All contents copyright 2001, John P. Hussman Ph.D.
Excerpts from these updates should include quotation marks, and identify the author as John P. Hussman, Ph.D. A link to the Fund website, www.hussmanfunds.comis appreciated.
Sunday December 30, 2001 : Hotline Update
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The Market Climate remains on a Crash Warning, which our models reiterated this week. Much of the fresh deterioration can be traced to bond yields. Long-term Treasury yields failed to give back their recent spike, while yields on many corporate bonds (particularly industrials) shot higher.
As I noted several months ago, I added an "overlay" to our measures of trend uniformity earlier this year, based on sharp reversals of market breadth. That measure has been responsible in keeping us as much as 20% unhedged during much of the recent rally. Unfortunately, the measure is only useful when signals during rising interest rate climates are filtered out. And as a result of the recent spike in yields, we've now lost the one reliable measure that has been constructive in recent weeks.
In short, none of our key measures of market action are favorable here. Certainly there are individual components that are positive. For instance, the advance-decline line is in an uptrend, as is the Russell 2000. But we also have substantial divergences, and it is the uniformity of market action - not one component or another - that is relevant in defining the Market Climate.
As I noted in the latest issue of Research and Insight, even if the economy was to launch into a strong and immediate recovery, it does not follow that stocks would deliver even modestly attractive long-term returns. The current environment of extremely high valuations, unfavorable trend uniformity and hostile yield trends is not one that is even attractive for taking short-term equity risks. That said, a shift to favorable trend uniformity would quickly move us to a more constructive position. Though I spend a great deal of time articulating views, evidence, and possible outcomes, the only factor that is really relevant to our investment position is the currently identified Market Climate.
I would have no objection to holding a constructive position, despite extreme valuations, if market action was favorable. Our returns over the past year have not been driven by a falling market. Though we've been fully hedged, we've also been fully invested in favored stocks the entire year. Our returns have been driven by the difference in performance between the stocks that we hold long and the indices that we are short as a hedge. That difference between the performance of our individual stocks and the performance of the major indices is our main source of risk. It can be either positive or negative. But it's also risk that I expect to be rewarded regardless of market direction. Historically, that difference has typically been even more positive in rising markets than in falling ones.
So I have little concern about the possibility that the market will rise further. I have no intention of speculating on an advance in the face of a negative Market Climate, but I certainly don't experience any unease when the market does periodically rally. Every Market Climate, even a Crash Warning, allows both rallies and declines. What is relevant is the average expected market return in each Climate, versus the risk sustained in the Climate. Currently, that expected tradeoff is very unattractive. If the Climate shifts, so will our position. We are not tied to any outlook - only to the currently identified Climate.
One of the early Zen philosophers, Dogen, once asked "If you are unable to find the truth right where you are, where else do you expect to find it?" If you think carefully about bull and bear markets, you'll find that they don't exist in the present. By that I mean that the whole identification of a bull or bear market is important to investors only for what it says about the future. And yet, each can only be fully verified by looking at the past. At any given instant, in the present, at the single point in which action can be taken, the existence of a bull or bear market can only be the subject of debate. Neither bull nor bear markets exist in the present. So while we can talk about bull and bear markets as a way of partitioning past historical experience, trying to invest based on your opinion about the matter will drive you nuts. My opinion is that stocks are in a bear market. That may or may not be interesting, but it's not relevant to our investment position.
Rather than investing based on concepts that can't be observed in real time, it makes more sense to us to invest based on factors that can be readily and objectively identified. That's why I constantly emphasize the currently identified Market Climate. Wise investors typically don't rely on forecasts. They either focus their attention on disciplined stock selection (e.g. Warren Buffett), or define bull and bear markets in objectively identifiable terms (e.g. Dow Theorist Richard Russell). We happen to do both. Investors invite nothing but frustration when they deny what is in preference for what they hope, speculate, or forecast. I certainly write about my opinions and forecasts. But we don't invest on them, and we have no attachment to them that would prevent us from a very abrupt about-face if the Market Climate was to shift. It's so important for clients to understand that. Because at some point it will happen, and it's best to realize that in advance. For now, however, we remain very defensive.
As for the economy, I reviewed a number of major national newspapers over the weekend, and was struck by the nearly unanimous view that the economy is set to recover and the worst is now behind us. The major pieces of evidence in this regard are consumer confidence, falling new claims for unemployment, and strong durable goods. I wish I could agree with the consensus, because I do so hate this responsibility to articulate the facts. But nothing in the data support the notion that these are meaningful signs of a turn.
Durable goods orders are so well known as the most volatile economic statistic that further comment seems unnecessary. Orders for transporation equipment simply whack this statistic around too much for it to be meaningful except on the most heavily smoothed basis.
Consumer confidence and new claims for unemployment are more frequently cited as evidence of a turn. The December confidence reading of 93.7 represents a jump of 8.4 points from the October low of 85.3. Meanwhile, new claims for unemployment have fallen below 400,000 on the 4-week average. How can we argue with that?
Well, consider April 1974. While the U.S. was already in recession, the downturn hadn't really bared its teeth. From a February 1974 reading of 62.7, consumer confidence shot up 32.4 points to an April reading of 95.1. New claims for unemployment, which had been running well over 400,000 per week, had plunged to less than 250,000 weekly. Though the unemployment rate was already on the rise, GDP did grow during the second quarter of 1974. But that was hardly the end of the recession. Over the following year, the unemployment rate shot from 7.4% to nearly 11% and stocks plunged to significantly deeper lows. The 32.4 point surge in consumer confidence and sharp decline in new unemployment claims meant nothing. And we're getting all worked up about an 8.4 point uptick in confidence?
As another example, consider August 1981. That month, consumer confidence swelled to 85.7 from a February reading of 69. Again, the economy was already in recession. Yet new claims fell below 400,000 per week in this instance too. The economy then turned down sharply, as did stocks.
As it happens, the 1974-75 and 1981-82 recessions were the deepest of all postwar economic downturns. Both were accompanied by protracted bear markets and plenty of false rallies.
In short, I hope that I am wrong, and our investment position doesn't rely on these views, but none of the recent data strike me as particularly compelling evidence of a near-term economic recovery.
As usual, no forecasts are required. The Market Climate remains on a Crash Warning for now. Downside risks should be taken seriously.
Wishing you a very happy New Year.
Sunday December 23, 2001 : Hotline Update
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The Market Climate remains on a Crash Warning here. That is not a forecast. A Crash Warning does not imply that a crash should be strongly expected. Rather, it means that conditions match about 4% of market history from which every historical crash of note has emerged. But every one of the Market Climates we identify include both rallies and declines. It's the average return/risk that is relevant to us. Again, once we identify a given Climate, we do not make short-term forecasts about rallies or declines within that Climate. What I can say unequivocally is that this is a condition in which market risk has been very unrewarding on average.
I am disappointed by the gullibility of investors here. Case in point, General Electric, which announced last week its intent to meet expectations of 17-18% earnings growth next year. This was widely taken as an affirmation that all is well with the economy. After all, if General Electric can achieve such growth, things really must be shaping up quite nicely.
Not that I doubt that GE will succeed in delivering this "growth." My skepticism arises from the sources of this predicted growth: acquisitions on the financial side, and cost-cutting on the manufacturing side.
Let's consider growth through acquisitions - what might be better called "manufactured growth." For those of you new to my soap-box on this subject, growth through acquisitions should never be taken as the basis on which to value a company. Here's why. Suppose a company has a $100 in total earnings, 100 shares outstanding, and a P/E multiple of 30 (i.e. $1 per share in earnings and a share price of $30). Now this company issues 10 shares of its own stock to acquire a few dull, no-growth companies having a total of $30 in earnings and average P/E ratios of 10 (not unusual for financials). Well, the high P/E company which used to have $1 a share in earnings now has ($130/110 shares = ) $1.18 per share in earnings. 18% growth in earnings per share!
Dynamic. I can barely control my enthusiasm.
Worse, assuming that the new earnings are still awarded a P/E of 30, the company in this example will have a total market capitalization of $3894, simply by combining two companies valued prior to the acquisition at just $3300. This is pure alchemy. The issue is not whether or not a company makes its acquisitions specifically with stock (high P/E firms get the biggest bang for the buck by using stock, but GE evidently uses cash). The point is that growth achieved through the acquisition of low P/E companies should not be rewarded with a high P/E multiple. The fact that investors do reward the "growth" of conglomerates such as GE reflects an ignorance that has historically proved to be temporary.
Now consider growth through cost-cutting (which takes the form of layoffs and reduced spending to other businesses). If other companies take GE's lead with aggressive and widespread cost-cutting (as many recent corporate statements suggest), it follows that in aggregate, the outlook for employment and corporate revenues is probably much bleaker than widely believed.
As for other corporate reports, given the extremely high cost of labor training and turnover, it is difficult to take the tingly feelings about an expected upturn seriously when those statements are accompanied by the announcement of major layoffs. Yet this occurs with the same regularity as companies that beat Wall Street expectations by a penny. Again, I'm disappointed at the investor gullibility being seized upon by these companies.
Wall Street analysts are eager accomplices. One example is their emphasis on "operating earnings" instead of net income according to generally accepted accounting principles. Unlike net income, operating earnings exclude a host of fairly arbitrary "extraordinary expenses", as well as fairly ordinary ones like depreciation, taxes, and interest on debt.
Let's be clear about something. In order to value a security, you take the cash flows claimed by owners of that security, and you discount them back to present value. If you want to value stocks on the basis of net income, fine. There are better methods, but go ahead.
On the other hand, "operating earnings" include not only the income claimed by shareholders, but also the interest claimed by bondholders. If you're going to value the stock as some multiple of operating earnings, the next calculation you make had better be to subtract off the value of the debt.
For many companies, even if you appropriately adjust for capital spending and growth, the result is a negative number. You'll even get a negative number if you use the peak level of earnings attained last year. In many cases, that is an indication that the stock is fundamentally worthless and the debt itself is not supported by cash flows. Think Enron. This is also the case for many networks that have plunged to nearly nothing. By our calculations, which should be considered opinion in this case, the group also includes several telecom companies still holding substantial market value, such as Qwest, Level 3, Adelphia and Nextel, several energy companies including Calpine, and certain large lending institutions and insurance companies that I'm going to pass on identifying. We don't sell short individual stocks, because even though we trust our ability to identify overvalued stocks, those stocks don't reliably decline over the short run. Still, we know what we want to avoid.
With regard to the overall market, the S&P 500 still trades at an extreme 21 times peak-earnings (the 1929 and 1987 peaks attained 20 times peak-earnings). That valuation multiple already assumes a recovery in earnings to their prior record, and also assumes that those peak earnings figures were reliable in the first place. One has to wonder, though, if share repurchases are considered a legitimate use of earnings for the benefit of shareholders, then what are grants of shares through options to management and employees but a dilution of earnings at the expense of shareholders?
In any event, this gullibility has been enough to prop up the market, at least temporarily. A Crash Warning only implies a poor average return to market risk. I don't have any special belief that investors will send stocks immediately lower, and we are not positioned in a way that relies on a plunge. And though the current Climate has historically delivered terrible average returns, nothing prevents investors from driving prices temporarily higher. But there's no evidence that we could rely on a rally either.
Very simply, what investors choose to do in the short-term is out of our control. So we focus on the present. We continue to align our position with the Market Climate currently in effect. We continue to invest in a wide range of individual stocks, and manage those positions on a day-to-day basis. The effect of current conditions is that we have hedged away the effect of overall market fluctuations on that portfolio of stocks. I have no forecast of where the market will go over the short term. Nor do we have any need for such forecasts. We only need to observe the present.
Ultimately, the problem with propping up markets that misallocate capital is that America's scarce and hard earned savings go down the drain at the hands of incompetent managers. And as the fruit of this saving, the nation has unproductive excess capacity and sock puppets. There really is no patriotism in this.
On the bright side, our stock holdings are fully hedged here. Alternatively, T-bills remain safe and very liquid. You don't have to hold them forever, but sometimes a small, safe, positive return is a lot better than a lot of volatility and an expected loss.
And though I wish I could offer more optimism about the markets, there are always blessings elsewhere.
Wishing you a very merry Christmas.
Wednesday Morning December 19, 2001 : Special Hotline Update
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Just a note, the latest issue of Hussman Investment Research & Insight is now available online (click here). The print version will be mailed on Thursday of this week.
The Market Climate remains on a Crash Warning here. I realize that this must seem odd, with analysts almost universally convinced that the market has nowhere to go but higher. But it's exactly that extreme bullishness that should give investors pause. The main aspects of the current Climate are discussed in the latest Research & Insight, but I want to add a few observations not covered there.
First, a number of clients have asked how frequently a Crash Warning generates an actual crash. There is not a straightforward answer because it depends on how one defines a Crash. For example, based on the model currently in use, we saw a Crash Warning on July 13, 1990. That marked the start of the most recent bear market prior to last year. Was it a crash? Not really, but it was certainly a worthwhile signal. Still other signals have generated only modest declines or even rallies. Probably the most informative statistic is that the market has historically declined an average of -18% annualized during Crash Warnings. Believe me, it is very difficult to define any condition in which the market declines predictably at all, so this is a climate that should be taken very seriously. In addition to signalling the big ones - 1929 and 1987 - near their exact peaks, and warning of the plunge this summer, Crash Warnings also emerged before many other important declines, for example, the February 1962 signal that was followed immediately by a 30% market plunge over the next few months.
To reiterate a point I make with almost every signal, however, a Crash Warning does not mean that the market must, or should be strongly expected to crash. While the annualized market loss during Crash Warnings has been significant, the market can and does advance (occasionally strongly) in this climate. Even so, on average it has not been worthwhile to take market risk when a Crash Warning has been in effect.
As always, once a particular Market Climate is identified, I do not believe that I (or anybody else) has the ability to predict rallies or declines within that Climate. That always strikes the market timers as unfortunate and frustrating. We wish them luck in their attempts to do better, but in all the research we've done, there is simply nothing we've found that provides such clues with any reliability. Except for the fact that stocks are strenuously overbought, I don't really have a short-term forecast. But I can say without hesitation that I believe significant market risks should be avoided here.
