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 March 31, 2002 : Hotline Update
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The Market Climate remains on a Warning here. There are a number of competing aspects of market action here. Barring fresh breakdowns in other market internals, an advance of just over 4% in the S&P 500 on a weekly closing basis would be enough to shift our measures of trend uniformity to a positive condition. But a further decline of less than 2% in the corporate bond market would represent a fresh breakdown. If that were to happen, we would need S&P strength to be confirmed by other action, particularly other measures of risk-premiums. So again, too many cross-currents to make any forecast about the future Market Climate, even a few weeks out.
For now, however, all of that is irrelevant. The present, identifiable Market Climate is negative, and that is sufficient to place us in a defensive, fully-hedged position.
As always, our defensive position should not be interpreted as a bearish forecast. Our position is not driven by a forecast of the future but by the identification of the present. To understand this, you have to understand that we typically measure the Market Climate weekly (though we'll move intra-week if compelling reasons exist). We have no forecast about how long the current Market Climate will remain in effect, or when it will shift. It's quite possible that we could be in a constructive Climate even a few weeks from now. But with the current Climate being the most negative one we identify, it's also possible that the market could plunge. So it makes no sense to forecast where the market might be say, 3 months or 6 months into the future, because we don't know whether a new Climate will be operative at that point, or how strongly the current one will express itself.
Indeed, since we measure the Climate weekly, the only time frame over which we might be considered to be "forecasting" is the coming week. But over that short a period, the random "noise" in market action overwhelms the average weekly return. For instance, in the present Climate, stocks have declined at an annualized rate of more than -15%. But since we make no forecast that the Climate will actually remain negative for an entire year, that -15% can't actually be taken as a forecast of what we expect over the next year. At the same time, a -15% annualized decline works out to just -0.3% per week. But since the standard volatility of the market is easily 2.0% on a weekly basis, the magnitude of any decline we might "expect" for the coming week is completely insignificant on a statistical basis.
So we are left with a very specific investment position, yet one that requires no forecasting. Once you invest on a forecast, everything becomes attached to whether or not that particular scenario will come true. The market becomes a roller coaster of emotion, hope, elation and despair. But none of this is necessary. All that is required is a set of tools to evaluate the present, and then to take opportunities as they arrive.
Certainly, no tools are perfect. Even last year, we discovered new tools that allowed us to re-classify a small but important set of historical observations from "unfavorable" to "favorable", based on breadth momentum and interest rate trends. Those new tools are exciting because they may help us to participate more fully in early bull market rallies, as well as brief but powerful bear market rebounds. We constantly try to improve our tools by applying careful theory to a well of historical data. But the goal of these tools is not to forecast the future. The goal is to better identify present conditions.
As the Zen teacher Thich Nhat Hanh writes, "The best way of preparing for the future is to take good care of the present, because we know that if the present is made up of the past, then the future will be made up of the present. All we need to be responsible for is the present moment. Only the present is within our reach. To care for the present is to care for the future."
Tuesday Morning March 26, 2002 : Special Hotline Update
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The Market Climate remains on a Warning condition for now. Clearly, not much has changed since Sunday's update, but there are two features of market action that warrant attention.
First, sentiment continues at an extreme level of bullish complacency, which is typically an unfavorable sign in overvalued markets lacking favorable trend uniformity. The Investors Intelligence percentage of bearish investment advisors is back below the important 30% level, while the AAII investor sentiment survey reports just 11% of individual investors are bearish here. Meanwhile, the CBOE volatility index (which measures option premium costs and is a very good intermediate-term indicator) remains at an uncharacteristically low 20% reading, with virtually no increase during the recent selloff. Typically, important intermediate lows are accompanied by a significant spike in the VIX. In short, taking the sentiment indicators together with the combination of overvaluation and unfavorable trend uniformity, we have absolutely no inclination to expose ourselves to market risk at present. Our fully invested stock portfolio remains fully hedged with an offsetting short position in the Russell 2000 and S&P 100 indices.
Second, a few of the breadth (advance/decline) indicators are looking somewhat oversold. But I believe that this could be misleading. When we look across the various industry groups, the only ones that have corrected measurably from their highs are cyclicals, telecom, transportation stocks, and to a lesser extent, forest/paper. And even these are not particularly oversold. By and large, the remaining industry groups are still overbought and uncorrected. So the weakness in breadth reflects downside uniformity in this selloff, rather than a broadly overextended selloff. Such a condition does little to limit the potential downside follow-through. In the context of complacent sentiment, spiking interest rates, rising energy prices and the most negative Market Climate we identify, I continue to take that potential seriously.
That's not a forecast, but we're clearly comfortable with a fully hedged stance here.
Sunday March 24, 2002 : Hotline Update
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The Market Climate remains on a Warning condition. We remain fully invested in favored stocks, and those holdings remain fully hedged with an offsetting short-sale in the Russell 2000 and S&P 100 indices. There is no forecast implied by this position. Our current stance is based on the currently identified Market Climate. Although the average return to stocks has been poor in the current Climate, we certainly don't narrow that into an expectation of where the market will move on any particular day or week. Though we are willing to respond to mid-week market action if necessary, our identification of the Market Climate is generally based on weekly closing market data. So nearly every shift in the Market Climate can be traced to a single week of market action which tips the scales.
That leaves us with a perspective that may seem odd. We are willing to take strong stances, both defensive and aggressive, with regard to market risk. Yet except when the market is strenuously overbought in a negative Climate, or deeply oversold in a positive one, we rarely have any forecast at all about the market outlook even a few days or weeks out. Our current defensiveness (fully hedged) is not a forecast of market action, but an identification of the prevailing Climate at this moment. To ask "Where do you think the market is going?" (as we are often asked in media interviews) is to invite frustration. It's like asking Columbus whether he thinks the trees at the edge of the earth are maples or pines. We just don't look at the world that way.
Now, my long-term view is a different story, because ultimately, the long-term return on stocks is tightly linked to valuations. I have a great deal of confidence that the S&P 500 will deliver a very unsatisfactory return over the coming decade. It's difficult to get around this conclusion without making assumptions that are both implausible and inconsistent with all historical experience.
Shorter term, I have literally no view at all about where the market will move over the next week, month, or year. In fact, I don't believe that the attempt to forecast these shorter term returns would be of any benefit at all to our portfolio management. Though we're fully hedged at present, even a good week or two of market action could move our measures of trend uniformity to a constructive position, and we would immediately lift a portion of our hedges in response. Such a move would not be a forecast of further gains, but a response to a different Market Climate, which would remain appropriate until the next shift (which might occur a week, a month, or a year later).
In short, I have no forecast of where the market is going. Such forecasts are completely irrelevant to our investment management. What is relevant, from our discipline, is that the current Climate is the most negative one we identify. That might change next week, or it might not change for a year. There is no need to forecast when the next shift will occur. For now, we remain strongly defensive.
In his latest message to shareholders of Berkshire Hathaway, Warren Buffett makes a number of comments worth repeating.
First, he writes at length about the insurance business, making an extensive distinction between "exposure" and "experience." When an insurance company writes a policy, it often bases the policy and premiums on its historical experience of losses in that area. This is often a terrible mistake. Buffett notes, for example, that late in a boom, the experience of corporate defaults and lawsuits is generally very low, but this can often be the time when exposure to such risk is the highest. The low incidence of shareholder lawsuits may cause insurers to ignore the risks of insuring the errors and omissions of corporate boards, and may encourage financial institutions to lend money to marginal borrowers that are bad credit risks.
Though Buffett's comments were in regard to insurance, I kept thinking about all of these poor buy-and-hold investors whose experience over the past 20 years has been of short, shallow bear markets. They easily equate the prospect of a bounce in the economy with the prospect of recovering all of their losses and moving to new highs. Yet particularly with trend uniformity unfavorable, they fail to grasp the precarious exposure to risk that underlies current valuation extremes.
Of course, Buffett also made several direct remarks about stocks. Here, he made a distinction between good businesses and good investments - a distinction that still seems to be unclear to most investors:
"Charlie [Munger] and I still like the basic businesses of all the companies we own. But we do not believe Berkshire's equity holdings as a group are undervalued."
"Our restrained enthusiasm for these securities is matched by decidedly lukewarm feelings about the prospects for stocks in general over the next decade or so. I expressed my views about equity returns in a speech I gave at an Allen and Company meeting in July (which was a follow-up to a similar presentation I had made two years earlier) and an edited version of my comments appeared in a December 10th Fortune article. I'm enclosing a copy of that article. You can also view the Fortune version of my 1999 talk at our website www.berkshirehathaway.com."
"Charlie and I believe that American business will do fine over time but think that today's equity prices presage only moderate returns for investors. The market outperformed business for a very long period, and that phenomenon had to end. A market that no more than parallels business progress, however, is likely to leave many investors disappointed, particularly those relatively new to the game."
As I noted last week, we don't necessarily have much company in our view of the markets, but the company we keep is good.
A comment about Bill Gross' criticisms of General Electric last week. Gross asserted that GE achieves much of its growth through acquisitions of low P/E companies using its high P/E stock. While this is a typical strategy for "manufacturing" growth, GE itself generally does not make its acquisitions with stock (as evidenced by a slightly declining number of shares outstanding over time). Nevertheless, Gross is precisely on the mark in his criticism of GE's "growth." Whether or not stock is used as the "currency" for acquisitions, it is always true that acquisitions boost earnings in proportion to the earnings yield of the acquired company.
The GE strategy of acquiring hundreds of low P/E, high-earnings-yield companies is highly accretive to earnings per share. Only a combination of ignorance and alchemy would reward this higher level of earnings with a high P/E, when the source of the earnings was the acquisition of companies valued at low P/Es. Growth manufactured through acquisitions simply does not deserve a premium valuation, which is clear when you do a discounted cash flow analysis. Ultimately, investors have learned this lesson again and again in history. I doubt that Gross has any intent to "pick a fight" with GE. He's simply trying to save investors from the brutal consequences of learning the hard way. Both his remarks and his intentions are worthy of respect.
Thursday Morning March 21, 2002 : Special Hotline Update
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The Market Climate remains on a Warning condition. In recent weeks, we've asked very little of the market in order to shift to favorable trend uniformity - all that would currently be required is an advance of about 4% in the S&P 500 Index on a weekly closing basis, without fresh breakdowns in other market internals. So far, no such rally, but we are close to fresh breakdowns, specifically in Treasury and corporate bonds.
Market technician Larry Williams has a name for a market in which bond prices drop and stock prices rise, creating a wide gap. He calls it "the jaws of death" - largely because those jaws have a tendency to snap shut, usually by a downward adjustment in stock prices.
In any event, we continue to lack the favorable trend uniformity that would convince us that market risk has at least moderate speculative merit. For now, we remain fully hedged.
Our approach has something of a learning curve, because it's unique. Why, for instance, should we focus so singularly on two factors - valuation and trend uniformity? The answer is that valuation and trend uniformity are not just arbitrary features of the market. These dimensions are important because they define investment returns. See, the total return on stocks is driven by two pieces - the level of yields, and the trend of yields (i.e. falling yields imply rising prices). The level of yield is "value", and the direction of yields is "trend." So the breakdown of market conditions across those two dimensions is intimately linked to the definition of total return.
But where does this notion of "trend uniformity" come from? Why not define "trends" by comparing the yield (or level) of the S&P to some moving average, and be done with it? The reason, as I have noted before, is that you can only read "information" out of prices if you have more than one price to look at. It's the uniformity (or lacking that, the divergence) of action across investment vehicles that conveys information about what other traders know, and about their risk preferences.
Beneath all of the mathematics, bells and whistles that we use to derive our models are basic investment truths that have been effective as long as markets have existed. For example, Dow Theory is essentially a theory of trend uniformity, and also pays great attention to values. This is one of the reasons I respect Richard Russell www.dowtheoryletters.com. He is one of the few analysts that makes an attempt to "read" the averages, and is a careful interpreter of Dow Theory. The tools and methods of Dow Theory differ greatly from our own, and those differences lead to market interpretations that will not always agree, but reduced to its core, the focus of Dow Theory focus is the same as mine - valuation, and trend uniformity.
Consider the words of Robert Rhea, one of the early Dow Theorists of the 1930's:
"The movements of both the Railroad and Industrial stock averages should always be considered together. The movement of one price average must be confirmed by the other before reliable inferences may be drawn. Conclusions based on the movement of one average, unconfirmed by the other, are almost certain to prove misleading."
"The most useful part of Dow Theory, and the part that must never be forgotten for even a day, is the fact that no price movement is worthy of consideration unless the movement is confirmed by both averages. Many who claim an understanding of the Theory consider only the movements of the Industrial stock average if they happen to be trading in industrials. Some even chart only the one average and profess to be able to interpret the movements correctly. It is true that there are times when such conclusions seem justified, but over any extended period such procedure inevitably results in disaster."
