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.
Sunday September 30, 2001 : Hotline Update
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The Market Climate remains on a Crash Warning here, and we remain defensive. That defensiveness is not based on a forecast of future conditions, but on the identification of present ones. For investors constantly trying to guess what the market may do next, this discipline may be somewhat new. You can think of it this way:
Buy-and-hold investors essentially see the market as a big hat with both positive and negative returns in it. On average, they believe those returns are in the 10-12% annual range, but that they can't be predicted. Market timers, on the other hand, do think those returns can be predicted, and spend most of their time trying to forecast whether the next draw from the hat will be a gain or a loss.
We believe neither. Very simply, we believe that there are different hats. And each hat has a very different return/risk profile. Some have an outstanding historical profile (favorable valuation/favorable trend uniformity), and some have a dismal one (unfavorable valuation/unfavorable trend uniformity). We believe that it is possible to identify which hat is in front of us, based on objective evidence. If the hat has a favorable tradeoff between expected return and risk, we are willing to take a constructive market position. If the hat has an unfavorable tradeoff, we are defensive. But in either case, once we identify the hat in front of us, we have no further ability to forecast whether the next draw from the hat will be an advance or a decline. Of course, our research is ongoing, so we are constantly evaluating new data and analysis tools. But after more than two decades testing every available approach, I am convinced that we are much better served by identifying rather than by attempting to forecast.
Still, we do keep a set of econometric models just to satisfy our pure idle curiosity about what the statistical forecasts suggest about the future. I was fairly surprised last week when we ran our monthly updates, as I was certain that the market forecasts would be more favorable in the wake of the recent decline. Instead, they got worse, and our GDP forecasts fell off a cliff. Now, the GDP model has no idea who bin Laden is, or what is going on in the news. It is based on statistical indicators, with a heavy weight on information derived from market action. By that, I don't mean stock market action in particular. Rather, market action includes factors such as interest rate spreads, technical divergences, and currency movements, to name a few. What struck me is that even though there is no "Osama bin Laden" variable, the model is picking up from the profile of current market action that the economic outlook has suddenly become strikingly weak.
As a rule, when market downturns coincide with economic downturns, the bear market bottom has never occurred until the recession is widely and firmly recognized by the media. At bear market bottoms, the existence of a recession is taken as common knowledge. The media is no longer tentative about the possibility, and there's no tiptoeing around the subject using phrases like "The R-word."
While I expect this sort of wide recognition by early November, the market may garner some hope in the next couple of weeks. The employment report due on Friday is certainly likely to weaken, but the survey is actually based on employment on the week beginning September 10th. For that reason, it's probably the October report (due the first week of November), not this week's number, that will finally define a recession in progress.
Over the short term, a reasonably stable market this week would create at least the possibility of favorable trend uniformity. As I've repeatedly noted, it's not the extent of a rally, but its uniformity that is important. Given the still very oversold condition of the market, investors may become sufficiently bold to take on more risk. I have very little doubt that this remains an ongoing bear market, but we would be willing to take a modestly constructive position (certainly not significant or aggressive), if we see evidence of trend uniformity emerge. In general, it is not difficult for the market to recruit trend uniformity, so we have to remain open to the possibility of a modestly constructive shift to our position. Such a shift would almost certainly be brief, and within the context of a bear market. But again, we don't predict. We identify. We continue to watch the information conveyed by market action. We'll act if and when there is sufficient evidence to shift our position. For now, we remain on a Crash Warning. Until that changes, we are bound to a fully defensive position. For those of you following your own strategies, we urge you not to carry a position here that rules out the possibility of a crash.
Friday Morning September 28, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. Indeed, rather than improving in recent weeks, our models have actually become more negative. This is largely a result of the specific characteristics of market action. This action includes plunging short-term Treasury yields, relatively firm long-term Treasury yields, and rising yields on corporate bonds and utilities. That pattern defines a significant increase in economic risks, and in conjunction with other data, the result is the most negative year-over-year forecast for GDP that we've seen in the historical data. Our models project a 2% plunge in real GDP over the coming year, which historically is a deep recession. Yes, there will be some amount of government spending ahead, but this spending will be only a small and partial offset compared to further declines in capital spending, exports, residential investment, and consumer spending. I always emphasize that market action gives the first and best information about economic developments and trend changes (which is why we monitor "trend uniformity" so closely). It was market action late last year that warned us of an oncoming recession and severe risk to profit margins and capital spending. It is market action now that prepares us for a much deeper recession than generally anticipated. And while forecasts and projections don't actually determine our market position, I should note as an aside that our econometric market projections have rarely been worse.
As usual, if the market recruits evidence of favorable trend uniformity, we will quickly become more constructive (not aggressive, but constructive). Unfortunately, Thursday's action was replete with the kind of divergence that reduces that likelihood. True, the Dow gained over 100 points, but new lows outpaced new highs by nearly 10-to-1, the Nasdaq fell, and utilities sunk to a new low.
Speaking of econometrics, Wednesday's Wall Street Journal contained a strikingly disingenuous piece by Burton Malkiel, titled "Don't Sell Out." The thrust of the article was that current P/E ratios are justified because of low interest rates and inflation. Malkiel supported this view with statistical evidence from 1965 to the present.
It takes a certain boldness to argue that the S&P 500 P/E is historically justified, when it remains higher than at the peak of any prior market cycle. I conducted the same statistical analysis Malkiel describes, and replicated his results. It's true - if you run that research from 1965 to the present, the "predicted" value of the S&P 500 P/E, based on current inflation and interest rates, is indeed about 22. What makes that result disingenuous is that Malkiel evidently picked the 1965 starting period specifically because it excludes virtually any historical experience with inflation or interest rates similar to the present. Had Malkiel included readily available data since 1945, rather than starting at 1965, his analysis would contain observations that do resemble the present. But his analysis would no longer predict a P/E of 22 based on current interest and inflation rates. Instead, the predicted P/E ratio falls to just 13.8, slightly below the historical average. Adding even more data doesn't substantially change that result.
A statistician can prove it's always Saturday if he's willing to restrict his data set enough. That's essentially what Malkiel did. His article is garbage. Which is unfortunate, because his book, "A Random Walk Down Wall Street" is quite good. I used to regularly put it on my students' reading list when I taught finance at the University of Michigan.
In recent weeks, we've heard a lot about valuation. It must be confusing to hear some analysts saying that stocks are cheap while others say they are overvalued. Here's how to sort through all of that.
For nearly a century, S&P 500 earnings have been well contained in a 6% growth channel connecting peak-to-peak and trough-to-trough. While growth can certainly be faster when measured from trough-to-peak, even the past decade or two of growth has been contained by a 6% channel. That 6% is the basis of long-term capital gains. In addition to capital gains, stocks historically paid a dividend yield of about 4%. The sum of those two is the basis for the often quoted "10% long-term return on stocks." Of course, in recent years, stock prices have grown much faster than earnings and dividends, driving the P/E far above its historical average and the dividend yield (D/P) far below its historical average. As a result, past returns have been somewhat higher than 10% annually, but that also means that stocks are now priced to deliver far less than 10% annually in the future.
Now, the long-term growth in earnings results from the fact that part of those earnings are driven back into new investments (over and above the depreciation of existing assets). If you do the calculations for the S&P 500, about 60% of earnings are actually available to pay dividends or repurchase stock. So in order to generate a 10% long-term rate of return from 6% earnings growth, you need another 4% as income, which requires the earnings yield to be about 6.67% (since 4% is 60% of 6.67). A 6.67% earnings yield is simply a P/E ratio of 15.
In short, given the very consistent behavior of historical earnings growth (peak-to-peak), a P/E of 15 is about the level at which stocks would be priced to deliver a long-term return of 10% to investors.
Every defense of current P/E ratios must assume either a higher long-term growth rate than is evident from historical data, or it must assume that investors are willing to hold stocks for a long-term return of substantially less than 10%. Analysts who are willing to make such assumptions will arrive at different conclusions about valuation. The only problem is that they may or may not have any basis in historical fact. The whole "Dow 36,000" argument was essentially based on the notion that all earnings could be paid out as dividends, earnings would still grow, and that investors would be willing to hold stocks for a long-term return of just 6% annually. One implication of that particular model was that a 1% increase in interest rates would send stocks plummeting by 50%, but nobody brought that up because nobody took the time to examine the assumptions of the model seriously.
Every argument for a P/E over 15 on the S&P essentially asks you to part with something: either you part with earnings expectations that are consistent with history, or you part with long-term return expectations that are consistent with history.
Frankly, I don't believe that investors will maintain such inconsistent assumptions indefinitely. That means that stocks may have more trouble ahead. Again however, we closely monitor trend uniformity, and will act on it if we see constructive developments from market action.
I hate to sound so negative in a market already captivated by fear. But as I've noted before, terrorism didn't cause this downturn. I have never been of the opinion that "talking up" the market or the economy is helpful. Richard Russell of Dow Theory Letters often notes that a bear trend continues until it is fully expressed. I fully agree with that. Bad investments go bad, and while talk and hope can affect exactly when that occurs, the conclusion is inevitable. The sooner the economy works through the adjustment in capital spending that was required well before September 11, and the sooner that the financial markets stop misallocating capital, the stronger this nation will be in the long run. Unfounded offerings of speculative hope only do damage to the financial future of real people who often can't afford the risk of losses. So I apologize to those who wish I would "talk up" the market. But I don't see how that would be better than honesty.
Tuesday Morning September 25, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. That keeps us in a defensive position. We will quickly shift to a constructive market position if and when the market is able to recruit sufficiently positive trend uniformity. This evidence has not yet appeared. That is all we need to know to define our current market position. Everything else in this update is detail or opinion.
We'll start with a few details. Monday's action reflected the typical "fast, furious" action that defines intermittent bear market rallies. Yet despite the fact that the market was up from the first instant of trading, seven times as many stocks hit new lows on Monday than new highs. Breadth was fairly good, with advancing issues holding a strong lead over declines, but the distribution of gains focused clearly on battered "leaders" such as EMC, GE, Oracle, Dell, and Intel, all which bounced by more than 10%. The average stock clearly lagged the large-cap indices on Monday. Meanwhile the utility average hit a new bear market low. When I talk about favorable trend uniformity, I am clearly not talking about days like Monday.
The fact that stocks have suffered several consecutive down days has been noted as evidence of a very oversold market. Certainly that is true. Unfortunately, pre-crash market action typically generates a series of at least 5 consecutive down days in the NYSE Composite, accompanied by a large number of new lows. Friday marked the fifth consecutive decline. Nor was Monday's bounce inconsistent with pre-crash action. One need only recall the powerful "relief rallies" of October 22 1929 and October 13 1987, both which came off of very depressed market action of the preceding week, and both which were followed by the real thing.
That said, there is absolutely nothing to prevent the market from recruiting favorable uniformity through a continued advance either. Being calm in the face of such a wide range of possible outcomes is difficult for many investors. They worry that maybe Monday was the start of a new bull leg and that they are missing out on a legitimate rally. Which is possible. They also worry that if they buy here, the market might turn down and crash. Which is possible too. As a result, investors are nervous, constantly second guessing what the next move might be, constantly listening for somebody on CNBC to give them hope and assure them about their current position.
Why bother with that sort of idiocy? A wide range of possible outcomes has a name: risk. Once we know that the risk is high, what we're really interested in is the average of those possible outcomes: the expected return. We know that the current climate has historically been associated with very high risk, which sometimes means very very powerful rallies, and sometimes means crashes. But we also know that the average of those outcomes has been a negative return. If you don't care about risk or expected return, and want to take the gamble that this rally is legitimate (and it might be), go ahead and buy. But that is neither a good investment nor a reasonable speculation. It's just a flat out gamble. I realize that many investors feel they always have to be on the "right side" of the market, and imagine that short term trends give a clue about that. But I have absolutely no evidence that supports that fantasy. So we remain defensive, and will continue to be defensive until evidence emerges that investors have developed a robust preference for market risk again - we measure that through trend uniformity. It still is not apparent. That fact requires us to maintain a defensive posture here. Our discipline does not require us to be bearish or short, but a defensive posture is not optional for us.
All of that is a long way of saying that nothing would surprise me here. I certainly would not be surprised by a crash. I also would not be surprised by a further advance of several hundred Dow points. Which outcome occurs is a coin flip, but on average, that coin flip loses money. So we remain defensive. We'll shift when we have the evidence to do so. As always, no forecasts are required.
Sunday September 23, 2001 : Hotline Update
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The Market Climate remains on a Crash Warning here. I frequently note that we do not attempt to forecast the market. Rather, we attempt to identify the Market Climate currently in effect, and position ourselves accordingly. For now, that climate keeps us highly defensive.
A common question, articulated hourly on CNBC, is "Who is selling?" This partial-equilibrium view of the markets never ceases to amaze me. The fact is that every share of stock being sold, every one, is also being bought by somebody else. Yet I heard statistics last week like "60% of the orders at Schwab and E-Trade are buys." and "Investors sold $9 billion of their mutual fund holdings last week." I assure you that whatever stock was sold by those mutual funds was bought by somebody else. Most likely by those investors at Schwab and E-Trade.
In other words, stocks are never sold or bought on balance. They are traded. If the sellers are eager and the buyers back down, the trades occur at lower prices. If the buyers are eager and the sellers pull away, the trades occur at higher prices. But money never goes into or out of the markets when all transactions are netted together.
This is also why I want to throw objects at the TV when I hear analysts wax rhapsodic about all the money parked in money market funds, just waiting to be invested. What should be clear (but evidently is not), is that those funds are already invested in securities, primarily Treasury securities and commercial paper. And every security must be held by someone. If you sell $1000 in commercial paper by liquidating your money market funds, somebody else has to buy that commercial paper. The investments in money market funds are not just idle money - they are financing corporate and government borrowing. As long as that quantity of debt is out there, somebody has to hold it. The only question is at what price.
Thus far, this decline has really not been about mass selling. What we're seeing is not a lot of selling but a lot of trading. The speculative public is not attempting to liquidate in any serious way. Nor are we seeing aggressive buying from value investors (the rightful owners to whom stocks always return in a bear market). At the bottom of a bear market, those are the two groups that trade with each other. The speculators get out and the value investors get in. In contrast, what we are seeing here is largely reallocation. Mutual funds that are overweighted in tech are moving into broader names. While many funds that are underweighted in tech are trading in the opposite direction. For all of the lost wealth (which is determined by price changes, not money flows), we really aren't seeing any attempt at mass liquidation by speculators.
