All contents copyright 2002, 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 June 30, 2002 : Hotline Update
Press "Reload" on your browser to access the latest update file
The Market Climate remains on a Warning condition. At present, there is not much likelihood of a near-term shift in this condition. The best chance at such a shift would be the combination of a decline in interest rates coupled with a very lopsided market plunge in which declines significantly outpaced advancers. This is a combination that has historically opened the way for intermediate-term bear market rallies. Both of the intermediate rallies seen so far in this bear market (March-May 2001 and Sep-Dec 2001) had this character. Unfortunately, the market has not generated the kind of washout that might give market risk at least speculative merit, if not investment merit.
Interestingly, other good analysts of price-volume behavior have made similar observations about market action here. Paul Desmond of Lowrys (www.lowrysreports.com) notes "The desire to dump stocks is now at the highest level in eight months. The Selling Pressure Index is just 4 points below its Sept 21st extreme of 773. And yet, prices have repeatedly eased lower, never giving investors the impression that stocks are deeply discounted. One analyst recently described the decline as similar to being eaten by ducks. There has been no real panic selling, thus far not a single 90% Downside Day."
In short, market conditions are presently characterized by unfavorable valuations and unfavorable trend uniformity. We would be willing to take at least a moderate exposure to market risk if the market generated a convincing momentum reversal. Such shifts in the speculative environment can sometimes be captured very close to market lows, and we never try to pre-empt shifts in the Market Climate. So until something in the Market Climate does shift for the better, we will remain fully hedged.
Since I have a difficult time condensing an idea into fewer than 23 paragraphs, it's nearly impossible to answer all of the notes I receive and still manage investments. Still, our outstanding shareholder services representatives do pass on comments and questions to me, and I try to work the most common ones into these updates. Good questions frequently require extensive answers, and these updates strike me as the most suitable forum for that.
Two topics deserve mention this week. The first relates to hedging. Currently, we are fully invested in over 100 favored stocks, with our largest positions representing about 2% of assets. Against this position, we have an offsetting short sale divided across the Russell 2000 and S&P 100 indices. While we can and will take unhedged positions when the Market Climate is sufficiently favorable, we are hedged at present, and our returns are driven by the difference in performance between the stocks that we hold long and the indices that we use to hedge.
While this performance difference is a source of risk, it is also our primary source of returns over time when we are hedged. Understand, however, that it is impossible for our favored stocks to outperform the market on a daily basis. Even though we carefully select which risks to take at any given time, we are fundamentally long-term investors. Even when we're hedged, we fully expect to experience many periods in which our favored stocks pull back, relative to the market, for a day, a week, a month, or for several consecutive days, weeks, or months - independent of market movements which are occurring. Unfavorable action in even a small handful of our stocks can and will produce this sort of behavior. In short, the fact that we are hedged does not mean that we take a risk-free position. We expect to be compensated for those risks that we choose to take, but it is risk nonetheless.
The second issue is the relentless tide of accounting scandals on Wall Street. In general, these are not accounting problems but ethics problems. With the exception of Enron's off-balance sheet debt, most of the scandals are arising not because items are left out of the books, but because they are misclassified to keep them out of "operating earnings" or "cash flow from operations" or other headline numbers that have little to do with the free cash flow that can be claimed by shareholders. Much of this elaborate misdirection can be avoided by holding companies to a higher standard than simply operating earnings that beat expectations by a penny. Operating earnings are the only first number in a tedious set of calculations and corrections that must be made in order to determine what can actually be claimed by shareholders. Usually (though not always), even a misleading set of numbers will cough up a confession if you poke at them a little.
A few of our prior updates will help to elaborate this point.
In our April 14th update, I wrote "When people talk about cash flow being an indicator of earnings quality, they're talking about the first figure on the Statement of Cash Flows: 'Net Cash Provided by Operating Activities.' Most of this cash disappears as unspecified "investments" and other uses of cash flow that make it unclear that the cash flow was ever legitimate in the first place. Often these 'investments' are simply expenses that have been purposely misclassified. The investments are then written off later as 'extraordinary losses', keeping them entirely out of the calculation of operating earnings..."
The April 14th update continued with a brief analysis of Enron. This week, we can illustrate these ideas by analyzing another randomly selected company. Let's see. Oh, here's one. Worldcom.
Last week, Worldcom disclosed that it had overstated cash flow by more than $3.8 billion since 2000. Essentially, Worldcom had purposely misclassified billions of expenses as "investments", keeping them entirely out of the calculation of operating earnings (why does that sound familiar?) Wall Street analysts were shocked, arguing that it was impossible to see this coming.
Evidently, they don't read these updates. As long as investors demand that companies deliver free cash flow (operating earnings minus a host of deductions, including capital investment over-and-above the amount required to replace depreciation), it makes no difference whether or not expenses are misclassified as investments. You deduct them anyway, and you measure the promise of those "investments" in part by the cash flow derived from existing assets. In any case, telecom companies like Worldcom, Qwest, and others simply fail this kind of test.
In our December 23, 2001 update, I noted "If you're going to value the stock as some multiple of operating earnings, the next calculation you make had better be to subtract off the value of the debt. For many companies, even if you appropriately adjust for capital spending and growth, the result is a negative number. In many cases, that is an indication that the stock is fundamentally worthless and the debt itself is not supported by cash flows. By our calculations, which should be considered opinion in this case, the group also includes several telecom companies still holding substantial market value, such as Qwest, Level 3, Adelphia and Nextel, several energy companies including Calpine, and certain large lending institutions and insurance companies that I'm going to pass on identifying."
Since last December, the stocks I listed by name have lost about 70% of their market value (the troubled financials are also weakening substantially, but since I refuse to be responsible for a run, I'll still pass on identifying them). Adelphia is now closest to being fairly valued. Having plunged from about $30 in December to 70 cents a share at Friday's close, Adelphia's stock price is now within less than one dollar of what I believe it to be worth.
