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.com , is appreciated.
Friday Morning June 29, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. Long-term interest rates are one of the important factors that could reasonably shift conditions to a more constructive stance. Unfortunately, bond prices were hit hard on Thursday, making a shift out of this Crash Warning more difficult. Internally, we continue to see weak market action from important sectors, including recent weakness in retail and consumer sectors. That suggests potential softening of consumer demand, which is the key pillar holding the economy from full blown recession. Richard Russell (www.dowtheoryletters.com) notes that lumber and copper prices have also begun to follow other commodity prices lower. That market action is also important because it suggests potential softening ahead in housing, and a further softening in industrial activity. As I've noted frequently, the earliest and most reliable economic signals come out of market action, not from widely followed and often lagging economic statistics. Market action suggests caution here, and with both trend uniformity and yield trends hostile, there's no reason to attempt to speculate in a strenuously overvalued market. Stocks have gone nowhere for two years now. There's no reason getting excited over day-to-day action when the Market Climate continues to indicate a poor return/risk profile.
Short term rates have moved higher in response to the latest Fed move, as have long term yields, particularly on Thursday. Part of this can be traced to the release of the minutes of the FOMC's May 15th meeting. In that meeting, there was clear dissent as to whether rates should be cut by 50 or 25 basis points. The minutes suggest that Wednesday's 25 basis point cut was an intentional signal that the market should not expect the Fed to be aggressive about future cuts:
"Members who preferred or could support a 25 basis point easing action gave particular emphasis to the desirability at this point of taking and signaling a more cautious approach to policy, relative to the 50 basis point federal funds rate reductions the Committee had been implementing, given the lagged effects of the substantial reduction in the federal funds rate to date, the accompanying buildup in liquidity, and the related risk that a further aggressive easing action would increase the odds of an overly accommodative policy stance and rising inflationary pressures in the future."
In short, the Market Climate remains on a Crash Warning, and the market action that could be of most help is actually going in the wrong direction. Day-to-day rallies always entice investors into participating and taking on new market risk. At present, however, market conditions indicate that the expected return to that risk remains poor. We continue to find interesting and attractive values among individual stocks. But since those stocks are also affected by market movements, we have hedged away the portion of our risk that is tied to market fluctuations. What is left is risk that we are willing to take, and that we expect to be compensated, over time, for taking.
Tuesday Morning June 26, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. Moreover, trend uniformity is quietly worsening, with disturbing weakness in sectors such as consumer stocks, utilities, transports, retail, and healthcare. While the action in utilities may be related to regulatory issues, much of the broad deterioration in trend uniformity suggests a rather sudden weakening in the outlook for consumer spending, as well as continued problems related to energy.
That said, there's no question that the Fed will ease again here (I still wouldn't venture a guess as to the extent, and our discipline doesn't require such forecasts). We can't rule out the possibility that the eagerness of the Fed to ease will help to support the market. Nor can we rule out investor frustration that the repeated easings has met with little tangible economic improvement. Rather than guess which way investors will react, we'll stick to our own discipline of identifying rather than forecasting. Our discipline requires that we avoid speculating on market risk unless we have evidence from observable market conditions that the average return/risk tradeoff is favorable on average. For now, we still lack sufficient evidence.
Keep in mind that given current market valuations, taking market risk cannot be considered an investment (in the sense of buying a stream of cash flows at a reasonable price), but is instead a speculation (purely on the expectation that high valuations will move even higher). Even so, if trend uniformity were constructive, it would be reasonable to speculate, and we would do so. We simply don't have enough evidence that such speculation is reasonable here and now. Indeed, we have important trend deterioration suggesting a weakening consumer, which would be this economy's Achilles heel.
Sunday June 24, 2001 : Hotline Update
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The Market Climate remains on a Crash Warning here. If long-term bonds continue to act well (moving toward the 5.4% level, for example), I would expect enough improvement in our yield trend model to move off of this warning. If bonds could improve sufficiently without a significant intervening market decline, we could even move to a constructive Market Climate and reduce the extent of our hedging. At present, however, we still don't have enough evidence to make such a move.
Recent market action has alternated in strength between technology and financials, the two groups which we are most inclined to avoid here. That gives our day-to-day portfolio movements an odd appearance over the short run. On rallies, investors are frequently piling into tech stocks, which we are underweight. And on declines like Friday, they sought a haven in financials, which we are also underweight. It is important to recognize that this is fairly transitory behavior, and we have no reason to expect it to continue indefinitely. Still, for those of you who monitor our day-to-day fluctuations, which have been in a narrow range for the last couple of months, the bulk of the daily "noise" is generated by how techs and financials have been performing relative to the rest of the market. Over time, our returns are driven by how our stock selections perform, overall, relative to the market, and by how effective our models are in capturing return when taking on overall stock market risk. Right now, we remain fully invested in favored stocks in most of our portfolio strategies, and we have hedged away the bulk of our exposure to overall market fluctuations, because we don't expect such risk to be well compensated. A Market Climate shift would make us willing to hold our favored stocks with a smaller hedge.
I continue to view the economy as in recession. Interestingly, the Chairman of the National Bureau of Economic Research (NBER) Recession Dating Committee just posted a report saying "The data normally considered by the committee indicate the possibility that a recession began recently." That committee determines the official start and end dates for U.S. recessions (but does not attempt to forecast them or identify them in real time), and is headed by Dr. Robert Hall, also one of my Ph.D. advisors at Stanford. Dr. Hall notes that industrial production and employment weigh heavily in the determination of when a recession begins, but that the economy "has not yet declined nearly enough to merit a meeting of the committee, or the determination of the peak date."
Certainly, the committee will not meet until evidence of a recession is very clear. Still, in saying such a meeting has not occurred, I notice that Dr. Hall added the word "yet." Whether that meeting occurs sooner or later will be determined by how consumers behave in the next few months. I'm not alone in expecting a sharp slowdown in consumer spending growth. At the same time, the Fed will be easing again this week (no guess as to the extent). In my view, it's the hope that Fed easing will be effective that has kept consumers eager to spend. Yet as the months have passed, it's notable that concerns are growing that the Fed may be ineffective. As that consensus grows, the consumer may very well pull back harder than widely expected.
Barron's had a fascinating piece this week that plots the S&P 500 earnings yield against the ratio of Producer Prices All Commodities / Producer Prices for Finished Goods. The relationship is impressively tight. Unfortunately, the author, John Mueller, goes too far in suggesting that this implies that the "standard theory" of P/E ratios is incorrect. Baloney. Plain vanilla finance theory suggests that the earnings yield on stocks should be proportionate to "k - g", where k is the long term return on stocks required by investors (which must compete with interest rates) and "g" is the long term growth rate of earnings. As it happens, Mueller's ratio has a very strong positive correlation with interest rates (such as the 10-year Treasury yield), and a very strong negative correlation with S&P earnings growth (such as the 10-year growth rate). Thus, Mueller's ratio is highly correlated with the k-g of standard, plain vanilla finance theory. And unfortunately, there is zero correlation between subsequent S&P 500 returns and deviations of the actual earnings yield from the yield implied by his price ratio. That's not to undermine Mueller's research, which is excellent. But it is hard to swallow when a researcher finds an interesting fact, and then imagines that it overturns standard finance theory.
As usual, we don't need to forecast. The Market Climate remains defensive here. We know what would have to occur to see a shift, but for now, we're defensive.
Sunday June 17, 2001 : Hotline Update
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The Market Climate remains on a Crash Warning here. Last week, a number of important market internals deteriorated from favorable to unfavorable trends. That will make it much more difficult for the market to recruit favorable trend uniformity in the near future. Again, the best hope for a positive shift in the Market Climate would be a very, very strong rally in long-term bonds. Barring that, there is a real risk we could begin to see a very broad downturn. That's important, because the relatively favorable advance-decline line has been one of the key factors that has kept some analysts constructive. A sharp deterioration in market breadth would be most unwelcome.
On the sentiment side, we continue to see smart money selling hand in hand with giddy public optimism. Sales of stock by corporate insiders continues to be ominously high compared to insider purchases. Specialist short selling also remains high, as well as short selling by commercial hedgers. In contrast, speculators are strongly on the buy side, and the percentage of bearish investment advisors is once again below the important 30% level. The expected favorable impact of Fed easing is, in my view, fully priced into stocks. The real surprise would be an economic downturn that erodes into a fully recognized recession, and a profit slump that fails to show signs of an upturn in the near future. Last weeks earnings warnings and industrial production figures gave the first hint of that.
More disappointment is likely. Technology analyst Dan Niles noted a couple of weeks ago that while Intel was still giving upbeat lip-service about a third quarter upturn, consumer vendors such as Handspring were suddenly forecasting a 50% plunge in sales. Niles noted that there is typically a lag of about 3 weeks between when consumer companies recognize a slowdown and when components suppliers feel it. One would think companies like Intel would also recognize this, but as we saw last September (when Intel did a major about-face in its guidance just after predicting strong numbers), they evidently do not. So in the next week or two, we're likely to hear of "sudden" order dropoffs and cancellations from a wide range of technology companies. A few companies such as Oracle may eke out expected earnings due to a few big orders from a small number of key accounts near the end of last quarter. But for companies that rely on a large number of orders from a variety of customers, I would expect trouble.
In any event, the current Market Climate remains defensive here. A very strong rally in long-term bonds could help to move us to a more constructive position, as long as we don't see a sharp downturn in market breadth first (as measured by significantly more individual stocks declining than advancing). Unfortunately, we are seeing a real deterioration in market internals, so weaker breadth may very well be just ahead. We know exactly what must occur in order to warrant a more upbeat position, but for now, the evidence is clearly weighted to the defensive side.
Friday Morning June 15, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. This means that the market is exhibiting extreme valuations a lack of favorable trend uniformity, and hostile yield trends such as long term interest rates. In this Climate, our discipline requires us to be defensive. No forecasting or opinions are necessary. No guessing about the next Fed move. No speculation about whether the GE - Honeywell merger goes through. The factors that have defined a historically poor expected return/risk tradeoff are currently indicating such a poor tradeoff. Everything else in this update is opinion, commentary, and background. The current Market Climate is all that we need to identify to set our investment position.
