overall market conditions, and they may not track movements in the overall stock and bond markets, particularly over the short-term. While the intent of this strategy is long-term capital appreciation, total return, and protection of capital, the investment return and principal value of each Fund may fluctuate or deviate from overall market returns to a greater degree than other funds that do not employ these strategies. For example, if a Fund has taken a defensive posture and the market advances, the return to investors will be lower than if the portfolio had not been defensive. Alternatively, if a Fund has taken an aggressive posture, a market decline will magnify the Fund's investment losses. The Distributor of the Hussman Funds is Ultimus Fund Distributors, LLC., 225 Pictoria Drive, Suite 450, Cincinnati, OH, 45246.
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. |