Sunday December 16, 2001 : Hotline Update
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The Market Climate has shifted to a Crash Warning. I don't want to overemphasize the risk of a crash. It simply should not be ruled out. Market conditions currently match those seen in only about 4% of market history - overvaluation, unfavorable trend uniformity, and hostile yield trends (particularly in long-term interest rates). Every historical crash of note has emerged from this single set of conditions. A Crash Warning does not mean that the market must crash, or that a crash should be strongly expected. It does mean that downside risk should be taken seriously.
As I've frequently noted, a market crash, first and foremost, is driven by a sharp increase in the risk premium demanded by investors. When investors demand a higher rate of return from bonds for example, they cannot force the stream of future payments up. The only way to obtain a higher long-term return is to drive the price down, so that the fixed stream of payments delivers a higher percentage return on the investment. Similarly, when investors demand a higher return from stocks, they can't force the growth rate of earnings up at will. Again, the only way to obtain a higher long-term return is to drive the price down and the yield higher. With the dividend yield on the S&P 500 at just 1.4%, even an increase in yield to 2% would require a 30% plunge in market values.
The price/peak-earnings ratio on the S&P 500 is 21. The historical norm is 14. Though inflation and interest rates are low compared to the past few decades, they were lower through most of historical data prior to the mid-1960's. In contrast, no other market cycle in history has seen the price/peak-earnings ratio at 21. The 1929, 1972 and 1987 pre-crash peaks never exceeded 20 times peak earnings. Claims that stocks are fairly valued due to low interest rates are based on limiting the data set so that current interest rates are the lowest in the entire sample. That's just careless analysis when more complete historical data is readily available.
Here is why a Crash Warning specifically requires three conditions. First, overvaluation. Overvaluation implies only that risk premiums are low, and that stocks are priced to deliver a poor long-term rate of return. It does not mean that stocks must necessarily decline over the near term, or even over a period of a several years. Second, unfavorable trend uniformity. This implies an underlying skittishness, rather than a robust preference to take on market risk. Finally, rising yield trends in long-term interest rates, utilities, corporate bonds and other securities signal an environment in which risk premiums are being pressured higher. Combine these three elements and you have a Crash Warning. Low risk premiums on stocks, an underlying skittishness of investors to take risk, and upward pressure on risk premiums. Not every occurrence of this combination leads to a crash. But every historical crash of note has emerged from this climate.
Very simply, there are better conditions in which to take market risk. We are defensive here.
Friday Morning December 14, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable trend uniformity. There remains a good chance of a shift to a Crash Warning this week, but we don't move in advance of such shifts. In any event, we remain nearly fully hedged at present, so a Crash Warning would involve only a marginal change to our position.
I just don't understand the view that the economy is turning here. There is simply no reliable evidence of this. If stock market rallies - even rallies of 20% - were signals of economic rebounds, then we got 5 of those signals all the way down into depths of the Great Depression. Stock market changes have long been one of the important elements of our Recession Warning composite. The market certainly gives useful signals, particularly when taken along with the NAPM index, credit spreads, and other indicators. As I reported at the time, our Recession Warning composite was triggered in October 2000; a signal which typically occurs just before or very early into U.S. recessions, and certainly did in that instance. Interestingly, one of the important negative signals in that composite is simply whether the S&P is below where it was 6 months earlier. As it happens, the S&P is still below where it was 6 months ago. There just isn't much useful leading economic information to be drawn from the recent rally.
Most of the "evidence" for an economic rebound is derived from circular reasoning. The hope for an economic rebound has spurred the recent market rally, and the rally, in turn, is being taken as evidence that the economy is about to recover. The Fed is 0 for 11, with no signs that the string of rate cuts has been effective. But instead of recognizing that the Fed Funds rate is an irrelevant price and that the entire increase in the monetary base has been drawn off as currency in circulation, analysts keep saying that these rate cuts are "in the pipeline." These analysts are simply not looking at the banking statistics. It isn't analysis to believe that rate cuts will "kick in", even though bank reserves are no larger than they were a year ago. It's superstition.
A few facts. No recession has ever ended with our measures of trend uniformity negative. No recession has ended with the Dow Utility average below its 12-month average. No recession has ended with the "future expectations" measure of consumer confidence below the "current conditions" measure. The reliable indicators are almost uniformly on the downside here.
In contrast, the indicators being hailed as evidence of a pending recovery just don't have a robust correlation with economic turns.
This recession is unusual in that it began with a business downturn while consumers have largely offset that decline. GDP is not even down year-over-year. My expectation is that consumer activity is about to slow enough that it will fail to offset the business downturn. Now, consumer spending never really falls year-over-year. As much as people focus on consumer spending, the entire decline in GDP during a recession takes place as a contraction in fixed investment, housing, and capital spending, not consumption. But the growth in consumer activity has largely buffered this decline so far. That is likely to change. Nobody seems to be considering the possibility that the consumer will join rather than offset the downturn in the months ahead. As usual, dollar weakness would likely signal a fresh downturn in the economy.
As usual, the most constructive evidence we could get would be a shift to favorable trend uniformity. It would increase our willingness to take on market risk, and would improve our expectations for the economy. But here and now, the likelihood is leaning toward the Market Climate slipping to a Crash Warning. Needless to say, that wouldn't be an improvement.
Tuesday Morning December 11, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable trend uniformity. There's a good chance that the Market Climate will shift to a Crash Warning this week, but most of our models are based on weekly closing data, so we will not have confirmation of that until Friday. A Crash Warning does not mean that the market must, or should strongly be expected to crash. Rather, it means that the Market Climate reflects 1) overvaluation, 2) unfavorable trend uniformity, and 3) hostile yield trends, particularly interest rate trends. That combination has only occurred in about 4% of market history, but every historical crash of note has emerged from this one set of conditions. Again, however, a Crash Warning is not a forecast of a crash, but an identification of conditions that have given rise to past crashes. We don't forecast. We identify.
I continue to see the recent surge in long-term interest rates taken as evidence of an oncoming economic upturn. It simply isn't true. Interest rates rise for essentially two reasons. One is inflation expectations. The other is increased risk premiums. The recent surge in bond yields is evidence only that risk premiums have advanced back to normal levels.
The whole notion that interest rates rise due to output growth is simply false anyway. Statistically, faster economic growth is correlated with lower bond yields, and this relationship is highly significant statistically. The strong positive relationship is between inflation and bond yields. As I've written frequently over the years, higher output growth is actually disinflationary. Inflation and rising interest rates emerge when output growth can't keep pace with demand growth - that is, when observed output growth slows in the face of strong demand. That's not what we have here, so we have to infer that risk premiums, not inflation, are the cause of the bond yield surge here. That was predictable weeks ago, at least from these updates.
I realize that it seems counterintuitive that strong output growth should be disinflationary. Think of it this way. If inflation is too much money chasing too few goods, what happens if there are more goods? You guessed right. Again, inflation (and interest rate pressure related to inflation) emerges when output growth can't keep pace with demand growth. That is, when output isn't growing enough.
Don't conclude that slow output growth is always inflationary though. When output growth slows, but demand growth slows even faster, there is no pressure on inflation. As usual, you have to think about equilibrium - it's not the rate of growth in GDP, but the relationship between supply growth and demand growth that's crucial.
With the NAPM inflation index falling, and the ECRI future inflation gauge now at the lowest level on record, growth expectations and inflation pressures are simply not behind the recent surge in bond yields.
So the proper inference is that risk premiums are rising. Look in the corporate debt sector and you'll see the same thing. Look at utility yields and you'll see the same thing. Yet stocks currently reflect among the lowest risk premiums in history. As I've written frequently, every market crash is driven first and foremost by a surge in the risk premium demanded on stocks by investors.
This is why we take the Crash Warning combination so seriously. A Crash Warning is a situation in which stocks are overvalued (so risk premiums are low), trend uniformity is poor (so investors are not displaying a robust preference to take on market risk), and yield trends are hostile (so yields and risk premiums are under significant upward pressure). When low yields on long-term securities are forced higher, watch out.
If P/E ratios and yields on stocks were to remain constant forever, stocks would be priced to deliver approximately 7.5% annual total returns; roughly 6% from long-term earnings growth (the peak-to-peak norm for the past 10, 20, 50 and 100 years on the S&P), and 1.5% from dividend yield. Now suppose that investors demand 8.5% long-term returns from stocks. They can't force the long-term growth rate of earnings up through wishful thinking, so they have to force prices down until the dividend yield is 2.5% rather than 1.5%. That relatively modest increase in required returns - from 7.5% to 8.5% - would induce a 40% plunge in market prices.
Please, please, please don't imagine that this could not possibly happen. Such a decline would not even bring the P/E ratio on the S&P 500 to the historical norm for bear market lows. Again, these are not forecasts, and we would be quick to reduce our hedges if trend uniformity was to improve. But here and now, we have a defensive climate that may very well shift to a Crash Warning by the end of this week. About three-quarters of market history is spent in relatively constructive climates. About 96% of market history is spent outside of Crash Warnings. There have always been, and will always be, very favorable climates in which to take stock market risk, sometimes very aggressively. This is not one of them.
Sunday December 9, 2001 : Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable trend uniformity. Keep in mind that our measures of trend uniformity are concerned not simply with the trend of major indices but with the behavior of risk premiums. Favorable trend uniformity is a signal that investors have a robust preference to take on market risk, and it is that which has historically allowed overvalued markets to become more overvalued. Overvalued markets lacking favorable trend uniformity have historically generated a wide range of short term returns (both positive and negative), but a poor average return. In other words, high volatility and low expected return. We avoid market risk in those situations. Understand though, that the current Climate allows both positive and negative returns. The difference we have with market timers is that once we identify the prevailing Market Climate, we don't believe that it is possible to forecast returns within that Climate. In short, the recent rally is completely consistent with an unfavorable Market Climate - one which we have no intent of "playing." We have been carrying a very modest net long position during most of the recent rally, but that stance has typically left less than 15% of our stock portfolio unhedged. That's about as constructive as the data have allowed us to become.
Overvaluation, even with unfavorable trend uniformity, does not typically lead to market crashes. Historically, market crashes have always required one additional element: rising yield trends, particularly in bonds and utilities. That element has been missing from market action in recent months. Unfortunately, bond and utility yields have been pressured higher in recent weeks. As a result, we may very well move to a Crash Warning in the weeks ahead, which always warrants a fully hedged portfolio. For now, however, we remain in a defensive but very slightly unhedged position.
As you know, I am a strong adherent of the view that market action conveys information. But I'm also a strong adherent of research. What I find frustrating is the relentless parade of amateurs offering interpretations of stock and bond market action, without having the faintest idea of what they are talking about.
Another note to CNBC anchors: next time your guests wax rhapsodic about how the recent increase in bond yields signals an economic upturn ahead, ask them this. In the 6 months prior to the past 5 recession lows, how much have long-term interest rates risen in anticipation? They didn't. Bond yields fell every time, by nearly 1/2% on average. Indeed, in the 27 recessions since 1871, there is not a single instance when bond yields rose strongly in anticipation of a recovery. Indeed, even though yields have increased slightly on average in the months following a recession low, this tendency is not statistically significant. Yields are as likely to fall as they are to rise. And as a side note, the rate of inflation in the 6 months after a recession low has always been even smaller than the rate of inflation in the 6 months prior to that low.
The recent selloff in bond prices and the increase in yields is simply not evidence of a coming economic turn. You may recall that I advised locking in mortgage rates several weeks ago at their lows. The reason had nothing to do with expectations of an economic turn. Rather, bond prices had become overextended in an unsustainable flight to safety. Their yields had become, in my analysis, too low to properly compensate for maturity risk (the risk of price fluctuations in response to changes in interest rates). Evidently, the bond market agreed. The recent plunge in bond prices reflects nothing more than a normalization of risk premiums. There is no information about economic prospects contained in that action.
The interpretation of the recent stock market advance as evidence of recovery also comes as news to analysts who actually do careful research. One of these is Lakshman Achuthan of the Economic Cycle Research Institute, who notes that while most people seem to think that the stock market bottoms six months before economic turns, 50% of the time in the post-war era the lead has been four months, 25% of the time it's been five months and 25% of the time it's been three months (click here for full article). So if the September low was the real thing, then the economic rebound has to start by February. The only basis for such an expectation would be a naive reliance on the average 11-month duration of post-war recessions, without any examination of additional data.
Yet on a closer inspection of this data, even if the current downturn followed the pattern of relatively mild post-WWII recessions, this recession would end in July or August 2002 (click here for further NBER analysis). Indeed, Dr. Robert Hall, the chair of the NBER Business Cycle Dating Committee (and a member of my dissertation committee at Stanford) offered the same suggestion in a recent press conference. Achuthan notes that such a recovery date would set a bear market low between February and April 2002, at levels below what we saw in September.
Now combine these facts with others. Consider the fact that sustainable bull markets following recessions have begun from price/peak-earnings ratios below 10 and never above 14 (the current ratio is 22). Consider the fact that the percentage of bearish investment advisors has always been between 55-70% at post-recession market troughs (the current percentage is 27% bears, and never moved beyond 43% even at the September lows). In my view, a sustained bull move here seems extremely improbable.
As I always note, favorable trend uniformity here would generate a modest amount of speculative merit, and we would remove a portion of our hedges as a result, regardless of my personal views. But nothing short of a major stock market decline would give stocks investment merit here. All of the analysis above is intended to provide background and context - to place the day to day flow of information (and disinformation) in perspective. But in the end, we are defensive not based on forecasts about the future, but based on the identifiable present. We continue to identify a hostile Market Climate here, and we remain defensive for now.
Thursday Morning December 6, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable trend uniformity. Trend uniformity actually improved more on Tuesday than it did on Wednesday. Wednesday's action was more characteristic of a short-squeeze. Most major indices have advanced almost exactly to their respective 200-day moving averages. There's nothing magical about those averages, but bear market rallies typically find great resistance around those levels. Importantly, the CBOE volatility index also plunged to the lowest level in months, action which frequently accompanies the peak of intermediate rallies.