That said, I believe that the current Crash Warning has taken on a sudden urgency. Surely, the market has pulled back enough to allow a corrective bounce, but there is also a real risk that this Crash Warning will live up to its name. In recent days, we've seen our measures of trend uniformity plunge quite abruptly. This has occurred not only in our own proprietary measures, but measures such as the Lowry's statistics, market leadership (with new lows flipping above new highs on the Nasdaq), and in widely ignored indices such as the Dow Transports and Utilities.
As I've noted before, Dow Theory is a fairly straightforward version of trend uniformity, which most investors view as antiquated. But when placed in the context of market valuations, it actually has quite a good historical record. Richard Russell of Dow Theory Letters ( www.dowtheoryletters.com) notes, "If you're losing money in the market here, you don't understand the Dow Theory, which has been issuing warning after warning." Specifically, the favorable action of the Dow has been sorely unconfirmed. When that happens in an overvalued market with breadth rolling over, it typically spells trouble. And that's what we have now. As Russell puts it, "Nobody is thinking in terms of the economy getting worse in the months ahead ? nobody, that is, except maybe the stock market."
In short, market action is suggesting that something is terribly wrong with the view that the economy is "just about to turn the corner." From our perspective, it is also suggesting that investors do not have the robust preference for market risk that generally underpins legitimate bull moves. Weak trend uniformity implies an underlying skittishness, and that can lead to a jump in the risk premium demanded by investors. With the yield on stocks at just 1.25%, even a tiny increase in the risk premium demanded by investors has the potential to generate a very dramatic downturn.
So again, the Market Climate is defensive, and that's all we need to know. My own views about the urgency of this Crash Warning do not feed into our position, and it does not translate into any shift in our investments. But it certainly does make me more comfortable with our current stance. It's not terribly obvious from the major averages, but market internals are weakening ominously. A follow-through in the form of a market crash certainly is not ensured, but it's also not something I rule out.
Sunday June 10, 2001 : Hotline Update
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The Market Climate remains on a Crash Warning this week. And while we never rule out the possibility of a sudden shift in Climate, the most likely components that would trigger a shift moved further away from such a signal last week. As I noted last week, the easiest way to recruit favorable trend uniformity would be a very strong rally in long-term bonds. A decisive break below 5.4% on the 30-year Treasury and below 5% on the 10-year Treasury would probably be sufficient. But such a move would have to occur without any significant intervening selloff in the market. The reason is that other important and currently favorable trends are close to breaking down. In all, not a particularly promising set of conditions. As usual, we'll let market action speak for itself. If we recruit sufficient trend uniformity, I expect to lift off somewhere between 30% and 50% of our hedge. So while we would still carry a partial hedge, it would be limited enough to participate in any continued rally. Again, at this point, conditions don't appear very promising for a positive shift.
When writing about long-term returns in our updates, I've noted that peak-to-peak earnings growth for the S&P 500 has historically been less than 6% annually over the past 10, 20, 50 and 100 years. One aspect of this, however, is that when earnings have grown unusually above their 5- or 10-year averages, the subsequent growth rate of earnings tends to be much less than 6%. The same is true when return on equity (earnings/book value) and profit margins (earnings/revenues) have been unusually high. So historically, a long period of rapid earnings growth does not beget further rapid earnings growth. To the contrary, earnings growth typically falls well below average as profit margins and return on equity settle back to normal levels. Based on current profit margins, return on equity, profits as a share of GDP, and other measures, it's very plausible that S&P 500 earnings may take as much as 5 years to substantially better last year's peak levels.
Of course, the S&P currently has more technology in it than historically. It's arguable that that's not a benefit but a liability. But as I've noted in prior updates, even allowing for the faster historical earnings growth of technology stocks, the fact that the S&P 500 carries more technology now than before has the effect of lifting the long-term earnings growth rate of the index by about 1.4% or less.
The bottom line is that the coming 5-10 years could very plausibly see not only a pullback in the P/E ratio of the S&P (from the current 24 times record earnings, and nearly 28 times current earnings), but stagnant earnings as well. In that event, stocks may not simply underperform T-bills. They may actually generate a net loss. That's important, because one of the justifications that investors are using to hold stock here is that they are "long-term investors."
Still, valuation does not determine market direction, particularly over the short run. Risk preferences do. Trend uniformity is essentially a signal that investors are willing to take more risk. It does not matter whether their reasons are rational, irrational or even completely delusional. A strong preference for risk exhibits itself as trend uniformity, and we won't fight it. Keep in mind that the Market Climate has been constructive on several occasions even in the past year. Most notably, during the summer of 2000 (turning negative on September 1st) and again early this year. So it's not particularly hard to turn our models constructive. It's just that the current market fails to do so. And that makes us concerned that the apparent strength of the recent rally masks an underlying insecurity and skittishness among investors that could reveal itself without notice. We'll be happy to take a constructive signal if it emerges. But we don't have such evidence here.
Thursday Morning June 7, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. With a period of favorable seasonality now out of the way, we can expect more natural responses to news developments. We saw that on Wednesday with Hewlett Packard's warning that business is slowing, rather than recovering, particularly internationally. The main focus on Thursday will be Intel's mid-quarter update. As noted a week ago, the latest semiconductor book-to-bill plunged to the lowest level since the last recession in the latest report. And on Monday, Cypress Semiconductor warned that their revenues would be cut in half due to massive order cancellations. That said, it's difficult to have assurance about investor response. Intel's creativity in technology is matched by its creativity in accounting, so we can't rule out implausible projections like revenues being down but earnings remaining on target. We could also get bad news, but still see investor enthusiasm if someone offers a throw-away comment like "We're starting to get a tingly feeling that it seems there may be a definite possibility that business may perhaps improve in the second half." We'll see. But holding onto stocks here because of what Intel may or may not say is no different from holding stocks based on whether the coin lands on heads or tails. It's pure speculation. At this point, the Market Climate remains negative, and there's no evidence that stocks offer a favorable return/risk tradeoff here.
I've already mentioned weak Transport stocks failing to offer a Dow Theory trend confirmation. It is also important to notice utility stocks falling out of bed here. That tends to be a negative sign historically, more so in steeply valued markets like this one, and dangerously so when bond yields are also higher than they were 6-months earlier. Recall that utilities, bonds, and valuations were in a similar situation just before the 1987 and 1990 market plunges. As usual, we'll become constructive if and when the market recruits favorable uniformity. Unfortunately, an increasing number of sectors are deteriorating rather than firming. A very, very strong rally in long-term bonds would be the market's best bet at generating sufficient evidence to be constructive. Until we get such a signal, there's not a compelling reason to take on significant market risk.
Wednesday Morning June 6, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. At this point, the greatest hope for a shift in the Market Climate lies with the trend of long-term interest rates. A drop below about 5.4% in the 30-year, and below about 5% in the 10-year would probably be sufficient to move us off of a Crash Warning. That would be a fairly large bond market rally, but not out of the question. If that were to happen without a significant break in stocks, more favorable bond market action could kick in enough positive trend uniformity to allow a constructive position here. While there are a number of other internal developments that could also help, most are still too weak to consider them plausible candidates to trigger a Climate shift. For now, we are defensive.
There is no sense in trying to second-guess the market or move ahead of the evidence. No sense in trying to divine whether the recent bounce will continue or not. We don't have the evidence to act on it, and our discipline does not allow us to substitute the seat of our pants for evidence. At this point, the evidence continues to suggest disturbingly great risk. That's especially true since the worst bear market plunges invariably come immediately on the heels of bear market rallies (how could it be any other way?) Again, the best hope for a constructive position, at this point, would be a strong continued improvement in bond market action, without any significant intervening downturn in stock trends and breadth. We don't see that yet. We wouldn't mind seeing it, and we are very willing to establish a constructive position if the evidence supports it. But there is no such support at present.
On the bright side, two pieces of news. First, Amazon projects a 4th quarter profit on a "pro-forma" basis, excluding, of course, interest charges on debt, acquisition and restructuring charges, and anything that Generally Accepted Accounting Principles might otherwise place in the way of that hypothetical pro-forma profit. Second, I'm happy to report that on a pro-forma basis, I am now 6-foot-4.
Sunday June 3, 2001 : Hotline Update
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The Market Climate remains on a Crash Warning here. Indeed, trend uniformity deteriorated yet again last week, taking us further from the possibility of a constructive position in the near future. The market also saw a smaller likelihood of registering even narrow forms of uniformity such as a Dow Theory trend confirmation. During the recent rally, the Dow Transports have failed to confirm the advance in the Dow Industrials. And last week, the Transports headed south, creating a larger hurdle for a Dow Theory confirmation. Probably the only analyst who understands the importance of this enough to write about it is Richard Russell (www.dowtheoryletters.com). I realize that this seems too archaic to most investors to even consider it important. That is, unless you actually study the historical data, at which it becomes clear that these nonconfirmations in an overvalued market can be as important as signals from market breadth and interest rates. So while we base our determination of the Market Climate on our own model, it is important that we also see a lack of confirmation from other measures of uniformity such as Dow Theory.
As usual, we have no views about short term action. The market does lose favorable seasonal influences about Wednesday, but that's not a factor that we trade on. Still, the loss of seasonal benefits will leave the market with a relatively sad looking plate to nourish it: rising long-term yields both in the U.S. and abroad, extreme valuations, falling profit margins, poor trend uniformity, and negative indications from various technical oscillators. In all, we're comfortable with a defensive position here.
The latest employment data continue to be awful. New claims surprised on the high side of estimates, and payroll employment fell again last month. The rate of unemployment declined a tick because the size of the labor force fell more sharply than the number of jobs did. If you track actual payroll figures, you'll notice that the Labor Department also revised recent data upward by over 400,000 jobs over the past year ("benchmark revisions"). But even after those revisions, year-over-year job growth is at a level always and only seen during recessions. This is true regardless of whether you include or strip out manufacturing. In all, a continued negative employment picture.
Meanwhile, we're getting fresh layoff announcements both from "old economy" companies like DuPont, and "new economy" companies like EMC. In both cases, stocks are selling off, which demonstrates that investors are taking those cuts not as a signal of profit improvement ahead, but instead as a signal that future growth rates may be less than reflected in the stock prices. After all, why slash jobs if you really expect a quick rebound to 40% annual growth rates in the second-half of the year?