My concern remains that we will. This is a market with very very thin risk premiums in an environment where risk premiums are being pressured higher. That sort of action can cause sharp, discontinuous price moves. While our actual investment position is not based on a crash forecast, we don't rule it out. In my view, that would involve at least one day where the loss on the Dow substantially exceeds 1000 points. I don't think there is a concrete sense among Americans that recent events, both in the nation and in the market, may have been the beginning of the beginning. Despite the careful words of President Bush that this campaign will be long and difficult, there's too much belief that these operations can be localized to a small number of places, when the reality is that this cancer is metastasized to countless cells. Very simply, I strongly believe that stocks should currently be priced with a risk premium that is somewhat higher than the historical average. What we actually see is a market priced at one of the thinnest risk premiums in history. The only way to shift that risk premium is for prices to decline substantially from here. Again, though, our current position is driven by the Market Climate in effect, not by my personal views or projections.
A few days ago, I mentioned the a so-called "valuation" indicator derived by comparing the earnings yield on the S&P 500 (based on projected future earnings) with the 10-year Treasury note. This is sometimes called the "Fed model" since it appeared in one of the Fed's reports in recent years. I was disappointed to see that Barron's magazine decided to run a raging bullish cover story "It's Time to BUY STOCKS" based on this indicator. Evidently, even Barron's editor Alan Abelson's durable sense of doom about the market was not enough to muzzle the enthusiastic treatment of this oh-so-pathetic indicator.
We begin with a few simple facts. The indicator shows three extreme spikes in the historical data - two overvalued spikes in 1987 and 2000, and one extreme undervalued spike in 1974. On that basis, we can concede that when the indicator spikes far out of its typical range, valuations are probably skewed one way or another. Unfortunately, even taking these spikes into account, the indicator has zero statistical correlation with market returns over the following year. Literally zero.
As Einstein once said, "Everything should be made as simple as possible, but not simpler." Comparing the prospective earnings yield with the Treasury bond yield is elegant. But that "elegance" actually imposes extremely tight restrictions on the relationships between factors that affect valuation, but are left out of the model, including growth rates, capital spending, risk premiums, and debt levels. As a result, the only readings that have any usefulness at all are the extreme outliers (to which the current reading is not even close). And even if the indicator was valid (counterfactually), the article asks readers to accept as given that earnings are properly reported here, that they will grow by nearly 50% over the coming year, and that investors are willing to key the long-term return they require from stocks to the yield on 10-year bonds, which has been abnormally depressed in a flight to safety. If readers accept all of this, they are rewarded with the conclusion that stocks are 17% undervalued - "The biggest bargain in years." In short, the Barron's article is a terrible waste of cover space, and a dose of unfounded confidence to investors who would be better served with reality. It is difficult to rate an indicator as "reliable" when it has literally zero statistical correlation with subsequent returns.
While the national income of this country may decline modestly during this recession, the main issue is not income but wealth. Wealth is simply a claim on future income, embodied in securities such as stocks and bonds. Even if income does not change by much, wealth can rise or fall because of changes in the attitude of investors toward risk, and declines in the value of collateral behind debt. The issue is very simple: U.S. wealth is overstated because the prices of stocks, bonds (particularly corporate), even real estate, are excessive in relation to the replacement value of the underlying assets, and the income streams that are derived from them. GDP may decline by a few percent, but that is not really a significant decline in income. Unfortunately, I remain concerned about a further, and very pronounced, decline in investors' wealth.
Friday Morning September 21, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. Long-term interest rates jumped again on Thursday, which contributed to the "hostile yield trends" that help to define a Crash Warning. One analyst on CNBC this morning talked excitedly about the massive wave of mortgage refinancings that would soon be boosting consumer spending. The fact is that despite the plunge in short term interest rates, long term yields and mortgage rates have been flat or rising. The decline in short rates is a safe-haven effect. Long-term rates are being pressured by a declining U.S. dollar and anticipated increases in government spending, debt, and money creation.
Another analyst argued on Thursday that the U.S. economy might turn down this quarter, but that a very fast "V-shaped" recovery could be expected in the 4th quarter. Surely, the repeated Fed easings and new government spending would drive the economy higher. This is hope talking, and frankly, it's irresponsible to offer such glib hope to investors when their financial security depends on candor. As I've noted before, a recession is essentially a time when the mix of goods produced by the economy has become out of line with the mix of goods demanded. There is no generic "stimulus" to fix this. Implicitly, politicians and analysts tend to view the economy as if it produces a single good, and the task is simply to stimulate the demand for that good. The fact is that most recessions represent just a 1-2% decline in real output, and no decline at all when output is measured in dollar terms. It's not total output that's the problem in a recession. It's the mix.
Essentially, recessions are painful because the mismatch between production and consumption causes major displacements from certain industries, and often shortages in others. Unfortunately, the workers displaced from one industry are usually not well suited to fill the staffing needs in another. That transition takes time. New capital spending in emerging industries takes time as well. Prior to last week, the U.S. faced formidable difficulties in adjusting to excess capacity and a mountain of debt in technology and telecommunications. Now we suddenly have excess capacity in the air travel and tourism industries. In a recession, a handful of industries bear the bulk of the damage, while the rest of the economy is only slightly affected.
What will make this recession worse than average is not the fact that a couple of additional industries are affected, but that the extreme speculation and excessive debt of recent years will propagate the effects of this downturn through the financial system. Those problems are nothing new, which is why we remain light on financial and technology stocks. Overvaluation and debt, not last week's tragedy, are the main dangers to the economy here. The economy faces a very difficult and time-consuming adjustment. It's not something that should be expected to form a "V" bottom.
I thought that President Bush gave a great speech Thursday night. My hope is that the market will enjoy a relief rally as a result. My concern is that this rally will be short lived. If the market suffers another down day, the historical portents are not good at all. Crashes are typically preceded by a series of 5 consecutive declines in the NYSE Composite, with a large number of stocks hitting new lows. While investors seem to believe that stocks are cheap here, the worst historical crashes didn't even get going until the market was already down more than 14%. My main short-term concern is that the Friday before a crash often experiences a very large decline that caps an already terrible week and leaves investors panic-stricken and unable to sleep over the weekend. We've already heard news of major margin calls going out in the past couple of days. Another decline on Friday could potentially trigger "forced" rather than discretionary selling. So again, my hope is that the market will enjoy a relief rally on Friday.
I wish I could offer more upbeat and optimistic comments here. But honesty will serve you better. In the final analysis, though, no forecasts are required. We simply maintain a position in line with the current Market Climate. That Climate keeps us highly defensive .
Thursday Morning September 20, 2001 : Special Hotline Update
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The Market Climate has moved to a fresh Crash Warning. For those of you who are new to this, a Crash Warning does not mean that a crash must occur, or should be strongly expected. Rather, it means that market conditions match about 4% of market history, and this 4% contains every major market crash of note. A Crash Warning does not rule out powerful counter-trend rallies. Indeed, there is a very wide range of short-term outcomes when the market is in this climate. But that's what we call risk. The average of those outcomes is what we call expected return. Quite simply, a Crash Warning is characterized by very high risk, and very poor expected return. Again though, history includes many very, very sharp short-term rallies during what we define as Crash Warnings. It's just that every crash of note is also contained in this one sliver of historical data.
We define a Crash Warning as the combination of three factors: 1) extreme valuations, 2) unfavorable trend uniformity, and 3) hostile yield trends.
On the subject of valuations, I keep hearing analysts saying that this market is cheap. What they really mean is that stocks are significantly off of their highs. Unfortunately, that fact has nothing to do with value. Value is measured by the relationship between prices and fundamentals such as earnings, dividends, book values, revenues and free cash flows. On that basis, stocks remain well over twice the historical norms, and even more extreme relative to typical bear market lows. Yes, stocks have declined, but they would still have to fall by half to approach historical valuation norms. 50% is about 4000 points on the Dow. I can't emphasize enough that the rationale to buy here is purely speculative. It has NOTHING to do with value.
Second, trend uniformity remains terrible, with absolutely no evidence of a reversal here. Remember that favorable trend uniformity is essentially a signal that investors have a robust preference for taking risk. Right now, there is no evidence of the sort. In a market with razor thin risk premiums, any increase in risk aversion can lead to spectacular price declines. Yes, stocks bounced off of their lows on Wednesday, and everybody was eager to call it a bottom. But we just don't invest that way. It's impossible to rule out the possibility that the market hit a low on Wednesday afternoon, but there is no value in speculating about it. When the market gets very depressed, we can (and frequently do) make small but important changes in our hedges that allow us to lock in profits and benefit from any surprise advance. But we certainly would not take a constructive market position here with zero evidence of trend uniformity.
Third, yield trends have moved back to a hostile, rising condition. As recently as last week, bond yields were behaving favorably. Unfortunately, long-term bond yields have surged higher in the past two days across all credit grades. Short-term Treasury yields have declined, but other yield classes including utilities, long-term bonds, and stock yields are in hostile uptrends. Again, when yields are low and yield pressures are upward, spectacular price declines can result. For example, in order to drive the yield on stocks from 1.5% to just 2% - a tiny half percent increase - prices have to plunge by fully 25%. Strictly speaking, we consider the "cash yield" (free cash flow / price) as more indicative than the dividend yield, since free cash flows can be used not only to pay dividends but also to repurchase stock. But however you measure the yield on stocks, there's no value here.
To put all of this together, think of it this way. Suppose you were buying a house that you wanted to rent out. You would start by estimating the stream of future rents you would get, and subtract off the stream of future costs, including interest, taxes, any improvements you'll have to make if you want to charge higher rents in the future. What's left is your "free cash flow". When you buy the house as a long-term investment, you are really buying that stream of future cash. The more you pay for the house today, the lower your long-term return on that investment, in percent. The less you pay for the house, the greater your long-term return. Now, over the short term, the real estate market might be hot or cold. But that is irrelevant to the long-term return. Market action only matters for the short term, speculative return. The worst situation is when valuations are extreme, market conditions are unfavorable, and interest rate action is bad. The same is true for stocks. When stocks are overvalued, it means that they are priced to deliver unsatisfactory long-term returns. The short-term return depends on market conditions - what I call "trend uniformity". The climate is particularly bad when yield trends are hostile. That's where we are today. No forecasts are required. All we need to do is identify the current climate and shift our investment position when the climate shifts.
Again, I want to stress that the U.S. economy was already in recession (which will ultimately be dated as beginning during the first quarter of 2001), and the market was already in a bear market before last week's tragedy. I think there is great comfort in that. Terrorism certainly affected the timing of the inevitable bear market decline, will force the recognition of this recession, and might perhaps deepen it slightly. But to believe that terrorists caused this downturn is to grossly elevate their status and importance. They are nothing but fleas on the wound of a lion.
Tuesday Morning September 18, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable trend uniformity. That places us in a defensive position, and we have absolutely no inclination to try picking a bottom here. As things turned out, Monday was not a particularly bad day for the markets, with most indices down about 7% - roughly what one could have expected from the action of foreign markets, with deeper losses largely isolated to travel and insurance related companies. There's certainly the potential for a rebound from the compressed and oversold levels of the market, but we simply will not take a constructive market position until the market recruits sufficient evidence of favorable trend uniformity. As I've noted repeatedly, it is not the extent of an advance that is important to the Market Climate - it is the uniformity. Good, sustainable rallies generally recruit favorable trend uniformity quite early. But we won't try to pick a bottom. We leave that to those with either more audacity or less intelligence than ourselves.
I want to emphasize that one aspect of the current Market Climate is extremely unfavorable valuations. I've heard repeatedly today that the market is cheap. On the basis of any reasonable fundamental measure - price/earnings, price/dividend, price/book, price/revenue, price/ cash-flow, there is no basis for such an assessment. I wish it were true. I wish that with all the fear, sadness, and terror in the world, I could at least encourage investors that stocks were cheap and most certainly headed higher. I have no basis to do that. As I noted on Sunday, my main hope for short-term market stability was to detach the normal downward action of a bear market from any association with the events of last week. Stocks were already in a bear market, and the economy was already in recession before these tragedies. While terrorism may have been a catalyst to determine when the inevitable damage would express itself, it is not the cause of this bear market, nor is it the cause of what I have viewed for months as an ongoing U.S. recession. To believe differently is to ascribe much more power to these pigs than they actually have.
The notion of a cheap market is a market that is priced to deliver superior long-term returns. That's not the case here. One popular "valuation" model compares the earnings yield on stocks with the 10-year Treasury note. While this comparison has captured certain periods of extreme overvaluation, it is a useless predictor, in terms of its overall relationship with subsequent market returns. Moreover, there is no economic sense to this indicator unless you impose extremely strong assumptions about the risk premium on stocks. As a result, the model only fits the data well during a couple of decades of relatively high and falling interest rates. The model completely breaks down when tested over a more extensive historical data set. In short, there's no reason to believe that stocks are "cheap" just because they've declined. This is still a market that would have to fall nearly in half to reach historical valuation norms. 7% is not 50%. We don't have to reach such norms in the short run, or even in a single bear market. Stocks can certainly enjoy solid advances even when they're overvalued, provided that trend uniformity is favorable as it was through most of the past decade. But neither trend uniformity nor valuations are favorable here.
As usual, I have no views about short-term market action. I always attempt to find favorable trades by selling lower-ranked holdings on short-term strength, and buying higher-ranked candidates on short-term weakness. If I can do that on a given day, it's a good day in the market. Long-term investment returns are simply the compound result of those consistent daily actions. We don't need to forecast the market or catch bottoms. And we won't try.
Fortunately, there is good news elsewhere than the markets. Earlier this year, I lost one of my dearest friends to diabetes, which doesn't sound good at all. But last week, her brother Geoff received a long-awaited but unexpected call. He immediately checked into the hospital for a successful kidney and pancreas transplant. Geoff is a single father to two great boys. Suddenly, after a lifetime of struggle and disease, he is no longer a diabetic, thanks to the gift of a stranger. I suspect his sister Lisa pulled some strings up there too. While we're on the subject, she would want me to remind you to sign your donor card (click here). We also got another bit of good news. With so many people still missing in New York, a former student wrote today to tell me they found Billy, shaken but safe. As the line goes in Desiderata, "With all its sham, drudgery and broken dreams, it is still a beautiful world. Be careful. Strive to be happy."