On the positive side, I note in passing that Cisco, Oracle, EMC and Sun Microsystems have now finally reached the value targets that we published in January 2001, and which Alan Abelson was kind enough to review in Barron's at the time. These targets got a lovely on-air reception by the guys on CNBC's Squawk Box, since they were a fraction of the prevailing market prices (EMC for example was trading near 80). Aside from Cisco, these stocks are starting to look interesting (though only as part of a fully-hedged portfolio). Being about 80-90% off of their highs, we've also got to allow for the possibility of indiscriminate selling by disillusioned investors. We're never very aggressive about stocks that show apparent value without a certain amount of evidence from market action. But at least the techs aren't the focal point of overvaluation anymore. Suffice it to say that we continue to find little merit in telecom or financials. Media companies, investment banks, and a number of high-profile Japanese companies (traded as ADRs) are also deteriorating rapidly in our valuation work.
In other markets, we're still nibbling gradually on precious metals stocks on declines, and would avoid long-term bonds beyond a maturity of about 10 years, as import price inflation and a falling dollar threaten to have an unfavorable impact on reported inflation even if economic activity remains weak. I consider this a reasonably good second chance to lock in a mortgage refinancing rate if you've been considering it.
In stocks, the Market Climate remains unfavorable, which holds us to a fully-hedged position for now.
Wednesday Morning June 26, 2002 : Special Hotline Update
Press "Reload" on your browser to access the latest update file
The Market Climate remains on a Warning condition. Trend uniformity continues to deteriorate to a striking extent. We don't need to make any forecasts in order to justify a fully hedged position - unfavorable valuations and trend uniformity are sufficient evidence in that regard.
Our investment position is fairly neutral to market risk here - we are long stocks characterized by favorable valuation and market action, with an offsetting short position in the Russell 2000 and S&P 100. This position makes no "bets" on market direction, and its returns are driven by how our favored stocks perform relative to the market. When we're hedged as we are now, the intent is for this relative performance to accrue over time - it's fairly impossible to accrue it on a daily basis (though I've actually received hostile e-mail when we've pulled back by even a percent or two). So regardless of market action, a neutral stance is a comfortable position for us. In contrast, the potential risk to an unhedged, buy-and-hold position is unusually serious.
I've noted for months that a plunge in the U.S. dollar would probably one of the main signals of renewed weakness in the U.S. economy. On Tuesday, the dollar dropped to a fresh low. Much of the optimism for an economic recovery has been based on a rebound in consumer confidence and the Purchasing Managers Index off of last year's troughs. I expect these figures to deteriorate in coming reports, throwing the thesis of a new economic recovery into question.
With Tuesday's selloff, the NYSE Composite has registered five consecutive declines with substantial new lows in each session. This is notable, because it is an occurrence that has typically preceded major market plunges (including 1987 and 1990) within a matter of weeks. Now, not every occurrence is associated with a subsequent plunge, but given the hostile Market Climate at present, we have to be on alert for the possibility of a major break of the September lows.
In technical action, Richard Russell (www.dowtheoryletters.com) notes that the decline in the Dow Transports on Tuesday took out the prior May low. For several weeks now, the Transports had failed to confirm the break of the May low by the Dow Industrials. Tuesday's action took away that favorable divergence, and was a renewed confirmation of an ongoing bear market under Russell's (authoritative) interpretation of Dow Theory.
The S&P 500 looks sick as well (click here).
In short, it's always possible that the market could be retesting the September lows, rather than risking a substantial break, but in any event, we do not have evidence that would justify taking market risk at present. Although my tone in this update is intentionally serious (and slightly ominous), the simple fact is that no forecasts are required. The current unfavorable status of valuation and trend uniformity is sufficient to hold us to a neutral position. Since we take risk on evidence rather than opinion, we would be fully hedged even if my opinion about market direction was favorable.
Sunday June 23, 2002 : Hotline Update
Press "Reload" on your browser to access the latest update file
The Market Climate remains on a Warning condition. At present, valuations and market action continue to display very unfavorable features, which makes us alert to substantial downside risk. However, the awareness of substantial risk is not a forecast, and I have no meaningful forecast of market action ahead. Overvaluation implies an unsatisfactory long-term return to holding stocks purchased at current levels, while unfavorable trend uniformity implies a lack of speculative merit to taking market risk. That's enough to keep us fully hedged, and no forecasts - particularly short term ones - are required.
It is important to understand that we are fully hedged here - we are fully invested in stocks that exhibit favorable valuation and market action, while hedging their market risk using short positions in market indices such as the Russell 2000 and the S&P 100. This position has certain characteristics. The most important being that there is virtually no relationship between our performance and the performance of the market on any given day. It is futile to interpret the performance of a market neutral position in the context of market direction. Our day-to-day performance is driven by the difference in performance between the stocks we hold long and the indices we hold short, not by any strategy toward market movements.
Also, market conditions are currently characterized by overvaluation, particularly among large-cap stocks, and by downward pressure on profit margins. As a result, we find ourselves holding a lot of stocks that could be considered "small cap value", where "value" in this context is defined in the classic sense - slow and stable growth with low valuation multiples. But this is strictly a function of market conditions. We would be very eager to hold large cap stocks along the classic "growth" definition if that was the group displaying favorable market action and value along our own measures.
Frankly, I don't believe that a good stock selection approach should make any meaningful distinction between "value" and "growth". The price of any security is the present discounted value of the stream of cash flows that that security will deliver to investors over time. If the price is low enough that the implied rate of return to that stream of cash flows is very high, that stock is a "value" stock. But such a stock may in fact be growing very rapidly too. A decade ago, Personal Investor Magazine published my top stock pick in terms of both "value" and "growth." That stock had a P/E ratio of 35, because in that particular market climate, the best values were often found among what would commonly be defined as "small cap growth." By the mid-1990's the best values were often found among what would be defined as "large-cap growth." Currently, "small cap value" is favored by market conditions, but that will also change. In short, I don't find the classic distinction of growth versus value to be of any use at all. Value is implied by the relationship between a security's price, and the cash flows it can be expected to deliver, regardless of how quickly or slowly those cash flows are growing. A growth stock may or may not be a value as well.