Still, investors insist on attaching hope to every new piece of bad news, attaching their hopes to completely baseless opinions that the economy might be turning the corner soon. Yeah. And the check is in the mail, the cable guy will be there at 10, this won't hurt a bit, and she really does have to wash her hair on Saturday night.
Thursday Morning May 31, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. As usual, I have no opinion regarding short term action, particularly here, when about a week more favorable seasonality is pitted against probably weak economic data. All that's essential to know is that the Market Climate is highly defensive at present.
Sun Microsystems surprised the market Wednesday by warning that revenues would miss previous expectations by more than 10%. What they did not say is that earnings would likely come in negative. In the April 1st update, I noted my expectation for earnings losses for both Cisco and Sun in the quarters ahead. Cisco has delivered a quarterly loss already, but reported their standard "penny ahead of estimates" through a cartoonish set of earnings adjustments and "extraordinary" charges. My view for Sun hasn't changed, so now we get to see how well their accountants can dance.
It is important to emphasize again that earnings are an unreliable measure of value here. This is partly because earnings are so heavily managed by accounting quirks, but also because profit margins are likely to come down further. Especially for technology stocks, a seemingly "attractive" P/E should not be taken as a sign of value. As I've noted before, what you really buy when you invest in a stock is a stream of "free cash flows" thrown off by a company over time. To bundle up a pile of outrageously large losses and then label them "extraordinary" doesn't turn them into cash again. It just lets the company draw little happy faces on their press releases. Cisco, Oracle, Sun and EMC are also of concern because they continue to require freakishly large increases in working capital, including inventories and questionable receivables, in order to support their reported numbers. In general, these companies have had to withhold more than 20% of incremental revenues as working capital in recent years. Unfortunately, both capital expenditures and required increases in working capital have to be deducted before you arrive at the cash flow that can actually be distributed to shareholders. Moreover, when stock repurchases are made simply to offset dilution from options grants to employees (which is the rule these days), those repurchases are not a distribution to shareholders, and must also be deducted from free cash flow. Despite their constant management of earnings reports, these companies have generated a ridiculously small stream of cold hard cash for shareholders, in relation to the prices investors are paying for the stocks. But watch CNBC, and all you'll hear is that the P/E ratios look more reasonable now than a year ago.
In the May issue of Research & Insight, I noted the risk of a downturn in personal spending. Evidently, this risk has not escaped the Fed, which noted in the minutes of their March 20 meeting "consumers might well endeavor to boost their savings, and even a fairly small increase in what currently is a quite low saving rate would have large damping effects on aggregate demand that could weaken, if not abort, the expansion." Now, increased attempts to save do not generally cause economic weakness (as Keynes believed) because greater savings are typically channelled to greater investment activity. The problem here is that capital spending is weak, both here and abroad, so attempts to save more won't easily trigger increased investment. As a result, the economy has uncharacteristically large risk of a sharp downturn if consumption weakens. The employment data in the next couple of months are critical. Consumer confidence is largely explained by past changes in employment, inflation, and manufacturing activity. Weak employment data creates a strong likelihood of declining confidence and spending, and that would be the point at which this downturn would accelerate to a more recognizable recession. Something to watch.
In the meantime, an alert client informs us that in a recent survey of consumer attitudes, consumers now look at the unused portion of their credit card limit as "savings." Evidently, the Fed wants them to spend that too. The question arises, "Then what?", but we stopped believing years ago that the Fed actually cares about the long-term. We've got our opinions on how all of this will unwind. But again, the main concern here is the Market Climate, which remains on a Crash Warning for now.
Monday May 28, 2001 : Hotline Update
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The Market Climate remains on a Crash Warning here. Just a research note. With the assistance of Nelson Freeburg of Formula Research, we've found an interesting and surprisingly useful measure of trend uniformity to add to our arsenal. When combined with our other criteria, it allows a constructive position in an additional 5% of historical data, during which periods stock returns have averaged about 24% annually. That's a better result than dozens of other "overlay" strategies we've tested, none which could even generate incremental returns above the T-bill rate, despite being very good models in their own right.
That's the good news. The bad news is that even this measure is fully defensive here.
As usual, we will quickly become constructive when and if we receive sufficient evidence to warrant such a move. In the past two weeks, internals have deteriorated again, reducing the likelihood of a near term shift, but we'll let the data speak for itself. In the meantime, however, the greatest risk during bear markets typically comes on the heels of strong short-term rallies. So until and unless this rally is able to recruit evidence that internals are uniform (rather than simply evidence that Nasdaq investors are lemmings), we associate the current bounce in the market with greater risk, not less. This is particularly true in light of rising long-term interest rates, and an emerging but unrecognized recession. On the sentiment side, we're seeing very aggressive insider selling activity contrasted with a delirious optimism by individual investors, as measured by the AAII investor sentiment survey. In all, not a comfortable picture.
Again, I want to stress, we do not base our positions on opinions or forecasts, nor are we market timers. We set our positions to be consistent with the Market Climate objectively identified at any given point in time. Our interest is not to forecast specific rallies or declines, which we see as futile, but rather to position ourselves based on the average return/risk characteristics of a given climate.
A market timer views future returns as being drawn from a big probability distribution (or "bell curve"), containing a wide range of possible returns - a few large negative ones, a few large positive ones, and a lot of small returns either way. A timer attempts to predict which side of the distribution (positive or negative) the next draw will be taken from. In contrast, we view future returns as being drawn from several entirely different probability distributions, each with a different return/risk profile. We call them Market Climates. Our goal is not to forecast which side of the distribution the next particular draw will be taken from. Rather, our goal is to identify which distribution we are in.
In short, we continue to identify the current Market Climate as hostile, and we are not inclined to speculate on the current rally in view of the Market Climate we identify here.
As for the economy, we expect the ongoing (and unrecognized) recession to start gaining traction in the weeks ahead. Thursday's new unemployment claims and the April unemployment report due on Friday are likely to be important in that respect. Investors have become very willing to look over the valley to an economic recovery that they believe the Fed has assured. And given the simplistic faith that "Fed moves act with a 6-month lag", even weak economic data has little effect just yet. But if we move into June, and the weakness begins to accelerate rather than rebound, we may see a great deal of confidence erode quickly.
Over the very short term, there is a slight upward seasonal bias that will persist through early next week. We wouldn't speculate on such a weak basis, but we wouldn't be surprised by a bit more top formation either. In any event, the Market Climate currently remains hostile, and for our discipline, that's all we need to know.
Thursday May 24, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. Generally, a favorable trend signal emerges rather easily in a legitimate bull market, but this rally is missing a significant number of "typical" bullish features. Though a number of internals could potentially move trend uniformity to a postive condition, none are budging yet, which keeps us skeptical about this advance, and concerned about a sudden failure.
If we do recruit a favorable trend signal, we expect to quickly remove anywhere between 30-50% of our hedges, placing us in a still-hedged but constructive market position. But we're not acting pre-emptively, and we're not holding our breath for such a signal either. Regardless of how many new unemployment claims appear in the data to be released this morning, our expectation is that unemployment is likely to move much higher, and consumer spending is likely to deteriorate - an unusual and very negative factor in recessions.
I've noted that most of the talk of having hit bottom in the economy is without support from the data. I have very little doubt that rather than having hit bottom, the economy is about to turn far uglier, far faster, than most analysts imagine. So far, most of our arguments have been based on macroeconomic indicators, but now the anecdotal evidence is suddenly catching up. DuPont noted Wednesday that it is seeing a dropoff in activity from Europe for the first time in this slowdown. Ford will incur billions of dollars in costs from its latest recalls, its Chairman vowed Wednesday to "make up the difference" through cost-cutting elsewhere - almost a sure promise of major layoffs ahead.
Technology looks no better. Wednesday's data from the Semiconductor manufacturers trade association (www.semi.org) reports that new order bookings for semiconductors in April plunged 41 percent from the March 2001 level, and is 74 percent below year-ago levels. The industry group reports a sudden surge in order cancellations of previously reported sales, and the Chairman added that "The severity and depth of this industry correction is unprecedented." For those of you who follow such statistics, the semiconductor book-to-bill ratio plunged to 0.42 ($42 of new orders for every $100 of product shipped), the lowest level in a decade.
Meanwhile, Greenspan speaks to the Economic Club of New York today. I haven't a clue as to whether he views the economy as weakening or strengthening. Literally not a clue. The reason is that the economic outlook varies depending on whether you look at the rear view mirror, out the front windshield, at the indicator panel on the dashboard, at the growing pile of wreckage along the side of the road, or at passengers like Joe Battapaglia, Abby Joseph Cohen, and Charles Schwab, dangling their little watches back and forth whispering "Relax. Just Relax..."
So Greenspan's talk will be news, but I have no opinion on whether that will be positive or negative. The economic outlook is increasingly bleak, but I have no opinion about how long investors will be able to look over the valley (or canyon) in hopes of a recovery. The pleasant feature of our approach, though, is that we don't need to make forecasts. We don't position ourselves in hopes of predicting the next rally or decline. Rather, we position ourselves in line with the objectively identified Market Climate. No forecasting required. Right now, that Climate remains hostile, but a number of events could occur to shift us to a more constructive position. When we see that objective evidence, we'll shift our position. For now, we remain defensive. And whether we're fully hedged or constructive, we'll continue to hold a diversified portfolio of attractively valued stocks with favorable market action. In good markets and bad, that's always been our secret weapon.
Sunday May 20, 2001 : Hotline Update
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The Market Climate remains on a Crash Warning here. Despite hope to the contrary, the weight of the evidence continues to indicate a recession in the U.S. economy. Moreover, some of the first 2nd quarter earnings warnings began to emerge last week, and except for purely speculative comments that "we may have hit bottom", there was nothing in the actual data to support this. On the sentiment side, specialist short sales and insider selling remain very firm, while the latest survey of individual investors from AAII show only 18.8% bearish. So we've got an indicated but unrecognized recession, an overbought market, smart-money selling contrasted with extreme bullish enthusiasm by the public, all in the context of an overvalued market with lacking trend uniformity and rising long-term interest rates. Overall, this picture doesn't inspire enthusiasm.