I noted on Sunday that the main hope for a favorable shift in trend uniformity would be a significant thrust in market breadth. One of the only other analysts commenting on this feature of market action is Richard Russell (dowtheoryletters.com) who writes: "Yesterday's action resembled a mini-breadth thrust with good statistics all around. Of course, it wasn't a real, bonafide breadth thrust and the "good action" came in December. It would have been more impressive if had come right after the September 21 low. Many, if not most, important low points in downside corrections are identified by a sudden massive surge in breadth to the upside. Some of these surges see ten-to-one advances over declines accompanied by massive volume. We didn't see anything like that following the September 21 low. Yesterday's pseudo-surge showed better than two advances for every one decline, but it was far from extreme, far from a real breadth surge."
I remain very suspicious of the current advance. Of course, we continue to adhere to the prevailing Market Climate, so forecasts and opinions are only useful to the extent that they place current action in a larger context. While it is tempting to believe that short-term movements can be "timed," there is nothing in current market action that distinguishes it from pre-September action, specifically the powerful rally following the March lows. We aren't constructive now for the same reason we weren't constructive going into the market plunge that followed that rally - we don't have favorable trend uniformity. Anything that would make us constructive here would have made us constructive then, which would have been unfortunate. Ultimately, I suspect that our defensiveness will prove well placed, but if trend uniformity becomes favorable, we will be quick to remove a portion of our hedges.
While I typically don't have strong opinions about short-term market direction, the main exception is when the market moves significantly against the prevailing Climate. So for example, an oversold decline in a favorable Market Climate prompts a strong opinion that the market will rally. Likewise, an overbought rally in a negative Market Climate makes me suspect trouble. For that reason, I suspect trouble.
In any event, what matters most in achieving any goal, including financial ones, is disciplined, daily action. Ultimately, the majority of our returns are not determined by market fluctuations or isolated "home runs", but by the daily discipline of buying highly-ranked stocks on short-term weakness and selling lower-ranked holdings on short-term strength. On a stock-selection basis, the bulk of publicly traded stocks are clearly overvalued. The most extreme examples are no longer the networking stocks but the large biotechs. Still, we continue to find enough attractive stocks to purchase. We've also found excellent opportunities to take profits on holdings that have become overextended. So underneath our defensive posture is a portfolio that continuously seeks to take opportunities as they emerge.
On the economic front, many analysts took the latest NAPM report as "proof" that the economy is turning. The NAPM might beg to differ. The text accompanying that report notes "Keeping in mind that the NAPM Indexes are indexes of change from one month to the next, it is not surprising that, following October's high rate of decrease in business activity in the aftermath of the events of September 11th, members experienced increased activity in November. However, the reports of increased activity were somewhat offset by reductions in six of the Report's nine other indexes. The November Index registered the seventh decrease in New Orders in the past eight months (exception was June 2001 at 53.1 percent). Comments from members included: "Fewer new sales"; "Partly, recovery from terrorist disruption in September"; "Strengthening sectors of the economy, computers, autos, meetings"; and "Not sure of future business, not committing." Employment in the non-manufacturing sector contracted in November for the ninth consecutive month. NAPM’s Non-Manufacturing Employment Index for November was 44.3 percent compared to 43.5 percent in October [readings below 50.0 indicate contraction]. Comments from members included: "Some early retirements - freezes on new hires - layoffs coming," "Team members not replaced as they quit," "Staff reduction," and "Budget crunch - positions open, but not able to be filled."
So that's the proof that the economy is turning. Somehow I don't feel any better.
Wednesday Morning December 5, 2001 : Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable trend uniformity. Current action is generating some interesting disparities, and additional market action is necessary before the picture is resolved. On the positive side, Tuesday's rally generated some improvement in our measures of trend uniformity - not enough to define a favorable shift, but reasonably good action nonetheless. At the same time, we maintain an asset allocation model which has suddenly shifted to 100% Treasury bills. While this model has been historically reliable and we monitor its signals, we do not use it in practice, since our approach of being fully invested in favorably ranked stocks (and hedging them when necessary) has historically been preferable to other alternatives. But if we were interested in an unhedged position across the S&P 500, Treasury bonds, gold stocks and Treasury bills, we currently would hold T-bills only. That defensive an allocation is extremely rare, having occurred only 5 times in the past quarter-century. These include July 1981 (just before the 81-82 bear got angry), August 1987 (about a week after the final bull market peak and about 6 weeks before the crash), July 1990 (just before another bear market plunge), August 1986 (a 3-week whipsaw signal associated with no important action), and September 1999 (early, but timely enough).
If trend uniformity was to shift to a favorable condition, that shift would override every other model, forecast, or opinion that we carry. Favorable trend uniformity moves us to a constructive position. The extent of that position depends on other factors, but we don't fight favorable trend uniformity. Nor do we have such uniformity yet.
I cannot stress enough that stocks are currently priced to deliver very poor long-term returns. The only question is whether or not it is attractive to speculate. The current rally is essentially a microcosm of the recent tech bubble, and prior bubbles such as 1929. In Benjamin Graham's immortal words, investors have turned their attention from dividends, asset values and earnings, "to transfer it almost exclusively to the earnings trend." Investors are so focused on the future trend of the economy and earnings that they are completely ignoring that stocks will be terribly overpriced even if a V-shaped recovery and an earnings rebound materialize. The focus is the turn, the turn. For some reason, the level of valuations - even if that turn occurs - simply doesn't enter into their calculus.
We don't invest on the basis of my opinions or anybody else's. We hold a position in line with the prevailing Market Climate, defined by valuations and trend uniformity. That said, my opinion is that this rally is terribly overbought, and we are seeing a volatile top-formation. Such formations are often marked by repeated attempts at resistance levels, followed by sharp pullbacks and then renewed attempts. Dow 10,000 appears to be about that resistance area at present. Rallies like Tuesday's can generate quite a bit of bullish enthusiasm, as well as self-doubt from the bears, but in the context of the past few weeks of action, it's not clear that we're seeing anything important.
My definition of "important" is simple. An important rally generates favorable trend uniformity. It's clear that we can earn very good returns without taking on market risk. In a market that is priced to deliver very disappointing long-term returns, the only reason to take market risk is if broad action suggests a compelling reason to speculate. That's what trend uniformity measures. No uniformity, no speculating. It's really that simple. Again, we can make money without speculating on market risk. Only the greedy feel forced to "play" every rally. And greed ultimately charges its own price. We'll wait for more evidence. For now, we remain defensive.
Sunday December 2, 2001 : Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable trend uniformity. Our measures of trend uniformity go beyond a simple examination of recent behavior, so the fact that the market has rallied in recent weeks is not a sufficient signal of quality to take significant market risk.
That said, breadth as measured by advances versus declines has been fairly resilient. If there is any hope at all in the near future for a shift to favorable trend uniformity, it would be a further positive thrust in breadth. Without such action, there are not enough positive developments to warrant speculation on market risk. As usual, we'll allow the market to generate its own evidence, and act if and when that evidence emerges. For now, we remain defensive.
I am trying to find enough evidence of an oncoming economic recovery to override the extremely negative readings our own models are generating. I have not been able to do so to-date. While factors such as oil prices, short-term interest rates, the recent market rally, M2 growth and other indications are frequently cited as harbingers of a near-term rebound in the economy, these factors are statistically too weak to override signals of further weakness. The other problem is that many of these indicators depend on mechanisms that are simply not operative here. For instance, the success of the relentless string of interest-rate easings by the Fed depends on the willingness of banks to increase credit risks and the willingness of corporations to expand borrowing. That isn't happening in an economy overburdened with capacity and a banking system overburdened with low quality debt. So the hope that the Fed moves will be effective is more superstition than logical deduction.
In contrast, many of the most reliable indicators suggesting deep weakness depend on mechanisms that are clearly active here. For example, the NAPM Purchasing Managers Index and the change in the Help Wanted Advertising Index both have near-perfect correspondence with GDP fluctuations. Both measure very direct aspects of the economy - business activity and employment. There is no leap of faith required to analyze or interpret these. Real GDP is not even down year-over-year, and has declined by less than 1% from its peak, and the Dow remains near 10,000. Does anyone really think that the non-event that we've seen thus far is really enough to correct the excesses of the preceding bubble? In contrast, these indices currently suggest a plunge in GDP of nearly 2.5%, a decline similar to what we saw in the 1974 and 1982 recessions. Both periods ultimately turned out to be outstanding points to buy stocks, but only because by the time the damage to the economy was evident, stocks had declined to price/peak-earnings ratios of about 7 (about one-third the current level). The latest reading from the Help-Wanted Index represented one of the sharpest monthly declines on record, and took the index to levels not seen since the 1960's. Indeed, the year-over-year decline in the Help-Wanted Index is the deepest on record. On this basis alone we can expect the unemployment rate to push toward 7% in the months ahead. And again, the historical correspondence of such changes with GDP fluctuations is striking. A decline in the NAPM Purchasing Managers index toward 32 in the next couple of months would be the clearest confirmation of economic weakness.
In any event, current conditions are difficult for the stock market. Either we have an economy likely to weaken dramatically more than widely believed, leaving stocks inordinately vulnerable at current valuations, or we have an economy that is about to deviate from the projections of the statistically strongest indicators in favor of statistically weak ones. And in the event this rebound occurs, we have a stock market that has so fully priced in that rebound that there is nowhere reasonable for prices to advance.
This underscores the difficulty with a strenuously overvalued market. Overvalued markets anticipate everything going right, and in the event that everything goes right, returns are tepid because the good news is already built into prices. The risk of matters going bad is overwhelming, and that risk has teeth when trend uniformity is weak. If trend uniformity shows sufficient improvement, we will establish a moderate positive exposure to market fluctuations, despite valuations and economic conditions. But at present, we remain comfortably defensive.
Friday Morning November 30, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable market action. As usual, we would be willing to reduce our hedges if the market recruits sufficient evidence of favorable trend uniformity. While that sort of uniformity would not create any investment merit for stocks, it would create enough speculative merit to warrant a positive exposure to market fluctuations.
We simply don't have such conditions here, and until we do, there's no sense in second guessing when, how or if favorable trend uniformity might emerge. We'll act when we have the evidence in hand. That said, my opinion is that the market is more likely to shift to a Crash Warning than to a favorable climate, but we'll allow market action to develop that outcome.
In the meantime, new claims for unemployment shot higher again, and it's fairly clear that new hiring remains weak, as reflected by help-wanted advertising. That creates a strong likelihood that the unemployment rate will surge even higher when it is reported next week. Global unemployment is also rising, with Japan's rate at a record high (due to their very rigid labor market, unemployment is typically minuscule there).
Much of Thursday's rally seems to have been due to a technology dog-and-pony show out West. These aren't really investment conferences so much as sales pitches, but investors are thirsty and nostalgic for a new bubble in tech, so while the market remains overbought and vulnerable, we also shouldn't be terribly surprised if investors get excited by Friday's pitches as well.
In any event, it's difficult to interpret recent moves as much other than short-term noise. The underlying signals from valuation and trend uniformity remain unfavorable, and we remain defensive for now.
Thursday Morning November 29, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable trend uniformity.
Scientists from Germany and Chile have discovered a black hole in space 14 times the weight of the Sun. What's interesting about black holes is that you don't observe them directly. You infer their position mathematically with indirect evidence, and you confirm their existence by activity around the edges of that location. Icebergs are similar. You identify the mass of the iceberg with instruments, and you confirm its existence visually from its very tip.
Which brings us to Enron. With the downgrade of its debt to junk status, Enron by its own admission is likely to cease operating as a going concern. This will be the largest corporate failure in history. And it's the tip of the iceberg. The edge of the black hole.
I continue to view debt as the most important problem facing the financial markets over the coming year. The second is the likelihood that consumers will join rather than offset the downturn in business activity, leading to even greater default risks.
We already know the problem by the size of the debt burden among corporations and individuals, the inexorable rise in defaults and ratings downgrades, the continued pressure on profit margins, the plunge in help-wanted advertising that virtually assures a significantly higher unemployment rate, and Tuesday's Beige Book report that demonstrates broad and continued deterioration in economic conditions in the majority of U.S. economic regions during October and early November, as well as growing debt defaults.
While Enron certainly compounded its problems by maneuvers that kept its debts off the balance sheet, debt of whatever nature has to be serviced. It has to be serviced whether the investors in your stock know about it or not. The economy faces the combination of weak cash flows, a banking system too burdened with poor credit risks to take on new ones, consumers too saddled with existing debt to launch into a sustainable spending binge, and companies unable to obtain sufficient new credit from the bond market.
And although investors are widely taking the recent rally in stocks as the harbinger of a recovery, our measures of trend uniformity remain stubbornly negative. This is rarely the case during the launch phase of a legitimate bull market, and it creates a growing suspicion that this rally is nothing more than a bear market trap.
As usual, we'll take evidence from positive trend uniformity if it emerges. In that event, we would probably close down somewhere between 30-50% of our hedges to give our portfolios more exposure to market fluctuations - regardless of my views about the economy, market valuations or other factors. But here and now, the evidence remains clearly defensive.
We can always find individual stocks that exhibit favorable market action and valuation, and we remain fully positioned in such investments. But in an environment like this, we also continue to hedge away the majority of market risk in those stocks.
As I noted on Sunday, the market narrowly avoided slipping to a Crash Warning last week thanks to last Friday's good but very light action. We still do not have a Crash Warning, but the possibility of a shift remains strong. In any event, this is not a market where we are willing to take on much market risk.
Too many black holes and icebergs.
Wednesday Morning November 28, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable trend uniformity.
The NBER dated the current U.S. recession has having started in March. While I strongly agree with that assessment, many observers on CNBC and elsewhere have essentially scoffed at the notion that the U.S. is even in a recession. The accompanying argument is that the recession will be over soon anyway. Unfortunately, these arguments are based singularly on the average length of post-war consumer-led downturns and typical lags between Fed moves and subsequent recoveries. None of these arguments speak to the current situation. Here we have a recession led by a plunge in business investment, a largely unresolved stock market valuation bubble, excessive capacity on the heels of a capital spending boom, a mountain of low-quality corporate debt, a very weak market for new corporate debt (aside from rollovers of existing debt) and a skittishness of banks to expand such lending, record consumer debt as a fraction of income, and the first synchronized international downturn since the mid-1970's.