As for what I call "unfavorable trend uniformity", Rhea wrote long ago: "When the Averages disagree, it’s usually a sign of distribution." On that front, I should note that Richard Russell has been writing about the failure of the Transports to confirm the recent highs in the Dow Industrials - a fact that is not outright bearish, but is certainly a concern.
In short, our focus on valuation and trend uniformity is not arbitrary, but driven precisely by the factors that define total return. Meanwhile, our emphasis on uniformity of market action, rather than attention to the large-cap indices, is built on principles that have been used by successful investors, in various forms, since the markets began.
With the majority of investment managers and analysts bullish and optimistic, we don't keep much company these days. But the company we keep is good, including Warren Buffett and most recently, Bill Gross of PIMCO (manager of the country's largest bond fund). In his latest update, he comments about General Electric, noting:
"It grows earnings not so much by the brilliance of management or the diversity of their operations, as Welch and Immelt claim, but through the acquisition of companies (more than 100 companies in each of the last five years) using high-powered, high P/E multiple GE stock or cheap near Treasury Bill yielding commercial paper. In the use of that CP, GE Capital is using near hedge fund leverage of 7-8 times at what appears to be (based on its Aaa rating) non-hedge fund risk... Without the benefit of this leverage afforded to them by the Street, their operations to me resemble more closely the failed conglomerates of yesteryear such as Gulf + Western and LTV. PIMCO will own no GE commercial paper in the foreseeable future."
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The bottom line is simple. The Market Climate remains hostile here, and we remain fully hedged. We'll promptly reduce the extent of our hedging if the market exhibits evidence of favorable trend uniformity. Until that occurs, however, we remain on a Warning condition. Our approach does not distinguish current market conditions from those that existed prior to every historical crash of note. That's not a forecast, but it is a statement that market risk has neither investment merit nor speculative merit at present.
Sunday March 17, 2002 : Hotline Update
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The Market Climate remains on a Warning condition here. At this point, the easiest way to recruit favorable trend uniformity would be a further advance in the S&P 500 of about 4% on a weekly closing basis, without any fresh breakdowns in other market internals. The selloff in bonds continues to be threatening on that score. The S&P remains below its level of late December, when the market lost its favorable breadth momentum on our measures. Again, a favorable shift in trend uniformity would not make stocks a good value or investment, but it would create enough speculative merit to move us to a moderately less hedged stance. For now, our stock holdings remain fully hedged.
I want to emphasize that despite my criticism of measures such as operating earnings, and my view that stocks are strenuously overvalued, there remain a large number of stocks that I believe are quite attractive so long as we can hedge away their market risk. When we are fully hedged, as we are at present (and provided that our long-put/short-call option combinations have identical strike-prices and expirations), the source of our returns is the performance of our favored stocks relative to the indices which we use to hedge. If our favored stocks outperform the indices, either by rising more or by falling less, we enjoy positive returns regardless of the direction of the market. Conversely, during occasional periods that our stocks lag the market, either by rising less or by falling more, we can experience negative returns. In short, my skepticism about operating earnings and market valuations does not imply that the markets are devoid of opportunities. We continue to find many risks that appear well worth taking, as long as we can hedge away those risks that are not.
Last week, investors took heart from a surge in industrial production. Unfortunately, there is still little evidence that the increase in production represents something other than inventory rebuilding. More importantly though, capacity utilization showed virtually no improvement, rising to just 74.8% from the January low of 74.4%. If the economy is indeed in a sustainable recovery, this figure should surge well above 82% in short order over the next few months. Something to watch.
I am certainly hopeful for a stronger U.S. economy, but I am not a fan of encouraging a further expansion in low-quality debt to achieve that end. It would be far better for long-term U.S. growth for the financial markets to allocate capital properly. But capital is allocated based on price signals given by the markets. When those price signals are distorted, so is the capital allocation. This is evidenced by the internet bubble, which essentially sent years of personal and business saving up in flames. A misvalued stock market is a poor allocator of capital. So ironically, the attempt to expand lending and support the markets with easy monetary policy and cheerful economic forecasts is the last thing that will produce long-term economic stability.
It's just an unfortunate situation, because the party is over, and the piper still has not been paid. It is wishful thinking to imagine that the most extreme economic, debt and investment bubble in history was corrected by a mild economic downturn, a market decline that leaves stocks at 21 times peak earnings (higher than at the 1929 and 1987 peaks), and just a few large-scale defaults from a corporate debt position which continues to claim a record share of operating earnings to finance.
In any event, the major indices continue to lack investment merit, and we continue to require more evidence of speculative merit before removing even a portion of our hedges. We continue to be defensive here.
Oh, I used to buy for dividends, when I was just a lad
and then I bought for growth, and for a while I was glad
and then the Nasdaq wiped me out for seventy percent
and now I'm running like the wind, all the way to Ireland
trying to catch a Leprechaun, and that's what I'm determined on
Cause - if - I could just get that magic shillelagh
I'd make Cisco go back to eighty-two
I'd drive my Enron to the sky, sell my Lucent at its high
I'd recoup my investment on Sun Micro and Yahoo
Oh, if I could just get that magic shillelagh
I could buy a drink and watch CNBC
But if I can't catch that Leprechaun, all that I'll be counting on
is the monthly check from my Social Security.
The meter doesn't look right until you hear it...
Thursday Morning March 14, 2002 : Special Hotline Update
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The Market Climate remains on a Warning condition for stocks. The weak retail sales figure was the first significant piece of data contradicting the view of a rapidly rebounding economy. My impression is that much of the activity in new orders reflects inventory building rather than final demand, and weak retail sales are consistent with that. In any event, as I noted on Sunday, the main figures to watch in the upcoming months will be capacity utilization on the capital side, and the Help Wanted Index on the employment side. Those figures ought to spike higher if the economy has entered a sustainable rebound. Otherwise, we may very well see a fresh downturn within a few quarters, as the U.S. economy experienced after the remarkably short 1980 recession.
Of course, there are increasing arguments that the U.S. was never in a recession in the first place. These arguments derive from the false belief that a recession is defined as two quarters of negative GDP growth. It will not be clear until several years of revisions whether GDP actually did so last year. But recessions are not defined this way in the first place. On the basis of monthly data relating to a decline in broad economic activity, it's clear that the NBER applied its criteria consistently. Dr. Robert Hall, the Chairman of the Business Cycle Dating Committee, responds to the growing arguments unequivocally: "With respect to the past year, we believe that there has unquestionably been a recession." He also notes that the consumption of services has grown more weakly than goods consumption in recent months, suggesting that questions about the economy's strength are not strictly confined to declining industrial production.
Again, our hope is that the U.S. is indeed in a recovery. Though we would quickly establish a moderately constructive position if favorable trend uniformity emerges, the question of whether or not the economy is recovering is irrelevant to our investment position. As I noted a few weeks ago, about 25% of the historical data is characterized by an expanding economy but unfavorable trend uniformity. On average, stocks underperformed Treasury bills during these periods. When the S&P 500 P/E was above average (as it is now), stocks actually fell significantly on average. So an economic recovery, in and of itself, is not a bullish signal. The favorable market performance associated with many historical economic expansions is fully accounted for by 1) favorable post-recession valuations, with the S&P 500 averaging less than 9 times prior peak earnings at the recession low, expanding to just over 11 times peak earnings in the first year of the bull market, and 2) favorable trend uniformity, which typically emerges almost immediately in the form of a powerful breadth thrust off of a bear market low, and is confirmed within a few weeks by much broader trend uniformity.
Currently, the S&P 500 trades at over 21 times prior peak earnings. Moreover, the recent advance generated neither a classic breadth thrust nor positive trend uniformity. To its credit, the recent advance did indeed generate enough of a positive breadth reversal to move us to as much as 20% unhedged during the fourth quarter, but that signal was reversed in late December (the S&P has made no net progress since then). At this point, the market's best shot at recruiting favorable trend uniformity would be an advance of about 4% in the S&P from current levels, on a weekly closing basis.
As I've often noted, we don't trade on forecasts, but there are a number of models that we maintain purely for informational purposes. Our bond model has become quite positive here, our gold model is flat (gold is extremely volatile, so we can't rule out a large move in either direction - but there's no significant expected return), and our U.S. dollar model is deteriorating. That set of features suggests downward pressure on real U.S. interest rates (i.e. nominal interest rates declining without a corresponding decline in inflation rates). Such an outcome would be consistent with an economy weakening in the face of aggressive money creation. Again, we don't trade on such forecasts, but somehow that set of projections seems to ring true.
As for stocks, our investment position is affected by the currently identified Market Climate. That Climate remains hostile for now, and we remain fully hedged.
Sunday March 10, 2002 : Hotline Update
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The Market Climate remains on a Warning condition. The simplest way to change this would be for the S&P 500 to advance by about 3% further on a weekly closing basis, without any fresh breakdowns in other internals. Bond market action has been quite threatening in this regard, but we still have not had enough negative action there to prevent a positive shift in our measures of trend uniformity.
I want to emphasize that a positive shift in trend uniformity would not be a signal that stocks are a "value." Favorable trend uniformity implies only that risk premiums are in a persistent and relatively robust downtrend. This has nothing to do with value. A favorable shift would imply only that investors had become sufficiently attracted to risk-taking that their preference should not be fought aggressively. It would not be a signal that stocks have investment merit, in the sense of prices being reasonable in relation to the present discounted value of future cash flows. Rather, favorable trend uniformity speaks only to speculative merit - the likelihood of positive average market returns driven by falling risk premiums.
The goal of our approach is not to time or forecast the market, nor to generate "buy signals" and "sell signals", nor to catch bottoms or tops. Quite simply, we believe that there are several identifiable Market Climates, and that each Climate is associated with a particular probability distribution (or "bell curve") of market returns - some positive, some negative. Our only interest is the average expected return/risk of each particular Climate. We believe that the average return to market risk varies significantly across Climates, but that it is impossible to predict whether the next move will be a rally or a decline. This is where we differ from market timers.
Again, shifts in the Market Climate are not forecasts about future returns, except in the broadest terms of average return to market risk. A positive shift in trend uniformity, if it occurs, should not be confused with a forecast that the market will go higher immediately following the signal, or that any particularly important low has been registered. A positive Market Climate says nothing except that the average return to market risk tends to be favorable while that Climate is in effect. We make absolutely no forecast as to how long a given Climate will persist, when it will shift, or whether the next specific move will be up or down.
For purposes of our investment stance, the Market Climate remains in the most negative possible condition here and now, and we remain fully hedged at present.
Among the most interesting aspects of market action, I continue to be struck by the failure of trading volume to confirm what we're seeing in price action. Stocks that rally tend to be on lighter volume, produced by thin but very eager buying, combined with a backing away by sellers. This is "short squeeze" type action. In contrast, stocks that decline tend to be on heavy volume, which smacks of "distribution" by large interests.
This pattern seems to be confirmed by the sentiment figures. The latest survey of the American Association of Individual Investors shows just 15.6% of these investors bearish. In contrast, Vickers reports a sharp spike in recent sales by corporate insiders, with sells outpacing buys by over 3-to-1. Mark Hulbert of the Hulbert Financial Digest reports that the top risk-adjusted market timers over any time frame are uniformly bearish here. This contrasts with Investors Intelligence figures that show a much smaller overall level of advisory bearishness, at just 29.2%. Finally, the CBOE volatility index has declined to just 21.6%, a level of complacency among options traders that has typically marked intermediate tops in the market. In short, there is a clear contrast between investor groups that are buying and those that are selling, and the ones with the best records are on the sell side.
None of this will prevent us from becoming constructive if the Market Climate shifts to a positive condition, but it does feed into the amount of market risk we would be willing to take, particularly with valuations still extreme.
As for fundamentals, I have a built-in aversion to saying "this time it's different." That said, with regard to the economy, this time it's different. That opinion doesn't affect our investment position, but I do find it disturbing that investors, economists, and politicians are all so eager to call the recession over.
Frankly, I think that the current bounce is a misleading calm before the storm, much as the strikingly short 1980 recession was. That recession, you may recall, was over within 6 months. Between the end of the recession in mid-1980 and November of that year, the Dow advanced about 6%, and that was the end of it. Stocks turned back down, and within 12 months, the U.S. was in a new, separately identified recession - one of the worst economic downturns since the Depression.
The failure of the 1980 recovery was certainly not predictable from the Purchasing Managers Index, which had soared from 29.4 in May to 58.2 in November 1980, while the New Orders Index surged from 25.6 to 65.3. Consumer confidence had soared from 50.1 to 87.2 in the same time span. The telltale warnings in 1980 were the failure of capacity utilization to surge higher, as it typically does after recessions, while the Help Wanted Advertising Index also stalled, increasing only from 76 to 84. Both of these failures were informative - one indicated an excess of capacity leading to a lack of strength in capital spending. The other indicated a lack of underlying hiring interest, driven by strong downward pressure on profit margins and a reluctance to increase payroll costs. Needless to say, both capacity use and the Help Wanted Index are worth watching here.