As I noted last week, our view on market overvaluation is in part predicated on the belief that long-term returns of 9% or more on the major indices would offer sustainable investment merit here, while substantially lower returns would not. If like some analysts, you're convinced that stocks should be priced to deliver 7% long-term returns into the indefinite future, then it is accurate to conclude that stocks are modestly undervalued here. If, counter to the historical behavior of peak-to-peak earnings over the entirety of recorded history, you believe that S&P 500 earnings will grow dramatically faster than nominal GDP in the long-term, then you may also conclude that stocks are undervalued. In either case, conclusions about valuation always follow from premises. Analysts who are willing to assume implausible or counterfactual premises are also destined to arrive at substantially different views about valuation than ours.
Last week, the U.S. dollar fell to a fresh low and the yield curve flattened further, both as expected. This market action reflects substantial risks of much slower economic activity. At this point, however, I am concerned that a flight out of the dollar could hurt long-term bonds, so maturities beyond about 7 years are becoming vulnerable.
Also last week, it was reported that the U.S. trade deficit hit a record high. As I've noted frequently, every strong economic expansion in the past has emerged from a surplus in the U.S. current account, reflecting a great deal of U.S. savings available to finance investment and consumption growth well in excess of U.S. GDP growth. With the trade deficit at the deepest deficit in history, we can be fairly confident that the U.S. is not positioned to embark on a consumption and investment driven economic boom anytime soon. This is underscored by relatively weak capacity utilization and help wanted indices, which have a strong history of distinguishing strong recoveries from faltering ones. These indices are confirming indicators - not the basis of our economic views, but consistent with the conclusions from a much broader set of data.
I really believe that most of the optimism about the economy boils down to two sets of data - Federal reserve moves, and confidence surveys such as consumer confidence and the ISM Purchasing Managers Index. Early last year, I argued that Fed easings were likely to be ineffective in an investment-driven downturn, and nothing in the lending statistics has yet changed that view. The confidence surveys, of course, were wildly skewed by 9/11 - particularly because they generally ask whether the respondent feels that conditions are "better" than they were the month before. Who would not answer "yes" to that question with the post-9/11 shock as the frame of reference? The difficulty is that this recovery in sentiment is now fairly complete. At this point, I believe that fresh declines in both consumer confidence and the ISM figures are very likely.
As you know, we've already been nibbling on gold positions on declines on the basis of declining real interest rate trends in the U.S. relative to foreign countries - one of the key drivers of currency and gold moves. If the ISM Purchasing Managers Index declines below 50 in the months ahead, we would probably step up our investments somewhat. In any case, we're only talking about a few percent of total assets, but these small investments can provide substantial diversification benefits in market conditions that are favorable to gold. In any event, gold stocks should rarely be chased. Their volatility makes moving-average systems fairly useless. About the only way we're willing to buy them is on declines, when various criteria are met regarding valuation and market action.
The bottom line - I have no short-term forecast of market action, particulary because stocks are once again fairly oversold. That always creates the possibility of a "fast, furious" bear market rally to clear that condition. But the overall Market Climate remains very hostile, and substantial market losses, even from current levels, cannot be ruled out. Economic conditions also appear to be at risk for fresh deterioration and disappointment for expectations of a "second half recovery."
Normally, large counter-trend rallies do not develop until the market experiences a very strong whipsaw in the behavior of market breadth, which suggests that we are likely to see at least one week of dreadful breadth (declining issues dramatically outnumbering advancing ones) before the market mounts any kind of sustainable bear-market rally, or (much less likely) a new bull market. For now, we simply have no evidence of investment merit or speculative merit upon which to justify taking market risk. Accordingly, we are fully hedged.
Tuesday Morning June 18, 2002 : Special Hotline Update
Press "Reload" on your browser to access the latest update file
The Market Climate remains on a Warning condition here. Until that changes, we will hold to a defensive position. Monday's rally did little in that regard, appearing as a typical bear market rally to clear an oversold condition - fast, furious, and prone to failure. Monday's action was paced by technology and financial stocks, and being light on those sectors in our long positions, but hedged with market indices that include them, it was not a day that we would have expected much in the way of returns. Volume also dried up, which is also characteristic of a short squeeze - typical for bear market rallies off of oversold lows. As William Peter Hamilton noted nearly a century ago, a market that becomes "dull on rallies and active on declines" is not to be easily trusted.
As a sidenote, gold stocks have sold off substantially in the past two weeks. Due to their high volatility, gold stocks should almost strictly be purchased on weakness. The ratio of gold ($/oz) to the XAU has moved above 4.0, which I consider to be an important and favorable measure of value. We use a number of more sophisticated measures, but the gold/XAU ratio seems to perform well despite its crude construction. Also, long-term interest rates have resumed a downtrend, with the yield curve flattening as anticipated. This is likely to create significant and fresh downward pressure on the value of the U.S. dollar. The outlook for gold stocks would be particularly good if the ISM Purchasing Managers Index were to decline back below 50, but even here, we've recovered a modest interest in gold stocks on declines.
In any event, the stock market remains somewhat oversold, so we should not be surprised if this advance continues a bit in order to clear that condition. Of course, given the hostile Market Climate, we should also not be surprised if the bottom falls out. That's an attractive feature of being hedged without a net short position - we couldn't care less which direction the market goes, because we are not substantially positioned to derive benefit or endure losses from taking on market risk. There are plenty of sources of risk that we believe are worth taking, and we are fully invested in a wide variety of stocks. But we have hedged away the bulk of their market risk because the expected return to such risk is unfavorable. In other words, we're still taking risk, but it's not general market risk. The net effect is a position that does not depend on market direction for returns. Rather, given our current investment stance, our returns are presently driven by the difference in performance between the stocks that we hold long, and the indices that we use to hedge.