Despite the optimism over a few weeks of falling new unemployment claims, the fact is that unemployment is driven not primarily by new claims, but by a sharp slowdown in the rate of new hiring. On that note, the index of help wanted advertising has fallen to the lowest level in two decades. This almost ensures a further surge in the unemployment rate, and given the tight correlation, a further plunge in consumer confidence. Aside from debt problems, the main risk to the economy here is that the consumer will join businesses in this downturn. Why this probability is given no consideration by analysts, I'll never know.
The latest issue of Fortune includes a long article by Warren Buffett (click here - note that the article spans several separate web pages). He notes that at last year's market peak, stocks had become so extended that the long-term return, including dividends, was likely to average about 6%. Given the decline since then, he notes, "I would expect now to see long-term returns run somewhat higher, in the neighborhood of 7%."
If you have a firm understanding of market history and the drivers of returns, it is extraordinarily difficult to escape that conclusion.
Think about it this way:
Price = Price/Earnings x Earnings/GDP x GDP
Looked at from this standpoint, stock returns are driven by changes in valuations (P/E ratios), changes in corporate profitability, and economic growth. Most damaging to the long term outlook is that P/E ratios are extraordinarily high, so even if we see improvement in GDP and profitability, it would not translate into price gains unless the P/E was to hold stable or advance. Moreover, the simple fact is that even with the recent decline in corporate profits, the ratio of corporate earnings to GDP remains well above the historical average. This ratio is sensitive to the overall rate of GDP growth. The recent high levels were dependent on a capital spending boom that created a frantic demand for output and very rapid and sustained GDP growth rates. Unless we actually see a full revival of the capital spending boom, those profit margins will not revive either. Indeed, as I've noted, corporate profits actually tend to decline or stagnate even in the first year of an economic recovery. In a recovery, profit growth is unlikely to outpace 4-6% nominal growth in GDP.
What we are left with is a market that will deliver somewhere between 4-6% annual capital gains even if P/E ratios remain at current extremes forever. Kick in a minuscule dividend yield, and you have a total return somewhere between 5-7%. Again, this does not even assume a decline in the P/E ratio over the long term.
As Buffett points out, from 1964 through 1981, stocks earned nothing. Indeed, the past century contains a series of secular bull and bear periods each running about 17 years in length. We have just come off of a secular bull run of just over that duration.
On that note, a quick calculation. Assuming that over the next 17 years the P/E on the S&P falls from 31 to the historical average of 14 (not even to undervalued levels) and earnings growth averages a historically high 7% annual rate, stocks would earn a total return (including dividends) of about 3.5% annually. That's not a forecast, but it underscores how dependent long-term investors are on the P/E ratio remaining abnormally high both now and far into the future.
Investors often ask, "if I sell stocks, what am I going to buy, Treasury bills earning 1.9%??!?" And the answer is yes, unless you have another way of hedging your stocks against market risk (or your fund does it for you), short-term Treasury securities are an appropriate investment. Longer term assets (both stocks and bonds) are priced to deliver such low returns that even a slight increase in required returns will lead to capital losses. Also, default risk is sufficient to make corporate debt unattractive at present yield levels. You don't have to hold Treasuries forever. But sometimes risky assets are not priced to deliver satisfactory returns, and during those times you defend your capital.
It is simply not investors' God-given right to demand high long-term returns from assets that are overpriced. Stocks may earn positive short-term returns if investors are in a speculative mood. But you have to understand that speculation is not investment. Our measures of trend uniformity essentially attempt to measure whether investors are in a speculative mood, and whether that mood is robust. If if is, we'll take at least a moderate exposure to market risk, even if it is purely speculative. Here and now, we do not have such evidence, so we find stocks unattractive from both an investment and a speculative standpoint.
As a final note, investment advisory bearishness has now declined back under the important 30% level, according to Investor's Intelligence. Merrill Lynch calculates that the exposure to equities recommended by Wall Street equity strategists is at a record 76%. Meanwhile, Mark Hulbert of the Hulbert Financial Digest (which tracks investment newsletters) notes "We would not see this high a [percentage exposure to equities recommended by advisors] if there existed a huge wall of worry that could sustain a long-term bull market. When will we know the bear market is behind us? It will come when most are skeptical of a rally. We will know it because the prevailing mood at the time will be that we should avoid being suckered into another false rally. The average recommended exposure to stocks will hardly budge from a low level. I hope I'm wrong. I'd like nothing more than for stocks to be at the beginning of a long-term bull market. But if they were to do so, it would be one of the only times in market history in which a bear market bottom was recognized as such almost immediately by a large proportion of newsletter editors."
The bottom line, if you want to play, go somewhere other than Wall Street. My 5-year old daughter recommends Mouse Trap.
You roll your dice, you move your mice. Nobody gets hurt.
Sunday November 25, 2001 : Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable trend uniformity. The Market Climate narrowly avoided slipping into a full Crash Warning last week, had it not been for Friday's broad advance. As a practical matter, such a shift would not have much effect on our position, as it would simply move us from our current mostly-hedged position to a fully hedged position. For now, we remain largely though not fully hedged. Still, Friday's rally was on extremely low volume driven largely by program-trading. That raises our alertness to the possibility that last week's avoidance of a Crash Warning was spurious. Market action over the next several weeks may settle that issue more decisively.
Investors continue to base their decisions on very simplistic platitudes about cause and effect. "Fed actions kick in with a 6-12 month lag", "Bull markets start six months before a recession ends", "When the Fed pumps money into the economy, some of it has to find its way into the market." These views are characterized by blind acceptance without asking why they should be true. In that sense, they are not tight logical arguments linking valid premises to conclusions. They are simply toy chains with missing links.
The notion that Fed actions mysteriously "kick in" only gets traction if one can explain the mechanism linking open market operations to increased lending. You have to show that Fed actions make banks more likely to lend and businesses more likely to borrow. Yet even with the extremely aggressive easing by the Fed, virtually all the increase in the monetary base over the past year shows up as currency in circulation, not as additional bank reserves. Meanwhile, capital spending shows absolutely no sign of recovery. Enormous amounts of lip service about an impending bounce, but no evidence.
One of the most important signals of a bottom in the economy would be the emergence of favorable trend uniformity. Our measures of trend uniformity have never been unfavorable at the end of a recession, and typically turn positive several months in advance of an economic upturn. Many analysts believe that the recent rally is a signal that the economy is hitting bottom and about to recover. Without favorable trend uniformity, we can't agree, at least not yet.
The notion that bull markets start six months before a recession ends also gets traction only if one understands why they have started. Corporate earnings typically stagnate or fall during the first year of an economic recovery. All of the advance in the market during these periods is driven by an increase in price/earnings ratios, not in earnings. The expansion in P/E ratios has invariably been from deeply undervalued levels to moderately undervalued levels. It has never been from overvalued levels such as 31 times earnings. This is a market that has nowhere reasonable to go even if the economy does turn higher.
Early bull markets are always "valuation driven" in the sense of rising P/E ratios, never "earnings driven". Those looking for robust earnings growth have no basis for such expectations, with the possible exception that companies are using the current downturn to gather and dump major costs like garbage in the form of extraordinary losses. That may allow them to mislead investors with "better" earnings later on, but there is nothing of shareholder benefit in this.
Finally, the notion that "liquidity finds its way into the market" ignores every aspect of equilibrium, which I've discussed at length in recent reports.
The only argument for rising prices here is the possibility that investors will, in the absence of earnings recovery, be willing to drive P/E ratios higher. If trend uniformity was positive, we would be willing to speculate on this possibility. We don't have evidence to do so here. Without such evidence, we are watching the market here the same way we would watch gamblers playing roulette in Vegas. We don't kick ourselves for not playing if somebody wins a few spins. Because when the odds aren't in your favor, the house eventually gets your money.
In other developments, the latest report shows the U.S. trade deficit narrowing at a record pace. This was completely predictable (see page 4 of the November Research & Insight) and reflects a continuing plunge in U.S. domestic investment. Most European economies are now slipping into recession, notably Germany. But even with that weakness abroad, our imports are likely to continue falling even faster than our exports.
As for the U.S. recession, The NBER held a conference call on Friday, and is increasingly expected to declare that a U.S. recession began in March. I don't dispute the starting date, as it's what I've been saying since, oh, about March. Rather, I'm not certain that the NBER has the overwhelming evidence it typically requires to date the start of a recession, particularly in terms of indicators like personal income less transfer payments. In short, there's an even chance that the recent NBER meeting did not generate a firm determination that the U.S. is in recession.
Of course, I do expect that it will ultimately determine that a U.S. recession began during the first quarter of this year. The real issue is whether that determination comes from the latest meeting. If the NBER doesn't reach that conclusion here and now, we're apt to see a bunch of analysts on TV cheering things like "It's official! The U.S. is not in a recession after all!" Which you can be sure will result in a visit by the TV guy to remove the objects hurled into my picture tube.
Tuesday Morning November 20, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable trend uniformity. It's an open question whether the recent rally has legs or whether we're just seeing its pointy little head. The next several weeks will be informative. Currently however, our measures of trend uniformity remain negative. Among other subtle negatives, utility stocks hit another new low on Monday. While we don't place great emphasis on moving averages, it's interesting to note that the major indices all remain below their 200-day moving averages, which tend to be important resistance points for bear market rallies. So far, this rally has not generated favorable trend uniformity, which typically comes very quickly in bull markets. The Dow has recovered about half of its prior bear market losses, which is not unusual for bear market rallies. And still, this rally has not taken the major indices above their 200-day averages. In short, we've got typical bear market action to date.
Meanwhile sentiment remains very unfavorable as well. The percentage of bearish investment advisors is again down to the important 30% level. Moreover, Merrill Lynch reports that the consensus equity allocation among Wall Street strategists is now 76%, "truly unbelievable", and an all-time high. The report notes "there was never a subsequent 12-month return that was negative when readings were below 50%. By contrast, subsequent 12-month returns were positive only half the time when readings were above 60%, and never outperformed cash when readings were above 61%." The indicator projects a 12-month market loss of more than 25%.
I don't really place much faith in such forecasts, and don't base our own positions on such views. Still, the high level of bullishness underscores how much blind faith there is about an impending recovery. The underlying assumption is that the worse the news gets, the stronger the subsequent recovery. But that assumes that the level of activity we saw during the recent boom - particularly in capital spending - was a sustainable level on a sustainable growth path. As I noted over a year ago, however, about 2-4% of GDP in recent years was the froth of an unsustainable capital spending boom, and was tightly linked to wide and expanding profit margins. If anything, we're likely to see further cuts in capital spending in the year ahead. I can't emphasize enough how much I disagree with the "V shaped recovery" thesis. The prospect for near-term earnings recovery is zero.
Note to CNBC anchors. Next time your guests wax rhapsodic about the coming rebound in earnings, ask them this. In the first year of recovery following the past 5 recessions, how much have S&P 500 earnings grown? Answer: they didn't. They consistently fell, about -10% on average. The entire hope for rising prices rests not on earnings growth, but on rising P/E ratios (from the current multiple of 31). That's a tough sell in a market still lacking trend uniformity.
Even if trend uniformity was favorable, it would still be true that on a valuation basis alone stocks are priced to deliver poor long-term returns. The sole reason to invest in stocks here would be based on speculative merit (buying on the expectation of richer valuations), not investment merit (buying a stream of cash flows at a reasonable price). In our discipline, speculative merit requires favorable trend uniformity. We are willing to take on more exposure to market fluctuations if we see this. Currently we do not. Though my opinion is that this rally is likely to fail, the current Market Climate is all we really need to know here. We remain defensive.
Sunday November 18, 2001 : Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable trend uniformity. Moreover, if the broad market is down even modestly next week, trend uniformity will probably take a marked shift for the worse. On that basis, my opinion is that the bear market may significantly reassert itself over the next several weeks. Our position is not driven by opinions however. On the basis of the currently identified Market Climate, we remain well hedged and defensive here. A shift to favorable trend uniformity would not make stocks good investments here, but it would make stocks reasonable speculations, and we would increase our exposure to market fluctuations on that basis. Currently however, stocks lack both investment and speculative merit. We can always find individual stocks that satisfy our criteria for valuation and market action, but we continue to hedge against their market risk here, so we are relatively indifferent to market direction.
In last Wednesday's special update, I noted my main objection to the idea that bull markets are the natural offspring of recessions. To recap, it's quite true that the market typically sets its low within 6 months before the official recession trough. But what is striking is that the average price/peak-earnings ratio at these points historically averaged just 8.9. Over the following year, that ratio typically expanded to 11.6 - still well below the historical average of 14. In other words, the powerful bull market rallies following recessions universally emerged to bring stocks from deeply undervalued levels to still moderately undervalued levels. They never began from overvalued levels. The current price/peak-earnings ratio is 21.
I noted two weeks ago that those looking to refinance their mortgage would be well served to lock in a rate immediately. I expect that recent mortgage rates will mark the low for this cycle. While short term interest rates may actually fall somewhat further, longer term Treasury yields are likely to be fairly flat, and any debt security that is not completely free of default risk is likely to see higher rates ahead.
One of the frequent arguments I hear is that the wave of home refinancings will "put money in the hands of consumers" and thereby boost the economy. As usual, we have to go back to the concept of equilibrium (see the recent issue of Research & Insight for a detailed discussion). If homeowners are paying lower mortgage payments, it must be true, in equilibrium, that mortgage companies are receiving lower payments. If mortgage companies are not taking a hit to its profits (and this doesn’t yet seem to be the case), it must be true that the individuals who lend to mortgage companies must be receiving less. Those lenders are essentially investors who buy mortgage bonds, bank CDs, money market funds, and other fixed income securities that finance mortgage loans. In short, the increased purchasing power of mortgage borrowers is matched by a loss of purchasing power by investors who buy "safe" securities or live on fixed incomes.