I note in passing that January Capacity Utilization came in at 74.2%, down from 74.4 in December. The January Help Wanted Index came in at just 47 - a negligible change from the deep trough of 45 in November. In this light, one also has to interpret the recent employment figures with skepticism. This is particularly true given that the Labor Department still adjusted January and February employment numbers strongly higher, even though unseasonably warm weather argues that these upward seasonal adjustments were unnecessary.
On the subject of accounting, I notice the phrase "cash flow" being discussed more often by guest analysts on CNBC and the like. Unfortunately, this is almost entirely lip-service. The focus remains squarely on operating earnings, and when cash flow is discussed, it is painfully clear that these people have no idea what they're talking about.
Probably the best examples are the ridiculous assertions by various companies, including General Electric, that "the quality of our earnings is supported by our cash flow", and that "Cash is cash. You can't lie about cash."
Look. There is a difference between the cash position of a company, and the cash flow of a company. The cash position is cash on hand, in the bank. And yeah, you can't really lie about that unless, you're actually lying about it. But "cash flow" is not the change in the cash position. Cash flow is simply earnings, adding back depreciation and amortization. "Operating cash flow" or EBITDA also adds back interest expenses and taxes while excluding extraordinary charges. If earnings are misrepresented, it invariably follows that cash flow is being misrepresented.
If you look at the Statement of Cash Flows in any annual report, you'll see three sets of numbers: Operating Activities, Financing Activities, and Investment Activities. This is where the rubber meets the road. As long as you can classify certain costs as "investments" rather than expensing them, you can keep them from reducing your operating cash flow, and of course, boost your operating earnings as well. Meanwhile, debt service shows up in the financing activities, so the more debt you take on, the more you can mislead shareholders by reporting huge operating cash flow (EBITDA) that is actually the property of bondholders. A stock is not a claim on EBITDA. It's a claim on free cash flows that can actually be delivered to shareholders after all other claims have been discharged, such as debt service and investment to replace depreciation and provide for growth.
Of course, it's common practice to mislead investors by focusing on operating earnings. But this is a regulatory, accounting, and ethical lapse. Common practice doesn't make it proper or informative. When investors allow incentives such as stock options that compensate executives for managing earnings announcements rather than compensating them for delivering free cash flow to shareholders, what can they expect? We routinely vote against such programs when they are presented on proxy ballots. Employee stock purchase programs (say, at a 15% discount from market value) are a reasonable employment perk. Stock options are a different matter, particularly when managements simply lower their strike prices if the stock price declines. This is a "heads I win, tails you lose" game against shareholders.
I visited the local Barnes & Noble over the weekend. At the bottom of one of the shelves, I noticed an audiobook copy of "Investing for Dummies", loosely covered in half-torn shrink wrap. Curious, I peeked inside and discovered that one of the tapes had been stolen. Apparently, the thief failed to notice that it was a two-tape set.
One has to wonder what kind of desperation would lead someone to steal "Investing for Dummies." But it's clearly a sign of the times.
Thursday Morning March 7, 2002 : Special Hotline Update
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The Market Climate remains on a Warning condition. As I've noted frequently in recent weeks, there are a number of ways that the market could generate enough evidence to trip trend uniformity to a positive reading. The easiest of those would be a continued market advance of about 4% in the S&P 500 Index on a weekly closing basis, without any fresh breakdowns in other internals. At present, the S&P 500 is still below the levels of late December, when our recently developed measure of breadth momentum turned negative.
Now, 4% doesn't seem terribly far away, so we have to allow for the possibility that we could obtain such a move. The most significant problem, however, is that the market is strenuously overbought here, and many precarious technical conditions (such as an extremely low option volatility index - the VIX - and an extremely high McClellan Oscillator) are in place. So not only do we need this rally to continue from an extremely extended position, we also need further gains to hold on a weekly closing basis. That's a stretch, but again, we move if and when the evidence is in hand.
A positive shift in trend uniformity here would have nothing to do with investment merit, but rather speculative merit. In other words, if market action improves enough to deliver a positive shift, the inference would be that investors had developed a robust preference for taking risk. That's a psychological preference that has nothing to do with value, and there is also no natural point at which you can say "OK, that's enough." Most of the advance from 1995 through 2000 occurred in an overvalued market exhibiting favorable trend uniformity. It just doesn't pay to fight the psychological risk preference of investors. We certainly don't have to be aggressive if the market exhibits favorable trend uniformity, but we would take a moderate amount of market risk on a positive shift.
Two questions then arise. First, if we do get a favorable shift, it would be on an excruciatingly overbought condition. Would we really want to remove a portion of our hedges at that point? Second, what if the market breaks lower after the signal?
The answer is to the first question is simple, and long term clients have seen it before. I call it my "40% rule."
Anytime you have a position that is no longer appropriate to market conditions, you do 40% of whatever change is required immediately - regardless of market conditions. You just pull the trigger and move. See, the main thing that paralyzes investors is fear of regret. In many cases, they fail to move at all, and then open themselves up to consequences that are ultimately unacceptable and devastating. The 40% rule essentially locks in an acceptable level of regret, while at the same time eliminating the possibility of unacceptable regret.
For instance, say you have all your retirement money in the stock of your company. You know that this position is poorly diversified and opens you up to unacceptable risk. Suppose that you feel strongly about the company and decide that, say, 50% of your money in the company's stock is an appropriate risk. Well, you've actually got twice as much stock as you should. The 40% rule says "make 40% of the required move immediately, and then work off the remainder fairly quickly, taking opportunities the market gives you." In this case, you would pull the trigger on 20% of your holdings (40% of 50%), and then work off the additional 30% on short-term strength (even if that strength follows a decline that took you below your original selling point).
This approach ensures some level of regret. If you sell a portion of the stock and it goes up, you regret the sale. If you sell a portion of the stock and it goes down, you regret not having sold more. But as soon as you've made the first move, you've locked in an acceptable level of regret, and shielded yourself from unacceptable regret. And you've taken action, which is the best antidote to fear.
So in our case, if trend uniformity reasserts itself, our target will be to remove as much as 40% of our hedge, but we would only immediately execute 40% of that target (i.e. 16% of our hedge) on an overbought condition. We would then look to cover as much as 24% more fairly soon, as short-term opportunities presented themselves.
With regard to a subsequent downside reversal, a favorable shift in trend uniformity at these levels would also be accompanied by what I call a "hot" sell trigger. It would not take a substantial amount of deterioration to reverse the signal. So in the worst case of a favorable signal that immediately reverses, we would briefly find ourselves about 84% hedged rather than 100% hedged, and would then place those hedges right back on.
In short, we know exactly what would need to happen in order to take on a more constructive position, exactly how we would go about scaling into that position, and exactly what would have to happen to reverse the signal.
My opinion is that this market is so strenuously overbought that the market will break lower without giving a favorable signal at all. But in the unlikely case that investors are willing to send this market into a renewed bubble in the face of extreme valuations, the S&P would only have to advance another 4% or so on a weekly closing basis to induce us to participate at least moderately.
In any event, the Market Climate remains on a Warning condition, and is also extremely overbought. Despite my comments about possible shifts in trend uniformity, the currently identified climate remains hostile, and we are fully hedged.
Wednesday Morning March 6, 2002 : Special Hotline Update
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The Market Climate remains on a Warning condition. I have no particular forecast regarding short term action, but since my opinions generally align with the prevailing Market Climate, I lean toward the expectation that this rally will fail. That said, a sufficient improvement in trend uniformity would indicate at least moderate speculative merit for market risk, and would place us in a more constructive position. For now, we're defensive.
On the sentiment side, an interesting contrast is apparent. Investment advisory bearishness remains at a low 30% level, and the CBOE volatility index is ominously low as well. In contrast, the so called "smart money" is selling, with insider selling spiking higher in recent weeks. Mark Hulbert (Hulbert Financial Digest) reports that among the market timers with the top risk-adjusted performances of the past 5, 10, 15 and 20 years, "almost all of the top risk-adjusted market timers are bearish, and their average market exposure is quite modest." In short, the pattern of investor sentiment is distinctly negative here. That doesn't ensure a market decline, but it does weigh on the bearish side.
Perhaps the most constructive aspect of current market action is leadership, where new highs are nicely outpacing new lows. More improvement in market action would be required for a positive shift in trend uniformity, but internal action has been fairly positive in recent sessions.
In short, we can't rule out a positive shift in trend uniformity, but my expectations are aligned with the current Market Climate. For now, that Market Climate is a Warning condition, and we remain defensive.
Tuesday Morning March 5, 2002 : Special Hotline Update
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The Market Climate remains on a Warning condition, and we remain fully hedged. I generally have no views regarding short-term market action, but I should note that almost by definition, overbought rallies in negative Market Climates frequently set the market up for sharp downside reversals. That's not a forecast, but it's certainly nothing to rule out in an overbought, strenuously overvalued market still lacking favorable trend uniformity.
Nothing in my comments should be taken to rule out the possibility that trend uniformity could improve sufficiently to warrant a more constructive position. But until such a signal actually emerges, we have no basis on which to take market risk. Extreme valuations mean that stocks have no investment merit. A lack of favorable trend uniformity means that stocks have no speculative merit. We would certainly be willing to moderately reduce our hedges (say, by 40%) on the basis of speculative merit alone, but here and now, we still do not have sufficient evidence to do so.
One of the interesting features of the markets here is that investors haven't learned their lesson. The lesson, of course, being the need to ask "at what price?" The tech bubble was at its core the result of investors entrusting their financial security to companies promising an upward trend in prices, earnings, revenues, EBITDA, page-views, and so on, regardless of what price they had to pay.
Now, once again, investors are frantic to keep from missing the trend of a new economic expansion, regardless of what price they have to pay. Never mind that the strength of such an expansion is suspect and that even a strong economic expansion is no guarantee of a rising market. At least for the past few sessions, it has been enough for investors that the economy seems to be improving. They want the bad times to be over. They are frantic to avoid missing out on a rebound that they feel they have paid for with tears and undue patience.
They do not know what patience is. Patience is seeing the Dow approach 1000 in 1964 and seeing it bottom out below 800 in 1982. I rarely have much of a short-term expectation for the market, but I strongly believe that investors will be able to look out at some point 5-10 years from now and see the major indices below current levels. There is no serious probability that the market will "run away" in a sustained, long-term uptrend from these valuations. This is not a market that will reward long-term investment. It may or may not reward short-term speculation.
Again, we can't rule out a positive shift in trend uniformity, which would be sufficient to move us to a somewhat less defensive position. But that move will occur on evidence, and the evidence is not in hand. Overbought, overvalued markets lacking favorable trend uniformity are minefields. For now, we remain defensively positioned.
Sunday March 3, 2002 : Hotline Update
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The Market Climate remains on a Warning condition here. While the Dow has been quite strong, the S&P 500 Index remains down for the year, as are most mutual funds.
Two immediate questions arise in the current environment. First, is the economy in a recovery? And second, if so, shouldn't we be holding a favorable investment position?
With regard to an economic recovery, it's clear that the ISM Purchasing Managers Index was a very good report for January. I take that as a favorable sign, but at this point, even that strong report says very little regarding the strength of any economic recovery. Likewise, if the rate of unemployment stays relatively constant this month, that will represent a fairly strong decline in the momentum of unemployment, which would also be a positive. Since the unemployment rate is affected by shortfalls in new hiring, there's an even chance that it will spike higher. But assuming the unemployment rate is about flat, all that we'll be able to say is that the economy has stabilized, which is a far cry from the rampant enthusiasm with which many analysts are viewing the economy. Debt problems remain, and the main drivers of past recoveries - housing, autos and capital spending - continue to be vulnerable.
The main force behind Friday's advance was evidently the ISM Purchasing Manager's Index, which moved above 50. This survey asks purchasing managers to compare current conditions with those of the prior month. If more than half of the respondents answer "better", the PMI moves above 50%. Oddly, over 75% of corporate CEOs at the Boca Raton CEO Summit reported that they believe the economy is still in a recession. But the market is starved for good news, and the PMI was positive enough to let traders infer "the recession is over." The result was Friday's short squeeze.
I say short squeeze because we just aren't seeing the kind of upside volume that typically accompanies sustained rallies. Both Richard Russell (www.dowtheoryletters.com) and Lowry's (www.lowrysreports.com) have noted this as well. Meanwhile, the spread between Moody's AAA and BAA bond yields has widened further, suggesting an acceleration of defaults ahead. Suffice it to say that there are enough negative divergences in market action to leave trend uniformity in a deteriorated condition.
So on the issue of the economy, we have to conclude from the evidence that there is a legitimate stabilization here. The evidence also suggests, however, that any expansion is likely to be relatively weak except for a 1-2 quarter bounce of inventory rebuilding, and that the sustainability of any upturn may be cut short by accelerating debt problems.