Again, the potential for our favored stocks to behave differently than the market is a source of risk, but it is also our most reliable source of expected return in a hostile Market Climate. On a day-to-day basis, that performance spread can go either way, and because we are fully hedged, we will not have much relationship with market movements at all. Over time, however, the value and strength of our holdings, relative to the market, has served us very well.
So we remain a calm boat, on course despite a turbulent sea - neither tossed by the waves, nor sent under by them. Our sails are aligned with the prevailing wind. When the wind changes, we'll adjust the tack again. For now, we remain defensive.
Sunday June 16, 2002 : Hotline Update
Press "Reload" on your browser to access the latest update file
The Market Climate remains on a Warning condition, freshly deteriorated. Last week, the market lost support from breadth (advances versus declines) and leadership (new highs versus new lows), as internal action surrendered a great deal of the resilience that has marked recent months. That doesn't necessarily mean that conditions will worsen further. As usual, I have no forecast of market direction. But we need no forecast to know that the present, identifiable Climate is unfavorable. That might change next week, next month, or next year, but until it does, we will maintain a defensive position.
This insistence on maintaining a position in line with the prevailing Market Climate, while requiring no meaningful forecast of future market action, is what distinguishes us both from buy-and-hold investors and from market timers. We focus strictly on the present. The present is the only point in time where reality can be observed, and where action can be taken.
The prevailing Market Climate is the result of two observables: valuations, and market action. Currently both are negative. We know that historically, this combination has been associated with a very poor return/risk profile for the market, taking all such periods together on average. But we measure the Market Climate weekly. On a weekly basis, the average loss works out to a very small number - much smaller than typical weekly volatility. So beyond a small, unreliable, and statistically insignificant tendency for the market to decline over the coming week, we have and need no meaningful forecast of market direction. And yet, we have great comfort holding a fully hedged position. It takes a while to fully understand this approach. At its core, our strategy is focused on observable reality rather than hope, forecasts, or blind expectations of reward from market risk.
Of course, reality is always interpreted by its observer, and the same fact can be interpreted in different ways by two observers, depending on the clarity or baggage that they bring along. Probably the best example is last week's statement by Abby Joseph Cohen on CNBC that the S&P 500 is 20% undervalued. In order to understand why we observe reality and see stocks as overvalued, while she observes reality and sees them as undervalued, you have to understand that while reality is reality, the concept of value is subjective. When anybody talks about value (including us), they are implicitly assuming some particular long-term rate of return that they believe is reasonable.
Consider a bond that promises to pay $100 a decade from now. If an investor believes that bonds should be priced to deliver a 4% long-term return, the "fair value" for that bond is about $68. In contrast, if an investor believes that bonds should be priced to deliver a 12% long-term return, the "fair value" for that bond is about $32. Which view of "value" is correct? It depends on what you believe about other investors and their willingness to accept 4% versus 12% as a sustainable rate of return.
The same holds true in stocks. The price of a stock is also the discounted value of the future cash flows it will throw off to investors, only there is an additional issue since the cash flows are growing and uncertain. Still, the problem is much simpler than widely believed, and the range of plausible outcomes is also much narrower than widely believed. As Warren Buffett noted last year, among the 100 leading stocks in the market, you can wager a tidy sum that only a tiny handful will achieve 15% earnings growth over a 20-year period.
Earnings for the S&P 500 as a whole are even better behaved, since earnings growth simply does not differ much from nominal GDP growth over the long-term. From year-to-year, of course, earnings vary a great deal, so trough-to-peak growth can be extremely high, and peak-to-trough growth can be horrifyingly negative. But regardless of whether you look over the past 10, 20, 50 or 100 years, peak-to-peak earnings growth for the S&P 500 has been strikingly well behaved, growing at a nominal rate of 6% annually with great consistency.
Given that fact, the question of "fair value" comes down to the model you use. Take the "dividend discount model" for example. This model says simply that the long-term rate of return on stocks is equal to the long-term growth rate of dividends, plus the dividend yield. (As long as you take dividends as per-share values, this model is valid even in the presence of stock repurchases). The real problem is that some people make frighteningly implausible assumptions about the "fair" long-term return that stocks should be priced to deliver.
For example, suppose you believe that stocks should be priced to deliver 2% more than long-term bonds over the long term, and long-term bonds are yielding 5%. Well, you're now looking for the level of stock prices at which stocks will be priced to deliver 7% long-term returns. If dividend growth is 6% annually, the dividend discount model will then tell you that the "fair" dividend yield is 1% (i.e. 7% total return = 6% growth + 1% yield). With dividend yields currently at 1.5% then you will conclude that the S&P 500 is undervalued here, and that "fair value" is 50% above current levels.
But let's test the robustness of this model. Suppose that bond yields rise by 1%. In that case, we need to get an 8% long-term return, with only 6% contributed by dividend growth. Suddenly, we need the dividend yield to be 2% instead of 1%, implying a 50% decline in "fair value" in response to a little 1% rise in interest rates. This result should bring the careless use of the dividend discount model into question when very low risk premiums are being assumed. Essentially, the Glassman and Hassett "Dow 35000" garbage is essentially an irresponsible contortion of dividend discount.
Now consider the so-called Fed Model, which holds that the prospective earnings yield on the S&P should be equal to the 10-year Treasury yield. As long as you're willing to forecast a wildly optimistic level of operating earnings for the coming year (Abby's specialty), you'll also be willing to call stocks undervalued.
Of course, operating earnings include not only claims of shareholders, but also interest owed to debtholders and taxes owed to the government. And even including good signals from two extreme readings (positive in '74, negative in '87), deviations from the Fed model have absolutely zero statistical relationship with subsequent returns. I fully believe that the Fed model lacks any usefulness as an investment management tool. In fact, the raw, unadjusted earnings yield on the S&P 500 is statistically more reliable. But go ahead and use it anyway if you enjoy confusion and disappointment.