"But no," one might argue, "doesn’t the Fed just pump this money into the economy?" A notion that makes me want to grab a large sack and ask for the location of that pump. Unfortunately, there is none. When the Fed "lowers rates", all it does is buy Treasury securities from banks, and it pays for those Treasuries by crediting the reserve accounts of these banks. As noted in the August Research & Insight however, banks hardly need reserves to carry on lending operations, so the vast majority of these reserves are simply withdrawn as currency and held by the public. What really happens is a portfolio shift by the public from interest bearing Treasury debt to non-interest bearing money. Fed actions usually follow movements in market rates, but if there’s any effect on interest rates, it is because there is a slightly smaller stock of Treasury debt that must be held and a slightly larger stock of currency that must be held, and interest rates move to balance supply and demand in this new equilibrium (i.e. people are willing to hold more currency and fewer bonds when interest rates are lower). In short, Fed moves may redistribute income from lenders to borrowers, but they don’t "pump money into the economy" in the form of aggregate purchasing power.
In his recent monthly market comment, Bill Gross of PIMCO lays out the argument for poor long-term stock market returns ahead. Not bad for a bond guy. The argument is a version of the one I’ve made repeatedly in recent years. Essentially, if you hold the P/E constant, prices must grow at the same rate as earnings, so the total return earned by an investor over time is simply the sum of the earnings growth rate and the dividend yield. Because earnings growth is linked to nominal GDP growth over time, Gross argues that in a low inflation environment, the total return on stocks is likely to be only about 5% annually from current prices.
Gross is correct, though I think he overstates the probability that current P/E ratios can be sustained, and he somewhat underestimates the probable long-term earnings growth rate. As far as the P/E ratio is concerned, Gross falls into the same trap as Burton Malkiel did a couple of months ago in relating inflation and P/E data only from the 1960’s to the present (see our late September updates for a discussion on this). The longer term data are not nearly as kind to the thesis that low inflation is associated with high P/E ratios. Gross also estimates a long-term growth rate for earnings of about 4% in a low inflation environment. The historical data suggest that 5.7% is more likely, since productivity growth moves somewhat inversely with inflation.
In any event, whether you assume a higher earnings growth rate and a lower sustainable P/E (as we do) or a lower earnings growth rate and a higher sustainable P/E (as Gross does), the result is the same: stocks are priced to deliver very unsatisfactory long-term returns. Arguments for strong stock returns from here must assume that the market can sustain rising and unprecedented P/E ratios, as well as unprecedented long-term earnings growth. I doubt that buy-and-hold investors recognize how improbable the assumptions have to be in order to justify even historically average returns from here.
I honestly don’t think that investors will continue to price stocks to deliver 5-7% long-term returns much longer. If stocks were priced to deliver 9-10% long-term returns, the S&P 500 would be half its current value. That’s not a forecast, but an observation about values here. It doesn’t drive our investment position (the Market Climate does), but you might keep it in mind if you are mistaking the S&P 500 as an investment rather than a speculation here. Meanwhile, it’s interesting to note that the surge in the 10-year Treasury yield now places stocks back in "overvalued" territory on the basis of the Fed Model. Oh well, I never liked the Fed Model anyway.
Wednesday Morning November 14, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and still unfavorable trend uniformity. While there have been some improvements in that uniformity, we still do not have enough evidence to take on a significant amount of market risk. We do have slightly less than 20% of our portfolio unhedged, however. Even if this is a legitimate bull market (which is highly suspect), the market is so overbought that better buying areas are very probable. More likely, the recent rally remains nothing other than a standard bear market rally off of a deeply oversold low. Given the strenuously overbought condition at hand, this rally has quite probably registered and now retested its highs. The action over the next few weeks should be informative. As always, there's no need to make predictions, as the current Market Climate remains defensive.
One of the striking features of this market is that even after the beating that investors have endured over the past year, they continue to formulate their investment arguments on every conceivable basis except the one that counts: price. The current argument goes like this:
1) Bull markets typically begin about 6 months before the end of a recession.
2) We've got a tingly feeling that the economy will bottom within the next quarter or
two.
3) Therefore, we're in a new bull market. Buy before it gets away from us.
There are two difficulties with this logic. First, the expectation of an economic turn is not based on evidence about the current economy (its origin from weak capital spending rather than a consumer slowdown, high debt levels, rising credit risks, the fact that it is the first globally synchronized downturn since 1974, etc). Instead, recovery expectations are based on "typical" lags between monetary easing and economic recovery. Early this year, the conventional wisdom was that the economy responds to interest rate cuts with a 3-6 month lag. Now the conventional wisdom is that it responds with a 12 month lag. This is not wisdom, or analysis, but blind hope.
More importantly, however, the belief that bull markets are the natural offspring of recessions completely ignores why those bull markets have historically emerged.
I examined the historical record using official NBER recession dates from 1871 to the present. Keep in mind that stocks currently trade at 30 times current earnings, and would have a P/E of 21 even if earnings were still at their prior peak levels.
It is quite true that the market typically sets its low within 6 months before the official recession trough. But what is striking is that the average price/peak-earnings ratio at these points historically averaged just 8.9. Over the following year, that ratio typically expanded to 11.6 - still well below the historical average of 14. In other words, the powerful bull market rallies following recessions universally emerged to bring stocks from deeply undervalued levels to still moderately undervalued levels. They never began from overvalued levels, and began only once from average valuation levels.
That single exception in over a century of data was the rally that began in September 1960 (prior to the Feb 1961 recession trough), which started from a price/peak-earnings ratio of 14.5. Though stocks did rally initially, they actually underperformed Treasury bills over the two years following that low.
More recent market troughs have followed the more typical case, with market lows occurring within 6 months of the economic trough, at price/record earnings ratios of 7.4 at the 1974 low, 6.9 at the 1980 low, 7.0 at the 1982 low, and a relatively high but still undervalued 11.4 at the 1991 low.
The current price/peak-earnings ratio is 21.
The main lesson of recent years is that investors invite disaster when they stop asking "at what price?". What is disturbing is that they still haven't learned that lesson.
We have no illusions that stocks have broad investment merit here. We can certainly find individual stocks that reflect favorable valuation, and we will certainly take on more market risk if trend uniformity emerges. But that willingness would be based on speculative merit. Stocks are priced to deliver very unsatisfactory returns to long-term buy-and-hold investors. I strongly believe that the ability to selectively accept and avoid market risk will be a great asset in the coming decade.
I continue to expect the current economic downturn to be deeper and more prolonged than the typical consumer slowdown. As for the start of this recession, I have long argued that the NBER will ultimately date this recession as having begun during the first quarter of 2001. This week, the NBER cautiously adopted that view, noting "Employment reached a peak in March 2001 and declined since then... we have aligned the recent data with March 2001 as a possible [economic] peak, though the committee has not yet made any determination of a peak."
Sunday November 11, 2001 : Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and still unfavorable trend uniformity. That combination holds us to a defensive position. As I've frequently noted, high risk implies a wide range of potential outcomes. What matters is the average of those outcomes, in relation to that risk. Regardless of whether one of those outcomes could be a gain, the issue is how the average outcome stacks up against the range of the outcomes. Quite simply, we invest on the basis of expected return to risk. Not on the basis of expected return alone, and not on speculation or forecasts about one particular outcome. Market timers are willing to invest on the belief that they can predict such specific market moves. We aren't market timers. Here and now, we have a Climate that is associated with a wide range of potential outcomes, where the average or "expected" return is unsatisfactory. That's all we need to know. There is no need to attempt prediction. When the objectively identified Climate shifts, so will we.
That said, my opinion (which we don't trade on) is that the market is likely to fall back below the 9000 level in the weeks ahead. While we may even see a retest or break of the September lows, there's really no need to attempt that prediction. My view about breaking Dow 9000 is based on the simple tendency of large market moves to be corrected, combined with excessive levels of bullishness among market strategists (71% allocated to stocks - the highest reading since the data has been recorded).
I continue to believe that the most pressing financial issue in the year ahead will be debt. On that front, credit spreads (the difference in yields between low grade corporate debt and risk-free Treasuries) continue to widen. Worse, the plunge in the producer price index creates further default pressures here. The worst thing for a debtor is to have fixed dollar payments that have to be serviced, and for the inflation rate to fall short of the level required to generate those dollars. The decline in inflation pressures is experienced by debtors as a substantial increase in the real interest rate required to service their debt.
From a broader perspective, the prospect of anything more than a bear market rally here seems fairly remote. By definition, price equals the price/earnings ratio, times revenue, times profit margin. For stocks to mount a sustained advance, one has to argue for a net expansion in those factors. Yet here we are at a P/E of 30 on the S&P, in an economy which in the best scenario will quickly rebound to its 2.7% long-term growth rate. And given that profit margins are tightly linked to the economic growth rate, a 2.7% economic growth rate implies at best no further decline in profit margins. It does not imply a rebound to the profit margins that were based on a capital spending bubble and years of sustained 5% GDP growth.
So the best case scenario involves profit growth being roughly the rate of GDP growth in the year ahead. Which lays the entire case for a bull market on expanding P/E ratios. As much as we've long argued that lower interest rates tend to support higher P/E ratios, once you've hiked the P/E to 20 times record earnings and 30 times current earnings, the effect of interest rates in boosting the P/E further becomes negligible. Thus, the entire argument for a sustained market advance must arise from the expectation of higher P/E's, based not on further interest rate declines, but on a robust and strongly increasing preference of investors to take on market risk. In the absence of such a robust preference, stocks are likely to go nowhere even in the best case.
How do we measure that investors have adopted a robust preference toward market risk? Trend uniformity. If the market recruits sufficient trend uniformity, we would take it as a signal that investors had acquired a taste for market risk, and we would be willing to take a modestly constructive market position. It is important to understand that such a position would not be based on investment merit (in the sense of buying a stream of cash flows at an attractive price). Rather such a position would be based on speculative merit.
Currently, the market reflects neither investment merit nor speculative merit. Risk implies a range of outcomes, and we can't rule out that one of those outcomes may be a further advance. But the expected return to risk of the market here remains abysmal. We don't take on risks of that nature. For now, at least, we remain defensive.
New article: www.worldlyinvestor.com
Wednesday Morning November 7, 2001 : Special Hotline Update
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The Market Climate continues to be characterized by extremely unfavorable valuations and unfavorable trend uniformity. At present, the market is severely overbought. While I rarely have opinions about short-term action, there is a very obvious historical tendency for the worst market plunges to come during periods of unfavorable trend uniformity, on the heels of overbought, overvalued conditions. Indeed, that's true almost by definition.
Still, we are always open to the possibility that favorable trend uniformity will develop. There is no need to be nervous about that possibility. Market timers will be nervous that we could be missing out on a rally and will end up covering a portion of our hedges at even higher levels. Die-hard bears will be nervous about any possibility that we could become constructive in a bear market. But we are neither market timers nor die hard bears. We simply act on evidence about the prevailing Market Climate. We follow that discipline because our research supports it far more than any alternative we've tested (and we try to test everything we can get our hands on). Currently, there is not sufficient evidence to take on significant market risk. We are very modestly net long here (the dollar value of our shorts never materially exceeds our long holdings), but the bulk of our stock position is hedged against market fluctuations.
As Richard Russell (dowtheoryletters.com) often points out, every market move (up or down) is corrected. Last quarter, we had a profound market plunge. Now we have an upside correction that has added an extra (and quite possibly final) upside extension into very overbought territory. Even if this uptrend will be sustained, it's very likely that an eventual downside correction of this move will take prices below where they are now. In other words, chasing the market and buying an overbought spike, even in a sustainable uptrend, is usually a poor investment move.
As a general rule-of-thumb, corrective moves generally give back anywhere from 1/3 to 2/3 of the swing from oversold to overbought conditions (or vice versa). That would create a reasonable possibility that the Dow will give back 500 points or more and break at least briefly below the 9000 level in the weeks ahead. And as you've probably guessed, I am inclined to do absolutely nothing with that opinion. As I've said countless times, we invest based on evidence regarding valuations and market action, not on anybody's opinion, including my own.
In short, while there are reasonable arguments for a defensive position based on technical indicators, sentiment, and so forth, we would ignore all of them if the Market Climate was favorable. Currently, it is not, and that's all we really need to know. We remain defensive for now.
Tuesday Morning November 6, 2001 : Special Hotline Update
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Just a note. I made a few late clarifications to the new issue of Hussman Investment Research & Insight before it went to press. Most of these involve the role of government intervention in the economy. The final version is now posted to the web.
The Market Climate remains characterized by extremely unfavorable valuations and unfavorable trend uniformity. That said, market action was quite good on Monday, with breadth strong and the utilities bouncing back. Too early to say whether we'll get much follow through, but we'll act on the evidence if it emerges sufficiently. As always, it is entirely unnecessary to second-guess future shifts in the Market Climate. As for my opinion, I suspect that the strong action in the utilities was more an oversold bounce than a reversal. And it's always difficult to get very enthused over a rally that is strenuously overbought.
The Fed will almost certainly cut Fed Funds by a half-percent on Tuesday. Cisco also beat drastically lowered expectations. I've written enough about Cisco's unethical management of earnings, so I'll leave you with John Chambers' guidance about future quarters "It's more a question of does it turn up from here, lay flat, slightly up or turn down?"
It is striking how eager investors are to look over the valley toward the next recovery. If this was a typical cyclical economic downturn, that would be reasonable behavior. In a global recession (the first synchronized international downturn since 1974), and sharply deteriorating credit quality on a mountain of debt, the turn is unlikely to be so swift. Investors have been conditioned to treat declines as brief buying opportunities because of 18 years of rising valuations which took the P/E on the S&P from 7 in 1982 to 30 today. From a broader perspective, it is clear that the coming decade, starting from a P/E of 30, will be much less persistent in its advances. It will probably also be very frustrating to buy-and-hold investors due to unsatisfactory total returns.
All which is to suggest that investors should not be so fearful of missing the next upturn that they expose their financial security to further catastrophic losses. Certainly falling interest rates have supported low stock yields. But now we find both stocks and bonds in a situation where they are priced to deliver extraordinarily low long-term rates of return. Major advances emerge from conditions of high and falling yields. Currently we have very low yields, and still insufficient trend uniformity. That combination has historically produced disappointing returns, on average.
Still, as usual, if trend uniformity reasserts itself sufficiently, we'll step into at least a modest exposure to market risk. Meanwhile, we're sticking to our disciplined selection of stocks with favorable valuation and market action, while keeping them well-hedged for now.
Sunday November 4, 2001 : Hotline Update
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The latest issue of Hussman Investment Research and Insight is now available online, and will be mailed this week.