But let's suppose that this is in fact an economic expansion. Shouldn't we worry about our fully-hedged investment position? Shouldn't we take off our hedges and increase our exposure to market risk? Doesn't an economic expansion mean "bull market"?
No, no, and no. Historically, we can find many periods in which the economy was in an expansion and our measure of trend uniformity was negative. Indeed, that has been true in about 24% of historical data since 1945. As it happens, the total return on stocks has been positive, on average, during these periods. That is, if you want to call a 1% annualized total return positive. The fact is that you could have done better in Treasury bills, which would also have avoided a great deal of needless volatility.
Moreover, if we look at periods when the economy was in an expansion, trend uniformity was negative, and the S&P price/peak-earnings ratio was above its historical average of 14 (it's currently 21), the average total return drops to a -8% annualized rate. This condition applies to about 13% of history, and includes many periods of negative market returns, not the least of which was the 1987 crash. (Why does it escape investors that the 1987 crash occurred during an economic expansion?)
The conclusion, then, is that even if we were certain that the economy was in an expansion, it would not follow that the appropriate investment position is a bullish one. Frankly, I hope that the U.S. economy is in an expansion. But I have no preference regarding market direction. As usual, we'll continue to set our investment position based on the currently identified Market Climate.
What would shift that Climate to a constructive position? Unfortunately, there is little prospect for a near-term breadth thrust of the size that would move us to a more positive stance. That leaves us dependent on an improvement in broader trend conditions. There are a few complex ways to generate favorable uniformity involving a simultaneous improvement in various measures of risk premiums, but the simplest way to generate a favorable signal would be a further advance in the S&P 500 of about 7%, without fresh deterioration in other market internals.
I don't expect a further advance of that size, and I have absolutely no inclination toward taking on market risk to anticipate or speculate about such a move. But again, that's the most straightforward way that trend unformity could reassert itself convincingly enough to take a constructive position. In my view, such an event would essentially be a signal that investors had moved back to a "bubble" mentality. We certainly wouldn't move to an aggressive position, but such a shift could prompt us to leave perhaps 40% of our holdings unhedged.
At present, the evidence holds us a fully hedged investment position. As always, I hope that these comments are helpful in understanding why.
Tuesday Morning February 26, 2002 : Special Hotline Update
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The Market Climate remains on a Warning condition. Monday's rally demonstrated the same unconvincing breadth that has been symptomatic of this market since December. On the NYSE, advances beat decliners only by about 3-to-2, which is weak for the size of the rally in the major indices. On the Nasdaq, advances outpaced decliners by less than 5-to-4. Leadership, as measured by new highs versus new lows, was slightly improved on the NYSE, though the number of new highs was identical to the number of new lows on Nasdaq.
All of this may seem like minutia, but I am keeping a very close eye on internal action here. Aside from breadth and leadership, the behavior of bonds and the dollar remain important. A strong decline in either Treasury yields or the U.S. dollar would be a negative. It is highly unusual for both to occur together, so a simultaneous drop in both Treasury yields and the dollar would be a very powerful signal of impending economic weakness. That's not a forecast, but it conveys some idea of the market action that would be most telling.
In any event, the currently identified Market Climate is sufficient to hold us to a fully-hedged position. There are certainly interesting aspects of market action to watch, but in the end, the condition that drives our investment position is the currently identified Market Climate. We remain defensive here.
Sunday February 24, 2002 : Hotline Update
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The Market Climate remains on a Warning condition, and we remain fully hedged. Even if my views and opinions about the markets and economy were different, that currently identified Climate would still be sufficient to hold us to a defensive position. My comments are always intended to provide background and context, but they aren't what drive our position.
I thought that Friday's rally exhibited bad internal action. The major indices were up strongly, yet the number of stocks hitting new 52-week lows expanded, and there were fewer new highs. Given debt and accounting concerns, I am paying particular attention to two areas. First, bank and financial stocks are important, and they've been breaking down - in some cases gapping down. Second, there's an emerging pattern relating to flight-to-safety. As I noted last week, a strong decline in Treasury yields would actually be a bad omen here, because it would signal a rush to quality in the face of rising default risks and possibly fresh economic weakness.
More broadly, as I've noted repeatedly in recent weeks, a wide range of technical indices measuring broad market action and price-volume relationships have demonstrated a clear pattern of declining tops. This kind of action contrasts with the behavior of the Dow, suggesting "distribution" - large interests using rallies in the major indices as an opportunity to unload positions on heavy downside volume. Richard Russell of Dow Theory Letters and Ike Iossif of Aegean Capital have also noted the same pattern in various measures they follow independently.
In short, on a number of measures, the market is exhibiting growing signs of distribution and flight-to-safety. Most importantly, it is exhibiting misleading signs of strength in areas such as the Dow and Treasury securities, while the underlying internals are weakening. My concern is that this may set investors up to be blindsided.
In any event, the objectively identified Market Climate remains sufficient to hold us to a fully hedged position. My personal views don't drive our position, but they are equally defensive here.
Friday Morning February 22, 2002 : Special Hotline Update
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The Market Climate remains on a Warning here, which holds us to a fully hedged position based on current, observable evidence.
That is our investment position because it is based on factors that we can observe in the present. We don't require any forecast beyond this, because our discipline is to maintain a position consistent with what the market is doing rather than what we believe the market should be doing.
I used to believe that overvalued markets should go down. That belief was a source of success for me in the 1980's and early 1990's, but a source of frustration by 1995, when the market moved to historically extreme valuations and never looked back. It didn't take long to realize that something was seriously wrong with the notion that overvalued markets should fall. So I looked closer, going back as early as 1871.
As it happens, history is replete with instances where overvalued markets have become more overvalued. Indeed, you couldn't get to points of extreme overvaluation like 1929, 1972, 1987, and yes, today, if overvaluation was sufficient to turn the market south.
As it happens, one feature of market action turns out to be crucial in distinguishing overvalued markets that become more overvalued from overvalued markets that are vulnerable to a plunge. It is a measurable quality of market action that I refer to as "trend uniformity." Trend uniformity measures the broad internal action of the market across a wide range of individual sectors, security types, and gauges of risk premiums.
I partitioned the data into 4 "Climates", based on whether valuations and/or trend uniformity were favorable or unfavorable. Those Climates were characterized by substantially different return/risk profiles, and the differences are highly significant statistically. Most striking was the observation that overvalued markets with favorable trend uniformity have historically generated positive returns, on average.
Versions of this approach drive both our selection of individual stocks, and our choice of whether or not to hedge (or leverage) the amount of market risk we take.
Most importantly, the Market Climate is an identification of present, observable conditions, not a forecast, or a preference. As soon as you have a preference about market direction, you invite frustration. It is much more effective to act on evidence, and change those actions when the evidence changes. This doesn't mean having no view about the market. But it does mean having no attachment to that view, and instead having a constant willingness to change that view in response to new evidence. As Zen Master Huineng wrote, "The Great Way is not difficult for those who have no preferences."
For those who have asked about other analysts who follow a "no forecasting required" approach, the only other analyst I know that completely grounds himself in the present is Richard Russell of Dow Theory Letters (he also has a Fu-Manchu mustache, which makes him appear appropriately Zen-like). Since we follow different methods, we won't always agree, but his arguments are always well articulated. Of course, he'll also tell you his opinions, but like us, those opinions are nearly always driven by observable market action anyway. Richard publishes extensive daily commentary, so if you like daily analysis, his updates are well worth the price.
Our approach (particularly the analysis of market action) also owes a great deal to Nelson Freeburg, who publishes in-depth, well-researched trading systems in his newsletter, Formula Research (800-720-1080). Nelson's vast knowledge of trading systems and indicators regularly influences my own work, and we are fortunate to have him as part of an outstanding Board of Directors.
As for my approach toward valuation, no specific person has had much influence there. The main thing that has served me well is an understanding of present discounted value, and the constant attempt to answer one question: What is the expected stream of payments actually commanded by this security?
This is one of the reasons I am so concerned about the widespread focus on operating earnings, which often have nearly nothing to do with the actual stream of cash flows that is claimed by stockholders. I really do believe that investors are much too worried about illegal accounting practices, and not nearly worried enough about standard, common practices (such as the emphasis on operating earnings) that are dangerously misleading.
Again, a stock is not a claim on operating earnings. It is a claim on free cash flow after debt service (more on this in our November issue of Research & Insight).
I thought that Thursday's action was very interesting. As the loss on the Dow approached 100 points, I was struck by the sudden support and flattening out of the decline. For several minutes, it was as if certain interests were trying their very best to pick off offers in order to keep the Dow from hitting that -100 reading. I really don't believe in any kind of an organized "Plunge protection team", and certainly don't think that such an effort would be effective in halting a bear market even if it existed. But I look at tick-by-tick charts a lot, and the action looked very odd today.
Thursday's decline was largely par for the course, given that I thought Wednesday was just a short-squeeze to clear an emerging oversold condition anyway. I do have my eye on one feature of market action though. On Thursday, despite the market decline, new highs on the NYSE outpaced new lows by nearly 2-to-1. I'm interested to see if that favorable disparity holds or reverses. It will be a positive if the major indices move lower, but we continue to see new highs outpacing new lows. In contrast, I would take it as a particularly negative development if that figure suddenly flipped so that new lows substantially outpaced new highs.
Something to watch anyway. For now, the current Market Climate holds us to a fully hedged position.
Thursday Morning February 21, 2002 : Special Hotline Update
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The Market Climate remains on a Warning condition. Once again, the market dabbled with an emerging oversold condition, which was cleared by Wednesday's rally. As I've noted before, this is actually bearish action, because it prevents the kind of oversold condition that can give rise to a "breadth thrust." In the absence of favorable trend uniformity, such a breadth thrust is the only thing that could move us to a constructive position in the near term. So again, the net effect of Wednesday's rally is to perpetuate an unfavorable Market Climate.
Despite a 2% advance in the Dow, overall market breadth was unimpressive, with advances beating decliners by barely 3-to-2 on the NYSE, and not even 4-to-3 on the Nasdaq. Rather than evidencing favorable uniformity, the rally looked much more like a short-squeeze.
In any event, there is no particular need to speculate on how this action will be resolved. For now, we lack the evidence required to expose ourselves to market risk. The current Market Climate holds us to a fully hedged position.
Wednesday Morning February 20, 2002 : Special Hotline Update
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All site contents copyright 2002, John P. Hussman Ph.D.
Please see bottom of page for information on proper attribution of quoted material.
The Market Climate remains on a Warning condition, and our measures of trend uniformity have worsened considerably. Among the clearest breakdowns are the banking and brokerage sectors, where debt concerns continue to mount.
While investors have become very sensitive to improper accounting practices, the greater danger is actually from "standard" but extraordinarily misleading accounting practices such as the use of "operating earnings" as a headline number. The increasing focus on operating earnings encourages investors to ignore debt and bad investments until it's too late. The latest issue of Research & Insight goes into greater detail on this.
Barron's continues to report the S&P 500 P/E based on operating earnings - an ill-advised practice that the magazine started a couple of weeks ago. There is absolutely no sense to such a P/E. In the numerator, you have the value of the stocks in the S&P. But the operating earnings in the denominator include money that's actually due to bondholders and the government (the sum of which currently represents a record high share of "operating earnings"). The actual claim of equity holders on these "earnings" is strikingly small. Moreover, companies increasingly follow the practice of under-depreciating assets to pump up their operating earnings, writing down their assets instead as "extraordinary losses" which aren't included in that operating earnings number.
This is why investors continue to be shocked by sudden debt problems and investment losses in companies that have been regularly beating estimates of operating earnings by a penny. The operating earnings were never theirs in the first place.
As you know, I have a laundry list of reasons why the "Fed Model" (comparing the operating earnings yield with the 10-year Treasury yield) is invalid. Not the least of these is that despite good signals from a couple of extreme outliers, there is zero correlation between "misvaluations" on the basis of the Fed model, and the actual return in the S&P 500 over the following year. Literally zero. To that list, add the fact that a P/E based on operating earnings is meaningless unless one adds the total debt of the S&P 500 companies to the numerator, or subtracts the total debt service on S&P 500 companies from the denominator.
If you do just one thing to protect yourself, at least calculate the debt per share of the companies you follow, and the proportion of operating earnings that is devoted to debt service. Not all companies that look scary from this standpoint are in financial danger, but there is an outstanding payoff - in insight alone - from this simple set of calculations.
Stocks remain strenuously overvalued. Trend uniformity remains negative and deteriorating. In this climate, market risk holds no allure. Our stock positions remain fully hedged.
Monday February 18, 2002 : Hotline Update
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Just a note: The Semi-Annual Report of the Hussman Strategic Growth Fund is now posted to the Research & Insight page of the Fund website, www.hussman.net.