Sunday September 16, 2001 : Hotline Update
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The Market Climate is characterized by extremely unfavorable valuations and unfavorable trend uniformity. Largely due to recent interest rate action, the Climate is no longer on what I consider a "Crash Warning". As a practical matter, this is a distinction without a difference, as our portfolios remain highly defensive and will continue that stance until evidence of favorable valuations or market action emerges. Still, I am hopeful that the market will enjoy at least short term stability.
My fiduciary duty is to identify the return/risk tradeoff of individual stocks and the market, whether favorable or unfavorable, and to position our client's funds accordingly. At present, conceding and discussing the great risk in the market feels almost unpatriotic. Quite honestly, that's difficult for me, but I believe that investment discipline and fiduciary duty require me to deliver an honest assessment. The fact is that stocks remain priced to deliver relatively poor long-term returns, and the internal action of the market and the economy remain characteristic of a bear market. That said, I deeply hope that the market will display at least several days of resilience, if only to detach the natural downward action of a bear market from the horrifying and unthinkable tragedies of the last week. The action of the European markets suggest an initial decline on the order of 7-10% on Monday. Since the U.S. equity market is populated by U.S. companies, we can't rule out a larger decline. Yet given the very oversold condition of the market, and my expectation - or hope - that the Fed will deliver a "surprise" rate cut on Monday, a less severe outcome is at least possible. Those that know me well understand that I separate investment policy from such hope or opinion, but stability, particularly in the short term, is my hope. I am fortunate to have our portfolios positioned to allow me to place mostly buy orders here, on balance.
It's ironic that after my careful explanations of why the Fed's "open market operations" are irrelevant, we find ourselves in the one circumstance where the Fed actually matters. As I noted in the latest issue of Research & Insight, the Fed does play an important psychological role, and is indispensable during bank runs and other crises when the demand for cash soars. This is exactly such an instance. It's not that Fed actions can be expected to have much impact on bank lending. Rather, crises tend to trigger a run on cash - literal currency - and the Fed is responsible for expanding currency in circulation by increasing the monetary base. So while Fed actions can't be expected to stimulate the economy, they will be indispensable here in 1) bolstering the confidence of investors 2) providing banks with sufficient liquidity to meet any increased demands for cash. My hope is that the Fed fulfills these roles with as much flourish as possible. A half-point cut would be preferable, though it might smack of panic. If I was Greenspan, I would at least cut the Fed Funds target by a quarter at about 10:15 A.M. on Monday, giving the markets just enough time to digest any initial sell orders and providing something of a base from which to rally. That's not a prediction, but it's what I would do.
Several weeks ago, I noted that the break in the U.S. dollar suggested a rather sudden weakening in the economy just ahead. Last week's economic data - all of which was compiled before the attacks - confirmed that expectation, with new claims for unemployment surging, industrial production slumping, and consumer confidence falling abruptly. At this point, it seems clear that the U.S. is indeed already in a recession which began during the first quarter. But again, it is important to detach that unfortunate reality from last week's tragedy. Indeed, if we are going to sustain a U.S. recession, I think it is of great comfort to know that it was already in progress before these attacks. A U.S. recession is nobody's strike against us - nobody's victory.
In short, bond market action has taken the Market Climate off of a Crash Warning. We remain defensively positioned. Though the prevailing evidence points to an ongoing bear market which may pressure stocks toward more typical valuations, my hope is that the market will recruit enough buying interest to display at least a brief period of resilience.
With prayers for my former University of Michigan student, Billy Choi, who would frequently stay after class with insightful questions and a ready smile. May God Bless America.
Wednesday September 12, 2001 : Special Hotline Update
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Just a note. I generally don't comment on our positions or the Hussman Strategic Growth Fund in my regular market comments, but given yesterday's tragic events, it seems appropriate to make an exception.
Let me start by assuring you that the assets of both clients and shareholders are safe. The ownership claim of our clients on their securities is firm. In general, destruction of buildings and physical property may affect the clearing of financial assets, but rarely affects their custody. In other words, if you have a brokerage account somewhere, your assets are maintained on electronic systems, which are generally backed up in multiple locations with a very well documented "paper trail" indicating who owns those assets. The main financial risk of disruptions such as property destruction, bankruptcies, and the like is in clearing operations - that is, the timely delivery of securities and the settlement of payments. But even here, the main risk is time delay, not any uncertainty as to who owns what.
With regard to our positions, none of our client accounts are aggressively exposed to market risk here. The Hussman Strategic Growth Fund holds a well diversified portfolio of stocks, custodied at Firstar Bank in Cincinnati, one of the largest mutual fund custodian banks in the nation. About 90% of our stock portfolio is hedged by an offsetting short position in the Russell 2000 Index and S&P 100 Index. Since our favored stocks trade at significantly lower valuation multiples than the overall market, and are somewhat less volatile than the overall market, this position leaves us relatively neutral to movements in the overall stock market. We do carry some intentional risks that we expect to be compensated, for instance, a larger allocation to stocks with stable, attractively valued cash flows, and a smaller allocation to technology and financials, compared with the overall market. On days such as last Friday, when the broad market was very weak and technology was relatively strong, that position can run into short term pressure. But again, these risks are intentional, and ones that we expect to be compensated for over time. Also, for those who have asked, the Fund is now available on the Fidelity Funds Network.
With the Market Climate still on a Crash Warning, recent events leave the market fairly vulnerable. That said, I am not at all convinced that we'll see a crash, or even more than a few percent to the downside when the market reopens for trading. The European markets have been relatively stable. Though trading is very thin, we haven't seen any follow-through to the initial downside spikes. As I noted in the latest issue of Research & Insight, I view the Fed's open market operations as ineffective in stimulating bank lending, but the Fed "certainly has a role to play during bank runs and other crises where the demand for the monetary base soars." This is one of those times, and I would not be surprised to see a surprise half-point rate cut on whatever day the market finally opens for trading.
In short, I really am completely agnostic about the short term direction of the market. I do believe that any rally would be relatively muted unless we were to see a very pronounced improvement in trend uniformity. So rather than an immediate plunge, we might instead see relative stability, followed by further erosion which might devolve into a crash several weeks later. As usual, that's not a forecast, but with a Crash Warning in place, we have to allow for that possibility.
If there was any remaining doubt about an economic recession, the combination of reduced confidence and economic disruptions effectively remove such doubts, in my view. As I've noted many times before, a market crash is essentially a liquidity crisis in which the risk premium on stocks rises sharply. I doubt that Tuesday's tragedy will affect the long term stream of cash flows, or their growth rate by very much. But stocks are priced based on two factors. One is the long term rate of growth in cash flows, and the other is the long term rate of return used to discount those cash flows back to present value. It's variation in that "required rate of return" that causes most of the volatility in stock prices, and the most important factor for short-term movements is the risk premium. Given today's razor thin risk premiums, there is substantial downside risk to stock prices if that risk premium is shocked toward more normal levels.
[For mathematically inclined clients, a simplistic, but useful way to see this is to examine the dividend discount model: Price = Dividend/(k-g) where g is the long-term growth rate of dividends and k is the long-term return required by investors, written as the sum of the risk free rate and a risk premium (k = Rf + z). As you can see, the "valuation multiple" (P/D) is essentially 1/(k-g). The long-term growth rate g has varied very little historically. In general, changes in valuation are driven by shifts in k: changes in interest rates (Rf) drive longer-term trends in valuation multiples, while shocks to valuation multiples are almost always driven by shifts in the risk premium z.]
In short, we remain on a Crash Warning here, but continue to allow for a wide range of possible short-term market outcomes. The assets of our clients and shareholders are secure in terms of custody, and remain defensive in their exposure to market risk.
Sunday September 9, 2001 : Hotline Update
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The Market Climate remains on a Crash Warning here, which I take seriously. At the same time, however, the technical condition of the market is clearly compressed and oversold, which invites the possibility of a spectacular rally. As I've noted many times, Crash Warnings do not mean that the market must, or should be strongly expected to crash. It's just that every historical crash of note has emerged from this one set of conditions, which has historically emerged in less than 4% of the data. The current Market Climate is characterized by a wide range of potential outcomes - which is what we call "risk", but an average return that is quite negative. That poor tradeoff between expected return and risk keeps us in a defensive position.
It is important to recognize that risk cuts both ways. While we remain defensive based on the characteristics of this Climate, we also allow the possibility of missing out on a sharp intermittent rally. We avoid market risk here for the same reason we would avoid the roulette wheel in Vegas. Yes, there is a wide range of potential outcomes, some which could be very positive. But on average, you'll lose money on the gamble. This is what many investors just don't understand. They want to be told which specific direction the market is going to go, rather than focusing on the average tradeoff between expected return and risk. They want to predict future market conditions rather than identifying current ones. We don't do it. As much as I hope my comments are useful in explaining our approach and providing context to the day-to-day news, our actual investment position is not based on my impressions or opinions. We position ourselves in line with the prevailing Market Climate.
The unemployment rate came in at 4.9% on Friday, right on the button in my view, but a "major surprise" to Wall Street. I just don't understand why investors insist on hope in preference for evidence. That preference is why they are incessantly surprised by news that really would be no surprise if they would just look at the data. From my perspective, that look would tell them several things: 1) the U.S. economy is in recession, 2) the combination of weak producer prices and rising wage and benefits costs means that profit margins continue to be under pressure. Combining this with poor sales growth results in a dismal outlook for earnings 3) the pressure on earnings will continue to hurt capital spending, which is usually just a magnified image of earnings, 4) the same factors will continue to raise default rates, causing earnings problems and debt downgrades among banks and financial companies, 5) earnings shortfalls will also lead to continued job cutbacks, with the unemployment rate rising to at least 5.5% (indeed, once the unemployment rate has advanced by 0.5% from its lows, it has never reversed until rising by least 1.5% off those lows).
The refusal of investors to accept the basic premise of an ongoing recession and continued earnings pressure means that all of these very predictable outcomes will be great surprises instead.
A few comments on recent data. Other than the employment report, the major number last week was the Purchasing Managers Index from the NAPM. That report showed a continued contraction in the manufacturing sector, but the number edged higher, which gave investors hope that the economy had finally turned the corner. Since employment is typically a lagging indicator, Friday's unemployment report was regarded as ancient history by the bulls, while the NAPM figure provided hope. The other hopeful figure lately has been the index of leading indicators from the Conference Board, which has been rising for the past few months.
There are two difficulties in pinning recovery hopes on these numbers. First, while we do pay close attention to the NAPM figures, given their long history, it is important to recognize that manufacturing is only about 20% of the overall economy, and that manufacturing employment has also dropped to a fraction of total employment. In 1997, the NAPM started a broader "non-manufacturing" index, which covers 62 industries. Since the non-manufacturing series doesn't have a long history, we primarily follow the manufacturing figures for signals. But given the overall quality of the NAPM data, the non-manufacturing survey merits attention as well. On that front, the non-manufacturing NAPM reading plunged to a new low for the index last month, with declines in new orders, exports, employment and prices. In contrast, the manufacturing-only index ticked up slightly, but it still showed a contracting manufacturing sector. Taking all those figures together, the NAPM data offer no evidence of an economic upturn.
As for the leading indicators, 60% of the weight in those indicators is based on monetary factors such as interest rates and M2 growth. My views about monetary policy are outlined in the latest issue of Research & Insight. Needless to say, the rise in the "leading indicators" is not a valid indication of an upturn in my view, apart from the fact that statistically, the leading indicators are fairly poor predictors of economic turns anyway.
On the credit front, the Preliminary Bank Earnings Report just released by the FDIC shows that banks have increased the rate at which they are writing off bad loans, but the growth in bad ("noncurrent") loans is increasing even faster. According to that report, "Loan charge-offs and noncurrent loans (loans 90 days or more past due or in nonaccrual status) continued to increase during the second quarter. Banks charged-off $7.9 billion in bad loans during the quarter, an increase of $2.6 billion (50.0 percent) from the level of the second quarter of 2000. As has been the case in recent quarters, the greatest deterioration in credit quality occurred in commercial and industrial (C&I) loan portfolios at larger banks. Despite the rising level of charge-off activity, noncurrent loans remaining in banks' loan portfolios continued to increase as well. The relatively larger increase in noncurrent loans meant that the industry's "coverage ratio" fell for the sixth consecutive quarter."
In short, we have a Crash Warning in place, but also a very compressed and technically oversold market. That combination admits a very, very wide range of short-term outcomes. We are always open to the possibility that a rally will emerge with convincing trend uniformity. If that occurs, we will quickly become more constructive. It's the uniformity, not the extent of a rally, that is important. A large but internally weak rally in the major indices would not shift our position. But even a small advance, if sufficiently uniform, would turn us constructive. For now however, the Climate remains very hostile, and the economic backdrop is certainly consistent with a defensive stance.
Friday Morning September 7, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning, which I take seriously. Based on current market conditions (not forecasts or opinions), we remain defensively positioned. Our discipline requires no forecasts - merely that we maintain a position that is consistent with the current Market Climate. That word "merely" is something of an understatement. When the whole investment world is obsessed with picking a bottom and forecasting the next turn, I feel quite alone in my insistence on identifying market conditions rather than forecasting them. There's only one other analyst I know who thinks this way - Richard Russell of Dow Theory Letters, whose daily commentaries are outstanding. He follows different methods, so we won't always agree, but he is very strict about his discipline, as we are. And there's nothing like discipline in the long run. Ask Warren Buffett.
We've got an oversold market here which is also collapsing internally. That sets the market up for enormous volatility and "illiquid" behavior. In daily action, I've noticed many more short term spikes, both up and down, than usual. Vacuums of selling one moment, and then vacuums of buying the next. Though I am not forecasting a crash, that is typical pre-crash action, and I certainly wouldn't rule one out. The fact is that I have absolutely no short term view about this market, except that I expect some breathtaking volatility. As for our actual investment position, that's always driven by the objective evidence, and on that basis we are defensive. Again, no forecasts are required there.