One of the questions I've received lately is whether my view of stock valuations has changed due to the recent decline in the 10-year bond yield. The answer is yes, but so negligibly as to be irrelevant. When you form an assumption about the "fair" long-term return on stocks, you have to consider not only current bond yields, but also their historical tendency to change. A 1% increase in yield to maturity produces a decline of only about 7.8% in a 10-year bond, but a 1% increase in dividend yield would currently produce a decline of about 40% in stocks. Clearly, a change in bond yields does not, and should not, translate percent-for-percent to a change in long-term stock yields.
In my view, stocks should currently be priced to deliver long-term returns in the 9% area - a rate of return that reflects a relatively low level of interest rates, but a greater risk premium than typically assumed by perennial bulls. On the assumption of 6% long-term growth in fundamentals, a 9% long-term total return implies a 3% dividend yield. Currently the yield on stocks is half that level. No plausible decline in interest rates would justify a market dividend yield of 1.5% (compared to a historical average of 4%), a market price/book ratio of 5 (compared to a historical average of about 1.5) and a price/peak-earnings ratio of 20 (compared to a historical norm of 14 and average bear-market lows below 9).
Essentially, the total return on stocks can be partitioned into three pieces: 1) capital gains from long-term growth in fundamentals, 2) capital gains due to changes in valuation, plus 3) dividend income. Let's first assume that valuations are actually fair at current levels. What is the long-term return implied by current prices? Well, since the peak-to-peak growth in nominal S&P 500 earnings has been very well behaved at about 6% over the past 10, 20, 50 and 100 years, a constant price/peak-earnings multiple for the S&P 500 would also produce long-term capital gains of about 6% annually. Add in a 1.5% dividend yield, and stocks are priced to deliver about 7.5% over the long term, if earnings move back to peak levels and grow at 6% annually, and the price/peak-earnings ratio remains at its current level of about 20 into the indefinite future.
Of course, a price/peak-earnings multiple of 20 is the level seen at the 1929, 1972 and 1987 peaks. So we also have to be sensitive to the possibility that valuations will decline in the future. In that event, the contribution to returns from changes in valuation becomes negative. So a long-term return of 7.5% from the S&P 500 should be taken as somewhat optimistic. By comparison, the run from 1982 to 2000 took the price/peak earnings ratio from 7 to 34, which provided a massive source of capital gains in addition to earnings growth itself. And while many people rave about a new era of productivity growth, I'm not quite convinced that productivity growth born of constant output and falling employment is a sustainable trend. Even if it were, it should be understood that among economists, an increase of even 0.5% in long-term productivity would be considered a fantastic improvement. So maybe we're off by half of a percent. In any event, I believe that stocks are currently priced to deliver a long-term rate of return much lower than investors have historically earned, and more importantly, much lower than they are likely to eventually demand.
If you believe that over the long-run, investors will demand a long-term return in the area of about 9%, then stocks are about 50% overvalued. But that is not a forecast in any meaningful sense. Overvaluation means only that stocks are currently priced to deliver an unsatisfactory long-term rate of return. It implies little about short-term returns.
The bottom line is simple. The term "fair value" always incorporates the assumptions of the analyst. Currently, stocks are priced to deliver a long-term return of something less than 7.5%. If you are a long-term investor, and think that 7.5% is a great return, and that future investors will agree that 7.5% is a great return far into the indefinite future, then go ahead and buy stocks. If 7.5% seems implausibly low as a sustainable long-term rate of return, the conclusion is that market risk does not have investment merit, and the only rationale for buying stocks on an unhedged basis is speculative merit. On that front, trend uniformity is unfavorable, so market risk currently lacks that merit as well.
With our approach indicating a lack of both investment merit and speculative merit to taking market risk, we remain fully (and comfortably) hedged. That position will change when the prevailing Market Climate changes.
Sunday June 9, 2002 : Hotline Update
Press "Reload" on your browser to access the latest update file
The Market Climate remains on a Warning condition, freshly deteriorated. That's difficult to do, given that the bulk of essential trend supports for this market have already been lost. Last week, utility stocks joined the concert. Some of this is of course driven by "new era" energy companies rather than the old-line electrics, but the weakness is generalized enough to take seriously.
Markets are always driven by the relative eagerness of buyers versus sellers. Every security, once issued, must be held by somebody, which is why there is never such a thing as "money going into the market" - markets are simply locations where securities change hands. They are not big balloons which inflate or deflate based on so called "money flow." That said, it's often informative to form an idea about who is doing the buying and who is doing the selling. On that front, corporate insiders have accelerated the pace of selling to one of the fastest rates on record - well above anything seen even in the past two years. Meanwhile, the proportion of bearish investment advisors remains pinned near the 30% level, and even in the recent selloff, the CBOE volatility index has remained stubbornly low. In effect, the sentiment indicators have a particularly strong skew here - insiders selling and speculators still complacent. That's not typical of important lows.
So while stocks are certainly oversold, and thus open to the typical explosive bear market rally to clear that condition, it is not uncommon for oversold conditions to persist during bear markets. Given the confluence of overvaluation, poor technical action, and global tensions, we have to leave open the possibility of something decidedly more damaging on the downside.
That is not a forecast. Our current position is neutral to market movements - not bearish or bullish. But on the measures that we use to define the Market Climate, market risk has neither investment merit nor speculative merit here. Unhedged market risk adds to risk and volatility without adding to expected return at present. So while we remain fully invested in stocks characterized by favorable valuation and market action, those stocks are affected by general market fluctuations, and we have fully hedged against the impact of those fluctuations to the best of our ability.