The Market Climate remains characterized by extremely unfavorable valuations and unfavorable market action. While we don't publish data from our fixed income models on a regular basis, I should note that the bullish positions advised by those models for over a year have suddenly turned flat for long-term bonds. Short-term interest rates are expected to fall further, however. That's not to say that our bond outlook is bearish. Rather, after having been nailed to their most aggressive position since last year, these models are suddenly neutral. The extraordinary bullish move in long-bonds, in our view, is largely behind us. The Treasury has a long and illustrious history of making bad maturity decisions. The decision to eliminate the 30-year bond is likely to be one of them. Mortgage borrowers, very reasonably, are choosing to refinance their debt to lock in these low rates. The Treasury should be doing the same - taking advantage of the current flight to safety by expanding issuance of the longest-maturity Treasury bonds possible. Unfortunate move.
As for stocks, the market has now corrected its third-quarter decline and is still overbought. I rarely carry a short-term expectation for the market, but at this point, I would be surprised if the market did not at least correct the recent rally by falling few hundred more Dow points. Recent market action has been divergent enough to cause some concern. One of the gaping disparities is that utility stocks continue to plunge, hitting a new 52-week low last week, despite strong action in the bonds. It will be interesting to see how market action evolves over the coming weeks. Market action always conveys information, and divergent market action can be particularly revealing. At this point, the clearest signal we can draw from a wide range of indications is that debt default problems are about to accelerate.
Barron's has an article about the benefits to investment returns of missing the worst 5 days of the year. In my view, this perpetuates a ridiculous debate. Bulls just retort by showing how badly investors would do if they always missed the best 5 days of the year. In my view, the right way to frame this argument is to ask what conditions have typically been in effect during the best and worst periods. I addressed this issue in my 1998 paper on Time Variation in Market Efficiency. Though the "yield trend" model in the paper certainly isn't as effective as the model we actually use in practice, it's good enough to convey the basic point: if you look at the top 30 market weeks over the past 50 years, 10 occurred in conditions of both favorable valuation and trend uniformity, 4 during unfavorable valuation and favorable trend uniformity, 13 during periods of favorable valuation and unfavorable trend uniformity, and just 3 during periods of unfavorable valuation and unfavorable trend uniformity. In other words the vast majority of top market weeks occurred during conditions of favorable valuations.
In contrast, of the worst 30 market weeks, only 2 occurred during periods of favorable valuation and favorable trend uniformity, only 4 occurred during periods of unfavorable valuation and favorable trend uniformity, fully 18 during periods of favorable valuation and unfavorable trend uniformity, and 6 during periods of unfavorable valuation and unfavorable trend uniformity. In other words the vast majority of bad market weeks ocurred during conditions of poor trend uniformity.
As you can also see, the combination of favorable valuation and unfavorable trend uniformity tends to be the most volatile - having the majority of both strong and weak market periods. In any event, arguing about what the returns would be if you missed these periods or not is vapid unless you also stipulate the criteria that you would use to do so. Our criteria are very consistent with what would have worked: Be aggressive during periods of both favorable valuation and favorable trend uniformity, remain constructive during periods of unfavorable valuation and favorable trend uniformity, be defensive during periods of unfavorable valuation and unfavorable trend uniformity, and build positions on declines during periods of favorable valuation and unfavorable uniformity. And as usual, no forecasting is required. It is enough to identify the prevailing climate.
The unemployment report was unsurprising, despite the worst job losses in 21 years. Unemployment will probably worsen further in the November report as well, partially due to continued layoffs, but more importantly due to a slowdown in new hiring. Help-wanted advertising continues its vertical drop. In contrast, both earnings and economic estimates remain far too upbeat. Analysts still refuse even to consider the possibility that earnings and the economy could weaken rather than strengthen in the months ahead.
I have no preference for such a defensive view. But as you know, we are very serious about taking signals from market action. Some might argue that the recent market advance portends a recovering economy in the near future. Unfortunately, this advance has none of the favorable trend uniformity that usually presages economic turnarounds. All we see so far is a corrective rally off of an oversold low. If we begin to see better action, we'll move to a constructive position. Those of you who know me realize that I really would prefer to offer an upbeat outlook. As matters stand, valuations and market action force us to remain defensive for now.
Friday Morning November 2, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and still unfavorable trend uniformity. The NAPM indices plunged in October, commodity prices and interest rates are also falling sharply. While some analysts are quick to point to lower rates as evidence that stock valuations should move higher, it is important to consider why rates are falling. What we have is the combination of a flight to safety and a deflationary recession.
As I've noted before, the particular pattern of interest rate changes, commodity price diffusion, credit spreads, and other factors suggests that the current downturn is likely to be much deeper and more difficult to address than the standard post-WWII recession. We already anticipated that this recession would be deeper than usual, because about 2-4% of GDP represented the unsustainable froth of the recent capital spending boom. A 2% downturn is generally classed as a severe recession. Unfortunately, we've also got a consumer slowdown compounding the problem. Unless the interventions of the Fed and Congress are successful in not only stabilizing consumer activity, but reviving the capital spending bubble, a deeper-than-average recession is nearly assured. I suspect that this likelihood will be clearer after the October employment report is released on Friday, but in any event, further economic weakness is likely.
As for stocks, prices remain vulnerable, but it is important to remember that the Market Climate is not a forecast of future conditions but an identification of current ones. We are not forecasting that prices will plunge here. Rather, the current Market Climate has historically been associated with returns less than the Treasury bill yield, and high risk. That's not a climate that is suitable for significant risk-taking. But understand that high risk implies a wide range of outcomes. The current climate can produce substantial advances and substantial declines. It's just that on average, the returns have been less than the T-bill rate. I honestly believe that it is useless to try to predict short-term moves. Once we identify the current Market Climate, I know of no reliable tool to refine the analysis in a way that forecasts short-term moves. For now, the expected return to market risk is unfavorable, and as a result, we are largely hedged in order to mute the effects of market fluctuations.
Wednesday Morning October 31, 2001 : Special Hotline Update
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Just a note, the latest issue of Research & Insight will be available online by Friday afternoon, and will be mailed early next week.
The Market Climate remains characterized by extremely unfavorable valuations and unfavorable market action. That continues to hold us in a defensive position for now. Trend uniformity was actually harmed more by Tuesday's decline than by Monday's. Breadth was worse, downside leadership was worse, and bellwether groups performed worse (the utilities hit a 52-week low). In general, when you see a defensively hedged portfolio (such as ours) lose ground on a down-day, you can infer that trend uniformity took an unusual and substantial hit. That's what happened on Tuesday. As I noted at the time, Monday's decline was not particularly informative. Tuesday's action contained much more information in the poor quality of its market action. That raises our level of concern about the market, but since we're already well-hedged, it doesn't change our position much. Most of our day-to-day activity involves the regular attempt to buy highly ranked candidates on short-term weakness, and to sell lower ranked holdings on short-term strength. That discipline doesn't show obvious effects on a day-to-day basis, but it is very important to our longer-term performance.
As for the economy, I continue to view the key risk as debt. There's more on this in the upcoming issue of Research & Insight. For now, it's sufficient to note that market action - particularly interest rate risk spreads - are suggesting fresh and substantial concerns about corporate default risk. Given that I expect the unemployment rate to shoot above 6% in the coming months, consumer and mortgage defaults are also likely to head higher.
For those of you who own a home and have been waiting for the right time to refinance, I strongly believe that now is an excellent time to lock in your rate. While further economic weakness may drive bond yields somewhat lower, we're also close to the point where default risk is going to emerge, and that is likely to keep mortgage rates from declining much more even if Treasury yields do.
Nice article: www.smartmoney.com
Tuesday Morning October 30, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable trend uniformity. Just as we don't rush to bullish conclusions based on sharp one-day rallies during negative climates, we don't rush to bearish conclusions based on days like Monday. Monday's action struck me as a normal correction of the recent rally we've seen. That being the case, we really can't draw much information from it.
We'll get more information shortly, depending on whether the market rebounds or continues lower. I have no prediction regarding which will occur, and of course, that's one of the reasons we don't base our investment position on my predictions, or anybody else's. For now, the objectively identified Market Climate is negative, and that objective Market Climate holds us to a defensive position.
Interest rate action is favorable enough that I would view a market crash as unlikely, even given current valuations. But we don't have sufficient evidence to take a constructive position either. Neutral is fine with us. Even without a net short position, a neutral position has treated us well during the declines of the past year. What matters to us here is not market direction, but the performance of our favored stocks relative to the market. Regardless of whether the market rises or falls, it is that relative performance that drives our returns when we are in a hedged position, as we are today. For now, we find the expected return/risk profile of a neutral position more attractive than a highly bullish or bearish posture.
It is tempting to make forecasts here. It is also totally unnecessary. For now, we remain defensive and well-hedged.
Sunday October 28, 2001 : Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable market action. That keeps us generally well-hedged (we are slightly net long in practice), but we would be open to a more constructive position if trend uniformity improves, and specifically if the large-cap indices can pull back without much downside participation from the broader market. That's a fairly specific wish list, but those would be the most positive developments likely here.
I continue to hear projections of an imminent recovery in the economy, largely based on monetary indicators such as M2. I'll review some of the difficulties with these projections in next week's new issue of Research & Insight, but default risk features both directly and indirectly. I continue to expect that debt problems will be one of the key features of the coming year. Both consumer and business debt burdens are far out of line with historical norms, and pressures on debt servicing ability are the strongest in decades. Bill Gross of PIMCO presents an interesting chart on this, as well as an outstanding commentary on the current markets.
He also made another comment that I hadn't really considered before. As the manager of the largest bond fund in the country, he says "stocks, as well as bonds, are not always fairly valued." The comment struck me because I have always thought of bonds as a known stream of payments, so given any particular yield to maturity required by investors, the price of the bond can be calculated with simple algebra. So how can a bond be overvalued? Then I realized that Gross means the same thing we do when we talk about stocks. When we talk about "overvaluation", what we are really saying is that at some point, investors will demand a higher long-term return than what the security is currently priced to deliver. So if investors, in a willingness to accept low returns for a safe haven, drive long-term Treasury yields to 4.5%, but are unlikely to actually sustain that willingness over time, Treasuries are overvalued. If they are willing to accept overly narrow risk premiums on junk bonds because other yields are low and they underestimate default risk, then junk bonds are overvalued.
In this light, the whole argument about whether stocks are overvalued or not becomes very simple. The simple fact is that if corporate earnings simply remain within the same growth channel that has held for the past century, stocks are currently priced to deliver a long-term total return of less than 7.5%. The real difference between us and those that say stocks are fairly priced, is that we don't believe that investors are actually likely to accept 7.5% long-term returns for any sustained period of time. The argument that stocks are fairly valued here is essentially an argument that 7.5% is an adequate and sustainable long-term return on stocks, which will also be acceptable to investors into the indefinite future. That's really the assumption behind the much vaunted "Fed Model."
If you believe that 7.5% is a fine long-term return, and that future investors will agree, then it makes sense to buy stocks and hold them for that 7.5% expected return. But if you believe that investors are actually likely to demand long-term returns in the 9-10% range, then stocks are about double the prices likely to deliver such returns.
As usual, however, the fact that I view stocks as overvalued does not imply that they must necessarily decline now. If the market recruits favorable trend uniformity, it will be a signal that investors are willing, at least for a time, to take stock market risk regardless of price. For now, however, trend uniformity remains unfavorable, so we have to allow for the possibility of renewed skittishness. We know exactly what has to occur to move us to a constructive position, but for now, we remain defensively positioned.
Friday Morning October 26, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable market action. On the basis of current earnings, the S&P 500 P/E ratio is close to 30, but as I've long noted, the P/E ratio is subject to uninformative surges during recessions when earnings are pressured lower. A simple and statistically preferable measure is simply the ratio of prices to prior peak earnings. On that basis, the price/peak-earnings ratio is currently 20, which is the same ratio seen prior to the 1929 and 1987 crashes. Appealing to depressed earnings is insufficient to explain away current valuation ratios.
Trend uniformity remains unfavorable here, which is a signal of underlying skittishness among investors. It is not the extent of an advance that determines trend uniformity, but the tendency of market internals to advance together. Legitimate bull moves can demonstrate this uniformity very quickly, so there is often little delay in taking a bullish position after a major low. Rallies over the past year have failed to demonstrate uniformity. Our concern is that investors may yet demand a higher risk premium on stocks (certainly the economic and domestic backdrop would make this reasonable). And with risk premiums so thin, such an increase could generate abrupt market losses. For example, to increase the yield on stocks from 1.5% to just 2%, prices would have to plunge by 25%.
In my view, there is no question that the U.S. economy is in a recession. But all we hear from security salespeople on television is talk of an impending upturn. In contrast, our own indicators are suggesting that the U.S. faces one of the worst recessions of the post WWII era. Equally important, defaults are sharply on the rise, and I expect that the main economic story in coming quarters will not be an economic rebound, but a corporate debt crisis. This is the implication of extremely high debt loads, weak balance sheets, and significant pressure on profits.
We aren't currently expecting a crash, however, because crashes have historically required not only extreme valuations and poor trend uniformity, but rising yield trends as well. Currently, yields on the S&P 500 and utilities remain in uptrends, but Treasury yields are acting well, and that mitigates the risk of a crash.
What we are left with is a Market Climate that has historically generated a poor tradeoff between return and risk, but not all-out crashes. It is a Climate that has historically included both substantial rallies and substantial declines, but a poor return on average. We make no attempt to "time" or "forecast" intermittent rallies in unfavorable Climates because, very simply, we don't believe it is possible. As I've written frequently, once we identify the Market Climate in effect, we make no attempt to forecast short-term moves within that Market Climate. That's where we differ from market timers.
It is essential to understand that distinction, because frankly, our approach will frustrate you otherwise. Our discipline is built on taking risks that are associated with a favorable expected return, and avoiding, hedging or diversifying away risks that are associated with a poor expected return. We don't have to forecast short-term market moves to accomplish that. And I honestly believe that such attempts would be futile anyway. I don't know of one investor who has built a long-term fortune through short-term timing. Investors who have built long-term fortunes, like Warren Buffett, are the ones that know when to walk away. Bear market rallies can be seductive, and they can create an urge to "play" them. We continually research new ideas, but we simply don't make investment decisions that we have no basis to believe will be profitable.