The Market Climate remains on a Warning condition. Please take this seriously. This is a market that could very quickly lose substantial value. That's not a forecast. It is a plea to factor in the possibility of sharp market losses among the possible outcomes. We remain fully hedged here.
As I frequently note, our investment research is an ongoing process. One of the most useful new findings over the past year is that strong breadth reversals, combined with falling interest rates, are typically a very early and effective signal of rallies that occur within bear markets.
For obvious reasons, I don't discuss specific models in full detail. But one of the interesting findings over the past week is that when market action is characterized by neither favorable trend uniformity nor a strong breadth reversal, falling interest rates exert no favorable impact on stocks. In other words, all of the historically favorable impact of falling interest rates is captured during periods when some measure of trend uniformity would have already been favorable. When those measures have been unfavorable, falling interest rates - particularly on Treasury securities - have actually been a sign of economic weakness and a flight to safety triggered by default risks. These periods include the Great Depression and the 1998 Asian Crisis.
As a result, we no longer need to include "hostile yield trends" as a component of a dangerous market climate. Indeed, with trend uniformity and valuations both unfavorable here, a sharp decline in Treasury bond yields would actually worsen market conditions. Such a decline in Treasury yields would signal economic weakness and substantial concern regarding default risks.
I note all of this because our Treasury model has just shifted to a strongly favorable stance, suggesting that Treasury yields may indeed enter a decline here. As usual, I have no forecast as to how long this climate will persist, but it has shifted to a favorable condition for now. From an investment standpoint, the yield curve is so steep at the short end that 5-10 year bonds could benefit as much from falling rates as longer term bonds.
In short, the Market Climate remains on a Warning for stocks. Meanwhile, our Treasury models have become quite favorable, a condition that applies strictly to bonds that are free from all default risk. My interpretation is that we may be on the cusp of a fresh deterioration in economic conditions and an acceleration in defaults. But in the end, my interpretations and opinions are not what drive our investment position. The objectively identified Market Climate is sufficient to hold us to a fully hedged position.
Thursday Morning February 14, 2002 : Special Hotline Update
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The fund prices page has been updated, with comments on recent fluctuations.
The Market Climate remains in a Warning condition. At this point, the market has fully worked off the oversold status that it had started to develop last week. One interesting feature of market action is that since October, many measures of breadth and volume action have been making successively lower peaks. Both Richard Russell of Dow Theory Letters and Ike Iossif of Aegean Capital have remarked on this as well. This kind of action is characteristic of distribution - large interests reducing their investment positions with increasing downside volume. Distribution patterns typically appear while the market appears relatively strong - it is a feature of internal market action rather than something that's readily obvious by looking at the indices themselves. It's also interesting that insider selling has surged higher, after having declined substantially last fall. Evidently, despite the relatively steady surface action of the indices, there is a growing weakness in the internal action of the market.
Of course, we have our own measure of this, and it's called unfavorable trend uniformity. With valuations extreme, and market action showing both a lack of trend uniformity and a lack of momentum in breadth (advancing issues versus declining issues), we have no willingness to take on market risk here. We remain fully invested in favored stocks, but those positions remain fully hedged.
Tuesday Morning February 12, 2002 : Special Hotline Update
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The Market Climate remains on a Warning status, which we always take seriously. We continue to carry a fully hedged position.
As I noted on Sunday's update, during periods when we are fully hedged, it is (and should be) nearly impossible to predict our day-to-day performance by looking to what the market did that day. By definition, when we are hedged, we've essentially shut down the effect of market fluctuations on our portfolio. What we are left with is the pure differential between how our favored stocks perform and how the market performs.
Interestingly, very few of our favored holdings appear overextended even on a short-term basis. That's true by design, of course, since we make a daily discipline of selling lower ranked holdings on short-term strength, and replacing them with higher ranked candidates on short-term weakness. I really believe that investors vastly overestimate the benefit of forecasting, and vastly underestimate the benefit of discipline, particularly discipline that seizes the values of the day rather than chasing the speculative disasters of tomorrow. I continue to view most of the large-cap universe as being among those probable speculative disasters. Valuations are far too steep in relation to free, distributable cash flows. Despite all of the hope for an economic recovery, and the willingness to equate such hope with a positive investment outlook, I continue to view the major indices as steeply overvalued. With trend uniformity negative and yield trends still hostile, the current Market Climate holds us to a very defensive position.
Not that that's a bad thing. One can find attractive investment opportunities even in negative Market Climates, as long as the market risk can be hedged away. The job of an investor is to take controlled, diversified, attractive risks. That doesn't mean that investors are required to take every risk. I simply don't understand the "buy and hold" notion that market risk is always worth taking, in any climate and at any price. An attractive investment exhibits value. An attractive speculation exhibits favorable market action (what I call "trend uniformity"). When market risk has neither investment merit nor speculative merit, we simply shut it down.
For now, we remain fully hedged.
Sunday February 10, 2002 : Hotline Update
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Just a note. The latest issue of Hussman Investment Research & Insight is now available on the website. The printed version will be mailed on Tuesday. As a technical clarification, "EBITDA" (earnings before interest, taxes, depreciation, and amortization) corresponds to "operating cash flow", and EBIT corresponds to "operating earnings." As a practical matter, these definitions are virtually indistinguishable. This is because companies no longer have to amortize excessive goodwill, and also because they regularly under-depreciate investments and then write them off as "extraordinary losses" in order to keep the depreciation from reducing operating earnings. Nice. The arguments in the letter are unaffected by this trivia.
The Market Climate remains characterized by extreme valuations, unfavorable trend uniformity, and hostile yield trends. I've received a lot of suggestions on what to call this Climate, but simplicity being a virtue, I'll simply define this as a "Warning." There is very little risk that readers will ever take this as a good thing, nor is there risk that they will overestimate the danger, given that every historical crash of note has emerged from this single climate.
So the Market Climate remains on Warning status.
With regard to last weeks' market action, Friday was the key day. As you may have guessed, Friday's rally took the edge off of an emerging oversold condition. That is actually bearish. Without a strong oversold condition, it is very difficult for the market to register a sharp, positive reversal in breadth momentum. Meanwhile, a number of important measures of risk premiums continue to deteriorate. As a result, I view the possibility of a favorable shift in trend uniformity during February as virtually nonexistent at this point.
The most important elements in near term market action will probably remain debt and accounting concerns. While I believe that most of the problems will continue to be among technology, financial, and conglomerate firms, the day to day flow of news is very unpredictable. For that reason, we can probably expect some additional turbulence (both positive and negative) even in our own holdings as these concerns play out.
The difficulty for the overall market is that risk premiums remain historically low, yet there is increasing upward pressure for risk premiums to rise. This is particularly true given the action of fairly obscure securities that are signaling heightened default risk.
A market crash is always driven first and foremost by a spike in risk premiums. That's not a forecast, but we can't ignore the signs of upward pressure that are already evident.
We'll end on that thought.
Tuesday Morning February 5, 2002 : Special Hotline Update
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The Market Climate remains on a Crash Warning, which as usual, is a warning of risk, but not a forecast that a crash should be strongly expected. I am still weighing alternative descriptions for this Climate - extreme valuations, unfavorable trend uniformity and hostile yield trends. Every historical crash has emerged from this one set of conditions, which has only been observed in about 4% of history. The average annualized return in this climate is about -18%. That's certainly negative enough to make stock market risk completely unattractive, but is certainly not -18% on a weekly basis. My main goal in describing this as a Crash Warning is to drive home the extreme potential for loss and the rather complete unattractiveness of taking market risk in this Climate. The difficulty is that if, despite my best efforts, readers take this as a forecast of a crash, the term loses its impact if crashes don't regularly follow, even if losses such as Monday's regularly do.
In any event, this remains a Climate characterized by extreme risk and quite negative average returns. Every climate we identify includes both advances and declines. It's that average return to risk tradeoff that is critical, and this climate is the most unfavorable.
One positive would be if the market falls further, but the number of new highs can persist at a substantially higher level than new lows on the NYSE and Nasdaq. That would be a small first step toward the kind of firming of internals that is required to generate favorable trend uniformity. If instead we see the number of new lows flip above the number of new highs, it would be suggestive of heightened risks. At this point, it's too early to tell how this will play out, but it's something to watch.
For now, we remain fully defensive.
Sunday February 3, 2002 : Hotline Update
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The Market Climate remains on a Crash Warning here. What investors should take from this is not a strong expectation of a crash, but a recognition of the risk of substantial market losses.
It's important to understand that nothing we do is dependent on forecasts. While I regularly discuss my opinions and observations in order to provide background and context, those opinions do not feed into our investment stance. For the purpose of opinion and discourse, I often have something to say, but for the purpose of investment management, market forecasts are irrelevant.
Though I make this point in virtually every update, it is nearly impossible to stress it enough. I don't believe that forecasts are useful for investment management. For investment purposes, we don't forecast, we identify.
My favorite analogy involves hats. Buy-and-hold investors essentially believe that the market is a big hat full of green and red marbles. They don't believe that the next draw can be predicted, but they believe that on average, the marbles are green. Market timers differ because they believe they can predict whether the next marble will be green or red.
Very simply, I believe that there are different hats. You can identify which hat is in front of you, but that you can't predict what color the next marble will be. All of the hats have green and red marbles. Every one. But in one of the hats, for example, the marbles are big and green on average. The hat has a little sign on it, saying "favorable valuation, favorable trend uniformity." When that hat is in front of us, we don't try to forecast how long it will be in front of us, or when it will be replaced by a new hat. We simply focus on that hat until a new one shows up.
The current hat has a little sign on it, saying "unfavorable valuation, unfavorable trend uniformity." All we have to do is read the sign and identify the hat. To be sure, there are some green marbles in this hat, but on average, they're red. Some of them are big and red. And a few of them are big and red with lit fuses. We don't know whether the hat will be in front of us for a week, a month, or a year. We don't have any belief that we can predict when it will be replaced by a new hat, or that we can predict whether the next marble will be green or red. But knowing what tends to be in this hat on average is enough.
So where is the market going? Is the economy really recovering? Will the market crash? Is this a new bull market?
The question is, why do you care? If you care because you have an intellectual interest, or you are concerned for the financial security of your fellow Americans, there are plenty of comments in these updates that speak to those issues. But if you care about those questions because the answers drive your investment position, you're depending on forecasts rather than identifying the objective present. As soon as you do that, you're not invested based on what is, but based on what you think should be. And you've set yourself up for a roller coaster of emotion, frustration, second-guessing and self-doubt based on whether your forecasts seem to be turning out right or wrong.
Our approach is very straightforward. We identify the Market Climate based on rigorously tested, objective evidence, and then we align our investment position with that Market Climate. When the Climate shifts, our position shifts. I certainly believe that ongoing research is useful to test and validate new analytical tools and more precisely identify the prevailing Climate, but again, no forecasts are required.
This is why I still have hair. I can't imagine how people can be objective and invest well if their success is dependent on whether or not their forecasts are right. You can only exert control over things you can control, and you can't control the future. What you can control are actions. So you find a set of actions that you have confidence will produce results if you follow them consistently. A good day is a day in which you carried out those actions.
For us, a good day is one in which we buy highly-ranked investment candidates on short-term weakness, or sell lower-ranked holdings on short-term strength. A good day is one in which we keep our market hedge in line with the prevailing Market Climate. Whether the market rises or falls, or our portfolio is up or down, we try to have a good day every day, because the actions that define a "good day" are under our control.
I'm starting to sound like Zig Ziglar. So let's take a look at the current financial landscape. Not because it drives our positions, but because it gives us a clue as to why the current Market Climate is so persistently negative.
The reason, in my view, is debt. That's no surprise of course. I emphasized this through most of last year, well before Enron and other recent, high profile bankruptcies.
In this week's Barron's, Jonathan Laing has an interesting interview with David Hawkins, one of the accounting professors at Harvard Business School. Hawkins says "I could teach an entire class on just the stuff that came out last week. What we've seen so far is just the tip of the iceberg. I suspect that the 10-Ks coming out this month and next will make interesting reading in the post-Enron environment. Pitched battles are going on right now between accountants and companies."
We'll see shortly whether that expectation is correct. I am inclined to think that it is. Public accountants have suddenly become very aware of how devastating the practice of rubber-stamping questionable accounting practices can be on their reputations when these practices are eventually revealed.
With regard to the economy, The Economist has an excellent set of articles regarding the potential drag that debt is likely to have on any economic rebound (click here).
The cover of the magazine alone is worth the price. Under the title "Ready for take-off?" runs a bird frantically beating its wings, with the word "Debt" across its oversized belly. This is the most incisive magazine cover since another issue of The Economist last year, which pictured Alan Greenspan's head carefully morphed onto David Hasselhoff's body, running along the beach with a little Baywatch-issued red rubber dinghy, and the caption "To the rescue."