Friday Morning June 7, 2002 : Special Hotline Update
Press "Reload" on your browser to access the latest update file
The Market Climate remains on a Warning condition. While that's an identification of prevailing conditions and not specifically a forecast, I have chosen to call this particular climate a Warning with a capital "W" because every historical market crash of note is found within this one set of conditions. Those conditions are: extremely unfavorable valuations and poor trend uniformity. We used to include "hostile yield trends", but thanks to last year's research regarding breadth momentum reversals, that additional criterion is now unnecessary. At present, the market is displaying the same set of characteristics as it did just prior to past market crashes.
Whenever the market is on a Warning Condition, we are typically fully hedged. Given our current investment position (a "flat" hedge using long put/short call index option combinations with identical strike prices and expirations), it is fairly irrelevant to us whether the market rallies powerfully or crashes. The only thing that drives our returns here is the difference in performance between the stocks we hold long and the indices we use to hedge (mainly the Russell 2000 and the S&P 100 Index). The potential of our favored stocks to diverge from overall market performance is a source of risk, but it is exactly this risk that we expect to earn compensation for taking.
We never invest on opinions or scenarios (and neither should you), but I am very comfortable with our fully hedged position here. This is because I am more concerned about a crash than usual. As I noted on Monday's update, a market that breaks prior support often follows-through briefly, and then experiences a very powerful rally back toward the old support level before failing again. In this regard, Wednesday's rally was very anemic, and the subsequent decline on Thursday was accompanied by a sharp reversal in leadership - with the number of stocks hitting new lows suddenly flipping significantly above the number of new highs.
In both 1929 and 1987, the market crash began about 55 trading sessions after the peak. During those sessions, the market traced out a characteristic pattern of declining peaks and troughs, with a one-day rally just after the third trough (roughly 14% down from the peak), and then "five days of Armageddon." This is exactly the pattern that the S&P has traced since its late-March peak.
Friday will be important because the market is at a very important juncture. On one hand, stocks are quite oversold. Though oversold conditions can persist during bear markets, it is also to be expected that bear markets frequently produce explosive rallies ("fast, furious, and prone to failure") to clear these oversold conditions. If instead of rallying sharply, the market declines by an unusually large amount on Friday, it would be a sign of trouble.
Not that we would do anything differently in that event. I expect our current, fully hedged position to insulate us from the bulk of any unseemly market action ahead.
In short, the prevailing Market Climate remains on a Warning. That always includes a capital "W", but it is particularly important to note that here.
Tuesday Morning June 4, 2002 : Special Hotline Update
Press "Reload" on your browser to access the latest update file
The Market Climate remains on a Warning condition. On Monday, bank stocks, financials and retails all broke their respective 200-day moving averages. This is important, because these sectors have been crucial in preventing serious declines. The S&P also broke to a new low for the year. Typically, breaks of prior support levels result in initial follow-through lower, followed by a powerful surge back toward the prior support level, and then a fresh and more aggressive decline. There's no telling whether that sort of pattern will hold in this instance, but it would not be surprising to see such action unfold.
This kind of scenario is also consistent with what we see in other technical measures. I noted on Sunday that initial increases in the CBOE volatility index tend to be followed by market weakness. On the other hand, the market appears somewhat oversold on a short-term basis. So it's possible that we could see a further initial decline, followed by a typical bear market rally that to clear the oversold condition - fast, furious, and prone to failure - followed by renewed weakness, perhaps on Friday's unemployment report. As usual, that's not a forecast. Think of that scenario the same way as you would think of a horoscope.
Of course, we never invest on the basis of scenarios. For our purposes, both valuations and trend uniformity remain clearly unfavorable. That places us in a defensive position, and we have no inclination to "play" short term swings, or the prospect of short term swings. We invest on appropriate evidence. At this point, that evidence remains negative, and we remain fully hedged.
Sunday June 2, 2002 : Hotline Update
Press "Reload" on your browser to access the latest update file
The Market Climate remains on a Warning condition. On a weekly closing basis, the S&P 500 Index is up just over 10% from its September low. Analysts can call that a bull market if they wish. In our view, bull and bear markets don't exist in observable reality - only in hindsight. What matters is what can be observed. At present, valuations remain extremely unfavorable, so there is no investment basis for taking market risk. Trend uniformity also remains unfavorable, so there is no speculative basis for taking market risk. And so, we remain fully hedged.
We can't rule out the possibility that stocks are indeed in a bull market. But even if we believed they were, we would be fully hedged, because that belief would be pure opinion. The same goes for our investments in various industry groups. Even if we thought financial stocks might rally, they currently fail to satisfy our criteria of valuation and market action. Until a few weeks ago, we held a number of gold stocks, but we sold them on strength because they became overextended and certain trend supports were lost (see "Going for the Gold" on the Research & Insight page to see some of these considerations). I would expect to reestablish gold positions if the Purchasing Managers Index was to fall below 50 and long-term rates were to trend lower. But for now, we've taken good profits and are comfortable having done so, regardless of whether gold moves higher or pulls back. In each case, our positions are driven by specific, observable criteria - not anybody's opinion, including my own.
I really believe that the key to success in anything is daily action. Find a set of actions that you believe will produce results if you follow them consistently. Then follow them consistently. One of our daily actions is to position ourselves in line with the prevailing Market Climate, rather than investing on hope. Another is to take daily opportunities as they arrive - buying highly ranked stocks on short term weakness, and replacing lower ranked holdings on short term strength. By focusing on the present realities, we've already attended to the future. Since the present is the only point at which we can exercise action, a constant focus on the present typically results in repeated and effective activity toward our goals.
In contrast, many investors have focused on denying reality and hoping, hoping, hoping for a recovery. That hope has locked them out of all activity. All they can do is hold on, being happy when stocks rally, and being disappointed when they decline. But never taking action, because they've relegated action to the future, when they hope for some vague opportunity to break even.