That said, we are also prepared to reduce our defensiveness if the market is able to recruit sufficient trend uniformity, regardless of the other background conditions. It is very difficult to keep our models in an unfavorable condition in the face of an extended market rally, and this one is not an exception. When trend uniformity is favorable, the market generally has a positive return/risk profile, on average, regardless of valuations. For that reason, if the market is capable of extending this rally in a broad manner a few percent higher, we would expect to lift off a portion of our hedge. That would leave us in a still-hedged position, but with a somewhat greater exposure to market fluctuations.
Why not move even before such a signal, particularly if we're "close to the bar"? Well, that bar, or threshhold, between favorable and unfavorable trend uniformity is important, because it separates rallies that fail, on average, from rallies that persist, on average. That means that the worst failures - the rallies that show promise and then fail - are generally the ones that stop just below the bar. So we are not at all tempted to move pre-emptively. Rather, our greatest concern is that the market will establish trend uniformity, and then fail, giving us a "whipsaw" that forces us to shift back to a defensive position just after becoming constructive. That's a real risk, but we know from wicked experience that attempting to prevent whipsaws by ignoring favorable signals can lead to even worse difficulties. So we'll take a constructive signal if it occurs. Until then, we remain defensive.
Valuations and trend uniformity are effective because they are related to total return by definition (for more on this, see my 1998 research paper on time-varying market efficiency on our website). Remember, we are not market timers. We do not invest by trying to predict individual future rallies or declines. Rather, we invest based on the average return/risk characteristics of the prevailing Market Climate. We don't try to predict the future. We try to objectively identify the present. While I am happy to give my opinions, and identify them as opinions, we never actually have to forecast or second-guess the market. To act on anybody's hunch or second-guess about this rally, against the prevailing evidence, would violate our discipline. We are constantly researching new tools, interesting approaches, and the like, but without solid evidence that a strategy is effective when applied consistently (not just last month, or last year), we don't even blink. It's important for our clients and shareholders to understand exactly how rigidly we adhere to that discipline.
Thursday Morning May 17, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. Even so, investors are clearly nervous about missing out on a rally, despite a stunning degree of historical risk. That underlying nervousness is evidently preventing the market from generating trend uniformity. As I note in the latest issue of Research & Insight, trend uniformity generally signals a firm willingness of investors to take on market risk. And while investors are taking more risks here, their resolve is not firm, based on internal market action. That signals vulnerability. Moreover, with trading volume becoming very thin, the market is starting to look "amateurish" and jumpy. That can produce big days like Wednesday, but it is also what you see prior to crashes. As I've written before, a market crash is essentially a sudden wave of selling coupled with a lack of liquidity. The market has the potential for both here. Whether that potential is expressed, we'll see. At this point, we're defensive, but not positioned to strongly fight any continued uptrend.
It would be nice if it were possible to construct a "Holy Grail" timing model that would participate in every substantial rally without unacceptable drawdowns. That said, the model we actually use to identify trend uniformity has the highest return/risk ratio of any of the literally hundreds of approaches we've tested. We're fortunate to have Nelson Freeburg of Formula Research on our Board of Directors, and as one of the finest market analysts in the business, he has contributed enormously to the development of our current approach. Though our research in every facet of our management approach is always continuing, I sincerely doubt that a "Holy Grail" exists. Look at the people who have made money during the recent rally, and almost invariably you will find that they have still lost a fortune over the past year. Then look at a list of the wealthiest investors, and you will find none that have made a long-term fortune through short-term timing. Instead, you will find among those investors a common trait - adherence to a discipline, and the willingness to walk away from the table when conditions are unattractive. They simply don't attempt to take every seeming "opportunity." With valuations still extreme, trend uniformity still not generating the favorable uniformity that legitimate bull markets recruit very quickly, long-term interest rates in an uptrend, and weakness in other key groups such as utilities, this is still a table that we are walking away from. I wish we could buy into in this rally without exposing our capital to extreme loss. But then, I also wish I was 6-foot-4. Neither one is going to happen - at least not this week.
Until we have evidence that the Market Climate can be expected to generate a favorable return/risk tradeoff, tossing our money at this rally would be no different than tossing our money on the craps table because somebody happened to get a nice stack of chips on the last roll. We just don't behave that way. We continue to take the current Crash Warning seriously, and defensively.
Sunday May 13, 2001 : Hotline Update
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Just a note, the latest issue of Hussman Investment Research & Insight should be available on our website by Monday evening. We had sent an earlier version to press and stopped it to add some new research results. Unfortunately, this material significantly worsens our outlook for the economy ahead, and it is so statistically significant I preferred to incorporate it into the current issue. The print version will be mailed on Thursday of this week.
The Market Climate remains on a Crash Warning here. The action in bonds was particularly hostile last week, with 30-year yields surging to 5.88 on Friday. The 10-year yield also broke higher, placing long-term interest rate trends into a firm uptrend. As you know, when hostile yield trends occur in an overvalued market lacking favorable trend uniformity, market crashes have often, though not always resulted. And despite the insignificant uptick in the University of Michigan consumer survey, I continue to view the U.S. economy as being in recession. Worse, there is increasing evidence that this recession will be global. This is the first time since 1974 that both the U.S. and Japan have been in simultaneous economic contractions. Moreover, the European Central Bank has been steadfast in avoiding any and all interest rate cuts, so last week's surprising rate cut by the ECB should be understood as a sign of panic.
It is difficult to temper either my concern about the economy, or my disdain for all the eager analysts shouting "Come on in, the water's fine!" We will certainly move to a moderately constructive market position if trend uniformity improves, but I have to say that I have never been as uncomfortable about the joint prospects for the market and the economy as I am now. I hope that I am terribly wrong on both counts. Better to be wrong, miss a few percent in gains, and take a constructive position than to see the misery that indications suggest. On the market, I continue to believe that stocks are vulnerable to a crash. On the economy, I believe that the U.S. is in recession - one that threatens to be global in scope, and there is increasing reason to believe that overleveraged, undersaving consumers are about to shift their spending patterns in a fairly profound way. My reasoning will be clear in the upcoming report, but all I can say is that the U.S. trade balance may be about to show a stunning "improvement." And those of you familiar with economics know that that is not good news.
I received a good question the other day. Given that the S&P contains a higher weighting in industries such as technology, telecommunications, pharmaceuticals, and other "higher growth" industries, shouldn't the S&P deserve to trade at a higher P/E multiple than historically? The answer, I believe is yes. But the degree is virtually inconsequential. Specifically, the S&P 500 technology sector has historically averaged a P/E of 17 (as have other "high growth" groups), versus the average mutiple of about 14 for the 500 Index as a whole (which has always included some tech anyway). So even if the index weighting in "high growth" groups went from 20% to fully 60%, the justified P/E ratio would rise only from 14 to 15.5. The main effect would not be on the P/E ratio, but on the dividend yield, since the higher growth of tech companies has always come from "plowback" of earnings into new investments rather than dividend payments. But even here, there is no way to justify the current Price/Dividend ratio of over 80 on the S&P.
As for the Fed meeting on Tuesday, I have only one reason to differ from the consensus view of a 50-basis point cut. My contrary thought is that the FOMC must realize that such a consecutive string of 50-basis point cuts tends to make market participants believe that this is the norm. A more typical 25 basis point cut would be a signal to the market that the Fed sees decelerating risks of recession, and that rates should not be expected to be cut indefinitely. We've already got one of the fastest growth rates in the Monetary Base on record, so it's not clear that the Fed can justify further rate cuts on the basis of insufficient bank liquidity. And though I do believe that this recession is about to turn worse, not better, I don't believe that faster growth in the money supply will have a measurable impact. In short, while I expect a worsening recession, I don't see much help coming from more aggressive rate cuts. And given that most economists don't seem to recognize a recession, much less a worsening one, there's not a clear reason for a 50-basis point cut in view of already breathtaking monetary base growth. Arguing most for a 50-basis point cut is that the Wall Street analysts want it. Waaaaah.
(I told you I was finding it difficult to temper my disdain.)
In any event, 50-basis point cut or no, mid-May is likely to usher in a new string of earnings warnings. Now we see whether the recent rally has legs. As I said, I hope that I'm terribly wrong about all of this. We'll take a constructive signal if we get it, but for now, we're defensive.
Sunday May 6, 2001 : Hotline Update
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The Market Climate remains on a Crash Warning here. While it's always disappointing even to pull back by 5% or so, we continue to rigidly adhere to our discipline. Despite the recent advance, market internals have not generated the kind of uniformity that is normally obvious within a few weeks a legitimate bull market advance. Moreover, valuations remain breathtaking, with the S&P 500 over 25 times earnings and even more extreme readings on the basis of fundamentals such as dividends, revenues, book values and cash flows. Finally, interest rate and other yield trends remain hostile. That combination of unfavorable trend uniformity, unfavorable valuations, and unfavorable yield trends is what we characterize as a Crash Warning, and our discipline requires us to maintain a strongly defensive position during such periods.
Friday's unemployment report added confirmation to what we see as certain: the U.S. economy is in recession. Historically, the unemployment rate has never advanced more than 0.5% from its low without a recession in progress. The NAPM Employment Index has never fallen below 40 except during recessions. Consumer Confidence has never declined 20 points below its 12-month moving average except in recessions. Non-farm employment has never grown at less than 0.5% year-over-year except in recessions. The ratio of corporate bond yields to commercial paper has never increased by 0.5 from its low except in recessions.
On the other hand, bear market bottoms have never occurred anywhere near 25 times earnings. Indeed, while a series of 4 Fed rate cuts has historically been favorable for stocks, those previous instances have occurred at just 10.9 times peak earnings, on average. The poorest follow-throughs after prior Fed easings accompanied high P/E markets (where "high" means a P/E of about 15). And historically, bear market bottoms have not occurred until the accompanying recessions have been well recognized in the media.