A few excerpts: "Like a bird that has stuffed itself with too many worms, America's debt-laden economy will find it hard to get fully airborne. The root cause of this recession was the bursting of one of the biggest financial bubbles in history. It is wishful thinking to believe that such a binge can be followed by one of the mildest recessions in history - and a resumption of rapid growth... A turnaround in inventories may boost output in the first quarter of this year. But for a sustained recovery, consumer spending and business investment need to take over. And here lies the problem: consumers and businesses are up to their neck in debt... The share price bubble has popped and the IT investment boom has turned to bust, yet the credit bbble remains fully inflated. Only when it deflates will the full results be felt... Five of the past six full-blown recessions have included a double dip: output rose briefly as inventories turned around, but then fell again as final demand failed to follow through."
A companion article continues "Companies' interest payments are absorbing a record share of their profits, yet they continued to borrow more throughout last year. Their financing gap (capital spending minus cash flow) remains unusually wide compared with previous recessions, which suggests that investment has further to fall... Following a massive increase in debt during the boom, the Fed's interest-rate cuts are now encouraging companies and consumers to borrow even more to prop up spending... One of the best measures of the size of the potential adjustment that still has to be made is the private-sector balance (or net saving): the gap between total private-sector income and spending. Over the past 40 years to the mid-1990's America's private-sector net saving averaged 2.5% of GDP; it remained positive virtually throughout. Then it dived deeply into deficit. By 2000 net saving had slumped to an unprecedented minus 6% of GDP. By the third quarter of 2001, that deficit had narrowed to 2.5%, as firms slashed their spending, but it probably widened again in the fourth quarter as borrowing surged. This leaves net saving way below its historical norm. If households and companies now try to push their joint net saving back into surplus, that could severely restrain investment and consumer spending..."
I should add that the huge savings deficit in the U.S. shows up as an enormous trade deficit. The failure of the trade deficit to improve substantially has been largely because U.S. consumer spending and investment have not come back in line with income. This is unsustainable. As I've noted before, the first sign of a deep adjustment would be a plunge in the value of the U.S. dollar. We did see a decline in the dollar early into this recession, but it has surged to new highs. Again, our analysis suggests that this is ultimately unsustainable.
Finally, the FDIC recently issued another report discussing recent large scale bankruptcies (click here).
The bottom line is simple - with the Market Climate characterized by extremely unfavorable valuations and unfavorable trend uniformity, we have all the evidence we need to maintain a defensive investment position. Everything else is background.
Friday Morning February 1, 2002 : Special Hotline Update
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The Market Climate remains on a Crash Warning. Thursdays rally really didn't generate much information, being essentially a continued snap-back from Tuesday's decline. The main issue is that the rally completely took the edge off of any developing oversold condition, and that removes the hope for a near-term momentum reversal. A substantial rally in the S&P of about 7% could move trend uniformity positive by overriding other negatives. But the quality of such a signal would be lower than if we got a favorable shift off of an oversold condition.
For now, there's no real point in speculating about whether it will take weeks or months until a favorable shift in trend uniformity emerges. Until we actually observe a shift, we'll stay defensive.
This underscores an important feature of our approach. I am often asked questions about where the market or the economy may be headed. And while I have my opinions and regularly articulate them, they're irrelevant to our investment position. What matters is not what might or should occur in the future, but what is occurring in the observable present, as defined by valuations and trend uniformity.
Even if I expected a strong and immediate economic expansion and a significant improvement in corporate profits, our hedge would not change at this moment in time because we don't have the evidence to support an unhedged position. Opinions about what might occur don't allow us to act pre-emptively without that evidence.
Clearly, it's always useful to do fresh research, develop novel indicators, consider alternative models, and so on. When that research generates useful results, as it did with our research on breadth momentum reversals, we're eager to fold them into our approach. But unless the research generates strong and historically reliable evidence that the alternatives work, we stick to our prevailing discipline.
Now, in most cases, my opinion will be very much in line with our investment position. But that's because both are driven by the same information: the observable evidence regarding valuations and trend uniformity. That evidence keeps us locked to a defensive stance for now.
The bottom line is simple. We don't need to forecast or speculate. Until we see a favorable shift in the Market Climate, we'll remain defensive. Crash Warnings are characterized by strongly negative average returns, but also high volatility, which means that strong rallies can also occur, which we've seen in the past couple of days. Regardless of such rallies, this remains the most dangerous of all Climates we identify, and it should be approached accordingly.
Thursday Morning January 31, 2002 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. As I've noted before, snap-back rallies in negative Market Climates tend to be bearish, because they prevent the market from developing a clear oversold condition. Without a clear oversold condition, the probability of a strong breadth reversal becomes very small. In short, Wednesday's action damaged the prospect for any favorable shift in trend uniformity in the near future.
The only other prospect for a favorable shift in trend uniformity would be an advance of about 8% in the S&P 500. Such an advance would give us trend uniformity essentially by default, by overriding rather than eliminating the negative market internals currently present. That's not the most comfortable way to develop trend uniformity, but it's a fail-safe that reduces any prospect of staying out of any extended and substantial advance that might develop. I strongly doubt we'll see such a shift, but I think it's useful to articulate what would actually move us to a constructive position. For now, it would be either an oversold condition followed by a positive breadth thrust, or a further rally in the S&P of about 8% without any fresh breakdowns in market internals. Suffice it to say that the most probable outlook here is a continued negative Market Climate accompanied by continued downside pressure. But we'll take our signals as they come.
Corporate insiders have substantially increased the pace of their selling in recent weeks. Meanwhile, investment advisory bearishness remains below the important 30% level, and the CBOE volatility index hit a fresh low as recently as last Friday. That combination presents a very unfavorable sentiment picture. In the face of extreme valuations and unfavorable trend uniformity, overextended sentiment takes on added importance. Tuesday's decline was nowhere near enough to correct these extremes in sentiment.
On the economy, I've noted in recent updates that most recessions include one (and occasionally two) positive quarters of GDP growth, so the latest GDP reading was no surprise, and is not prima facie evidence that the recession is over. The best way to characterize the economy is to say it has stabilized, but it certainly does not follow that the next move is sharply upward, or even upward at all. There is a common difficulty with overvalued markets, misleading accounting of earnings, and overleveraged economies. In each case, the eventual adjustment is certain, but the timing is not. Sudden adjustments are typically triggered by events, and those events can occur out of the blue.
For instance, Enron's misleading practices went on for years before the game came to a grinding halt. Likewise, overvalued markets can stay overvalued for years (particularly when trend uniformity is positive), until market internals deteriorate and risk premiums are suddenly pressured higher. In the case of the economy, there is a growing and untenable gap between debt burdens and debt servicing ability, but even if you anticipate the eventual failures (which can be like watching grass grow), the triggering events emerge out of the blue.
There are always three factors operating behind every financial disaster: 1) extreme leverage, 2) mismatch between the cash flows provided by assets and the cash flows required to service liabilities, and 3) lack of transparency. Take your pick of disasters: Enron, Long-Term Capital Management, Barings Bank, Orange County, Dirk the Day Trader whose wife just found out they've lost the house - name the financial disaster, and you'll find people trying to hide an overleveraged, mismatched portfolio from the scrutiny of others.
If you consider how much bad debt is already in the system, and how aggressively assets are being written down, it is nearly inevitable that we'll see more Enrons shortly. Frankly, I'm suspicious about Tyco. Why would you voluntarily split a company into four pieces? My guess is that by doing so, you could partition good assets out into three of them, and put the dynamite into the fourth. That way, when the bad stuff goes up in flames, only one of the entities goes bankrupt, leaving the bulk of your assets free from the claims of creditors. Sure, there could be other reasons, but companies typically fight tooth and nail to avoid being split. I just think it's odd. But that's opinion. Pure opinion.
As usual, my opinions do not drive our investment position. Regardless of what my views on the economy, debt, or the market outlook might be, the fact is that we don't base our position on predictions or opinions. Currently, the objectively defined Market Climate remains negative, and that holds us to a defensive position.
What would move us to a more constructive position? A positive shift in the Market Climate. Until that actually occurs, we will remain defensive. All additional opinions and comments are background.
Wednesday Morning January 30, 2002 : Special Hotline Update
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The Market Climate remains on a Crash Warning. Keep in mind that a Crash Warning does not indicate that the market must, or should be strongly expected to crash. Rather, a Crash Warning means that current market conditions (extreme valuations, poor trend uniformity, hostile yield trends) match only about 4% of history, yet every crash of note has emerged from this one set of conditions. On average, stocks have declined at an 18% annualized rate during Crash Warnings. That's certainly a poor enough return to remove any willingness to take on market risk, but it isn't so dire that a crash should be considered imminent. For that reason, I'm considering changing my language on this. The difficulty is that without the word "Warning", investors may not grasp the serious risk of loss in this climate (whether or not an actual crash develops). For now, I'll stick with the term Crash Warning, and surround it with enough commentary to make the meaning clear.
With regard to trend uniformity, there is essentially zero chance of a shift to favorable uniformity in the next few weeks, and no chance of a positive momentum reversal signal until mid-February at the earliest. So at least for a couple of weeks, there's no point in thinking about anything but a defensive position.
Financials took a hard hit on Tuesday. Fortunately, we have virtually no holdings in that area. The market action in this sector is ominous, and the uniformity smacks of much deeper problems than simply PNC Bank's balance sheet. I continue to see default risk as the most likely concern of the financial markets over the coming quarters. That expectation seems to be playing out.
Sunday January 27, 2002 : Hotline Update
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The Market Climate remains on a Crash Warning, characterized by extremely unfavorable valuations, unfavorable trend uniformity, and hostile yield trends, particularly long-term bond yields and various measures of risk premiums.
I want to reiterate that the primary cause of every market crash has been an increase in the risk premium demanded on stocks. Short-term financial disappointments may contribute, but stocks are a claim on an infinite stream of future cash flows. One quarter or even one year of profitability is fairly insignificant unless the news significantly changes the whole expected path of future financial results.
The worst situation is when investors both reduce estimates about the future path of earnings, and increase the long-term return that they demand from stocks.
That's the risk here. Investors are still clinging to the New Era delusion that corporate earnings are likely to grow very rapidly. Yet even during the past decade, S&P 500 earnings only grew by 6% annually, properly measured from peak-to-peak. Even as analysts reduce their first quarter earnings estimates, they have back-loaded them into the fourth quarter in order to leave the full-year estimates unchanged. Consensus earnings estimates now require a 39% spike in fourth quarter earnings in order to keep the numbers on track. As the scrutiny on accounting practices increases, New Era delusions about earnings are vulnerable.
The historical 6% peak-to-peak growth rate of S&P 500 earnings is very robust - it holds for the most recent decades, and for the past century. Kick in a 1.4% dividend yield, and the S&P 500 Index is currently priced to deliver a long-term return of 7.4% annually assuming that P/E ratios remain at their current extreme forever. In order to drive the long-term return on stocks even 1% higher, the market would have to plunge over 40% (this would drive the yield on stocks from the current 1.4% to 2.4%). I wouldn't be surprised if the market did just that, but we don't act on such opinions. The current, objectively identified Market Climate is sufficient to keep us fully hedged here.
It is very difficult to find large-cap values in this market. Geraldine Weiss of Investment Quality Trends reports that only 6% of the blue chip stocks she follows are rated "undervalued". This is slightly better than the levels seen at the market peak in 2000, but a fraction of what is typical at bear market lows. In my own work, the overvaluation of many of the blue chips is striking. And again, the overvaluation is very robust. It doesn't matter whether one looks at basic measures such as median valuation multiples over the past (bull market) decade, or whether one uses a more complex discounted cash flow model. The bottom line is the same. Many blue-chip stocks would have to fall by 30-50% simply to match their median bull market valuations of the past decade, and even more to reach prices that would deliver 10% long-term total returns.
The most extreme valuations include mass retailers such as Wal-Mart, Target, Home Depot, Best Buy, Kohls, and Lowe's, and large drug and healthcare companies such as Amgen, Abbott Labs, Baxter, American Home Products, Forest Labs, Johnson & Johnson, Medtronic, Stryker, United Healthcare, and Tenet. Extreme overvaluations also extend to many other large blue chip stocks, consumer stocks, and financials, including GE, IBM, United Technology, Pepsico, Budweiser, Anheuser Busch, Colgate Palmolive, American International Group, Fannie Mae, Freddie Mac, Concord EFS, First Data, and others. Basically, make a list of the largest capitalizations on the market. Throw a dart. The stock you hit is probably dangerously overvalued.
To give some numbers, I view the appropriate valuation of Wal-Mart to be no higher than 34 (current price 58), Best Buy 38 (current price 72), IBM 62 (current price 109), United Healthcare 39 (current price 74), and AIG 35 (current price 78). I don't even understand why Fannie Mae trades at all.