In market action, corporate bonds have been behaving somewhat better, and it will be one positive if that trend can continue. But most of the economic attention this week will be focused on the Purchasing Managers Index and the unemployment rate. The Chicago PMI was strong, and the national figure comes out on Monday. That may give investors some brief encouragement in the face of a slightly oversold market. In contrast, I would expect that the unemployment rate will remain quite high, reflecting the dismal rate of hiring evidenced by the help-wanted index. As I've noted frequently, the help-wanted index and capacity utilization are the key figures that might help to confirm expectations of an economic rebound. Currently, both remain near their recession lows.
In other indicators, Barron's notes that the slight increase in the CBOE volatility index was cited by traders as a "positive sign that a short-term bounce is near." Unfortunately, that's not how the VIX tends to work. The VIX is still at a very low 22.8%. Typically, market declines accelerate once the VIX rises measurably off of its low. It's only when the VIX spikes to a very very high level that investors can form beliefs about the market being oversold. And even then, the extremes are typically identifiable only in hindsight. In short, the recent upmove in the VIX is a negative here.
In any event, the present Market Climate holds us to a defensive position for now.
Monday May 27, 2002 : Hotline Update
Press "Reload" on your browser to access the latest update file
The Market Climate remains on a Warning condition. This condition is defined by a combination of unfavorable valuation and unfavorable trend uniformity. I continue to view the advance off of the September low as a counter-trend rally in an ongoing bear market. My opinion is that the major indices will eventually fall below their September troughs.
While we did see a strong reversal off of the September low (allowing us to reduce our hedges by as much as 20%), the market never recruited trend uniformity. Basically, stocks launched off of the September low in unison, and then immediately began developing important divergences.
Interestingly, Lowry's ( www.lowrysreports.com) notes that the September low differed from more durable lows in that we never saw a swing in what they call "90% days."
Usually, bear market lows are preceded by a series of days in which down-volume represents at least 90% of up-volume and down-volume taken together, and the number of down-points among NYSE stocks represents at least 90% of up-points and down-points taken together. In general, a new bull market often follows the final 90% down-day with a 90% up-day just a few trading sessions later. The series of 90% down-days followed by a 90% up-day is taken by Lowry's as a signal of a completed washout, which often marks the start of a new bull market. The September low did not produce this, which makes Lowry's also believe that the bottom is not in place.
Among other indicators based on internal action, I noted that the 10-day average of the trading index (TRIN) had moved above 1.5 a couple of weeks ago. Part of my concern with this high reading is that it was not accompanied by any extreme of bearish sentiment (for example, a high proportion of bearish investment advisors or a spike in the CBOE volatility index). Normally, a 10-day TRIN above 1.5 is a measure of capitulation. The recent reading, emerging with high levels of bullishness among investment advisories and brokerage strategists, is more suggestive of distribution in large cap stocks, rather than capitulation. In short, the recent high TRIN strikes me as a danger signal, not a positive development.
On the economy, I continue to be in fairly thin company in my concern about the durability of economic strength. It's odd to see investors demanding aggressive cost cutting to improve profit margins, yet not realizing that if this is done economy-wide, those efforts will aggregate into greater job losses and weaker capital spending overall. Stephen Roach of Morgan Stanley is among the few analysts who seems to carry the same opinion. Also, there's an interesting commentary on contraryinvestor.com. It's one of the few places where I've seen comments about the continuing and almost surreal weakness in the Help Wanted Advertising Index.
Of course, we need no forecasts in order to carry a defensive position here. The current unfavorable status of valuations and trend uniformity is enough. We remain fully hedged.
Sunday May 19, 2002 : Hotline Update
Press "Reload" on your browser to access the latest update file
The Market Climate remains on a Warning condition. While we remain fully invested in favored stocks exhibiting favorable valuation and market action, the market risk of those stock positions remains fully hedged. We're still taking stock-specific risk of course; that portion of risk that is uncorrelated with movements in the overall market. But that's risk that we expect to be compensated for taking. In a fully hedged position (provided that the long-put/short-call combinations we use have identical strike prices and expirations), our returns are driven by the difference in performance between the stocks that we hold long and the indices we are short as a hedge. That position does involve risk, but again, it's the portion of the overall risk that we believe is worth taking. At present, market risk is not worth taking, and we've attempted to hedge it away.
Since November 21st 1997, Treasury bills have outperformed the S&P 500 Index on a total-return basis. That's exactly 4 1/2 years. At the time, the market was frantic for large-cap blue chip stocks, and index funds were drawing a great deal of investor enthusiasm. At the time, I was also writing that stocks were likely to underperform Treasury bills over the coming 5-10 years. Since then, precious little of the overvaluation that existed then has been resolved. The price/peak-earnings ratio on the S&P 500 Index was 23.7 then. It is 20.6 today, still well above its historical norm of 14, and a far cry from the average of 8.9 that has historically marked bear market lows. That doesn't imply a forecast, but it is lunacy to believe that stocks are priced to deliver long-term returns above single digits.
On valuations, the continual sales pitch continues to be that interest rates and inflation are low, so stock valuations are reasonable here. Of course, this argument hinges on ignoring all data prior to 1965, when interest rates and inflation were generally below current levels, but valuations were nowhere near as high. More importantly however, it's essential to understand what is being argued. The basic assumption is that when bonds are priced to deliver a low rate of return, stocks should be priced to deliver a low rate of return as well, which implies that a high P/E is justified. Fine. But if you accept that as a premise, you've got to follow through and accept it as a conclusion. Namely, to say that a high P/E is "justified" is equivalent to saying that low long-term returns on stocks are "justified." My concern is that people hear these analysts saying that high P/E's are justified, and then go on to assume that future stock returns from a "justified" P/E multiple will be at least average, if not above average.
The issue comes down to what one means by "fair value." If the premise is that stocks should be priced to deliver 7% long-term returns, and that investors are likely to demand no more than this in the indefinite future, then stocks are fairly valued. Yippee. But if your notion of fair value is the price that could be expected to sustainably deliver say, a 10% long-term rate of return, then stocks are about double the level that would plausibly generate that.