Could this time be different? Of course. Every time can be different. But we have no evidence upon which to base an investment shift here. If trend uniformity improves, we will move to a moderately constructive stance, regardless of the economic background. But what we see here is not evidence but hope. Comments like "Earnings have been very bad here, so we must be near a bottom." or "The employment report was worse than the worst expectations, so we must be near a bottom." This isn't evidence, but reckless optimism. Optimism that because things are bad they can't get worse. Unfortunately, bad things tend to happen when you've got the market at 25 times earnings, profit margins coming off of a historic high, wages rising much faster than prices in an environment of falling productivity, household and corporate debt levels far beyond any historic peak, stocks comprising a frightening percentage of household assets, default rates rising, the U.S. dollar overvalued and vulnerable, institutional investment managers 64% bullish on the coming 6 months, versus only 13% bearish, a recession that virtually every economist denies despite a laundry list of signposts that always and only occur in recessions, and a market that fails to generate levels of trend uniformity that have been easily achievable in legitimate bull market advances.
We refuse to abandon our discipline because "this time might be different", without also having an alternative approach that is more attractive on a return/risk basis when followed with rigorous discipline over time. Without evidence of such an alternative, deviating from our discipline would be substituting the seat of our pants for a thoroughly tested approach. We can't go back over history and see how investing by the seat of our pants would have performed over time, but having seen the vast majority of investors attempt that strategy, we're sure it wouldn't be good. Our models incorporate Federal Reserve rate moves already. Unfortunately, those rate moves are not enough to make us constructive here.
On the subject of rate moves, a further 1/2 point cut on May 15th is virtually certain. Friday's rally was essentially a response to that virtual certainty, so we view the coming Fed move as already priced into the market. The problem for stocks here is that a relatively vicious second-quarter earnings outlook is not priced in. Typically, pre-announcements begin about mid-May. So while I'm fairly agnostic about what happens over the coming two weeks, I have an increasing concern that mid-May could usher in a very risky three month period. Essentially, the next three months threaten to provide investors with further evidence of a recession, declining consumer confidence, substantially weaker profits, and a palpable concern that Fed interest rate cuts really aren't having much effect on a deleveraging economy. Of course, a market plunge could also be blamed on something quirky, like a sudden collapse in the Argentine currency board. The main point being that until the Market Climate shifts out of a Crash Warning, a market crash should not be ruled out. Again, a crash doesn't have to occur, but every historical crash of note has emerged out of this relatively rare set of conditions.
The bottom line is simple. If this is a sustainable bull market, we would expect evidence from trend uniformity soon, and will shift our position when it emerges. But while we would willingly become more constructive, it would be a bull market with nowhere reasonable to go on the upside. At this point, however, we continue to view stocks as being in an overbought and ultimately unsustainable bear market rally. With strong evidence of a recession in progress, our Market Climate on a Crash Warning, and the market at imponderably high valuations, this may very well be a bear market with nowhere unreasonable to go on the downside.
Wednesday Morning May 2, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. I would be thrilled if it was not so, and if we had a reasonable basis for being positively invested and optimistic about the market and the economy. Unfortunately, what I see is not evidence, but hope masquerading as analysis. The phrase "I think we've seen the bottom", repeated frequently, is about all the support behind this market. Yes, the Fed has cut short term rates four times in succession. Unfortunately, long term rates are actually trending higher. Yes, in previous instances when the Fed cut 4 times, the market was generally higher a year later. Unfortunately, that result was not due to earnings growth but an expansion in the P/E ratio from an average level of just 10.9 times peak earnings at the time of the fourth cut. The S&P currently trades at over 23 times peak earnings.
The NAPM figures on Tuesday were hailed for a 0.1% uptick, but that is still in recession territory. Moreover, the NAPM employment index has never been below 40, as it is currently, without an accompanying recession. And every recession for which data is available has been accompanied by an NAPM employment index below 40. A whole laundry list of such "necessary and sufficient" conditions suggest a recession in progress. Friday's employment report has at least some chance of confirming that.
In short, the market is not operating on data or evidence, but hope. While a further, broad market advance of about 4% could potentially move our trend models to a weakly constructive stance, we don't have that evidence at present.
The obvious question here is whether stocks are indeed in a new bull market. Currently, the evidence continues to suggest not only a negative answer, but a realistic risk that the market may instead crash. As I frequently note, a Crash Warning does not mean that the market must, or should be strongly expected to crash. Rather, it means that market conditions now match only 4% of historical data, and that this 4% contains virtually every market crash of note, including the most memorable ones in 1929 and 1987.
On the other hand, if market action continues higher, we can expect that our trend models will move us to at least a modestly constructive position (though still mostly hedged), regardless of valuations. There is, however, zero probability of our taking an aggressive or unhedged position in this market, regardless of trend action. The reason is simple: if this is, indeed, a new bull market, it is a bull market with nowhere reasonable to go on the upside. On current earnings, a 20% increase in the S&P would drive the P/E ratio over 30. The market is currently at nearly 85 times dividends and over 6 times book value, compared to historical norms less than a third those values. So while we'll take a modestly constructive signal if it arrives, that signal would almost surely be followed by tepid returns. We'll follow our discipline nonetheless.
In any event, until our models suggest otherwise, we continue to treat this as a classic bear market rally. Historically, the worst plunges come on the heels of these things. Even though the market has hardly crashed so far, I'm reminded of the rally off of the 1929 low, which was about a 30% bounce. The broad view was that the economy was not in recession then either. Then the dollar suddenly plunged, and both stocks and the economy followed in free-fall.
I've said it before: watch the dollar here. Essentially, a plunging dollar would mean that inflows of capital from foreigners has suddenly stopped, which would indicate a sudden weakening in domestic capital spending. If that were to occur, we would get a massive shrinkage in the trade deficit, but nothing good would come from it. Unfortunately, the evidence continues to point in that direction. So again, watch the dollar.
Bottom line, I wish I could be a bull, but market conditions rob me of that pleasure. Regardless of near-term trend action, there is no basis to believe that stocks are in a sustainable bull market. There's just nowhere reasonable to go from here. Investors are content to take on new risks based on hope and opinions. We don't invest on my personal opinions or anybody else's. Rather, we rigidly follow our discipline. Until and unless trend conditions improve sufficiently to warrant a modest constructive stance, we remain defensive. Indeed, we currently remain on a Crash Warning.
Sunday April 28, 2001 : Hotline Update
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The Market Climate remains on a Crash Warning, which we define as 1) extremely unfavorable valuations, 2) unfavorable trend uniformity, and 3) rising yield trends. This combination has occurred in less than 4% of historical data. We define this combination as a "Crash Warning" not because this combination always produces a crash. It hasn't, and may not this time either. Yet every historical crash of note has emerged out of this single, relatively rare set of conditions. We take that seriously.
It is important to recognize that our measure of trend uniformity extends beyond the major indices and is heavily influenced by "market internals". This includes the action of various industry groups, long-term bonds, corporate bonds, utilities, transports and so forth. While the recent rally has taken some of these measures well off of their troughs, the market has still not recruited enough uniformity to lower our defensiveness. One of the hallmarks of early bull markets is the tendency for trend uniformity to turn favorable very quickly - in some cases even just before the major indices hit their lows. This hasn't occurred with the recent rally, which makes us skeptical. If, however, the major indices were to advance another 5% or so, it's likely (though not certain) that uniformity would move us to a modestly constructive stance. If you're wondering whether the market could rally indefinitely without our trend models becoming positive, the answer is "no." Here, however, we remain defensive.
One of the most profound dangers we see here is the action of long-term interest rates. Long rates have been rising since early this year, and have spiked sharply in recent weeks. 30-year bond yields are up about a full percentage point, and even 10-year Treasuries are up about 0.6%. And while we've never agreed with the popular model of comparing earnings yields to the 10-year Treasury, it is interesting to note that a comparable 0.6% increase in the S&P 500 earnings yield would require prices to plunge by a quick 15%. In any event, the surge in long-term rates is not benign.
The big news last week was the advance GDP report, which showed a 2% increase for the first quarter. On that figure, we agree completely with Evan Koenig, the senior economist of the Dallas Fed: "This is an advance estimate, and historically, these have been subject to large revisions. Two percent is within the range of uncertainty for those forecasts... You're right to be skeptical of these numbers." Keep in mind that the initial GDP estimate was also positive in the third quarter of 1990. That was the first quarter of a new recession, and the final GDP figures were revised to negative readings. Marty Zweig did an interesting piece for Barron's a couple of months ago that measured the average error between initial and final GDP reports as more than 1.5%. So it would not be surprising to see this figure ultimately revised negative.
Furthermore, the popular notion of a recession as "two quarters of negative GDP growth" has no basis. I've got something of an inside line on this, given that one of the members of my dissertation committee back at Stanford was Robert Hall, who heads the NBER recession dating committee. Dr. Hall regularly stressed that there was no "definition" of a recession. Rather, recessions were identified as a broad decline in several important measures of economic activity, not simply in production, but in other measures such as capital spending and employment. While everybody focuses on consumers, the fact is that consumption virtually never declines in a recession. As Dr. Hall noted, "more than 100% of the decline in GDP during a recession is due to a decline in investment activity."
On those measures, recent data have been a disaster. Yes, the advance figure for GDP increased, but that increase was driven by higher government spending and a smaller trade deficit, while gross domestic investment plunged. As I've noted before, a plunge in domestic investment is almost always offset dollar-for-dollar by a corresponding "improvement" in the trade deficit. You may recall, for example, that the closest the U.S. has come to a zero trade deficit in recent decades was at the trough of the 1990-91 recession. In short, the real story wasn't the "good" trade number but the awful investment number.
Now turn to employment, and we see that new claims soared over 400,000 last week. Moreover, as I noted last month, the March unemployment rate would have been even higher if labor force entry had been typical. But since slow labor force entry one month is generally followed by higher than normal entry the next, the April unemployment number (due Friday) has a good chance of showing a surprising increase. Remember that the unemployment rate has never increased by 0.5% without an accompanying recession, so even a rise to 4.4% unemployment would suffice. In fact, the 3-month average unemployment rate has never advanced more than 0.3% without a recession. In general, that signal has occurred within 4 months after the start of a recession, but never leads. The March figures have already satisfied that condition.
Moreover, when the NBER officially dates the beginning of a recession (it doesn't attempt to forecast it or try to identify it in real-time), it tends to place important weight on when broad measures of activity, including investment and employment, first began to fall from their peaks. Given all that, I continue to believe that the recession began in the first quarter of this year, and I believe that the NBER will eventually conclude the same.