You may recall that in the August 23rd update, I noted a marked deterioration in some of our measures of trend strength were suggesting that the broad market could begin to weaken seriously. As it happened, that marked the high in the advance-decline line, which has turned down sharply. Equity-only advance-decline lines tracking stocks in the Dow and S&P indices have dropped to new lows, breaking under the March troughs. Meanwhile, the number of stocks hitting new lows has surged above new highs. On Thursday, the NYSE saw 165 new lows versus 70 new highs. On the Nasdaq, new lows outpaced new highs 295 to 48. It's certainly not true that every expansion in new lows results in a crash, but the market never crashes without a surge in new lows first. As you know, I had viewed the dearth of new lows to be the one shining positive in the technical picture. That positive is now gone.
That said, a new positive technical factor is the unusually long string of high "trading index" readings in recent weeks. Such a string usually points to an oversold market. High trading index figures essentially mean that very large stocks are under heavy liquidation. Unfortunately, most of the extreme historical signals emerged when valuations were also washed out. In the current instance, quite frankly, large cap stocks are under liquidation because they deserve to be liquidated. I hesitate to take much solace in that, and in any case, we wouldn't act on any signal that was not also accompanied by favorable trend uniformity. Trend uniformity could hardly be worse here.
Friday's action will be affected by two news items. The first is already in. Intel guided revenue expectations to the low end of their forecasts, but the report was not a complete disaster, so it prompted some after hours relief buying. My opinion about Intel's announcement is driven by analyst Ashok Kumar, who noted "It's inventory restocking now and not improvement in demand." Dan Niles of Lehman, the other thriving island of intelligence in a deep, dark sea of ignorance, noted that over half of Intel's quarterly revenues typically come in September. So in effect, Intel is just guessing. In any case, it may be worth the standard fast and furious bear market rally.
The second news item, of course, will be the employment report. The consensus view is that the unemployment rate will tick slightly higher, to 4.6%. My expectation leans closer to the 4.8%-5% range. The latest data on weekly claims moved back above 400,000, and last week's data was revised higher as well. But as I've noted before, the actual unemployment figure is an interplay between layoffs, new hires, and entry and exit from the labor force. Unusual behavior in any of those can throw the unemployment picture off on a month-to-month basis. My expectation is based on the underlying trends, which are still very unfavorable. Since we don't base our positions on such expectations though, we don't have anything "riding" on one particular outcome or another.
The bottom line is simple. The Market Climate continues to hold us to a defensive position. When the evidence shifts, our position will shift. Until then, this remains an environment where the range of possible outcomes is very wide, but the expected value of those outcomes, on average, is very poor.
Tuesday Morning September 4, 2001 : Hotline Update
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The Market Climate remains on a Crash Warning here. Except for partial evidence that the market is becoming oversold, the combination of valuations, trends, and yield action remains very negative. On the oversold front, the 10-day average of the TRIN (short for "trading index" : the ratio of advancing/declining issues divided by the ratio of advancing to declining volume) recently moved above 1.5, which has historically been followed by significant lows within a few weeks. The difficulty with the TRIN is that those favorable historical signals invariably occured in undervalued markets with high levels of public bearishness. We don't see that here. Indeed, there is still a great deal of complacency on the sentiment side, with only about 30% of investment advisors bearish and the CBOE volatility index not even reaching 28. On a solid oversold, one would expect much higher levels of bearishness. In any event, the relatively high trading index figures make us sensitive to the potential for a favorable shift in trend uniformity. We have absolutely no inclination to second-guess the current negative trend uniformity, and certainly would not try to move ahead of the evidence. In short, we see a weak signal of an emerging oversold condition. Unfortunately, that signal is not corroborated by other evidence, which makes us suspect that this "oversold" condition will be cleared by sideways action or a fast, furious, and false rally - rather than a sustainable advance.
Sun Microsystems was ravaged last week on a warning that earnings would probably come in negative for the current quarter, joining Cisco as another glamour tech company to show sudden losses. Of course, that's exactly what I warned would happen to the high-growth glamour companies nearly a year ago. More recently, on July 8, I noted "Sun Microsystems hasn't dropped a bombshell that earnings will actually come in negative this quarter or next. But I continue to expect that as well, given the creativity they've had to muster merely to keep earnings positive up to this point." Needless to say, I can't imagine why Sun's warning last week was a surprise to anybody. The constant hope for a near-term rebound in tech, the economy, and capital spending does only one thing, which is to prolong the agony and endlessly repeated surprise as the facts emerge.
I still don't see any evidence that an ongoing recession is recognized by economists or Wall Street analysts. Indeed, there's no evidence that they even consider it likely that we'll have one. That may change this week, which in my opinion will include a disappointing NAPM index on Tuesday and a sharply higher unemployment rate on Friday. The Chicago NAPM figures were upbeat on Friday, but the geographic pattern of recent layoff announcements suggests that Chi-town, my home-town, may not be the best indicator of national activity this time around. We'll see. On the unemployment front, remember that layoffs are only half of the job picture. The other half is new hires. It's the gap between those two that shows up as unemployed workers, and then only if they keep looking for jobs rather than leaving the labor force. Given the terrible plunge in Help Wanted advertising and the likelihood of smaller movement out of the labor force, my expectation is that the unemployment rate will jump from the current 4.5% to somewhere between 4.8% and 5%. Again, we'll see.
Alan Abelson presents an interesting chart in the latest issue of Barron's, showing that if extraordinary charges and option dilution is factored into earnings, growth in earnings per share from 1995 to 2001 drops to zero. Of course, accounting purists will object that option related compensation should not be deducted from earnings. If you believe that options represent compensation just as wages do, it is perfectly reasonable to deduct those charges. But even if you exclude them from earnings, you can't exclude them from the calculation of free cash flow, which is the only thing that matters for stock valuation anyway. It's a slightly technical argument, but the bottom line is that however you account for them, options grants combined with repeated "extraordinary" charges have effectively wiped out the entire "growth miracle" of the past several years. This is one reason why the S&P 500 trades at a price/book value ratio of nearly 6, compared to a historical norm below 2.0: companies have created virtually no underlying shareholder value by retaining earnings rather than paying them out as dividends. Indeed, the book values of the S&P 500 and Dow Industrials have declined over the past year, as assets continue to be written down.
The bottom line is simple. The Market Climate remains on a Crash Warning. The market is strenuously overvalued in a poor trend environment and an ongoing but still unrecognized recession. That climate, in our view, is a poor set of conditions for taking market risk. We are always sensitive to the potential for a favorable shift in trend uniformity, which would move us to at least a modestly constructive position. The slight evidence of an oversold market is certainly nothing to speculate on, since bear markets can remain deeply and repeatedly oversold without consequence, but it does allow the possibility of a sharp intermittent rally to clear the market for a fresh decline. A legitimate rally, in my view, is one that generates favorable trend uniformity very quickly. I doubt we'll see that here, but if that occurs, we'll act on it constructively. For now, we remain defensive.
Friday Morning August 31, 2001 : Special Hotline Update
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Just a note: the next update will be available on Tuesday morning, September 4th.
The Market Climate remains on a Crash Warning here. The number of stocks hitting new lows on the NYSE nearly doubled on Thursday. As I noted several days ago, this sort of expansion is particularly troubling when it occurs on a string of successive down days. Pre-crash action always includes that kind of relentlessness. Even a few days ago, we lacked this sort of action, which I took as at least one bright spot in the technical picture. With that bright spot suddenly gone, the term "Crash Warning" takes on more meaning. It's fairly unusual for both new highs and new lows to exceed 100 on a single day. It reflects wide disparity and lack of uniformity that can often lead to sharp selloffs.
That said, the market has become extraordinarily depressed technically. That sort of condition can lead to breathtakingly sharp short-term rallies. So while our position is clearly defensive - in line with the current, objectively identified Market Climate - a leaping short-term rally should not be ruled out. If the market is instead following a crash script, that script might include something like a 4% decline on Friday, to give people the long and sleepless weekend that typically precedes capitulation. That's not a forecast, just a comment about the pattern that often appears before crashes.
If I believed that short-term forecasts were required for successful investing, I would have been carted off to Happy Acres long ago. Frankly, I can't imagine how investors can function believing that the key to their wealth is knowing whether the market will rally spectacularly or crash violently in the near term. The fact is, very frankly, that both of those are definite possibilities. So what do you do? If you're like us, you recognize that variability of possible outcomes is the definition of risk. If you're going to take that risk with either a large long position or a large short position, you had better have a firm expectation that there is a significant expected return associated with that risk. Right now, the Market Climate is one that has historically been associated with great risk, but negative overall returns. That means that a significantly invested position in stocks is out of the question for us, regardless of any speculative prospect for a short term bounce. Similarly, even though the expected return to stocks is negative in the current climate, the risk (measured by the variability of possible outcomes) is also very wide. That rules out large short positions too, but allows moderate short positions - consistent with the expected market loss but appropriate to the risk - in our most aggressive client accounts. As for the Fund, we are simply neutral, with our stock positions fully hedged.
Again, successful investing does not require bold forecasts about future market action. While I certainly try to convey my views to clients and shareholders in these updates, it is important to understand that these views do not drive our position. All that is required is that we align ourselves with the objectively defined Market Climate at any time. If the market soars tomorrow, and we're neutral, so what? If I walk past the craps table in Vegas and somebody throws 11, I don't slap myself on the forehead for not betting. If the return/risk ratio is poor, we don't take the risk. Really simple, but extremely hard for investors to do once they get all involved with hope and fear of regret. Much better to lay out all of the reasonable outcomes for the market, both up and down, and ask whether any of those possible outcomes are intolerable given your current position. If the market could reasonably do something that would be intolerable to you, you're not positioned correctly. Period.
In short, I have no view about short-term market action. What I do believe, and what does affect our position, is that the current Market Climate is associated with a poor return/risk tradeoff for stocks. Risk means variability of outcomes though, so even though this is still a negative Climate, short-term rallies should be fully expected from time to time. No forecasts are required. We remain defensive based on current evidence.
Thursday Morning August 30, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. The latest revision to GDP took second quarter growth to 0.2%. The talk all day has been that this figure somehow proves the economy is not in recession, because analysts actually believe the fairy tale that a recession is defined as two quarters of negative GDP growth. I can't emphasize enough how little this 0.2% blip to GDP matters in regard to determining a recession here.
One of the most fortunate events in my life was to study under four brilliant economists at Stanford, who also formed my dissertation committee - Ronald McKinnon, an influential and original scholar in international economics; Thomas Sargent, a leading "rational expectations" theorist; John Taylor, also a "rational expectations" macroeconomist (currently serving in the Bush administration, and a leading candidate to succeed Alan Greenspan at the Fed, according to the Wall Street Journal), and Robert Hall, who heads the official Recession Dating Committee of the National Bureau of Economic Research.
Let me share a comment from Dr. Hall, which will put this GDP fantasy to bed (You can read his full comments on the "recessions" page of www.nber.org (click here) He writes: "Because a recession influences the economy broadly and is not confined to one sector, the committee emphasizes economy-wide measures of economic activity. In principle, the best such measure is real gross domestic product, GDP. But GDP is measured only at a quarterly frequency and is continually revised, often decades later. The traditional role of the committee is to maintain a monthly chronology, so the committee refers almost exclusively to monthly indicators. Most of the recessions identified by our procedures do consist of two or more quarters of declining real GDP, but not all of them. But our procedure differs in a number of ways. First, we use monthly indicators to arrive at a monthly chronology. Second, we use indicators subject to much less frequent revision. Third, we consider the depth of the decline in economic activity. (italics added)
In short, today's GDP number hardly even figures into the NBER's determination of a recession; particularly not one that is 0.2% away from zero. Based on monthly indicators such as employment, industrial production, as well as a laundry list of signals which occur always and only during recessions, I continue to believe that the U.S. economy is in a recession which will ultimately be dated by the NBER as beginning during the first quarter of 2001. That's not to say that the NBER would determine a recession if they were to meet and look at the data today. Much of the evidence I am referencing relates to market action and leading signals of various sorts. Then again, you should not expect the NBER to even consider meeting until there is a fairly widespread consensus that the U.S. is in recession. The Committee's role is not to forecast or identify recessions in real time, only to date their starting and ending dates.
As a sidenote, some analysts argue that an economic turnaround is ahead because of the recent rise in the Conference Board's Index of Leading Economic Indicators. Unfortunately, the LEI is not a very effective leading indicator statistically. Moreover, about 60% of the weight in the LEI is based on monetary indicators such as M2 growth and interest rates. As I've noted in the latest issue of Research & Insight, there is little reason to believe that the current campaign of Fed easing is having or will have any effect on bank lending. Yet those monetary components account for the entire recent advance in the leading indicators.
As for market action, we still do not see an explosion in the number of stocks hitting new 52-week lows. In large part, this is because those lows were typically registered in March, and the market remains above that March trough. As I noted in yesterday's update, a sudden expansion in new lows would be a very negative sign, because it would indicate a fresh collapse in market internals. In general, free-fall type declines occur only after an explosion in new lows has occurred. As yet, we have not seen that, which is one of the few technical rays of hope for the market. Unfortunately, we are also seeing continued weakness in financials in recent days, which is a fresh downward break. The recent swoon in mortgage related financials such as Fannie Mae is also of concern.
Short term, I am completely agnostic about market action. Wednesday's decline was something of a surprise in the sense that the market got even more compressed into its oversold condition. Bear markets often stage their standard "fast, furious and prone to failure" rallies from such compressed conditions. But it is important to remember as Richard Russell points out, that oversold conditions can persist in bear markets much longer than they would during bull markets. With fundamentals terribly unfavorable, terrible trend uniformity but an oversold technical condition, and favorable season influences, I would not rule out any sort of short-term market action here. But we never need to predict in order to set our position. As usual, we are aligned with the current, objectively identified Market Climate. We'll take a constructive signal if trend uniformity improves. But for now, that climate holds us to a defensive position.