Very few stocks in the S&P are priced to deliver long-term returns of 10% annually, and even this view assumes that recent earnings can be taken at face value. Companies like IBM and GE are particularly disturbing because of the inexorably rising profit margins and return on equity that we are forced to swallow whole, year after year, if their numbers are to be believed. Add the fact that much of the earnings-per-share growth is created by making acquisitions of slower growing, lower P/E companies, and one might think that the new, larger level of earnings should be valued at a smaller multiple than the prior earnings were.
But all is well. Abby Joseph Cohen recommends IBM in the latest Barron's Roundtable. There's a relief.
In that same Roundtable, you'll see some talk about EBITDA - earnings before interest, taxes, depreciation and amortization. That's commonly called "operating earnings" ("pro-forma" earnings are the evil cousin of operating earnings, and can reflect nearly any "as if" assumptions that companies care to make). One of the panelists, Meryl Witmer, clearly understands the game - she asks great questions like "What is the total enterprise value?" and "What are the company's capital spending needs?" Here's one analyst that gets it. See, if you're going to use operating earnings to value a company's stock, you have to first subtract out the capital spending (to get free cash flow), discount that to get the enterprise value (the value of both the stock and the debt combined), and then subtract out the debt. Most analysts just slap a multiple on operating earnings, which is ludicrous.
In regard to the economy, I doubt that the FOMC will change the Federal Funds rate this week. The accompanying statement will still indicate that risks continue to be weighted toward economic weakness. Most recessions are punctuated by at least one quarter of positive GDP growth, followed by a deeper downturn. The current one is shaping up the same way. But keep in mind that even if I expected a full and robust recovery, our market position wouldn't change. Our market position is driven by the prevailing Market Climate. Our hedging stance will shift when that Climate shifts. For now, we remain fully hedged.
Monday January 21, 2002 : Hotline Update
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The Market Climate remains on a Crash Warning here. Moreover, the yield on industrial bonds in the Dow Jones Bond Average continues to rise, further widening the risk premium on corporate debt. Yet we also see very strong inflows into junk bond funds, based on the belief that these high yields represent value rather than information about default probabilities.
That's always the challenge in the financial markets - separating the information signal from the noise. For instance, according to Enron's head, Kenneth Lay, Enron's plunge in mid-2001 offered investors a great value. Unfortunately, investors who interpreted the price decline as a valuation improvement soon learned otherwise.
So how does an investor separate signal from noise? When is a price decline a "value improvement", and when does it signal negative information? The answer lies in the information surrounding that price movement. It's impossible to explain this well without oversimplifying, so I'll oversimplify. Let's consider the price movement of an individual stock. If a stock plunges during a general market plunge, and earnings estimates are stable, you can probably infer that the valuation of the stock has improved somewhat. In contrast, if a stock plunges in an otherwise stable market, it doesn't matter what the earnings estimates are. Somebody knows something you don't. Again, that's a little simplistic, but it conveys the idea - you separate signals from noise by looking to the uniformity of action between one variable and other variables that are correlated with it.
For math geeks (which would include me), suppose that A = X + Y, and B = X + Z. You can observe A and B, but you can't observe X, Y or Z. All you know is that X, Y and Z don't move in lock-step with each other. Now, suppose you see a plunge in both A and B. You can make a pretty strong inference that X has declined, even if you can't observe X directly. It's true, of course, that Y and Z might have declined in tandem. But that's less likely. There's some uncertainty, so you have to split the difference statistically.
In contrast, if you see a plunge in A without a plunge in B, you can probably infer that Y has declined, even if you can't observe Y directly.
All of this should give you some idea of why the concept of "trend uniformity" is so central to our approach. Trend uniformity is essentially a method of inferring signals from noise. Trend uniformity tells us about whether investors have a robust willingness to take on market risk. And that robust willingness informs us about things that these investors see in their own businesses and personal situations that we can't possibly observe directly. The fact that we have unfavorable trend uniformity here is a signal that hopes for a sharp rebound in the economy and corporate profits are misplaced.
Moreover, the behavior of interest rates and corporate risk premiums currently suggest that high junk yields are not value, but warnings about important defaults ahead. Interest coverage (the ratio of corporate earnings to interest obligations) is currently near the lowest levels in history. Of course, you don't worry about such things if you concentrate on "operating earnings", since operating earnings don't require you to subtract debt service. Just direct your feet... to the sunny side of the street.
What would change our view? Simple. A positive shift in trend uniformity.
In the end, this is what market analysis is about. Seasoned analysts like Richard Russell call it reading the markets. Russell calls it a lost art, and he's right. Investors who look at a rally in stocks as a signal of impending economic rebound are engaging not in analysis, but in wishful thinking and superstition. As I've written many times, trend uniformity is not driven simply by the action of the major indices, but by the action of a wide range of market internals. When you are extracting signals from noise, divergences take on great importance. We continue to see important divergences that hold us to a defensive position here.
A final note. For years, I've received Investment Quality Trends, an excellent newsletter for dividend-oriented investors. I've never seen as many stocks flagged with the words "dividend in danger" than in the latest issue. It's widely believed that stock repurchases are an effective alternative to dividends, but as I've noted frequently, stock repurchases in recent years have done little but offset dilution from options grants to executives and employees. Peter Bernstein, author of the fascinating book on risk Against the Gods has noted that historically, low dividend payouts have a striking correlation with low earnings growth over the following decade. While he has his own explanations, I'll suggest a simple one. Dividends are cash. Earnings are theory. Low dividend payouts relative to earnings suggest that companies don't believe that their own reported profit margins are sustainable.
For now, the Market Climate remains on a Crash Warning, and we remain strongly defensive.
Friday Morning January 18, 2002 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. With valuations extreme, trend uniformity negative, and our breadth momentum overlay still on a negative reversal, there is nothing in our set of tools that allows us to take a constructive market position. So strictly on the basis of our investment discipline, we remain defensive. No forecasts or opinions required.
But if you want my opinion... Oh, is this going to get ugly.
I've noted frequently that the main concern of the markets over the coming year will ultimately revolve around debt. Today, K-Mart's bonds hit levels which make a bankruptcy filing very probable. Ford reported a $5 billion loss, wiping out nearly all of its cash not specifically targeted for employee pensions. And Moody's downgraded the debt of both Ford and Ford Motor Credit. Not to leave out telecom, Moody's also placed Sprint on a downgrade review.
Still, all of this remains happily below investor's radar. The reason is simple: operating earnings.
In recent years, the debt burden of corporate America has become increasingly intolerable, and much of the earnings have been diverted to stock repurchases in order to offset dilution from options grants, or burned up in bad investments that are routinely written off from book value. Coincident with this deterioration in the quality of corporate results, the concept of operating earnings has gradually replaced traditional earnings according to "generally accepted accounting principles". Indeed, CNBC now reports primarily operating earnings in order to make "apples to apples" comparisons.
Bad apples.
Operating earnings conveniently exclude undesirable realities like interest on debt, depreciation, and extraordinary losses. So regardless of whether or not earnings can actually carry debt burdens, or how aggressively bad investments are being written down from book value, investors need never know. As long as they concentrate on operating earnings, the game can go on.
Unfortunately, a stock is not a claim on operating earnings. It is a claim on free cash flow after debt service. Beware of analysts touting stocks on the basis of "huge free cash flow" when they have not subtracted out interest payments. Free cash flow after debt service is equal to operating earnings, minus interest, minus taxes, minus depreciation, minus normal annual amounts allocated to new investments. [Note: I say new investments because we've already subtracted off the amount required to replace depreciated capital. If you like, you can ignore depreciation and subtract off the entire amount allocated to investment, both new investment and the replacement of depreciation. The effect is the same]. If those investments pay off, the payoff will be included in future cash flows, and the future growth rate will be a little higher. But the investment (both new investment and replacement of depreciated capital) is deducted from today's free cash flow. Technically, the value of stock given to employees and management through stock options should also be deducted from operating earnings in order to derive the free cash flow available to shareholders.
In other words, if you are valuing stock on the basis of operating earnings, you're counting as yours all kinds of things that are in fact being allocated to debtholders, managers, employees, replacement of depreciated capital, and the Uncle. And if you're discounting the stream of expected future operating earnings without subtracting off the capital investment required to produce it, you're double counting.
It's as if investors are collectively putting their fingers in their ears and humming "hmm hmm hmmm... I can't hear you..." Which is why they don't pay attention until they get hit by a brick. I suspect that Enron was the warm-up pitch.
I seriously would prefer to be bullish and optimistic about economic and market prospects. It's more fun, and they put you on TV more often. But capital preservation is essential. I would really prefer the market to adjust in a way that stops misallocating capital. The tech bubble allowed America's scarce savings to be terribly diverted and wasted. Much of the reported earnings of recent years is now being quietly written off of the books, as is excessive "goodwill" from companies overpaying for their acquisitions. Yet all that analysts can say is that these writedowns will boost future earnings because companies will no longer have to amortize the bad investments over a period of years. Oh goodie.
On the subject of Thursday's market action, I noted Thursday morning that I have no opinion regarding short-term direction, and that continues to be true. Actually, after several days of market declines, Thursday's rally was somewhat bearish in the sense that it prevented the market from becoming oversold. Normally, the strong positive shifts in breadth momentum that signal sustainable bear market rallies don't emerge easily. They almost always require the market to suffer a period of terribly poor breadth first. So again, Thursday's rally served to take the edge off of any emerging oversold condition, and that leaves the market even less likely to generate a favorable trend signal in the near term.
As usual, all of this is opinion, background, and context. Our investment position remains driven by the prevailing, observable Market Climate. On that basis, we remain strongly defensive. So regardless of how accurate the opinions here turn out to be, we already know all we need for investment purposes. Accordingly, we are fully hedged.
Thursday Morning January 17, 2002 : Special Hotline Update
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The Market Climate remains on a Crash Warning here. While we remain defensively positioned, I have absolutely no opinion about short-term market direction. With valuations extreme and neither trend uniformity nor momentum measures positive, I have no inclination to attempt "trading" short-term fluctuations, or buying the latest dip to speculate on a short-term rebound.
The current Market Climate suggests that market risk continues to offer a very unfavorable expected return and intolerable levels of potential risk. But as usual, expected return is what tends to occur on average. Nothing rules out short-term rallies, even during Crash Warnings. It's just that those rallies are both unpredictable, and extremely prone to failure.
On the negative side, I've reviewed the most compelling data in recent updates, but some additional features are worth mentioning. Specifically, the recent rally was marked by a striking set of divergences in volume and breadth measures. Even as some of the major indices moved to successively higher highs, many indicators of market internals displayed a pattern of declining peaks. These indicators included measures of advancing versus declining volume, as well as measures of market breadth such as the McClellan Oscillator.
On the positive side, long-term interest rates continue to act well. If we see more persistence in this action, without further deterioration in corporate bonds, it's possible that we could move off of a Crash Warning to a still-negative but less dramatic set of conditions. As I've noted, the best indication of counter-trend rallies in bear markets appears to be strong reversals in breadth momentum in a falling interest rate environment. So a further decline in interest rates would be a precondition for acting on any substantial reversal to the upside.
As I've also noted, a further advance in the S&P (barring other important breakdowns) would also move us to a constructive position regardless of valuations or interest rate action. Unfortunately, the required advance was about 5% even at the peak a couple of weeks ago. At this point, the required advance is in excess of 8%. So while there is some possibility of taking a constructive signal from action in the major indices, the most likely source of a constructive signal would be a fresh upside reversal in breadth momentum coupled with a better interest rate environment.
For now, we have none of these. My opinion is that we won't see either, but we'll take any signal as it arrives. Until then, we have an extremely overvalued market showing poor internal uniformity, and a dawning realization by investors that the economy may not rebound as sharply as they had hoped only a few weeks ago (much less corporate profits).
This continues to be an unattractive condition in which to take market risk. We continue to carry a fully invested position in favored stocks, however, and are finding a sufficient number of good values in the broad market. Those holdings remain fully hedged here.
Sunday January 13, 2002 : Hotline Update
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The Market Climate remains on a Crash Warning here. That doesn't mean that a crash should be strongly expected, but it does indicate that current conditions match those from which prior crashes have emerged: extreme valuations, unfavorable trend uniformity, and hostile yield trends in long-term interest rates, utilities, and various measures of risk premiums.
On the subject of valuations, the S&P 500 currently trades near 22 times prior-record earnings (over 40 times current earnings). The most extreme readings prior to the current cycle occurred at the 1929, 1972 and 1987 peaks, all at 20 times record earnings. By themselves, extreme valuations only imply poor long-term returns, not poor short-term ones. It's the status of trend uniformity and yield trends that affects the short-term outcome of an overvalued market.