As usual, if the market recruits sufficient trend uniformity, we will move to a moderately constructive position. But we don't have sufficient evidence to take on substantial market risk here.
Tuesday Morning October 23, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable trend uniformity. That combination holds us to a defensive position for now.
One of the textbook characteristics of bear markets is that they frequently generate powerful rallies, often a result of panic buying to cover shorts in fear that the bottom has been reached. Usually, but not always, these squeezes can be distinguished from legitimate bull moves by the quality of market action. While the recent rally may prove to be legitimate, we simply don't have sufficient evidence to take on market risk here.
Moreover, we continue to see an almost pathological denial of the possibility that the economy could turn worse instead of better in the months ahead. The popular view being touted by security salespeople is that "things can't get any worse, so it's a good time to buy." As I've noted before, when a market downturn occurs in the context of a recession, the bottom has never preceded the recognition of the recession in the popular press. At this point, the media continues to view the existence of a recession only as a possibility. The October employment numbers may change that, but there is such a willingness to ignore all the recent data as an aberration that even the unemployment figures may not prompt the recognition of recession until much later. By extension, that means that the final low of this bear market most probably lies well ahead. That view doesn't drive our position, of course, but the data certainly support it.
In terms of quality, Monday's advance appeared very much like a typical bear market rally. Despite strong gains in the major indices, advancing issues outpaced declines by only 3-to-2, new lows exceeded new highs, and the utility average fell by over 1%. While the day didn't generate a deterioration in trend uniformity, it did not contribute much improvement, despite the gain in the major averages. Again, what is important is the quality of an advance, not its extent or duration. Legitimate bull moves typically recruit favorable trend uniformity very quickly. As in the April-May rally, the failure of the recent rally to do so is troubling.
As always, we'll respond to any favorable shift in trend uniformity with a constructive position, regardless of the valuation backdrop in which that uniformity may occur. It isn't necessary to second-guess or make forecasts about the recent rally - we don't yet have sufficient evidence to take market risk, and that's all we need to know. We remain defensive for now.
Sunday October 21, 2001 : Hotline Update
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The Market Climate remains characterized by unfavorable valuations and unfavorable trend uniformity. As you know, it's that unfavorable trend uniformity that makes us particularly cautious. Overvalued markets with favorable trend uniformity can remain overvalued for a great while. It's unfavorable trend uniformity that sends a signal that investors have a skittish tolerance for risk. And major market declines are driven first and foremost by an increase in the risk premium demanded on stocks. When the risk premium is thin to begin with, the resulting price declines can be spectacular. As usual, a change in trend uniformity would significantly impact our willingness to take market risk. There is no need to forecast when this might occur. We'll act immediately on sufficient evidence. For now, we remain defensive.
Apart from conveying information about the risk tolerance of investors, market action also gives considerable and early information about the economic climate. In that regard, I've noted in recent weeks that our economic indicators have essentially collapsed. What is remarkable about this is that these measures have absolutely no information that we are at war, or about any of the other uncertainties around us. Rather, the specific pattern and quality of market action is what drives the plunge in these economic readings - factors such as various interest rate spreads, the particular diffusion of commodity price changes, the action in currency markets, and so forth. Based on the information we derive from market action, I am concerned that the U.S. now faces the most severe recession in post-WWII history.
Unfortunately, this recession emerges when the U.S. is uncharacteristically burdened with low-quality debt. And it's that debt that will become the overriding financial story in the year ahead. I doubt that investors have even scratched the surface of pricing these risks into stock prices.
Over the short-term, investors are sufficiently focused on the "little picture" that the market is likely to remain very volatile, with many startlingly strong rallies within this bear market. Given the common pattern of recent Anthrax mail attacks on news bureaus, I suspect that a single terrorist is responsible and will be found, hopefully soon. That would most probably give the market cause for a sharp advance. And certainly, a resumption of favorable trend uniformity could create the prospect of a counter-trend rally within the context of an ongoing bear market. We would take a constructive position in response to such a shift. Unfortunately, the broader picture would still concern us.
From a broader perspective, I continue to view stocks as being in a bear market, and the economy as being in a recession. Both probably destined to be substantially deeper than the security salespeople featured on CNBC would have you believe. (I think "security salespeople" is a more accurate description than "analysts").
As usual, it is important to remember that trend uniformity can modify the effect of valuations on market direction. But with uniformity still unfavorable here, concerns about market valuation remain well placed.
Thursday Morning October 18, 2001 : Special Hotline Update
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The Market Climate remains characterized by extremely unfavorable valuations and unfavorable market action. There was a possibility of a favorable shift in trend uniformity as recently as last week. As I've noted many times, favorable trend uniformity is a signal that investors have developed a robust preference for stock market risk. That willingness to take risk is a psychological preference - it cannot be proven false, and it doesn't have a well-defined limit. That is why markets with favorable trend uniformity can generate strong returns even if stocks are overvalued by every objective measure. That is how stock prices reached the bubble heights of early 2000. But at bubble valuations, a loss of trend uniformity results in a very poor tradeoff between expected return and risk.
Presently, valuations remain extreme (except on invalid or poorly researched measures that we've discussed in recent weeks and over the years). At the same time, trend uniformity remains unfavorable, revealing that investors are still very skittish despite the recent bounce from deeply oversold levels. It's that underlying skittishness that concerns us. Price/volume behavior has indicated a persistence in risk aversion, even during the recent advance. That is why we remain defensive here. Our position is not about market timing or forecasting. It is driven by an identification of the current Market Climate.
As usual, we are very willing to establish a more constructive market stance if the quality of market action improves. It's that quality, not the extent or duration of an advance, that is essential.
Certainly the risks around us, both to the economy and to domestic security, make it somewhat implausible that investors will develop a very robust preference to take on risk. At this point, the recent rally appears to have been a classic bear market rally from a deeply oversold condition - similar to the rally from the March low which also failed to recruit favorable uniformity. As of last Thursday, the market had fully cleared that oversold condition and was overbought instead. In general, overbought conditions in favorable markets are followed by sideways action and then a further advance, while overbought conditions in unfavorable markets are followed by failure and vertical moves down. For now, we remain defensive, but we'll take our signals as further market action develops.
Sunday October 14, 2001 : Hotline Update
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The Market Climate is characterized by extremely unfavorable valuations and unfavorable trend uniformity. Last week's action was enough to squeeze the Market Climate out of a Crash Warning. However, there was enough deterioration even in Friday's decline to prevent the market from recruiting anything more favorable for now. As Richard Russell has pointed out, the price-volume figures (e.g. Lowry's statistics) also indicate very little abatement in selling pressure, which usually drops off very quickly in legitimate rallies. Not this time. At least, not yet.
Being off of a Crash Warning however, we are inclined to hold a very narrowly constructive position, and our current position is a modest net long bias. Our interest in such a position has nothing to do with any expectation that the market will advance from here. Rather, the only goal of a slight constructive position is to give us the reasonable expectation of gains if the market surprises us with a further advance. Since the position is only slightly constructive, we also don't have much concern if the market downtrend reasserts itself instead. In short, our overall market position is rather indifferent to what the market does next.
The most important aspect of our position (and the source of our gains over the past year) is not market direction, but the performance spread between our favored stocks and the market. Currently, we are fully invested in a diversified portfolio of favored stocks, and short a similar (though slightly smaller) dollar value in major indices such as the Russell 2000 and S&P 100. Overall market movements cause fairly little variation in that position. What matters is how our favored stocks perform relative to the market. Certainly, that relative performance is not "exciting" in the sense that we rarely see spikes where our stocks surge relative to the market on any individual day. We also rarely see the opposite. As a result, we see a rather "boring" day-to-day profile, where the overall gain or loss in our position is driven by the cumulative difference in performance between our favored stocks and the market. Boring gains are very exciting to us, particularly in a Market Climate that has historically offered an unsatisfactory average return per unit of risk. We have no interest in the excitement of "market timing" or "forecasting," particularly at present. When trend uniformity becomes broadly favorable, we'll be very willing to take a position more sensitive to market direction. But here and now, we still don't see sufficient evidence. We remain well hedged here, with a very narrowly constructive market position overall.
Finally, I appreciate all of the kind notes that readers have sent about these updates. For those of you who enjoy reading about daily market action, I also strongly encourage you to subscribe to Richard Russell's Dow Theory Letters (www.dowtheoryletters.com). We don't follow the same models, so we'll occasionally differ on market outlook, but Richard has a deep and unusual understanding of the fact that market action conveys information. There are countless analysts who focus on forecasting and predicting what the market should do next. But very few focus on identifying current market conditions, and holding a position in harmony with what the market is doing. Going with the flow, so to speak, is more effective in my view (... and for those of you aspiring to Buddhahood, it's also more Zen-like).
Friday Morning October 12, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning here, but that may change shortly. There is no question that stocks are strenuously overvalued on a long-term basis. That means that we cannot take an unhedged or aggressive stance toward the market. But there is enough of a momentum reversal in market action that we may be able to establish at least a modest exposure to market risk in the near future. That modest exposure will most likely be in the range of 20-30% of portfolio value. Unfortunately, we still do not see evidence of favorable trend uniformity that would allow us to take a stronger market position.
I doubt that stocks will go significantly higher without retesting the recent lows to some degree. Certainly the record of prior bear markets and crashes makes us alert to the possibility of a second dip lower. The most likely interpretation of this rally is that it is either a false rally destined for a quick whipsaw, or it is a bear market rally is destined to last several months. I doubt very much that stocks are in a new bull market. But we are not market timers and we don't act on forecasts. We act on evidence. Right now, it appears that we will have enough evidence to take a very modest constructive position. But, a very bad market decline on Friday could remove our willingness to take a constructive position at all. Friday is important in that regard.
On a short term basis, the market is strenuously overbought. That creates an apparent difficulty - how can we increase our market position on the basis of favorable action when it would require us to buy into an overextended rally? The difficulty is actually fairly small in practice, and those of you who are familiar with my methods will see the solution immediately: Make 40% of the required shift immediately. As I have written frequently, when new evidence dictates that your target position is different from your current one, the most important thing to do is to act immediately. Do 40% of the change right away, and work the balance as the market offers appropriate opportunities.
This is where many investors blow themselves up. Over the past year, for example, countless investors realized that they were recklessly overweighted in technology stocks. They knew that they needed to make a change, but they were paralyzed by the fact that these stocks were already down. Instead of acting immediately to put their portfolios back in line, they relied on hope. They told themselves that they would sell if the market got back to the old highs. Then after prices declined dramatically, they told themselves they would sell on the next big rally. Then when the big rally came, they convinced themselves that things were coming back and ignored the fact that their portfolios were still misallocated. In the end, these investors were wiped out by the combination of inaction, hope, fear of regret, and a desire to forecast rather than act on evidence.
Again, anytime it becomes clear that you should change your investment position and market conditions do not seem to favor doing the entire change, do 40%, and do it immediately. I call it "locking in an acceptable level of regret." For instance, if you realize you have to sell a position in a down market, you pull the trigger on 40% immediately. If the market goes back up, you'll regret having sold that 40%, but you still have the majority of your position. If the market plunges further, you'll regret not having sold everything, but at least your regret is acceptable. What you never want is to leave yourself open to unacceptable regret because you fear being wrong. The way to avoid that is to lock in acceptable regret by acting immediately, then working the rest of the position as opportunities arise.
In short, while valuations and broad trend uniformity remain negative, one of our narrower but important measures of market action is likely to turn favorable here. If that occurs, it will prompt us to take a modestly constructive position by removing a portion of our hedges, which would leave somewhere close to 20-30% of our portfolio unhedged. Certainly not an aggressive position, but at least modestly constructive.
As for the timing of this, it is not essential to make the full extent of the change immediately, particularly given an overbought market, but it is absolutely essential to act. The market does not always accommodate us with positive signals at the precise lows, or with negative signals at the precise highs. But what separates our approach from many others is disciplined action on evidence. Currently, the immediate action amounts to taking a net long position somewhere in the range of 8-12% of portfolio value, with the remainder executed as the market offers appropriate opportunities. That's not enough to cause any regret if the market plunges again, but it's enough to get the ball rolling.
For those of you who have become familiar with my 40% rule, it should be clear now that I actually follow it in practice. Indeed, those investors who are still overweighted in stocks or technology should calculate exactly how much they would have to sell in order to have an appropriately positioned portfolio, and make at least 40% of those sales immediately as well. In other words, even as we do a little buying in order to take a modest net long position, overinvested speculators would do well to execute 40% of their targeted sales here. As always, investing is not only about expected return. It is also about taking appropriate risks.
Currently, valuations remain extreme, the economy is most probably in the early part of a recession, and stocks are most probably in a secular bear market. An aggressive or unhedged position in stocks is not an appropriate risk. However, it appears that we may have enough evidence to take a modest exposure to market risk in the near future, in the context of what seems to be a counter-trend rally within a bear market. The key word is modest, and it is the very limited nature of that risk that makes it appropriate.
Thursday Morning October 11, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. The action of the market over the next two trading days will be important. While the market is now overbought on a technical basis, and our broad measure of trend uniformity remains clearly unfavorable, a strong showing for market breadth this week would be a favorable development. A broad lead of advancing issues over decliners would be enough of a reversal in momentum to allow us to remove somewhere in the range of 20% to 35% of our hedges. Certainly even that would not put us in an aggressive position, but it would be enough to give us a positive exposure to market fluctuations, and a tendency to move somewhat more with the market. We would require still broader trend uniformity to reduce our hedges further, but in any event, I do not expect that we would remove more than half of our hedges even if trend uniformity was to become quite favorable. Valuations are simply too hostile, and there are too many risks, economic and otherwise, to warrant an unhedged position.
For now, however, both valuations and trend uniformity remain unfavorable, and we remain defensive.. I continue to view stocks as being in an ongoing bear market within the context of a recession that will be worse than average. Interestingly, Warren Buffett recently wrote to Berkshire Hathaway management "I’m sure we are in a recession, probably a relatively deep and extended one." So even if I don't have much company in my assessment of the economy, I am very comfortable with the company I do have.