Wednesday Morning August 29, 2001 : Special Hotline Update
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Just a note - the Annual Report of the Hussman Strategic Growth Fund, as well as the latest issue of Hussman Investment Research & Insight are now available on the Research & Insight page of our website, www.hussman.net
The Market Climate remains on a Crash Warning here. Consumer Confidence weakened instead of strengthening, and last month's numbers were revised down. That introduced some new concerns about the economy, which market action including weak retail, housing and U.S. dollar trends have suggested for weeks. Actually, consumer confidence is something of a contrary indicator (though it would have to fall much more deeply to be a bullish factor here). At major market peaks, consumer confidence typically reaches new highs. You may recall that last year, confidence reached levels seen only at the peak of the late 60's "Go Go Market." In contrast, consumer confidence was terribly depressed during the last recession in 1991 and into 1992, which was an outstanding area to buy stocks. You may recall that the terrible consumer confidence prompted talk of further market losses and a "double dip recession." When I argued that it was actually a very favorable sign, the Los Angeles Times called me "one lonely raging bull." I'm sure I'll be similarly bullish at some point ahead. But here and now, we remain strongly defensive.
Wednesday will be interesting right away, as the Commerce Department announces revised second quarter GDP figures. Though I have little doubt they'll ultimately be revised to negative readings, these figures go through so many revisions that the extent of Wednesday's change is anybody's guess. A negative second quarter reading, of course, would be most in line with my view that the U.S. economy entered a recession at some point in the first quarter of 2001.
With regard to market action, the financials continue to weaken here, as concerns gradually increase about debt quality and defaults. We are not, however, seeing the significant surge in the number of stocks hitting new lows that typically precedes a crash. If market internals weaken considerably here, we should see it as an expanding number of new lows even if we don't see much deterioration in market breadth (i.e. the advance-decline line). This is because new lows will reflect weakness in individual equities even if the advance-decline line is supported by favorable action in interest sensitive stocks.
In short, unfavorable valuations and market action hold us to a defensive position here. We're watching a number of market internals in an attempt to infer more about economic prospects and crash risk. On the economic side, retail, housing, financials and U.S. dollar action convey the most information here. On the crash risk side, we're watching for any abrupt expansion in the number of stocks hitting new lows, particularly if it occurs on a string of consecutive down days. Given the recent decline, though, I have no opinion about short term action. Those are simply areas to watch.
Certainly the GDP revision could prompt further downside if it comes in negative. But seasonally, there tends to be a favorable seasonal bias that one might expect between now and about the end of next week, followed by particularly weak seasonal influences for the remainder of September. So on a seasonal basis, it may be another week or so before we see significant downside pressure.
As usual, no forecasts are necessary. We remain defensive here based on the Market Climate currently in effect.
Sunday August 26, 2001 : Hotline Update
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A few notes. The latest issue of Hussman Investment Research & Insight is now available on the Research & Insight page of our website. The Annual Report of the Hussman Strategic Growth Fund should be available on the web by Thursday afternoon. We expect print copies of both to be in the mail by Thursday as well.
The Market Climate remains on a Crash Warning here. As usual, we will move to at least a modestly constructive market position if the market can recruit sufficient evidence of favorable trend uniformity. Despite our views about the economy, debt quality, valuations and other financial conditions, it is important to understand that we take very important information from market action. While the information conveyed by current action remains quite negative, we always allow for the possibility of a rapid shift. That's one of the essential and useful features of market action - it conveys information far more quickly than government statistics or other sources. Market action, particularly in the context of extreme overvaluation, is why we remain defensive here. Market action is what warned us of an economic downturn late last year. And market action is what suggests that Friday's rally was a typical "fast furious and prone-to-failure" bear market bounce.
Somebody at Cisco got a tingly feeling on Friday. My guess is that it was lack of blood to the brain, but they decided to interpret it as an emerging possibility that maybe business might be starting to show initial signs of hope. That was all that investors needed. In a bear market, investors cycle quickly through 3 emotions all the way down:
1) On a sell-off down to the previous low: "Well, we've been here before. This is where we bounced the last time. I can't sell now." 2) On a sharp break to a new, deeper low: "It's gone down so fast, there's got to be a bounce soon. I'll get out then. I can't sell now." 3) On a fast, furious rally off the low: "Hey! It's coming back. I am a genius! I can't sell now."
Now go back to number 1) and repeat indefinitely.
Despite the strong gain in the major averages Friday, advances failed to outpace declines by even 2-to-1. Even more telling, even with that furious rally, Friday saw fewer stocks hitting new highs than any other day of last week (down-days included). This was true on the NYSE, the Amex, and the Nasdaq as well. Financial stocks also swooned suddenly. That was a new one, because financials have been clinging to the top of their upward trend channels for months. That will be an interesting group to watch from here, particularly given the recent upward spike in bankruptcies.
What strikes me about the current market is the utter complacency about valuations, and the superstition about the Federal Reserve. We've all heard that Fed actions take 6-9 months to "kick in". Will somebody please explain why these actions should "kick in" when bank reserves continue to decline, bank credit no longer bears any relationship to reserves anyway, capital spending is a magnified mirror image of profits, and profit margins remain firmly under pressure. As Stevie Wonder sings, "When you believe in things that you don't understand, then you suffer."
Frankly, if brokerage analysts could bottle stupidity and sell it, they could still be earning record profits. Well, evidently UBS PaineWebber has decided to go ahead and try. They've taken out full page ads (one in the latest issue of Barron's) giving a 1-year target for the S&P 500 of 1835, which is 54% above current levels. With earnings unlikely to expand more than single digits in the coming year, that would put the P/E ratio at about 40 on the S&P 500 and the price/dividend ratio at about 110. The ad argues that "Stocks should soon be benefiting from the sweet spot of a friendly Fed: low interest rates and improved earnings visibility."
Hey, if I ever use the phrase "sweet spot" as part of a serious investment analysis, please slap me silly. I have little doubt that this estimate was obtained by some version of the dividend discount model: Price = D / (k - g), where Ed Kershner decided to pick a long-term return on stocks k really, really close to the long term growth rate of dividends g. Gee, why didn't he just go ahead and set them equal and shoot for thrills? The way I see it, analysts are certainly free to make whatever projections they see as reasonable. The ethics of this lies in how you present it and how clearly you elucidate your reasoning behind it. When you take out full-page ads in a market far above historical norms of valuation, and your projections imply that valuations will reach twice the level they did at the most extreme peaks of past market cycles, you should back the calculations up with something more than the hope for a sweet spot, even if it's nothing more than a few numbers in the small print. Thank you, PaineWebber.
As usual, we'll act on any positive signal from favorable trend uniformity if it emerges. For now, we remain defensive.
Thursday Morning August 23, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. Wednesday's action didn't convey much information at all. Breadth was fairly narrow given the moves in the major indices, but that's largely to be expected on the bounce after a significant decline. Essentially we saw investors hoping to buy beaten down glamour stocks. Again, there was no broad uniformity to the bounce.
We are seeing one new development, though. There is some emerging evidence that the broad market may begin to deteriorate seriously. For months, some of our internal strength measures have favored secondary stocks, indicating comparatively favorable action in indices such as the Russell 2000 and the Value Line Arithmetic average (which is not weighted by capitalization, so it reflects broad action). The advance decline line has also acted well. Some of our measures of trend strength have deteriorated markedly in recent days, however, suggesting that much wider deterioration in the broad market may occur (i.e. weakness in the "average stock"). When the last vestige of trend strength - the broad market - gives way, we very well could see a major leg down, not simply this repeated churning down to slightly lower lows. Something to watch. In any event, our measures of trend uniformity are clearly unfavorable here, as are valuations. We'll become constructive if we see evidence of trend uniformity, but see nothing so far. As a result, we remain defensively positioned, and no forecasts are really necessary.
Wednesday Morning August 22, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning. As always, this is not an indication that the market must or should be strongly expected to crash. It simply means that current conditions - extreme overvaluation, poor trend uniformity, and hostile yield trends - have occurred in less than 4% of market history, and that 4% encompasses every historical crash of note. A Crash Warning certainly does not rule out the powerful intermittent rallies that are part and parcel of an ongoing bear market. But of course, it does not rule out crashes either. Attempts at prediction are ridiculous here, and also entirely unnecessary. We remain defensive here, based not on forecasts of future market action, but rather on an identification of current valuations and market trends.
In the current Market Climate, buying just because the market is down requires the willingness to suffer enormous losses for fear of missing the first part of any new rally. Look, it's generally not difficult for a legitimate rally to generate trend uniformity very quickly. What produces a good signal is the internal uniformity of a rally, not its extent. Good rallies typically don't have to go far to generate this uniformity, so in general, they give constructive signals fast. The failure of the market to do so in recent months was a warning sign, and one that proved correct. If the market can recruit more favorable trend uniformity, we will quickly become more constructive, but we don't act without evidence, and there is no such favorable evidence as yet.
One of the questions I heard today was "Who is selling? Who would sell with the market down so much already?" Well, first of all, the S&P still trades at 23 times peak earnings (about 26 times current earnings, and according to the Wall Street Journal, upward of 36 times earnings if companies reported them based on Generally Accepted Accounting Principles rather than "operating" or "pro-forma" basis). This is still a market that could fall in half just to reach median historical valuations. Remember though, that overvaluation only implies poor long term returns. The fact that the market is overvalued doesn't mean it has to decline in the near term. But with trend uniformity solidly negative, valuations do tend to bite. In any event, stocks certainly aren't cheap despite this decline.
Moreover, a market plunge does not require that a lot of investors are selling. Price movements reflect not trading volume, but the relative eagerness of buyers versus sellers. This is something I'd love to post on a cue-card in front of Maria Bartiromo, who I'm sure is a nice person, but still gets this wrong daily. Buying stock does not put money into the market as if it's a big balloon, nor does selling take money out of the market. Every dollar that a buyer brings in goes out in the hands of a seller. Every dollar that a seller withdraws comes from the buyer on the other side of the trade. Money goes through the market, and it's not the quantity of the stuff that moves prices. It's who is more eager. Put one eager seller in front of a bunch of other investors scared to buy, and prices can go down in a hurry, with very few shares changing hands. Indeed, it's illiquidity of this type that is characteristic of market crashes. The hallmark of a market crash is that very few investors actually get out.
So don't imagine that "everyone is selling" here. Most investors are holding tight and getting the daylights kicked out of them. But remember also that bear markets produce rallies that are fast, furious and prone to failure. They serve to keep investors holding on for the next beating, aided and abetted by Wall Street analysts who are perfectly willing to take profound risks with other people's money. Unfortunately, those are real people, with real families and real retirement plans. Remember that a bear market is like a spouse abuser who hands his black-eyed mate a dozen roses the next morning saying "Come on, Baby, I've changed". Don't listen. Just get out.
We may very well see a rally, or we may see conditions turn very ugly, particularly with new breakdowns in the U.S. dollar, the Dow (now below its July low), the Value Line, and consumer sensitive industry groups such as autos, retail and housing. As usual, I have no short-term prediction. The current Market Climate, however, remains on a Crash Warning. That's all we need to know.
Sunday August 19, 2001 : Hotline Update
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The Market Climate remains on a Crash Warning here. Market internals continue to deteriorate alarmingly; the most important casualty last week being the U.S. dollar. Other rather severe breakdowns include utilities and autos. The U.S. Dollar Index plunged through support at 114 as if it didn't exist, and closed last week at 112.94 (click here for a chart).
As I have noted frequently in recent months, if you want to know when the U.S. economy is about to take a sudden turn for the worse, watch the dollar. Well, in my view, here we go. The weakness in the U.S. dollar is essentially a reflection of very weak demand conditions in the U.S., both for goods, and for U.S. security investments by foreigners. Now, since the U.S. trade deficit effectively measures the gap between U.S. domestic saving and U.S. domestic investment (which is financed by foreign capital inflows), recessions generally produce a very rapid shrinkage of the trade deficit, as domestic investment falls hard and the need for foreign capital dries up. That's the second part of what's about to happen. In short, the U.S. dollar is strongly indicating that domestic demand conditions are about to take a marked turn for the worse. This means an accelerated economic downturn, but one that will likely be accompanied by a shrinking trade deficit beginning most probably with the August numbers. (Though the trade deficit always "improves" during recessions, that shrinking deficit will nonetheless be hailed as a "bright spot" in the economy by analysts in need of an undergraduate economics class).
Over the past 10 weeks, both the S&P 500 and the Nasdaq have been moving to a series of new lows, while the lows in the Dow have been relatively flatter in profile. The relative strength in the Dow, as well as the resilience of the NYSE advance-decline line, have been important in maintaining a relatively complacent attitude among investors. The Investors Intelligence figures still show fewer than 30% bears among investment advisors, which has historically been a relatively poor portent for stocks. Richard Russell of Dow Theory Letters (www.dowtheoryletters.com) has noted, rightly I think, a break in the Dow below its July low of 10,175.64 would be a significant event in terms of market action as well as sentiment. Richard also notes that about 48% of the issues on the NYSE now represent preferred stocks, closed end funds, ADRs and the like. As a result, the NYSE advance-decline line is heavily influenced by factors like bond market action. The NYSE line contrasts sharply with the Nasdaq advance-decline line, which is terribly weak. Alan Abelson of Barron's notes that a shift from Nasdaq stocks to NYSE stocks may also be a factor supporting the A/D line. In any event, I am struck by how many technicians base their bullishness on the combination of the A/D line and Fed rate cuts. While those certainly influence our analysis as well, our broader definition of trend uniformity has been unswervingly dour, suggesting that the advance-decline picture is unrepresentative of the broad weakness in market internals.
On the subject of Fed rate cuts, we expect a 25 basis point cut this week. True, many analysts are crying for 50 and 75, but there are enough inflation hawks on the FOMC that a 25 point cut is still most likely. Even the tame July inflation numbers did little to reverse the unrelenting upward trend in core inflation, and wage inflation is still very strong. While my own view is that the economy is likely to weaken much more sharply than the FOMC believes, I also believe that further interest rate cuts will be largely ineffective in stimulating loan growth or economic activity. As noted last week, even with aggressive Fed easing, the entire increase in the monetary base over the last year has been drawn off as currency in circulation, while bank reserves (as well as commercial and industrial loans) have declined. So even if the FOMC agreed wholeheartedly with my own views, an aggressive easing of monetary policy still would not be the appropriate response.
The current economic situation can only be termed "unfortunate". The downturn we have on our hands is the natural result of several years of gross misallocation of capital. Bad investments go bad. A good monetary policy is one that attempts to ensure that good credit risks are able to obtain financing. For now, that remains true even here. What I don't agree with is the attempt to ensure that any credit risk obtains financing. That almost appears to be what the Fed is shooting for - witness Greenspan's cheerful report that homeowners continue to withdraw equity from their homes in order to consume. As always, once the consumption binge is over and the bad investments are made, the debt incurred to finance them still remains to be repaid. There's no appropriate government policy to bail out these bad choices without ensuring that the next binge is even more destabilizing. Again, the situation can only be termed unfortunate.