As for trend uniformity, I've noted that the best indication of the recent rally was the combination of a strong upward reversal in breadth momentum, coupled with falling yield trends. We lost the falling yield trends in December. Last week, the market also registered a negative reversal in breadth momentum. Moreover, this reversal occurred with valuations extreme and bullish sentiment clearly overextended. The CBOE volatility index is at one of the lowest levels in years - which typically signals a vulnerable market, and the Investors Intelligence figures show just 22.7% of investment advisors bearish. To find that low a level of bearishness in recent years you have to go back to the week of April 3, 1998. That was the exact peak of the market before the summer 1998 market plunge.
On the yield measures, we've had some relief for Treasury yields in the past couple of weeks, but we've also seen a significant spike in the yield on many industrial bonds over that same period, including issues in the Dow 20 Bond Average. That means that the difference in yields or "credit spread" between safe and risky debt has widened sharply. This is often a signal of deteriorating credit quality and rising default risks. We'll have to watch carefully for fresh corporate debt defaults in the weeks ahead.
The Wall Street Journal reports that over 70% of the economists they've surveyed project a substantial gain in GDP in the first quarter - a figure that rises to over 95% forecasting a second quarter gain and over 98% forecasting a third quarter gain. For all practical purposes, the vast majority of economists now view the recession as complete. I've spent a lot of time over the past couple of weeks reviewing these optimistic economic forecasts from all corners, to make sure I'm not missing something (as Kipling wrote, "if you can trust yourself when all men doubt you, yet make allowance for their doubting too..." - advice that comes right after the bit about everybody losing their minds). I've concluded that we're all looking at the same data, but are giving it dramatically different interpretations. Those data are namely 1) the recent rally in stocks, 2) the recent improvement in the ISM (formerly NAPM) surveys, and 3) the substantial string of Fed easings "in the pipeline", which have accelerated growth in broad money such as M2, and 4) the likelihood that inventories will stabilize, taking away the biggest negative factor currently pressuring GDP lower.
Most economists seem very willing to take this combination of evidence as a signal of a strong and virtually immediate economic turn here. This willingness is largely based on gut feeling, combined with an unwillingness to get inside of the numbers or exhaust equally plausible alternatives. As William Poole of the St. Louis Fed noted over the weekend, "It is too early to pick a precise date for the recession trough, but there is a bottoming out feel to the data.''
Kind of a tingly feeling? I thought so.
In my view, it is very important to understand that the rally we've seen in stocks was a momentum rally from a deeply oversold low, starting from a very high historical level of valuation, and never generating the favorable trend uniformity which has always appeared prior to past recession lows. The best signals of this rally were deeply oversold technical readings, falling yield trends, and indicators of momentum reversal. None of these factors are present here.
I've noted that the upward spike in bond yields in recent months was based not on information about an economic recovery, but merely reflected a normalization of maturity risk premiums. Similarly, the recent stock market rally was not based on information about a recovery, but reflected a momentum move off of an oversold low. With our best measures now indicating a negative reversal in breadth momentum last week, the momentum rally is now evidently complete. That doesn't rule out all further upside, or a retest of recent highs, but the technical underpinnings of the recent rally are now gone.
The ISM surveys in recent months have indeed been relatively good. But the operative word is "relatively." These figures measure respondents' assessments of business conditions from one month to the next, where 50% means that there were as many reports of improvement as deterioration. So for example, a move from 40% to 45% indicates that conditions are still deteriorating, on balance, but not as rapidly as the prior month. Given the off-the-cliff behavior of the economy in late September and October, the November and December "improvements" in the ISM surveys are difficult to take at face value, especially because many of these readings remain below 50, indicating continued overall deterioration in conditions.
My views about the Fed easings "in the pipeline" have been covered in the past year's issues of Research & Insight. Suffice it to say that nearly all of the increase in the Monetary Base over the last year appears as currency in circulation, not increased bank reserves. And while the money market and time-deposit components of M2 and M3 have grown substantially, this is largely an artifact of investors shifting their investments away from new commercial paper financing. Commercial and industrial lending at banks continues to languish. As far as I can tell, the main targets for M2-based lending are auto loans, home loans, and consumer loans.
So let's look at autos, homes, and consumers. Evidently, most economists believe that the auto, home refinancing, and consumer debt activity in recent months represents a sustainable trend. It is difficult to understand why they would ignore the possibility that the recent surge in auto purchases was a one-time response to zero-interest financing, and borrowed sales from 2002. It's difficult to understand why they would ignore the possibility that the home refinancing spike was due to a sharp downward spike in mortgage interest rates that has now reversed substantially, so that the bulk of refinancings are probably now behind us. It is difficult to understand why the record burden of consumer debt will be impervious to a rising unemployment rate, particularly when companies are facing a substantial acceleration in wage inflation in recent months as they try to shore up profit margins - making substantial new layoffs inevitable. Ford's announcement Friday of 35,000 new layoffs underscores my views on both autos and layoffs.
Finally, it is clear that any rebuilding of inventories will be a boost to GDP, since the current decline in inventory investment is a major drag to growth. The real issue is that past recoveries have always been driven by autos, housing, and capital spending surging off of very depressed lows. As I noted last week, autos and housing never weakened (and if anything, have enjoyed unsustainable spikes recently), while capital spending is dependent on widening profit margins, and is unlikely to revive anytime in the next few quarters. In short, inventory rebuilding is the only plausible bright spot for GDP here. Other factors that have historically driven economic rebounds - autos, housing, the consumer, and capital spending - are actually the factors that are most vulnerable here.
The bottom line: I continue to view the economy as very vulnerable to fresh weakness. We may very well have a better first quarter GDP figure driven by inventory building, but there is no substantial basis to expect robust growth in GDP, profit margins, or capital spending. In the stock market, we have extreme overvaluation, unfavorable trend uniformity, hostile yield trends, unusually extreme bullishness (a contrary indicator), and a negative reversal in breadth momentum off of an overbought peak. That's not an enticing environment in which to take substantial market risk.
So while we remain fully invested in favored stocks, those positions are now also fully hedged against market risk here. We are no longer leaving a portion of our stock holdings unhedged, but we always build our positions with the expectation that our favored stocks will outperform the indices that we use to hedge. That difference in performance is a source of risk, but it has also been the primary source of our gains in recent years.
As I always emphasize, our investment position is not driven by forecasts, but by the current condition of valuations and trend uniformity that define the Market Climate. Our position is concerned not with what should or might be, but with what is. All of the additional content in these updates is background and context. Our position doesn't rely on these views, and we will be very flexible in changing our position if trend uniformity reasserts itself. The main thing that could bring that about here would be a further advance of about 6% in the S&P 500 without new deterioration in other important market trends. For now, however, we remain strongly defensive.
Sunday January 6, 2002 : Hotline Update
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The Market Climate remains on a Crash Warning here. The next two weeks will be important in determining the sustainability of the recent advance. For now, the expected return to market risk is quite unfavorable.
Though I certainly keep some analytical details proprietary, one of my goals in these weekly comments is to give clients and shareholders a good picture of what I am looking at, and how that translates into our investment position. Here are some of the current considerations.
First, we've had a substantial rally from the September lows, without any favorable shift in our core measure of trend uniformity. Typically, bull market rallies generate favorable shifts very quickly, so the failure to do so in this instance has kept us both skeptical and generally defensive. Still, our fairly neutral market approach gained ground both on the decline into the September lows, and during the subsequent recovery. Occasional down days have typically been driven by unusual declines in one or two stocks (Peregrine Systems in the case of last Thursday), not by hedging.
Looking across all of the reliable models I've tested, none of them have generated a better historical performance or better risk management than the Market Climate approach using our existing measure of trend uniformity. But as I noted in mid-2001, I did introduce a useful "overlay" inspired by one of our directors, Nelson Freeburg (publisher of Formula Research). The idea of an "overlay" is to use a model on top of some other core approach. This overlay, based on market breadth (the number of advancing issues versus declining issues), appeared to be a promising way of catching more of these bear market rallies.
By itself, the model is not nearly as reliable as trend uniformity. But there is one exception: strong, positive reversals in the momentum of market breadth, coupled with falling interest rates. Historically this combination has generated a reasonably good return/risk profile for the market, even when our existing trend uniformity measure has been negative.
That's the one signal that has been favorable during most of the recent advance, and it is why, despite extreme valuations, I left as much as 20% of our stocks unhedged until the interest rate climate turned hostile a couple of weeks ago. Since market breadth is clearly a form of "uniformity", it made sense to lay this on top of our existing model.
Now, in hindsight, had I given this indicator maximum weight during the recent advance, we might have been as much as 40% unhedged on the signal rather than 20%. But I rarely make these changes wholesale, and did not do so in this case either. In real-time, the breadth reversal was registered on October 12, when the Market Climate moved off of an earlier Crash Warning. The S&P is up just under 10% since then. I've found an approach to make historical signals even more timely without getting clipped, but again, that's hindsight. In hindsight, the 8996 stock funds tracked by Lipper averaged a 13.3% loss during 2001, after losing ground in 2000 as well, while we gained. Nobody gets to act on hindsight, but we're always trying to learn more.
In short, the best signal of the recent rally was based on a sharply positive reversal of breadth momentum in a falling interest rate climate. The fact that this signal is no longer favorable is important, in my view. Two weeks ago, we lost that favorable interest rate climate, and we moved to a fully hedged stance. Moreover, if NYSE breadth is not significantly positive in each of the next two weeks, we will get a negative reversal in breadth momentum as well. We currently have no basis on which to hold a constructive market position. Any broad market decline at all in the next two weeks will only reinforce that stance.
That said, we also have to ask "What if this really is a new bull market destined to carry stocks dramatically higher?" The answer is fairly comfortable. Barring further breakdowns by other market internals, a further advance in the major indices of roughly 5% would be enough to override other divergences in the trend picture, and that would shift us to a constructive position (up to about 40% unhedged) regardless of valuations or economic conditions. The only way we would stay fully defensive is if new divergences were to emerge despite such a rally.
So most probably, any uncertainty in the market picture will be resolved within about 5% of current levels. That's about as narrow a range of uncertainty as the market ever creates. In any event, we don't invest on forecasts or expectations, but on the prevailing Market Climate. For now, that climate remains very hostile.
As for the economy, we have a similar range of cross-currents. On the positive side, the ISM surveys (formerly NAPM) have improved nicely, particularly in areas such as new orders. That's one of the only really favorable signs we've seen. Yet given that the indices measure changes in reported conditions from one month to the next, the literal interpretation of these figures is this. In manufacturing, conditions continue to deteriorate, but not as fast on a month-to-month basis as they did immediately after the September attacks. In services, conditions have improved slightly since just after the September attacks. Frankly, I'm not sure this is saying as much as people seem to infer.
Against that questionably positive news, we have a massive plunge in new home refinancings, that also drove the ECRI leading economic index to its sharpest weekly decline since September. But though the refinancing index is seasonally adjusted, part of the plunge was due to the shorter Christmas week. So we still have uncertainty until we get more data.
What we do know with reasonable assurance is this. Much of the recent decline in GDP has been due to inventory runoff ("negative inventory investment"). If inventories were merely to stabilize, we would get a boost to reported GDP growth. But in order to see significant positive growth, new economic recoveries have typically relied on 1) a surge in housing investment coming off of a deep trough, 2) a surge in automobile purchases coming off of a deep trough, and somewhat later, 3) a surge in capital spending, coming off of a deep trough.
Capital spending is the only one of these that has even declined in the latest downturn, and it is also the last to turn up in a new recovery. Capital spending is driven by high profit margins and rapid earnings growth, which typically doesn't emerge until well into a new economic expansion.
So while a stabilization in inventories will take a big negative off of GDP growth, sustained economic growth anything like historical recoveries would have to be based on a surge in consumer spending - particularly housing and autos. But we just had that. Consumers are up to their eyeballs in debt. Zero rate auto financing already produced a pop in auto sales last quarter, which is why GDP didn't collapse. Housing and consumer spending benefited from a plunge in mortgage rates that triggered a spike in refinancings. But mortgage rates have surged higher in recent months. The surge in wages over the past two months, coupled with strong upward pressure in benefit costs, is likely to constrain both profit margins and capital spending, as well as spurring further layoffs in the months ahead. Historically, recessions end with a sharp decline in the momentum of unemployment (even if the rate of unemployment continues to rise). By our measures, even last month's report represented a further acceleration in that momentum.
We can't rule out a quarter of positive GDP growth, as we saw in early 1974 (followed by a further decline and bear market plunge), but we can't see any basis on which to expect sustained and robust GDP growth yet, and certainly not robust earnings growth.
Finally, while we don't rely on such forecasts, it's interesting to note that on the basis of econometric forecasting models we maintain, the 6-month forecast is the worst reading since September 2000, which itself was the worst reading in the model's history. The current 3-month forecast for the S&P is the most negative reading we've seen in history.
Again, we don't rely on such forecasts, and barring fresh divergences, we would move to a moderately constructive position if the major indices were to advance about 5% further. But here and now, our stance remains decidedly defensive.
I hope that these comments are helpful in understanding why.
| 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. |