A shift in trend uniformity, if it occurs, will give us the opportunity to take a modest amount of market risk. We never need or try to predict whether a favorable trend shift is a whipsaw that will be reversed, a short-term counter-trend rally or the start of a new bull market. When trend uniformity is positive, we try to hold a constructive position until the next reversal. That said, I strongly doubt that a favorable shift would be anything other than a counter-trend rally within a bear market, and I strongly doubt that this bear market will end except at much lower levels. Again, however, we remain in a negative trend condition for now, and the market is overbought. Market action over next few days should be informative.
Sunday October 7, 2001 : Hotline Update
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The Market Climate remains on a Crash Warning here. That could change if the market is able to demonstrate further broad strength in the days ahead. Unfortunately, though last week's action showed very early signs of improvement in trend uniformity, I have considerable doubt that we will see sufficient follow-through. Even here, with uncertainty about recent military actions abounding, we will adhere to our discipline. If the market recruits sufficiently positive trend uniformity, it would be a signal that investors have developed a robust preference to take on market risk. We would move to a moderately (but not aggressively) constructive position in response. As always, we will act on evidence about the prevailing Market Climate, not anybody's forecast or opinion, including my own.
That said, my personal opinion is that the market hates uncertainty, and that favorable trend uniformity will be difficult to recruit here. Unlike the initial strike of the Gulf War, which dramatically alleviated uncertainty, the current situation offers no such quick resolution.
A couple of weeks ago, a high-ranking friend in the military told me he was concerned that Americans were treating the September 11th attacks as if they were a hurricane or an earthquake that had a well-defined ending. As he put it, "This is the beginning of the beginning." The uncertainty here is not simply when the Taliban will fall, or whether bin Laden will be located and punished. The uncertainty is about resolution of this terror. We cannot be naive enough to believe that all will be resolved if bin Laden is destroyed. Fanatics extol their leaders, and few religions share the pacifism of Buddhism or the forgiveness of Christianity. Much of the middle-east believes in an eye for an eye, and fanaticism blurs the distinction between justice and murder, between enemies and innocents.
To eliminate the disease you have to understand it. The most chilling thing about bin Laden is that he sees himself as righteous. The greatest evil is often done by people who see themselves as avengers for some perceived injustice. Timothy McVeigh comes to mind, bombing the Oklahoma City Federal Building exactly two years after the Waco tragedy. But unlike McVeigh, who was a single individual, bin Laden is surrounded by like-minded fanatics.
Eliminating fanatics like bin Laden will not be enough unless we also deal with the perceived injustice, which is evidently the occupation of Palestine and our military presence in Saudi Arabia. By standing on such issues, and calling this a Holy War, bin Laden hopes to co-opt support from others on the same political side and indeed from an entire religion. The U.S. can tear such support from bin Laden by fully engaging the Middle-east peace process (in which the U.S. has refocused its efforts) even as it battles terrorism.
All justice requires the question "To what is each side entitled?" The U.S., Israel, and other people of the Middle-east are each entitled to security, peace, and self-determination. Criminals are entitled to punishment. But we have to distinguish the criminals carefully. Justice requires us to make such distinctions, and to judge fairly. The resolution of this terror depends on it.
Some might see heightened consideration of Middle-east peace here as a concession to terrorism, just as some people evidently see humanitarian aid to Afghans as "rewarding the enemy." But justice, humanity and alleviation of suffering are never concessions. I have no doubt that the U.S. will prevail, but we have to accept that resolution may not be quick, and that it will require as much virtue as force. George Bush is showing himself to be a fine President on both counts. For those of you who have asked, that's my opinion about recent events.
As for our investment position, we remain defensive. Any move to favorable trend uniformity in the near future would require positive performance in the broad market over the coming week. There's a possibility that we may see a somewhat patriotic rally at some point here, but as I've said, the markets tend to dislike uncertainty. For that reason, I question the likelihood of a favorable trend shift. In any event, we'll let the markets sort it out, and we will act as the evidence presents itself.
With prayers for the men and women in our military. May God bless America.
Thursday Morning October 4, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning here, and we remain defensively positioned for now. That said, Wednesday's action was one of the best examples of favorable trend uniformity we've seen in a long time. In order for the market to gain a firm footing, we need to see a continuation of that sort of quality. Given that a furious bear market rally has been long overdue from the oversold condition of the market, my interpretation of Wednesday's action is that it was more reflective of a concerted short-squeeze than it was of an important reversal. But the action was at least encouraging. In any event, we still don't have enough evidence of a favorable shift in trend uniformity. I am somewhat skeptical that we'll get it, but as always, my opinions do not drive our investment position. We'll shift our position quickly if sufficient evidence emerges. For now, the evidence holds us to a Crash Warning.
The government is pulling out all the stops in fighting this economic downturn, which I continue to believe will be a deeper than average recession. I received several questions on Wednesday asking whether I thought the government stimulus would be enough prevent a recession. Which is kind of like asking Columbus whether he thinks the trees at the edge of the earth are maple trees or pines. I don't even agree with the premise of the question.
If I can offer any faint praise for the plan, at least it focuses on tax reduction rather than spending increase to achieve deficit spending. Statistically, increases in government spending lack any kind of Keynesian "multiplier" effect. To the contrary, there is nearly zero statistical correlation between shifts in government spending and shifts in GDP, either currently or subsequently. For a given increment to spending, the largest kick always come from consumption or investment. Government spending is statistically sterile. On the other hand, tax reductions do have some effect on consumption and investment, and it is through this route that they have any hope at all of stimulating the economy. Unfortunately, the statistical effect is again very weak. The tax shifts that have the strongest effect tend to be those that shift incentives such as changes in capital gains taxes and marginal income tax rates, rather than lump-sum tax cuts. Unfortunately, it is the lump-sum type that the government tried this summer to no avail, and will largely expand upon. There is little chance that the Democrats would sign onto broad measures to eliminate capital gains taxes and cut marginal income tax rates.
So we are left with a "stimulus package" that will largely focus on lump sum transfers to "prime the pump" by "putting money into the hands of businesses and consumers" (my fingers actually made little choking and gagging noises as I typed those phrases). To see why there is little hope for such a plan, we have to go back to the concept of equilibrium - the notion that every security issued must also be held. Here we have a downturn in which businesses have dramatically scaled back capital spending (beginning long before Sept 11) and consumers are in the process of scaling back purchases. Both are saddled with unusually large debt burdens. Now, suppose the government cuts taxes and sends out some tax rebates. Simultaneously, the government must borrow more (or retire less debt than it otherwise would have). Somebody must hold those bonds in equilibrium. Most likely what happens, in aggregate, is that individuals use their tax rebates to buy the newly issued Treasury bonds.
In my view, there is only one situation in which government or Fed actions can stimulate economic activity. That is when government actions relax constraints that consumers or businesses faced in the absence of those actions. For instance, in a banking system where borrowers are very eager but banks are constrained by a lack of liquidity, a Fed easing has the potential to increase bank lending and economic activity. It's not the easing per se that does the trick in this case, but the fact that the easing helps to eliminate a liquidity constraint that was holding the economy back. Similarly, if consumers and businesses were very eager to increase spending, but their budgets didn't allow it and their ability to borrow was constrained, then a tax reduction could ease that budget constraint and lead to greater economic activity.
The problem here is that businesses and consumers aren't constrained. They are choosing to limit their spending. Similarly, banks aren't constrained by a lack of liquidity. Bank lending is weak because borrowers are choosing to take on less debt and banks are choosing to take fewer new credit risks. In this kind of environment, shifts in government fiscal or monetary policy are a wash, because government is, in aggregate, a zero-sum game. It only gives with one hand by taking with the other. Fiscal policy can reduce taxes only by issuing more Treasury bonds. Meanwhile, monetary policy simply substitutes one type of government liability - Treasury bonds - with another government liability - monetary base.
Whatever the size of the "stimulus package" here, the difficulty is quite simple. It will have little impact on incentives and it will have little impact on constraints. The most stimulative tax changes are also the most partisan, and are unlikely to pass Congress. Meanwhile, the amount of telecom debt alone that is likely to be downgraded by Moody's in the next week will nearly equal the size of the entire stimulus package.
With regard to the near term, as I noted on Sunday, I expect most of the impact of last month's tragedy to show up in the October employment report due next month, not Friday's report. The same applies to figures such as consumer confidence and the NAPM surveys. The market still has somewhat more room to rally in order to clear the deeply oversold status of recent weeks, so a further rally wouldn't be a surprise on the heels of "better than expected" economic data. Against that, we have third quarter earnings which will begin to emerge about mid-October. So while there is some prospect of a further bounce here, there is more vulnerability possible even a couple of weeks from now. As usual, we need not speculate on these possibilities. The Market Climate remains defensive for now, and we will shift that position when and if sufficient evidence emerges.
Wednesday Morning October 3, 2001 : Special Hotline Update
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The Market Climate remains on a Crash Warning here, reflecting the combination of unfavorable valuations, unfavorable trend uniformity, and hostile yield trends.
I've written at length about valuations lately. It is important to understand that when analysts say that stocks are "undervalued", they are basing that evaluation on two things: expectations for improbably strong earnings growth over the coming year (in the 30-50% range), and the assumption that investors are willing to accept a long-term rate of return equal to the 10-year Treasury yield plus a thin risk premium (implying a long-term total return on stocks amounting to something close to 7%). If either of those two assumptions is relaxed, the "undervaluation" argument vanishes.
Essentially, there are two meanings to the phrase "fair value." When I talk about fair value, I mean the level of stock prices which, under historically reasonable assumptions about future earnings growth, would deliver a long-term return in the range of 9-12% (depending modestly on the level of interest rates, but not so much that tiny interest rate changes would imply major stock price adjustments). When many other analysts talk about fair value, they mean the level of stock prices that pops out of a simple and often arbitrary model, assuming any arbitrarily high growth rate of earnings and any arbitrarily low long-term return that occurs to them depending on what they had for breakfast.
Believe me, they can be as irresponsible about these assumptions as they like. If they pick a long-term rate of return on stocks close enough to the long-term rate of earnings growth, lo and behold, the fair value of stocks effectively becomes infinite. (e.g. Long term return on stocks = Dividend yield + long term growth rate of earnings. So k = D/P + g. So P = D/k-g. Choose k = g. Party on). Unfortunately, those assumptions also typically imply disastrous price declines in response to tiny increases in the long-term rate of return. As I've noted before, Glassman and Hassett's Dow 36000 idiocy implies that stocks would fall by half in response to a tiny 1% increase in interest rates (quite apart from their further idiotic notion that earnings can grow over the infinite future with absolutely no investment in new capital).
With regard to trend uniformity, it remains negative, but we are always sensitive to changes in this status. It is crucial to understand that trend uniformity is not based on the extent or duration of a market advance. Rather, trend uniformity measures the quality of an advance. Without disclosing anything proprietary, trend uniformity considers the market action of a wide range of market internals, industry groups, and security types. Most legitimate and sustained bull moves very quickly generate trend uniformity, which I interpret as a signal that investors have developed a robust preference for taking risk. Some advances never generate this, as we saw between March and May this year. Those rallies are suspect, because there is a skittishness underlying them. When you have unfavorable trend uniformity in an overvalued market, the situation is very vulnerable because there is no natural floor to support prices. Again though, trend uniformity can change quickly, and we always allow for the possibility of a sudden shift.
As for yield trends, they remain hostile. Certainly short term Treasury yields are acting "well", but corporate yields are actually rising, utility yields are surging (generally a bad sign), and important yield spreads are behaving badly. The two most striking include the widening "credit spread" between corporate and Treasury yields, which suggests increasing risk of corporate defaults, and the narrowing "real spread" between short-term yields and inflation. Real short-term interest rates (nominal yield minus inflation) are now negative. In both historical and international data, negative real rates herald poor economic growth ahead. And such signals need not be due to high inflation, as Japan found over the past decade.
In short, we have no evidence upon which to shift to a constructive position yet. We're very sensitive to the possibility of a change in trend uniformity, but we don't second-guess or speculate on what shifts may or may not occur. We simply identify the prevailing climate. For now, that climate remains hostile, and we remain defensive.
| Past performance does not ensure future results, and there is no assurance that the Hussman Funds will achieve their investment objectives. An investor's shares, when redeemed, may be worth more or less than their original cost. Investors should consider the investment objectives, risks, and charges and expenses of the Funds carefully before investing. For this and other information, please obtain a Prospectus and read it carefully. The Hussman Funds have the ability to vary their exposure to market fluctuations depending on overall market conditions, and they may not track movements in the overall stock and bond markets, particularly over the short-term. While the intent of this strategy is long-term capital appreciation, total return, and protection of capital, the investment return and principal value of each Fund may fluctuate or deviate from overall market returns to a greater degree than other funds that do not employ these strategies. For example, if a Fund has taken a defensive posture and the market advances, the return to investors will be lower than if the portfolio had not been defensive. Alternatively, if a Fund has taken an aggressive posture, a market decline will magnify the Fund's investment losses. The Distributor of the Hussman Funds is Ultimus Fund Distributors, LLC., 225 Pictoria Drive, Suite 450, Cincinnati, OH, 45246.
The Hussman Strategic Growth Fund has the ability to hedge market risk by selling short major market indices in an amount up to, but not exceeding, the value of its stock holdings. The Fund also has the ability to leverage the amount of stock it controls to as much as 1 1/2 times the value of net assets, by investing a limited percentage of assets in call options. The Hussman Strategic Total Return Fund has the ability to hedge the interest rate risk of its portfolio in an amount up to, but not exceeding, the value of its fixed income holdings. The Fund also has the ability to increase the interest rate exposure of its portfolio through limited purchases of Treasury zero-coupon securities and STRIPS. The Fund may also invest up to 30% of assets in alternatives to the U.S. fixed income market, including foreign government bonds, utility stocks, and precious metals shares. The Market Climate is not a formula but a method of analysis. The term "Market Climate" and the graphics used to represent it are service marks of the Hussman Funds. The investment manager has sole discretion in the measurement and interpretation of market conditions. Except for articles hosted from the web domains hussman.net or hussmanfunds.com, linked articles do not necessarily reflect the investment position of the Funds. |