As usual, our investment position is based on objective evidence of the current Market Climate, not on forecasts, opinions or projections. My comments and expectations are intended to provide context, but they do not drive our position. For now, based on the objective evidence, we remain defensive. That said, I am certainly comfortable with that position.
Sunday August 12, 2001 : Hotline Update
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The Market Climate remains on a Crash Warning here. We continue to be well-hedged, but are open to a more constructive position if the market can recruit favorable trend uniformity. So far, there has been little or no progress on that front. While the advance-decline statistics have been reasonably firm, other market internals continue to falter, particularly those related to consumer spending including sensitive areas such as retail and home construction stocks.
Friday gave us a significant decline in the Producer Price Index (the core rate rose 0.2%, but the headline number was down). On the surface, that might seem like good news as it clears the way for more Fed rate cuts. Unfortunately, the weakness in producer prices (as well as industrial commodity prices) is essentially a reflection of soft demand. The lack of pricing power, combined with strong wage inflation, is a signal of further erosion in the profit outlook. This is particularly true in the technology area where discounting is turning vicious, while at the same time, wage pressures for skilled technology labor are enormous because stock options are no longer providing "stealth" compensation. Of the few analysts completely worth their salt, both Ashok Kumar and Dan Niles expect Intel to slash prices by about 50% later this month. You can imagine the pressures in other areas such as routers, data storage, and chip & telecom equipment. This again is why it is crucial that you do not rely on P/E ratios as accurate measures of value here. For many companies, P/E ratios seem benign, while price/revenue and price/book ratios are ridiculously high. This is a sign that profit margins and return on equity are very elevated, and most likely, about to plunge markedly. Even for the S&P 500, the current P/E near 27 significantly understates the extent of overvaluation, because profit margins are still historically high and under pressure. Count "safe blue chips" such as GE and Pfizer among these overvalued behemoths. The price/book ratio of the S&P is over 6, compared to a historical norm about one-third that level. Ditto for price/revenue and price/dividend ratios. In short, this is still a very hostile environment for profit margins. Don't take earnings at face value.
By extension, weak earnings imply weak capital spending and increasing debt problems. That's not isolated to the corporate sector. Problem consumer loans are sharply on the rise, particularly auto loans. At the same time, bank stocks are regularly trading in excess of three times book value. The historical norm is closer to one times book. So financial stocks are in a similar situation as the techs, in the sense that they are quite elevated in price, and vulnerable to earnings pressure. We don't have any policy against holding techs and financials - we're simply avoiding them here because they fail to satisfy the requirements of our stock selection criteria. As with our market exposure, we're very open to a constructive position in these sectors if they recruit sufficiently favorable valuation or market action to satisfy our discipline.
As for Fed easings, I continue to doubt the effectiveness of easy monetary policy in an environment where problem debt levels are unusually high and capital spending is retrenching. In order to be effective, a Fed easing must induce borrowers to borrow and lenders to lend. But look at the Fed monetary statistics. Over the past year, the Fed has bought about $32 billion of Treasury securities outright, and has paid for these by injecting $32 billion into the economy, which shows up as an increase in the "Monetary Base." Now, the Monetary Base consists of two things: currency held by the public, and reserves held by banks. The operative notion of easy money is that you create $32 billion in bank reserves, the banks lend out the money, the money gets spent, more loans happen, and through the magic of the "money multiplier", the amount of loans in the economy goes up by many times that $32 billion. So let's actually look at the data (since nobody else seems to have done this). What actually happened to that $32 billion increase in Monetary Base? Over the past year, bank reserves have actually declined by about $1 billion, while currency in circulation has increased by about $33 billion. This is old-style Keynesian money-under-the-mattress stuff. It's exactly what happened in Japan over the last decade. Easy money didn't matter. Lower and lower short-term interest rates served only to further reduce the cost of holding cash balances, while bank lending languished. The Fed can inject all the money it wants into the banking system. All it's done so far is to reduce the amount of Treasury securities held by the public (the Fed bought them instead) and to increase the amount of currency held by the public (since the "opportunity cost" of lost interest is negligible).
All of which is why I am entirely unconvinced that Fed rate cuts can be counted on as a bullish factor for either stocks or the economy. As usual, we'll quickly respond to any shift in trend uniformity. But lacking such objective evidence, and in light of what I view as a deteriorating and still unrecognized economic recession, I am quite comfortable with the defensive side here.
Thursday Morning August 9, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning here, characterized by extremely unfavorable valuations, unfavorable trend uniformity, and hostile yield trends. A Crash Warning doesn't imply that stocks must or should be strongly expected to crash. Rather, it indicates a Market Climate that has occurred in less than 4% of historical data, yet from which every major crash of note has emerged. A crash clearly should not be ruled out. Still, this climate should not be equated with a crashing market. Rather, the market has declined at an average -20% annualized rate when this climate has prevailed. But that's bad enough. It is important to understand that the poor overall performance of this climate is an average that includes steadily declining markets, trading ranges, the occasional market crash, and also strong intermittent rallies from time to time. As usual, I have no opinion regarding short-term market action, but the offensive average return/risk tradeoff in this Climate holds us to a well-hedged position for now.
One of the notable market factors here is the light level of trading volume. Essentially, the decline we've seen so far has been due more to weak buying interest than to heavy selling pressure. This is also suggested by the Lowry's statistics (which measure how much volume is required to move stocks higher or lower). In effect, recent weeks have seen weak buying pressure, but little aggressive selling pressure. Wednesday's action was different in that regard. Falling buying pressure combined with accelerating selling pressure is unwelcome. A market crash is always something of a liquidity crisis, where sellers aren't able to match orders with buyers except at substantially lowered prices. That's a growing concern here.
On the economy, as I've noted before, one of the classic signals of an oncoming recession is a downward turn in the growth rate of consumer debt. The initial thrust of this economic downturn occurred on the capital spending side, but consumer weakness has been relatively slow to emerge. Unfortunately, the latest report on consumer credit shows the first decline in four years. Moreover, recent market action has been hostile in ways that suggest weakening consumer demand ahead. One worrisome item among these is the recent downturn in housing stocks. Housing has been the main source of resilience in an economy otherwise plagued by collapsing manufacturing and capital spending. I don't take the information from recent market action lightly, particularly because it has been highly concerted and uniform among consumer-sensitive areas.
In short, far from blasting into a recovery, this recession is just starting to dig in. Wednesday's awful Beige Book report was largely dismissed under the view that "things always look bad at the bottom." Well, maybe we are at the bottom. After all, as you dig a hole deeper and deeper, you're always at the bottom, aren't you?
Tuesday Morning August 7, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. One of the important aspects of our investment approach is an emphasis on information conveyed by market action. Monday generated a great deal of such information, and it was just awful. Notably, the market's assessment of demand conditions, particularly consumer demand, was pounded with sudden forcefulness. We saw concerted weakness in retail, brokerage, energy, and importantly, housing stocks. The uniformity of that combination isn't coincidental, and it smacks of a sudden concern about the resilience of consumers, and by extension the economy and the stock market. It would have been even worse had the U.S. dollar weakened as well, but given some very poor economic news from overseas, the dollar held fairly steady. That's still an important area to watch. Even without dollar weakness, Monday's action conveyed very negative information from the standpoint of our investment discipline.
Among the most striking facts we've discovered in historical research (and in real time) is the tendency for markets to shrug off overvaluation when market action is uniformly favorable. Conversely, valuations become terribly relevant when the market loses that uniformity. This is a lesson that the perpetual bulls on Wall Street don't understand - even though valuations did not matter much in recent years, they have the potential to matter with a vengeance now. The benchmarks of value so easily ignored on the way up become magnets on the way down, and we're nowhere near the norms for those benchmarks. Failing to make this distinction, investors continue to be lured into speculating on the overvalued glamour stocks of the previous bubble. That tendency won't go away quickly - one of the ways that a garbage stock keeps people hanging on is by staging stellar intermittent rallies all the way down. There's no telling whether it will happen to Cisco after Tuesday's close, but given the breathless hope of investors that John Chambers will say something, anything positive, I wouldn't rule out a short-term pop. Nor would I rule out a crash, which is why I don't base our investment position on predictions.
We continue to keep our investment position in line with the current, objectively identified Market Climate. Until we see a favorable shift in trend uniformity or valuations, that Climate remains strongly defensive.
Sunday August 5, 2001 : Hotline Update
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The Market Climate remains on a Crash Warning here. Market breadth as measured by advances versus decliners has made decent headway in the past few months, and that should make it easier for other aspects of market action to deliver "favorable trend uniformity". But so far, nothing. We always allow for such shifts. In the event that the market can recruit sufficient uniformity, we will shift to a modestly constructive position (though certainly not an unhedged or aggressive position). For now, we remain highly defensive.
One of the interesting features of the employment picture is that, after hitting a record high last year, the percentage of Americans in the labor force has begun to decline. That means that even when workers are laid off, they have a tendency not to show up as unemployed because they leave the labor force. Only individuals actively looking for work are counted as unemployed. So we have a disturbing picture of mass layoffs combined with plunging help wanted advertising, but the effect on the monthly unemployment rate and weekly unemployment claims is masked by attrition of workers from the labor force. In the end, unfortunately, fewer people are working. And unfortunately for corporations, there is significant pressure on benefit costs such as medical insurance, as well as pressure to increase wages due to the lack of option-related profits. Rising employment costs will continue to exert persistent downward pressure on profit margins in the coming quarters.
Another disturbing feature of the current picture is the widespread use of "extraordinary" items to charge off bad investments, excessive inventory, worthless receivables and other assets that were supposedly being accumulated for the benefit of shareholders. These writedowns effectively wipe out a substantial portion of the earnings growth of the past 5 years, making the actual earnings performance much more mundane. Once extraordinary charges and options dilution are considered, it's not clear that companies actually accumulated much at all for the benefit of shareholders, and they sure didn't pay dividends. Yet investors have not substantially marked down P/E ratios, as if high rates of future earnings growth can be expected to resume despite never having actually existed in any sense that's relevant to shareholders.
Well, now the Commerce Department is getting into the act, substantially revising down the GDP growth reported for the past few years, including a reduction in year 2000 GDP growth from 5% to 4.1%. It has been noted that the accompanying productivity figures will also probably be revised substantially lower on Tuesday, making a lie of the widely assumed "productivity miracle" of recent years. Indeed, at least one major investment house is suggesting a crash in response to these numbers. While we remain on a Crash Warning, we're not convinced that the productivity figures will be the catalyst, mainly because of the dim-witted manner in which investors have allowed companies to dilute and write down their interests month after month right under their noses.
If they've learned anything from Wall Street, the Commerce Department should accompany their downward revisions with a statement that everybody there has a tingly feeling about a rebound just around the corner. You can be assured that John Chambers of Cisco will be saying exactly the same thing on Tuesday.
We'll see what happens (if anything) to our measures of trend uniformity in response to the coming week's events. We'll act on any change in evidence, but no forecasts are required. For now, we remain defensive.
Wednesday Morning August 1, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. There are no compelling reasons to expect a favorable shift in trend uniformity in the near future, but we never rule it out. If such uniformity emerges, we'll move to a more constructive position, but we remain very defensive here.
On Friday, Chicago's Superior Bank got a new name. Superior Federal Bank, becoming the first U.S. bank to fail this year. Superior's loan portfolio leaned toward lower credit risks, and it maintained a minimal amount of capital to shield it from loan losses. But with FDIC reports noting that large commercial banks have the lowest level of loan loss reserves in a decade, and showing concerns about deterioration in credit quality and regional risk factors, Superior is a microcosm of a much broader problem. Surely, most banks are better positioned and will avoid going into receivership. But you can bet that the same problems that plagued Superior's loan portfolio also plague every major bank in the country. The only issue is to what degree, but in any event, I am expecting significant earnings disappointments and loan writedowns among financial companies ahead. As I noted last week, our focus on capital spending slowdowns, earnings disappointments and weakening profit margins has now been supplanted by a new chief concern. Debt.
In our regular stock selection analysis, it's interesting to note that the highest rated candidates are all relatively mundane companies in relatively mundane industries. What gives them luster is that our models suggest significant undervaluation and relative stability of cash flows. Based on evidence from market action, those are the kinds of companies that are enjoying persistent buying interest here. Safety, predictability, low debt and stable cash flow is increasingly being recognized. That's just not what you usually see in emerging bull markets, when the underlying buying interest focuses squarely on growth - both blue chip and emerging growth. Not today. I take that as a strong signal that we probably won't see economic or generalized earnings growth anytime soon.
So while Bubblevision focuses on the latest pro-forma profit report, the big picture remains dominated by debt, continued economic risk, and overvaluation. The S&P 500 still trades near 27 times earnings and 6 times book. If trend uniformity were positive, we would be willing to take a very modest constructive position even at these levels. But given the actual market conditions which remain in place, it's difficult to imagine just what investors are hoping for - and what they think their money is actually buying - when they purchase stocks at current prices.
Sunday July 29, 2001 : Hotline Update
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The Market Climate remains on a Crash Warning here. We're beginning to see a fresh deterioration in important market action relating to economic activity. As I've stressed for years, the best information regarding the economy - particularly leading information - comes not from the widely followed statistics on employment, GDP and so forth, but from market action and survey data. The brief economics primer on our website gives more details on this. What we're seeing recently is emerging deterioration in the U.S. dollar combined with a strong plunge in industrial commodity prices. The concerted weakening in commodity prices already suggests a global force to this economic downturn, while further weakness in the U.S. dollar would suggest that demand for U.S. goods and securities was softening even more sharply than internationally. Until recently, the strength of the U.S. dollar has reflected more rapid deterioration of demand conditions abroad. In that context, a downturn in the dollar can expected to mark any acceleration of U.S. weakness. Needless to say, it's something I'm watching closely. A decline in the U.S. dollar index below about 114 would be particularly imporant.
While survey data on layoffs is volatile from week to week, we've seen a clear acceleration in layoff announcements from major companies along with 2nd quarter earnings reports. Given the high costs of employee training and labor turnover, it is ridiculous to believe that companies would be willing to make such cuts if they had any legitimate expectation for a rebound anytime soon.