So we would treat the GDP report the same way we treat pro-forma earnings. Hypothetical. Both capital investment and employment have weakened to an extent that historically has not occurred outside of recessions. And keep in mind that even 2% GDP growth is sufficient to drive profit margins down, not up. So in the unlikely event the U.S. has entered a slow recovery, despite continued weakness overseas, we're still likely to see more earnings pressure ahead. In the end, we're left with a situation where either economic growth is slow enough to produce recession, lousy earnings, or both, or one where the Fed has to suddenly reverse its course of easing and long-term rates press even higher. In either case, the stock market remains terribly vulnerable here. Like the story goes, the Tribal Chief cries "Choose your fate! Death, or Oooga Boonga!", the guy says "I choose Death!". So the Chief raises his fist into the air, "Death! ... by Oonga Boonga!"
Sunday April 22, 2001 : Hotline Update
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Just a note, we've added a few extra reports in the Research & Insight area of our website www.hussman.net.
The Market Climate has shifted to a Crash Warning. That climate is characterized by extremely unfavorable valuations, unfavorable trend uniformity, and rising yield trends. This is the most unfavorable of any Climate we define. Though it has only occurred in 4% of the historical data, nearly every important market crash has emerged from this single set of conditions. Needless to say, we take it seriously. Our current position is strongly defensive.
I realize that it seems desirable to try to trade in-and-out of the market in attempts to capture periodic bear market rallies. The difficulty is that we have no objective way of identifying when they are likely to begin or end. Certainly, they tend to begin when the market is oversold, but in bear markets, oversold conditions can persist and worsen for weeks or months at a time. So an oversold reading is simply not enough evidence to take a counter-trend position in a bear market (just as an overbought reading is not enough evidence to go short in a bull market). Unless we have evidence that allows us to say "market conditions are predictably favorable and risk is reasonable", any attempt to "play" a short-term rally in a defensive Market Climate would be a violation of our discipline. And as soon as that discipline is violated, there is no clear guidance as to when it should be re-established. Once you break discipline, you start investing on hope, "feel", and opinion. We just don't operate like that, and if history is any guide, we don't need to. All that is required is to position ourselves in line with the prevailing Market Climate. Despite the recent "fast and furious" bear market rally, internal market action has been terribly unconvincing.
That said, our models would readily allow us to hold a more constructive position if internal market action was to improve sufficiently. We would also move off of a Crash Warning if the action of interest-sensitive sectors such as bonds and utilities were to improve. We don't rule these possibilities out, but again, we don't try to second-guess whether or when they might occur. For now, the Market Climate is in the most negative possible condition, and we are positioned defensively. For our most aggressive accounts, that means a sufficient put option position to gain strongly in a market plunge. For less aggressive approaches, it means that our portfolio of stock holdings is hedged by cash positions or a short sale in the Russell 2000 and S&P 100.
Keep in mind that even in a neutral position, we remain relatively light in large-cap technology and financial stocks. So we can lose a bit of ground when those specific groups lead the market higher without similar performance from the broad market (or when they decline less, as was the case on Friday). Again, our allocation to each individual stock is strategic and driven by the characteristics of each specific stock and industry. We set our positions because we have objective evidence that their return/risk tradeoffs are attractive, not simply because a certain sector is moving this week.
Earnings reports are now in full swing, and the raw numbers are terrible. You'll notice that invariably, earnings growth numbers are far below revenue growth numbers, which indicates that profit margins have been hit hard. Investors have a terribly misguided impression that if a company's earnings collapse by 80%, it's still good news as long as the earnings report beats analyst estimates by a penny. This sort of view demonstrates a complete ignorance of how securities are priced.
As I constantly stress, value is determined by the relationship between prices and properly discounted cash flows. In simplest terms, a stock price is always based on two figures: the long-term growth rate of future cash flows, and the long-term rate of return demanded by investors. The faster the growth of cash flows, and the lower the long-term rate of return demanded by investors, the higher the value for the stock. Current stock prices can only be justified by assuming implausibly high future growth rates for earnings and cash flows, and by assuming that investors are willing to hold stocks for a ridiculously low long-term rate of return (for more on this, see my comments about Byron Wein's model, on page 3 of the April issue of Research & Insight).
Current earnings reports are not important for whether they beat estimates by a penny or two. They are important because they are inconsistent with the earnings paths required to justify current stock prices. In other words, investors are focused on whether the quarterly results are above or below expectations, but aren't considering the crucial question, which is whether assumed long-term earnings growth rates can be justified. Those expected growth rates are still completely disconnected from anything seen in history. It's those long-term earnings growth expectations that are crucial, and current reports leave little or no hope of those expectations being satisfied. For that reason, long-term earnings expectations are likely to crater in the next couple of months. That, combined with an increase in the rate of return demanded by investors, is what could combine to produce a market crash here.
We don't require forecasts here. We aren't positioned in a way that requires a market crash, but unlike most investors, we do not rule it out. Our defensive position is consistent with the Market Climate currently in effect. As always, these comments are simply intended to provide background and texture to the cold, hard evidence. We'll change our position as the Market Climate shifts. It's just that right now, the evidence remains very cold and hard.
Thursday Morning April 19, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable trend uniformity. That puts us in a continued defensive position. Indeed, with long-term interest rates now close to their 12-month moving average, and other yields also creeping upward, there is a possibility that the Market Climate could move to not only unfavorable valuations and unfavorable trend uniformity, but rising yield trends as well. That combined set of conditions is what we identify as a Crash Warning. It has historically occurred in only 4% of the data, but virtually every major market crash has emerged from this set of conditions, including the most memorable ones in 1929 and 1987.
At the same time, there is nothing in our models which would prevent a shift to what we call "favorable trend uniformity" if market breadth and internal action improve. Unfortunately, despite the recent bounce, we have not seen sufficient improvement here, and that's one of the features that makes us skeptical that this advance will have staying power. Despite the dramatic move in the major indices in response to the surprise rate cut, advancing issues on the NYSE did not even outpace declines by a 2-to-1 margin. Bonds and utilities were down on the day as well. All of this contributes to a rather unimpressive trend picture at present. Bull markets generally recruit trend uniformity quickly, while bear market rallies do not. So again, we're skeptical.
While we are gradually finding technology stocks that exhibit both favorable valuation and favorable market action, these stocks are generally mid-caps, and we are still less exposed to tech than the major indices. As a result, technology-centered rallies are generally not helpful to our portfolios, particularly when they are focused on large-cap tech stocks with high price/revenue ratios. That has been the case in recent days. Still, we're only a few percent off of our recent highs, so watching investors pile back into the tech sector inspires more pity than pain.
About the only bullish technical evidence is that a few weeks ago, the 10-day average TRIN moved above 1.5. The TRIN (or "trading index") is calculated by taking the ratio of advancing issues to declining issues and dividing that by the ratio of advancing volume to declining volume. A 10-day average over 1.5 indicates a very "oversold" market, and often precedes significant rallies by about 2 weeks. That was certainly the case this time around. The problem is that at current valuations, the market has a great deal of potential downside. So extreme "oversold" conditions can last for quite some time even as the market moves lower. Without additional confirmation from trend uniformity, the TRIN is not enough to give much hope.
The S&P 500 now trades at a P/E ratio of 24 and a price/dividend ratio of 80. That's just not what you see at bottoms, and indeed, it is far above what we have historically seen even at the most extreme pre-crash peaks. Day-to-day however, anything can happen, and as usual, I have no opinion on very short term action here. As I've noted before, there is no requirement that bear market rallies fail immediately, but until and unless we actually observe a shift in Market Climate, these rallies should be treated as selling opportunities. If market internals can improve sufficiently, we will quickly shift to a significantly more constructive position. There is as yet no evidence of this.
I've argued for many months that the trade deficit was likely to narrow considerably. We've seen gradual improvement recently, but today's report was finally decisive. And it is important. Remember, for every dollar of goods and services the U.S. imports, we have to export something in return. That "something" is either goods and services, or securities. So to the extent that we import more goods and services than we export, we make up the difference by selling securities to foreigners. In short, the trade deficit is really a measure of foreign capital flows into the U.S. - it bridges the shortfall between what we as a nation save and what we invest. In a nutshell, the trade deficit is shrinking because U.S. capital investment is plunging. The gap between what we save and what we invest is shrinking, and we aren't as dependent on foreign capital bridge the gap. It's not clear that this is a good thing.
So far, this shift in capital flows has been very orderly. But look at the U.S. dollar. It is now very overvalued relative to foreign currencies, and with interest rates falling here, the dollar is even less attractive to foreigners. The bottom line is this: if the dollar starts declining in earnest, which is a strong possibility, we could see foreign capital flows not only slow but reverse, as foreigners sell their U.S. securities. If that happens, we would see a dramatic narrowing of the trade deficit (possibly even a sudden surplus), combined with a collapse in domestic capital investment. A plunge in the U.S. dollar would suggest that economic conditions are likely to deteriorate very quickly. Foreign selling could also drive Treasury bond prices lower, at least until more serious economic weakness emerges. So keep your eye on the Dollar Index.
Finally, as I've noted before, the Fed can cut rates and inject bank reserves, but it can't force banks to lend or companies to borrow. With the economy terribly overleveraged at consumer, business and investor levels, it is not clear that the demand for new loans can be easily stimulated. I continue to view the economy as being in a "deleveraging cycle." These occurrences are generally not responsive to interest rate cuts - witness Japan, which has been retrenching for a decade (with its stock market near a 15-year low) despite near-zero interest rates.
Bottom line, the Market Climate remains defensive here. We are willing to shift to a constructive position as soon as we see sufficient evidence of internal market strength, but it is not evident at present. That, along with valuations and economic conditions, makes us skeptical that the bear market is over. Short term, however, I would allow for anything. There's no need to make forecasts. We'll keep our position consistent with the current Market Climate until evidence of a shift emerges.
Sunday April 15, 2001 : Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable trends. Last week, technology stocks surged, with the Nasdaq soaring 14% while the Dow, Russell, and S&P indices gained 3-5%. In effect, the entire gain in the broad averages was tech driven, and stocks generally treaded water outside of that group. That's another way of saying that last week's action did nothing to improve the internal "trend uniformity" of the market. That substantially increases the risk that this rally will fail, possibly sharply, since sustainable rallies generally recruit internal trend uniformity relatively early-on.