In short, there is no convincing evidence that the U.S. economy, or the global one, has hit bottom. This week will include important data from the NAPM, as well as the July employment report. Those may or may not contain decisive information. A uniform thrust in this data, either favorable or unfavorable, could help to change the outlook for better or worse. Mixed data would tend to prolong a trading range. For our part, our market stance is determined by identifiable conditions in effect, not on projections, so we remain defensive until sufficient evidence of trend uniformity emerges.
Thursday Morning July 26, 2001 : Special Hotline Update
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Just a note - kind of a public service. There's a computer virus (worm, whatever) that's going around called W32.Sircam.Worm@mm - it attaches itself to a random file on your PC and then sends itself to people in your address book. Evidently, we're in a lot of your address books, because you've been sending it to us, so I assure you that many of you have this thing. You got it if you received an e-mail from somebody that included two attachments (the first named "Part 1.1" asking for your advice), and if you clicked on the second attachment. You can purge the virus by going to www.symantec.com and following the link that says "Information on W32.Sircam.Worm@mm". They have a free tool that does the trick. McAfee.com also has a tool, but I'm not sure if it's free or not.
The Market Climate remains on a Crash Warning here. Wednesday's bounce was fairly weak internally, which frequently suggests failure. But we'll take whatever signals we get from trend uniformity as they arrive. Bonds and the U.S. dollar both declined, while utilities were up strongly as could be expected after such a terrible string of losses. Overall, there was no marked change in the sorry state of trend uniformity, and yield pressures actually worsened somewhat due to the bond market selloff.
Over the past year, I've emphasized that the main risk in the market was the likelihood of weak capital spending and collapsing profit margins. While that is likely to continue, another risk strikes me as likely to take center stage over the coming year: Debt.
The U.S. economy is currently more leveraged than at any time in history. This debt was the fuel for the consumption and capital spending boom we saw in recent years. Unfortunately, debt works like this. You borrow the money. You spend it. Maybe you have something to show for it, maybe you don't. But in either case, now you have to service it and pay it back.
And that's the problem. An enormous amount of debt in recent years was allocated to capital spending, speculative investments, and consumption. When the value of what was bought is insufficient to service the debt, the debt becomes a claim on what's left. Look at Lucent. Look at Nortel. Look at our old friend PSINET. Sure, these companies have assets, but the assets aren't throwing off enough cash flow to service the debt. In many cases, the liquidation value of the assets themselves aren't sufficient to pay back the debt. What's likely to happen over the next several quarters is a gradual realization that the net asset value of many corporations, after subtracting debt obligations, is actually negative. And if these companies can't service that debt, the bondholders walk away with what's left, and the equity holders get nothing. The process is already well advanced among the dot-com stocks (remember when people actually thought they were the future of capitalism?). That same problem is likely to start happening more and more in technology companies, and then to overleveraged non-tech ones.
Yet Alan Greenspan wants companies and individuals to borrow more. He actually speaks with enthusiasm about the fact that people have "extracted equity from their homes" to finance consumption. But debt is a claim on something. And if the stuff that was purchased doesn't finance the debt, the lenders have a claim on the other stuff you own. Just ask the poor investors who decided last year that it was a great idea to collateralize their home purchases with their tech-heavy stock portfolios. Then ask what happens as the unemployment rate rises (which is virtually inevitable, particularly with layoff announcements accelerating even while collapsing help-wanted ads signal slower hiring of displaced workers). I suspect that the willingness to finance consumption through increasing levels of debt is about to come to a quick finish. And the consumer is the only thing holding this economy together. Keep watching the U.S. dollar. It's the best clue as to when U.S. consumption and investment will pull back sharply, and when the river of foreign capital will dry up.
As usual, these views do not determine our investment stance. The current, objectively defined Market Climate does. But we're certainly light on financials and banks. If trend uniformity improves, we will shift to a modestly constructive position. That said, the big picture disturbs me.
Wednesday Morning July 25, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. Tuesday was a terrible day for trend uniformity, which was hit hard. The Dow utility average plunged another 12 points, the Transports dropped by nearly 100, the Industrials failed their recent basing pattern, the number of stocks hitting new lows jumped above new highs on both the NYSE and the Nasdaq, decliners led advancers by more than 2-to-1, and the U.S. dollar weakened further, among other ugliness. What struck me was the uniform thrust of the deterioration, which smacks of risk premiums suddenly re-emerging. And as I've noted regularly over the years, a market crash is first and foremost the result of a sudden increase in risk premiums.
Risk premiums get very little attention these days. Despite the difficulty suffered by the market over the past year or so, the large-cap stocks that dominate the major indices are priced to deliver razor thin risk premiums. Remember that if the S&P 500 P/E ratio could be held constant, prices would by definition grow at the same rate as earnings. As a result, stocks would generate a total return equal to the long term growth rate of earnings, plus the dividend yield. Since earnings growth for the S&P 500 has never grown faster than about 6% annually when properly measured from peak-to-peak or trough-to-trough, we're talking about a long term total return of about 7.2% if - and it's a big if - P/E ratios were held at current extremes forever. Let P/E ratios fall, and stocks are priced to deliver a whole lot less than 7.2% annually over the long term.
That's what overvaluation means. It doesn't mean that stocks have to fall in the short term, or even over a period of a few years. Favorable trend uniformity can postpone the effect of overvaluation, because favorable trend uniformity means that risk premiums are being driven down rather than up. No, overvalued markets don't have to go down. Especially over the short term. Overvaluation simply means that the long-term return on stocks is likely to be unsatisfactory.
Historically, the main factor that determines whether or not overvaluation "matters" is trend uniformity. With trend uniformity sharply deteriorating there is a strong risk that the overvaluation will begin to matter over the short-term. With yield trends upward, it may begin to matter with a vengeance. The combination of poor trend uniformity, rising yield trends, and extremely low risk premiums (overvaluation) means that risk premiums are under great pressure to rise - and that's what gives us a Crash Warning. Since investors can't quickly change the long-term growth rate of earnings, the only way to substantially increase the long-term rate of return offered by stocks is to lower prices vertically.
Look at it this way. With the S&P 500 dividend yield at just 1.2%, stocks would have to fall in half to double the yield to 2.4% (which would price stocks to deliver a long-term total return of about 8.4%). There is absolutely no historical precedent by which we can or should rule that out. Even recent Fed cuts don't rule it out, because historically, sequential easings of monetary policy have occurred at an average S&P 500 P/E of about 11, not the current level of 27. Trust me, you don't even want to think about the decline required for stocks to deliver the historical average long-term return of 10%. From a historical perspective, it's not implausible, except that the size of the required decline is completely bizarre. A 10% long-term return would require a 4% dividend yield. Not surprisingly, the historical average dividend yield on the S&P 500 has been just about 4%. Now you know where that long term 10% figure comes from. 6 plus 4.
Bottom line, we're on a Crash Warning. That requires us to be defensive. Despite everything I've written here, if the market recruits favorable trend uniformity, we will establish a modestly constructive position. But until we actually see such an improvement in trend uniformity, defensive is how we'll stay.
Tuesday Morning July 24, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. Utility stocks are acting particularly weak here. While a strong rally in that sector is very possible, the continued failure of the market to generate even weakly favorable trend uniformity is disturbing. As always, if we can generate favorable uniformity in the weeks ahead, we will take a modestly constructive position based on the inclination of investors to take on stock market risk. For now, we don't see enough evidence of that, and indeed, important factors seem to be deteriorating daily.
As expected, many companies are making their earnings numbers by excluding ridiculously large losses as "extraordinary", as if that somehow makes the money reappear. In many cases, those losses essentially wipe out the earnings that were supposedly retained by these companies for shareholder benefit over the past 3-5 years. Remember that the key justification for not paying dividends was that the earnings were being retained for stock buybacks and increases in book value for the benefit of shareholders. What we actually see, however, is that stock buybacks have largely been devoted to simply offsetting the dilution from option grants to employees and management, while the ostensible increases in book value are rapidly being written down as extraordinary losses. In short, many of the widely held glamour companies in the market (and certainly the glamour technology companies) have diverted or destroyed value that was supposedly being retained for the benefit of shareholders. And at the same time, their CEO's lace up their little tap shoes to dance and sing that they are meeting earnings targets. Unfortunately, as noted in the latest issue of Research & Insight, those targets have little relationship to shareholder value or free cash flow. If there has ever been a period of more unethical business conduct, I don't know of it.
Just a reminder. If you have money in stocks that you will need within the next few years, it should not be in stocks. That advice has nothing to do with expected market direction. Nothing. In finance, the operative rule is that the average maturity of a portfolio should be roughly equal to the period over which the funds will be needed. Certainly, the effective maturity of a 30-year zero coupon bond is 30 years. But due to interest payments, the effective maturity of 30-year bond with a 6% coupon is closer to just 13 years. For stocks, the effective maturity is approximately equal to the ratio of price to free cash flow. Historically, that has averaged less than 30. So an investor with a 30-year time horizon could be comfortable being fully invested in stocks. Currently, the ratio of stock prices to free cash flow is closer to 70. So if you have a 70-year investment horizon until you need the money, and you have no opinion about future market direction, go ahead and get fully invested in stocks. If, on the other hand, your investment horizon is closer to 30 years and you have no views about future market direction, the appropriate allocation to stocks is only about 43%. When a guy like Tom Galvin of CSFB advises about a 95% allocation to stocks (and something like 70% for "conservative" investors) as he did today, I've got to think he's talking to investors with the investment horizon (and financial intelligence) of fetal cells.
Sunday July 22, 2001 : Hotline Update
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The Market Climate remains on a Crash Warning here. The market had plenty of opportunity last week to recruit sufficiently favorable trends but it did not do so. At this point, we would require at least a strong rally in bonds or a significant improvement in market breadth, both which have stalled lately. Other factors would also be required, but those are the most important. Meanwhile, the dollar has begun to pull back from its highs. Still not a plunge, but a continued downtrend would be disturbing. As I've noted before, if you want to know exactly when the U.S. economy is about to weaken markedly, watch the dollar.
Though we would be willing to take a more constructive position on a shift to favorable trend uniformity, I continue to view a sustained uptrend as unlikely. Last week, the percentage of bearish investment advisors fell to just 23.1%, which is the lowest level since just before the summer plunge of 1998. Meanwhile, real short term interest rates have dropped to almost zero - that is, short term interest rates are about equal to the rate of inflation. Indeed, if you use the more stable "median CPI" rather than the basket version, short term rates are clearly negative. Negative real short rates have historically been among the most hostile of all market conditions. Combined with complacent sentiment and in my view, an ongoing but still unrecognized recession, we could very well see more downside activity. Again, favorable trend uniformity would override all of these considerations so far as our investment position is concerned. We certainly would not take an aggressive stance here regardless of trend action, but favorable uniformity would require us to take at least a modestly constructive market position.
The benefit of acting on evidence is that we know exactly what we should be doing here. For now, we remain defensive. No forecasting required.
Wednesday Morning July 18, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning here.
Intel reported a 76 percent plunge in earnings after the bell on Tuesday. But take heart. Evidently, Intel's CFO Andy Bryant has a tingly feeling about the third quarter. For my part, I'm much more inclined to agree with Dan Niles from Lehman Brothers, who has consistently been on the mark. Niles comments: "They set a pretty high bar for themselves in terms of the third quarter. Some of the numbers they gave are hard to reconcile with the data we're getting from the PC vendors. Most of Intel's pre-announcements in the past tend to come in the third quarter."
Still, until the third quarter actually plays out a bit, investors may very well take those tingly feelings to heart. We're closely watching trend uniformity on that front. Remember that favorable trend uniformity is essentially a signal that investors are increasingly willing to take on market risk. It doesn't matter whether their reasons are valid or not. The willingness to take risk is a psychological preference. You can't put an arbitrary limit on it, you can't predict how long it will last, and you can't fight it successfully.
In recent days, we've seen improvement in enough market internals to make a move to favorable trend uniformity at least a possibility. Leadership, transportation stocks, and Treasury yields, among other factors, have improved from their lows. Still, we don't have enough such action to trigger a shift, and we don't second-guess or pre-empt those shifts. If the market can recruit favorable trend uniformity, we will step out and take enough market risk to participate in the overall trend of the market. We certainly won't be aggressive about it, but a modest exposure to market risk would be appropriate, even at the risk of a possible whipsaw back to unfavorable trends. Nothing in our view about the economy or the overvaluation of the market would change, and we would not place a significant amount of capital at market risk. But again, favorable trend uniformity requires that we take at least a modestly constructive market stance. Until we see that, we'll remain defensive. No forecasting required.
Sunday July 15, 2001 : Hotline Update
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The Market Climate remains on a Crash Warning here. Last week's rally generated modest improvement in the sorry trend uniformity we've had lately, but not enough to generate any change in the overall Climate. Oddly, despite the strong rally in some of the major indices, advances outpaced declines by just under a 6-to-5 margin on the week. The Dow averages are in a fairly odd situation as well, with the Transport average very strong last week and close to breaking its May high, even while the Utility average is close to breaking out on the downside. In short, market action is a mixed bag, mirroring the economic picture.
It's not particularly difficult for the market to generate favorable trend uniformity, and if we could get enough favorable internal action, it would allow us a chance to speculate on a summer rally. There's really no investment merit in the market, but then, there hasn't been for about 5 years, and that doesn't prevent good, tradeable rallies when trends are uniformly favorable. Unfortunately, with the Market Climate currently on a Crash Warning, the main concern here remains the possibility of a free-fall.
Given that environment, the action plan is simple. We're defensive here. Every stock has two types of risk: risk specific to that particular stock, and risk that is correlated to the overall market. We're certainly willing to take on certain risks specific individual companies, so we remain fully invested in a well diversified portfolio of stocks. That's the portion of risk that we expect to be compensated for. But here and now, we continue to hedge away the overall market risk of our portfolio, because market risk is associated with a negative expected return here. If the market can recruit enough uniformity to shift our trend models to a more favorable condition, we'll remove a portion (though certainly not the majority) of our hedges in order to have a positive exposure to market fluctuations as well. But here and now, the evidence keeps us highly defensive. Evidence, evidence, evidence. No forecasts required.