Our own investment position remains relatively light on technology and financial stocks (neither which demonstrate attractive valuation or trend strength beyond very short term action). We have also fully hedged our market risk, using short positions or put options (depending on the investment strategy) on the S&P 100 and Russell 2000. Clearly, we don't blast to new highs during periods such as last week, when techs drive the indices higher without participation by the broad market. But that sort of action is generally not sustainable. In any event, the enormous spread in market action (14% in the Nasdaq versus 3% in the Dow) still induced only a relatively minor pullback. As usual, our allocation to various industry groups reflects valuation and market action in each of these groups, and we continue to see little evidence that either technology or financial stocks are attractive from an investment or speculative standpoint. We do hold a limited number of technology oriented stocks, but the issues that we find attractive typically have a more diversified focus, rather than being computer or internet-only companies.
The coming week holds the prospect of very unfavorable earnings developments, particularly on Tuesday, Wednesday and Thursday. As always, we don't require such negative developments to occur, but we do allow for a strong chance that the recent rally will evaporate on bad earnings news ahead. Investors are very eager to mark a "bottom" and move ahead with a new bull market, and I still see no evidence that they have actually done anything to reduce their risk exposure. These bear market rallies are opportunities, but investors really don't like to take them because they fear regret if the market rallies further. I've always believed that the only legitimate reason to feel regret is if you do something that you know is inappropriate based on the information you have at that time. If you make a decision that is careful, reasonable in terms of risk, and appropriate based on the best information you have, you might still be wrong, but there is no basis to regret it later even if you are wrong.
In contrast, a lot of investors know they are taking too much risk here, but refuse to deal with that because they want to ride the odds of an upmove. If they get a market plunge instead, they deserve to regret their decision to hold on, because they already know, before the fact, that they are taking too much risk. I realize that I've written a lot about this recently, but I continue to see investors wiping out their entire retirement security because they just can't pull the trigger and sell down to the comfort level. As I keep stressing, risk management requires immediate action. The question "Which direction is the market going?" is never necessary. Not for risk management, and not even for investment management. Indeed, for investment management, we prefer to ask "What is the current Market Climate?" And even this question is always second in importance to "Am I taking a proper amount of risk?"
Currently, stock margin debt outstanding is more than 20% of all commercial and industrial loans outstanding. That figure is unprecedented, and it won't last. Because stock valuations such as P/E and Price/Revenue ratios are still above the levels seen at every historical market peak, because investors are taking far too much leveraged risk in the market, because earnings are likely to crater, because investors continue to deny a deepening recession in the face of historical evidence that has always indicated one, because corporate insiders have strikingly accelerated the pace of their sales despite a market decline, and because investors and investment advisors continue to call for a new bull market in a Market Climate that still says "bear", my expectation is for a brutal continuation of this decline.
As always, our investment position does not depend on that view being correct. Sustainable bull markets have historically required uniform internal market action, which would tend to benefit even our market-neutral stance here. So if this is a new bull market, we have no reason to be concerned about our own position, and substantial reason to believe that our trend model would identify the new uptrend relatively early anyway. But here and now, the Market Climate is defensive, and my personal views are certainly in line with that position.
Wednesday Morning April 11, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable trends. That places us in a strongly defensive position. Bear market rallies tend to be fast and furious, and though they tend to fail, I've noted that they don't have to fail immediately. Clearly, investors want to believe that this is no bear market rally, but instead the start of a new bull market. From our perspective, there is no need to second-guess whether or not the market has made an important low, because there is certainly not enough objective evidence to act on such a hope. My opinion is that such hopes are misplaced. In any event, we will shift our position only when there is evidence of a Climate shift, and that would require an improvement in internal market action sufficient to define favorable "trend uniformity", or conversely, a plunge sufficient to generate favorable "valuation." Neither is currently in place.
Given that we are currently light on technology and financial stocks, we tend to perform best when those sectors lead the market downward, and we can pull back when those sectors lead the market higher. That said, our weighting in various industry groups is determined by which are exhibiting favorable valuation and market action. On those dimensions, technology and financial stocks remain quite unfavorable. So day-to-day swings aside, I continue to view those industries as vulnerable. As I noted in the latest issue of Research & Insight, the large-cap stocks that dominate the major indices still sport very high price/revenue multiples on a historical basis.
In general, companies with very high price/revenue ratios had better enjoy rapid top line revenue growth, rich profit margins that are defended by patents, and products which enjoy "inelastic" (price-insensitive) demand from buyers. This is why, for example, pharamaceutical companies have historically enjoyed higher price/revenue ratios than other industries (at this point, though, the price/revenue ratios for stocks like Pfizer are as intolerably high as for the techs). For most industries we currently have slowing revenue growth, plunging profit margins, and buyers who are postponing orders and demanding large discounts. That's not an environment that is friendly to high P/R multiples. It's not something a lot of analysts seem to be watching, focused as they are on whether earnings beat estimates by a penny. But the combination of high P/R multiples and collapsing profit margins really is the main valuation story here, and it is not improving. Moreover, credit quality continues to deteriorate, which is likely to adversely affect financials.
Keep in mind that much of the earnings growth in recent years was driven not by revenue growth but by expansion of profit margins. Much of the per-share revenue growth that did occur - especially for technology stocks - was obtained through acquisitions. Companies with high Price/Revenue ratios (like Cisco) effectively bought the revenues of companies with low Price/Revenue ratios, using their stock as currency. Strong stock market gains also allowed companies to compensate workers with options grants rather than cash, and since employee pension accounts grew faster than required to meet payments, many companies made no pension contributions at all, and instead, actually booked the excess gains in their pension plans as income. That extremely favorable confluence of circumstances has now reversed, and is likely to have extremely unfavorable effects on earnings going forward.
With respect to market internals, advances beat declines on Tuesday by only 2-to-1, which is fairly weak given such a strong day for the indices. Bond prices also plunged, and we still saw more than 40 stocks hitting new 52-week lows on the NYSE. Our main trend model showed little improvement, and certainly nothing close to a shift to favorable uniformity.
So on the dimensions that we consider, valuation and trend uniformity, the Market Climate remains clearly unfavorable. If the market can recruit enough internal strength, we'll take a small whipsaw and move back to a constructive position, regardless of personal opinions. But here and now, there is no evidence to expect such a shift, and certainly no basis for moving pre-emptively. All of which underscores a key feature of our approach. There is no need to make forecasts. All that is requred is to identify the prevailing Climate. Currently, that Climate is defensive. As for personal opinion, I continue to view stocks as being in a bear market, and as earnings releases begin, I view the next two weeks as having unusually hostile potential.
Sunday April 8, 2001 : Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable trends. Needless to say, the "surprising weakness" of Friday's employment report was no surprise. The rate of unemployment would actually have shot up had March seen a typical entry of new workers into the labor force. Since low entry in one month is generally corrected the next, we can already expect the April unemployment rate to jump.
It is hard to believe that investors think they've seen the worst when the Dow is currently not even off 20% from its highs. Truth is, we saw even more deterioration in market internals last week. Most importantly, it's critical to remember that the P/E on the S&P 500 is still higher than at the 1929, 1972 and 1987 pre-crash peaks. And even this measure is not as extreme as it would be on the basis of normalized profit margins and proper accounting of costs such as options grants to employees. On the basis of fundamentals such as revenues, dividends, and book values, the valuation of this market is still far beyond even the most absurd historical peaks. For example, the Price/Dividend ratio of the S&P 500 is 75, compared to a historical norm of about 25. And though dividends are relatively low as a fraction of earnings, they are quite in line with historical norms as a fraction of revenues. It's the earnings, and specifically the profit margins, that have been out of whack in recent years. That will change in the next few quarters.
Another brief comment about dividends. In recent years, it has become quite popular to argue that dividends are irrelevant because companies are using their cash flow to repurchase their own stock. The unfortunate truth, however, is that those share repurchases have occurred, almost exclusively, to offset the grants of stock to employees through options. Most companies have still sufferred dilution despite these stock repurchases. So stock repurchases are no favor to existing shareholders. They simply pay for the options grants to employees. On the income statement, companies can report strong results since they are compensating their employees with options grants that aren't deducted as a cost. Then, on the balance sheet, the companies take that cash flow and repurchase shares to offset the dilution. So shareholders have been misled to believe not only that earnings are larger than they really are, but also that those earnings are being retained to repurchase stock in a way that creates value for them. Neither is true, and as noted in the latest issue of Hussman Investment Research & Insight, earnings are a very poor measure of value here.
As I always emphasize, we are positioned in line with the objective Market Climate, and our market stance will shift when that Climate shifts, regardless of personal opinions. That said, my impression is that the so-called pain investors have experienced is nothing next to what lies ahead, and possibly immediately ahead. The Dow isn't even down 20%. Investors who can't envision the Dow below 5000 don't even realize that this would hardly be the historical median by most valuation measures. We don't have to get to median valuations in a single bear market, but it's clear that investors have no historical concept of value here. I also should emphasize that when we talk about the market being absurdly overvalued, I am talking about the handful of large capitalization stocks that drive the major indices. Unfortunately, while those stocks only represent about 10% of the companies on the market, they represent the vast majority of its total capitalization. By definition, those are the stocks that most investors own. Please, whether you agree with these views or not, don't rule out the possibility of matters becoming much, much worse. If a continued bear market would cause you to suffer an intolerable loss, you're taking too much risk.
Years ago, when I was an arbitrage mathematician at the Chicago Board of Trade, there was an options trader on the floor of the Chicago Mercantile Exchange named Marty Murray. They called him the "Garbage Man." Marty would sell short huge numbers of out-of-the money options and simply pocket the premiums he received, since the options always expired worthless. Now, in options trading, you generally run what's called an "analyzer." You consider a wide range of movements up and down in prices and market volatility, and you ask whether any of those possibilities will lead to an intolerable loss. If so, you immediately act to shut down the risk at that "node." Well, Marty had been shorting put options on the S&P 500, and had thousands of them short, now worth just a fraction. He didn't close the position because he couldn't imagine the market moving down more than 2 standard-deviations, which is a big move anyway. As it happened though, this was October 1987, and those put options he shorted, that were worth fractions just days before, were suddenly worth nearly a hundred points each. Marty lost everything, and then some. These days, some option traders on the Merc run their analyzers to allow for almost ridiculously large price movements. They call it a "3M" analyzer.
Marty Murray Memorial.
Investors may want to run a 3M here.
Friday Morning April 6, 2001 : Special Hotline Update
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The Market Climate continues to be characterized by extremely unfavorable valuations and unfavorable trends. Given that the Market Climate has not shifted, we have no inclination to second-guess whether or not the market has bottomed. When the Market Climate shifts, we'll adjust our market exposure, but here and now we remain strongly defensive.
As I've noted very frequently during the past several months, bear market rallies are typically "fast, furious, and prone to failure." Thursday's action certainly satisfied the fast and furious part. Now we get to see how prone the rally is to failure. There is nothing that requires such rallies to fail immediately, and it's not unusual for those rallies to last about 2-3 weeks before rolling over, though certainly not at the same pace as the initial surge from the low. Longer, "counter-trend" rallies can even last several months, but those kinds of rallies generally turn our trend models positive early on. So if this is a more sustained rally, we would expect to have objective evidence of that from market internals, and it's only then that we would shift our position. For now, I remain skeptical of this bounce, if for no other reason than its "textbook" character.
I generally have very little opinion about short term action. But in this case, there is such a strong prospect for earnings devastation in the next three weeks of reports, that a sustained rally seems very doubtful. As usual, that's opinion, and since our positions are not based on such opinions, I can announce those views with impunity. Of course, I think that opinion is right, but our investment position does not require it to be right. The problem with a large number of investors here is that they need to be right about a rally, and will suffer intolerable losses if they're wrong. That's a position we never allow.
As I noted in the latest issue of Hussman Investment Research & Insight, which is now available online and will be mailed on Friday, the media has never recognized a recession until the unemployment rate has increased by anywhere between 0.6% and 1.4%. Currently, that would require the unemployment rate to move to at least 4.5% and probably higher before the media considered the evidence to be overwhelming. It's only then that we're likely to see recession headlines, and only then that we're likely to see a bottom forming, probably at much lower levels. As I've noted before, the March employment report, due this morning, is the first one this year that won't be significantly skewed by seasonal adjustments. So this is the first clear reading we'll get. Not that government statistics are ever that clear, since they're always aggressively revised. In any event, my expectation is for a very weak jobs number, coupled with very bad earnings figures in the coming weeks. So this is the point that I expect evidence of a recession to come looming from out of nowhere, kind of like the scene in Ghostbusters where the 30-story-tall figure appears from behind the buildings. "Yup. It's the Stay-Puf Marshmallow Man."
Wednesday Morning April 4, 2001 : Special Hotline Update
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Just a note: You can hear my latest interview with George Gamble of Gem Radio by visiting the Research & Insight page of hussman.net. The latest issue of Hussman Investment Research and Insight will also be available online by Wednesday afternoon at 5:00 P.M. Eastern time.
The Market Climate continues to be characterized by extremely unfavorable valuations and unfavorable market action. As of Tuesday's close, the S&P 500 still trades at a higher price/earnings ratio than at the 1929, 1972 and 1987 peaks. As I discuss in the upcoming issue of Hussman Investment Research & Insight, the extreme overvaluation of the major indices is really driven by a small number of stocks. Most of the thousands of stocks in the U.S. market are at reasonable - though not compelling - valuations. Unfortunately, the monstrously overvalued handful is the same handful that accounts for the majority of market capitalization here. So while the S&P 500 remains remarkably overvalued as an index, and is likely to perform badly because of the overvaluation of its key components, I also want to stress that there is an increasingly large group of reasonably valued stocks in the market. They just don't have much effect on the major indices.
Now, regardless of what kind of portfolio an investor chooses, a bear market will have an unfavorable effect on the stocks in that portfolio. So while we are fully invested in favored stocks, we are also short the major indices in an approximately equal dollar amount. Current conditions lead to the prospect of large cap glamour stocks declining much more severely than the broad market over the remainder of this bear market. Currently, the largest 25 stocks in the S&P account for about 44% of its capitalization, which is an all time high concentration. The only way that large stocks will reduce their representation in the S&P is if they fall harder than the broad market, and indeed the S&P itself. The upcoming letter has some calculations to that effect.
The key point is that while the major indices, and the average investor, are likely to fare poorly even over the next decade, this should not be considered an indictment of all stocks. There is an increasing number of reasonably valued stocks available - though again, not compelling bargains. It's just that they have virtually no effect on the major indices. We can always find stocks we like, so long as we can hedge away their market risk in unfavorable climates. But as far as the major indices are concerned, the current bear market is capable of inflicting far greater damage than investors imagine. Given the likelihood of relentless earnings warnings followed by relentless earnings disappointments, the next three weeks may be important. We remain well-hedged for now.
Tuesday Morning April 3, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable market action. We are placing zero effort on attempting to pick a bottom. None. We don't need to. All that our discipline requires is to position ourselves in line with the prevailing Market Climate. On the dimensions that we use to define that Climate - valuation and trend uniformity - we identify no change. That's all we need to know here. Any sustainable bull trend will identify itself early enough with sufficient trend uniformity to place us back into a constructive position. Until that occurs, we view attempts at bottom picking on a par with sticking ones' fingers into an electrical socket to see if the power is back on. Dangerous, and ultimately unnecessary.
Despite the decline we've had, I still see no evidence that investors have done anything to reduce their risks. They feel discomfort, but they refuse to take any action to limit their risk to an appropriate level. I received yet another call today from a distraught man, retired, who had made his living trading in stocks over the past several years. Over the past year, he has lost nearly all of his wealth, but remains on margin. A client had shared some of my views with him several months ago, and he had ignored them. Now he wanted to know whether I think the market has declined enough to have set a bottom. He also mentioned "they say that the market will go up after April 15th because of tax refunds."
I responded the way I always respond in these situations: my opinion about the market is irrelevant. I told him he should not listen to my opinions about where market may go, nor should he be taking hope from people like Abby Joseph Cohen, Joe Battapaglia, or anybody else who tells them which direction the market is headed. Because right now, he has a larger problem. "Heads I win, Tails I'm wiped out." I told him that the only question he should be asking is this: "How much can I afford to lose and still be willing to hold on, without risking my financial security?" Pick a dollar figure that is the maximum you can afford losing, multiply it by two or at most three, and that's the maximum amount of stock you should be holding. He responded, "But then I'd have to sell some of my stocks." I told him that whatever portion of his portfolio is excessive, he should immediately shut down 40% of the excess. When you have a position that has intolerable risk, market direction doesn't matter - you deal with the risk immediately.
He answered "But they say that the market will go up after April 15th." At that moment, I was overwhelmed by a sense that the market is about to crash.
Sunday April 1, 2001 : Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable trends. The economy is in a recession and stocks are in a bear market. What is missing is not the evidence of these facts - they are supported by a wide array of reliable indicators, some with perfect historical records. What is missing is simply the recognition of those facts by investors. And between now and that recognition, I expect market conditions to become much worse. The most probable window for this is the next three weeks. By the end of this month, we may very well have seen an intermediate low (though not likely the final bear market one). However, I wouldn't rule out the possibility of that low occuring 20-30% below current levels. In other words, I wouldn't rule out a market crash in the weeks immediately ahead.
That's not a forecast, but a concern. The reason for my concern is that the next few weeks are when we finally see first quarter earnings, as well as the admission by corporations that the second quarter is likely to deteriorate as well. It is when we will see the National NAPM indices. If they're anything like the Chicago figures released last week, we may begin to see admission that a recession has taken hold. It is when we will see the March employment figures, which will be the first this year to be at least relatively unmarred by seasonal adjustments. In short, if there is any period that has as much potential to slam shut the gap between reality and investor expectations, it is the next three weeks.
That concern is, however, an opinion. Our investment positions are not predicated on that opinion being correct, nor do I hope for a market crash. The objective data has us in a significantly defensive position, but if market internals were to improve sufficiently, we would quickly move back to a still-hedged but constructive position. I realize that I repeat this constantly, but in an investment world that keeps trying to pick the bottom, and forecast the future, constant repetition of our philosophy is the only way to drown out the noise from CNBC. And that philosophy is simple: there is no need to forecast the market. What is required from our approach is not that we predict future conditions, but that we identify current ones. Those conditions have two dimensions: valuation - which focuses on the relationship between prices and properly discounted fundamentals, and market action - which focuses on the uniformity and strength of broad internal market trends. Presently, both dimensions are unfavorable, and that's all we need to know.
The point is simple. There is no need - none - to ask when or whether a bottom has, is being, or will be set. If the bottom has already occurred, we'll let market action confirm it, take a quick whipsaw, and move back to a constructive position. If the bottom has not yet occurred, which is my opinion, we needn't shift our position at all. We'll change our position when the objective evidence indicates such a shift. Until then, the evidence suggests that the potential for return is not worth taking market risk. We've got a fully invested portfolio of highly ranked stocks, but we've hedged away much of the effect of market fluctuations. So the risk that we are taking is risk that we also expect to be compensated for, and the risks that we don't find attractive have been diversified or hedged away. It's just not necessary to take every risk all the time.
By the way, I realize that most of you are quietly asking yourselves whether or not to buy Cisco. My opinion is that both Cisco and Sun Microsystems have earnings losses ahead, either in their first or second quarter reports. But I would no sooner tell you to avoid Cisco than I would tell you to avoid betting 7 or 11 on a roll dice. You could be lucky. But it's still gambling. I am wholeheartedly of the opinion that Cisco is a poor investment, on the basis of price in relation to reasonably discounted cash flows. But I have no opinion on Cisco as a speculation. If you want to play Russian Roulette for money, go ahead. Just understand that that's what the game is.
Though my inclination is to expect bad action in the next few weeks, you always should allow for anything over the short term. Longer term, investors don't even realize it's a recession yet. They hardly admit it's a bear market. And we haven't even seen a significant bank failure yet. At the bottom, all of those features will be present, and the consensus will be that matters are about to get worse. At the bottom, nobody will be trying to pick a bottom anymore.
| 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. |