The coming week could be decisive in that regard. Important earnings reports are released by Intel and Microsoft (we get to see how the numbers reported last week actually look in detail), Greenspan speaks to Congress, and in my view, there's a risk that the Argentine currency peg with the U.S. dollar will collapse. When you see short term rates shooting up in a country that's running major deficits on all fronts, it's a sign that the currency is in trouble. About the last thing you see just before the currency fails is an official pronouncement that the country has absolutely no intent to devalue, while at the same time overnight interest rates shoot over 100%. We'll see.
So again, we're defensive here. Given the important week ahead, we can't rule out a crash, and we can't rule out a shift to a favorable Climate. If we see a favorable shift, it's then, not before then, that we'll step out to take a bit more exposure to market fluctuations. Any favorable climate would almost certainly be just a breather in an ongoing recession and bear market, but we'll be willing to take on at least some market risk if we get a positive shift. For now, however, the climate is still a Crash Warning.
Friday Morning July 13, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. Given that the recent decline had placed the market in a somewhat oversold condition, Thursday's bounce demonstrated nothing to distinguish it from a typical bear market rally - fast, furious, prone to failure. In our most aggressive accounts, we took some put option profits off of the table on Wednesday, but the Market Climate remains on a Crash Warning, so we do remain well hedged in all of our strategies even after that move.
Investors continue to cling to every scrap of hope, and Microsoft offered them a shred by suggesting that revenues might come in about $100 million above expectations. Never mind that they simultanously wrote off an "extraordinary" investment loss of nearly $4 billion, and that it will be nearly impossible to maintain 40% profit margins going forward. Coming off of a significant market decline, investors seemed willing to take Bill Gates' tingly feeling about a possible upturn as a reason to buy perceived bargains. But then, to investors who measure bargains in relation to the highs rather than looking at properly discounted cash flows, the Nasdaq seemed like a bargain at 3000 too.
These intermittent rallies serve only one purpose, which is to keep investors holding the bag all the way down. Pick any Nasdaq stock that has lost a tremendous amount of value. Look closely at its price chart. You'll see that very few have offered investors any sort of natural point to get out. The rallies are invariably so strong that investors would be scared to sell for fear of missing out on further upside. The subsequent plunges are so sudden and deep that investors would be scared to sell because they had already lost so much so quickly, and they would be scared to miss a possible rebound. That's how investors end up losing 80% and more of their money in some of these stocks. Rallies like Thursday's keep investors hoping.
Keep in mind that while we view the market as very overvalued, and the economy as vulnerable, we would still be willing to take on market risk if the market could recruit sufficient trend uniformity. It still fails to do so here. Even Thursday's rally couldn't produce even a 2-to-1 margin of advancing issues over decliners.
I've noted the importance of the U.S. dollar in recent months. Certainly Argentina's problems have created some safe-haven demand. It would be a very bad sign if, in the face of this demand, the dollar were to slip further. That would signal a sudden deterioration in the U.S. economic picture. Again, the Argentina difficulties will tend to give the dollar a lift. The extent of that lift is important, and downside movement in the dollar would be a very unfavorable signal.
The other factor I'm watching closely is the interaction between labor supply and demand here. In recent months, we've seen a significant amount of attrition from the labor force - people who would normally be classified as unemployed have left the labor force, and that has kept the unemployment rate from rising as much as it otherwise would. Hours worked are also falling, which signals softer labor demand, again without increasing the unemployment rate. But what is really of concern here is help wanted advertising, which has suddenly fallen off of a cliff. The main reason that unemployment has been held in check (even though it has already risen by an amount never seen outside of recessions) is that new hiring has absorbed a lot of displaced workers in recent months. The plunge in help wanted advertising is a reliable and important signal that net job formation is about to slow significantly. For that reason, we may very well see the unemployment rate spike higher in the next few months, and that spike could shake consumers, and by extension the economy. Again, it is useful to consider the question of whether the U.S. economy could suddenly turn worse instead of better. It's not a question people are asking as they wait for the Fed rate cuts to kick in. But often, when people stop considering something as possible, the market has a spooky way of teaching them a lesson.
Wednesday Morning July 11, 2001 : Special Hotline Update
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Just a note: The latest issue of Hussman Investment Research & Insight is now available on the Research & Insight page of our website. Print copies will be mailed on Thursday.
The Market Climate remains on a Crash Warning here. That puts us in a defensive position. Everything else here is filler.
The basic market picture is this. The Fed has cut rates 6 times in 6 months. That's the most aggressive easing in the shortest amount of time since late 1929 through early 1930, when the Fed did exactly the same thing. Then, of course, there were the tax cuts, which were President Hoover's immediate reaction to the 1929 plunge. The consensus view was that the combined policies would work, and the market rallied sharply into the first half of 1930 before plunging again. Eventually, that plunge made the worst lows of 1929 look like the good old days.
Now, I'm not suggesting that we're headed for a Depression, though a deeper than average recession appears nearly inevitable (more on that in the latest Research & Insight.) Rather, the point is that rate cuts in and of themselves are not a panacea, and certainly not when the P/E on the S&P 500 is 26, versus an average of less than 11 when the Fed has repeatedly cut rates in the past.
The day-to-day action of the market is a battle between two factors. Hope for positive effects from interest rate cuts, versus continued deterioration of corporate earnings and employment, as well as sudden concern over the debt problems in Argentina (which we noted in early May). Investors have quietly agreed to look over the valley of current news, holding the expectation that things will be better "once the interest rate cuts kick in." And it's that view that has kept the market from falling apart more vigorously. Still, there is enough deterioration in trend uniformity and group action to suggest how this is likely to unfold. Consumer and retail stocks are weakening considerably of late, and if you look at the breadth of the largest growth stocks, it has been persistently weak. Richard Russell notes that his "Big Money Breadth Index" which tracks the advance-decline pattern of the largest stocks in the market, has just hit a new low. The A-D for the Dow is similar. So even as the market bounces around from day-to-day, we're seeing continued damage to market internals. That is where you look if you want to measure the probable return/risk tradeoff of the market. Weak internals in an overvalued market signal trouble, particularly when yield trends are hostile. The full combination constitutes a Crash Warning, which is what we have now.
The faith in the effectiveness of interest rate cuts has driven the percentage of bearish investment advisors to a dangerously low 25.5%, while the average equity allocation of Wall Street strategists is now above 70%, the highest level in this market cycle and quite probably a record. Meanwhile, corporate insiders are selling stock at the fastest clip in a decade. What is bothersome is not simply that they are selling heavily. As Jim Stack of Investech (www.investech.com) points out, insiders often sell on 10-15% market rallies. The problem is that insiders are nearly always net buyers at significant market troughs. This time, we failed to see insider buying at the April lows, but we're seeing heavy selling here anyway. In other words, insiders are not selling to take profits on positions they bought at the lows. They're just getting out. The stark contrast between Wall Street forecasters and corporate insiders mirrors the battle we're seeing in the market more broadly: hope for interest rate cuts pitted against cold hard business deterioration.
As usual, what we see is hope masquerading as evidence. The Blue Chip Economic Survey just came out with an upbeat view of a second-half recovery. Never mind that the consensus has never foreseen an oncoming recession until several months in. Meanwhile, market action continues to diverge badly. If market action were to generate sufficient trend uniformity, we would be very willing to speculate on a favorable return to market risk. But here and now, the evidence continues to suggest caution.
Just a question to think about, though, given the deterioration in employment as well as weakness in the market action of retail and consumer sectors: Has anybody stopped to entertain the possibility that the economy is about to turn worse instead of better?
Sunday July 8, 2001 : Hotline Update
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The Market Climate remains on a Crash Warning here. Last week's lovely swan-dives by EMC and AMD should offer some idea why we are skeptical about a quick recovery in the economy or in earnings. You may recall that in the June 17 update, I noted comments from Dan Niles, who aside from Ashok Kumar is one of the only Wall Street securities analysts worth his paycheck. Dan's contention was that there is about a 3 week lag between the point where consumer tech companies see a slowdown, and the point where it becomes clear to the components makers. What we saw on Friday was exactly that lagged effect. It's likely to become much worse.
The problem, as I projected a year ago in Research & Insight, is profit margins. With the enormous fixed costs that many of the tech companies are liable for, any surprise shortfalls in revenues cut very quickly into bottom line profits. At the same time, factors such as investment gains that many companies formerly used to boost earnings are simply not available here. So you can expect that the main tool companies will use to match earnings estimates ahead will be exclusion of "extraordinary losses" from earnings. Watch how ordinary these "extraordinary losses" become in the coming weeks. Sun Microsystems hasn't dropped a bombshell that earnings will actually come in negative this quarter or next. But I continue to expect that as well, given the creativity they've had to muster merely to keep earnings positive up to this point.
Earnings and earnings growth rates are the least reliable of all fundamental measures here, and should not form the basis for evaluating stocks. On the basis of P/E ratios, the S&P trades at a multiple of 26 compared to a historical norm of 14. But on the basis of revenues, book values, dividends, and cash flows, the S&P remains at nearly three times the historical norm. Even so, if the market was to demonstrate clearly favorable trend uniformity, we would be willing to significantly reduce our hedge and take market risk. We just won't do it without that favorable evidence from internal market action.
Long-term Treasury yields continue to push higher. This, combined with extreme valuations and poor trend uniformity, is extremely hostile. In effect, we have a market with extraordinarily low yields in a market environment where yields are being pressured upward. That can lead to large percentage losses in a hurry, and is one of the reasons why every historical crash of note has emerged from this one climate.
It's common to object to the dividend yield as a measure of valuation, given that companies have devoted more of their earnings to stock repurchases than dividend payments in recent years. Unfortunately, the vast majority of these stock repurchases have been made simply to offset dilution due to options grants of stock to employees and management. In other words, that portion of "earnings" devoted to repurchases was really stealth labor compensation in drag. Yet even if companies were to suddenly boost dividends back to their historical norm of 52% of earnings, and even if current earnings figures were reliable, the dividend yield on the S&P 500 would still be under 1.9%, less than half the historical norm.
In the midst of all the cross-currents and arguments about Fed easing, speculation about economic turnarounds and the like, our discipline focuses on what the Market Climate is, rather than what it might or should be. Currently, the Market Climate remains on a Crash Warning. We always take that seriously. We remain defensive here.
Sunday July 1, 2001 : Hotline Update
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The Market Climate remains on a Crash Warning here. Long-term bond yields continue to extend their hostile upward trend, while other market internals continue to diverge as well. The advance-decline line remains favorable, but that strength is more than offset by unfavorable market action in other areas. In all, we continue to have an extremely overvalued market with poor trend uniformity and hostile yield trends. Those three characteristics are what define a Crash Warning. As I always emphasize, this does not mean that the market has to crash, or should be strongly expected to crash. Rather, it means that the market is displaying characteristics which have occurred in only about 4% of history, yet from which every past market crash of note has emerged. Don't rule one out.
It is important to underscore that the most brutal damage of a bear market always comes on the heels of strong intermittent rallies. The more devastating the loss, the sharper and more violent those rallies are, and the sharper and more violent the following plunges are as well. Even though the Nasdaq has lost two-thirds of its value, the number of investors who have actually liquidated is small relative to the ones still holding on. One of the reasons that investors continue to hold those stocks with minimal selling is that the rallies have continually offered them hope. On its way down, the Nasdaq has enjoyed intermittent rallies averaging between 15-25%. Individual stocks such as Cisco, Oracle, Amazon, and a wide range of others have kept their owners holding the bag by generating intermittent rallies on the order of 30-50% before failing. Countless "seat of the pants" investors have tried to play these rallies, and have, on balance, become bagholders as well. As they say, "a long-term investment is usually just a short-term speculation gone bad." Unless they are accompanied by measurable trend uniformity, there simply isn't any disciplined way to "play" bear market rallies and survive, because they typically end both forcefully and randomly. To survive a bear market requires the willingness to sit out these bear rallies while other investors temporarily pat themselves on the back for their brilliance - just before the next leg down. See "Bear Market Insights" on the Research & Insight page of our website to get an idea of how this felt in the 73-74 decline.
There's a simple criterion that tells us whether or not to take market risk. It is the objectively identified Market Climate in place at any given time. Trend uniformity is generally very quickly and easily satisfied during legitimate bull moves. Even with these extreme valuations, favorable trend uniformity is all we would need to become more constructive here. Indeed, our measures of trend uniformity were favorable during the summer of 2000, through September 1st, as well as for several weeks at the beginning of 2001. But the failure of the market to generate even weak trend uniformity here continues to suggest that the recent rally is a trap. With the emerging weakness in consumer and retail related securities, it's also a trap that suggests more economic weakness than expected by the consensus.
A final note. There's a broad consensus that the economy will turn up in the third quarter, with no recession. This despite the fact that our most reliable statistical evidence indicates a recession in progress which will eventually be dated as having started during the first quarter of this year. The fact that first quarter GDP growth was slightly positive does not alter this. In evaluating the opinions that you hear to the contrary, keep in mind that the consensus of economists, as measured by the Blue Chip Economic Survey and others, has never forecast an oncoming recession, and usually remained rosy even several months after the actual recession was eventually determined to have started. We have no use for those opinions. The objective, available evidence suggests continued caution here, and when that evidence becomes more constructive, we will shift to a more constructive position. No forecasts required.
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The Hussman Strategic Growth Fund has the ability to hedge market risk by selling short major market indices in an amount up to, but not exceeding, the value of its stock holdings. The Fund also has the ability to leverage the amount of stock it controls to as much as 1 1/2 times the value of net assets, by investing a limited percentage of assets in call options. The Hussman Strategic Total Return Fund has the ability to hedge the interest rate risk of its portfolio in an amount up to, but not exceeding, the value of its fixed income holdings. The Fund also has the ability to increase the interest rate exposure of its portfolio through limited purchases of Treasury zero-coupon securities and STRIPS. The Fund may also invest up to 30% of assets in alternatives to the U.S. fixed income market, including foreign government bonds, utility stocks, and precious metals shares. The Market Climate is not a formula but a method of analysis. The term "Market Climate" and the graphics used to represent it are service marks of the Hussman Funds. The investment manager has sole discretion in the measurement and interpretation of market conditions. Except for articles hosted from the web domains hussman.net or hussmanfunds.com, linked articles do not necessarily reflect the investment position of the Funds. |