When we talk about valuation, we take account of competing rates of return on bonds and other assets, but we also look back further than 1965. At present, we believe that stocks would be "fairly valued" if they were priced to deliver a long-term rate of return of about 9%. That would require a Dow below 7000, but I have no forecast of such a move. Overvaluation implies only unsatisfactory long-term returns. It doesn't imply market losses over the short-term. Maybe stocks will simply deliver 7% over the long-term and maintain extreme valuations after all. It's just that when trend uniformity is unfavorable, we have to allow for the possibility of a more abrupt adjustment.
Corporate bonds, utilities and the U.S. dollar are all behaving very poorly. This places yield trends in a hostile climate that could easily spill over to upward pressure on stock yields. Such hostile trends are not always bad, but they are never helpful. In the context of high stock valuations and unfavorable trend uniformity, hostile yield trends should be taken seriously. Very few historical periods have been associated with worse characteristics across these measures.
In Treasuries, we continue to expect some flattening of the yield curve - the 0-2 year maturity range is likely to experience the most upward pressure, while while maturities beyond the 3-year mark should benefit. Though long-term Treasuries should perform well in any sort of fresh economic downturn, and they sport good relative yields, the yield curve is steep enough that the main weight in fixed-income portfolios belongs in the 5-10 year range. As for gold, we're not currently carrying positions, having liquidated a few weeks ago. But we would probably reestablish positions on a fresh decline below 50 in the Purchasing Managers Index if gold stocks were to pull back moderately.
I noted several months ago that the recent pickup in the economy was reminiscent of the brief recovery following the ultra-short 1980 recession - a recovery that was followed within 12 months by a fresh recession having a much more brutal follow-through. One would not have predicted that failure from the Purchasing Managers Index, or the leading indicators, or new claims for unemployment - all which improved strongly and gave an illusion of strength to the bounce. The two essential warnings were the failures of capacity utilization and help wanted advertising to improve (as they have strongly done following every other recession). These indicators telegraph incipient demand for capital and labor in the economy. It is important to note that neither of these have progressed in recent months - the help wanted index has dropped back to last year's lows, and capacity utilization remains anemic. I continue to view the widespread belief in a strong and sustained economic recovery as superstition built on a misunderstanding of monetary policy (most of the impact which has been to increase currency in circulation, not bank reserves), and rate-of-change indicators such as the Purchasing Managers Index. .
Morgan Stanley's Stephen Roach has some additional comments regarding the economy that are worth noting: click here.
As usual, we aren't attached to any particular forecast, but on the basis of present observable evidence, we're very unwilling to carry stock market risk here. We remain fully hedged.
Wednesday Morning May 15, 2002 : Special Hotline Update
Press "Reload" on your browser to access the latest update file
The Market Climate remains on a Warning condition, which holds us to a fully hedged and defensive position. We are not, however, bearishly positioned. Our performance is driven by the difference in performance between our favored stocks and the market indices we use to hedge, currently the Russell 2000 and the S&P 100.
Despite two strong days in the market, stocks still remain slightly oversold. Even one more day like Tuesday would probably be sufficient to clear that oversold condition. As I've noted before, about the only time I have a view about short-term action is when the market is very overbought in a negative Market Climate. Currently, stocks are not nearly in an overbought condition. At present, I have no particular expectation for short term market action.
That said, the fact that the Market Climate is negative leads me to expect this rally to fail. That opinion exists only as a pure, idle curiosity. Regardless of any personal opinions regarding the vulnerability of the market and the economy, our position is driven only by the current profile of overvaluation and unfavorable trend uniformity. If the market recruits favorable trend uniformity, we will reduce the extent of our hedging.
Presently, such a shift would require improvement across a wide range of market internals. Trend uniformity is not driven by the extent or duration of a market move. It is the quality of market action, not its quantity, that induces us to accept greater market risk.
Much of the low inflation performance of recent years was driven by low import prices aided by a strong dollar. In the environment of a weakening dollar, we may begin to see a modest upward creep in the inflation rate, with relatively greater effect on short maturity yields than long ones. This is likely to happen even if the economy weakens, and even without an increase in Fed-controlled rates. Unfortunately, there is also an important feedback between short-term interest rates and inflation. Increases in short-term rates tend to increase monetary velocity (that is, people don't like to hold currency in their pockets when they have to give up interest earnings to do so). That tends to place further upward pressure on inflation. It's not a vicious spiral, but there's enough feedback that even a mild inflation induced by a weak dollar is likely to put upward pressure on short-term yields, regardless of Fed action. Except in a deflationary environment, T-bill yields of 1.7% will be difficult to sustain.
In effect, the combination of a lackluster economy and a falling dollar is likely to produce a mild stagflation, accompanied by a flattening of the yield curve - upward pressure on short-term yields and modest downward pressure on long-term yields.
In an interesting development, Standard & Poors now intends to calculate an additional measure called "core earnings." Reuters reports "The new guidelines proposed by S&P would depress earnings by companies in the S&P 500 index -- a key gauge of the U.S. market -- and make stocks appear about a third more expensive on a price-earnings basis. General Electric, for example, reported operating earnings of $1.42 a share last year. According to S&P's new calculations, its actual earnings were 22 percent less, or $1.11 a share, stripping out 19 cents of pension gains, 4 cents for the cost of stock option grants and 6 cents for gains from asset sales."
Not perfect, but it's a start.
Tuesday Morning May 14, 2002 : Hotline Update
Press "Reload" on your browser to access the latest update file
The Market Climate remains on a Warning condition here. Since March, the market has seen a number of powerful rallies such as Monday's, each which have failed to persist for more than three sessions. This series of rallies has served to clear oversold conditions even as the market has declined, in the classic form of bear market rallies - fast, furious, and prone to failure. That said, it is never useful to invest based on scenarios. Though my opinion is that this rally will also fail, I have no attachment to that view, and it is not what drives our current position. Our fully hedged stance is driven by the current Market Climate - a combination of overvaluation and unfavorable trend uniformity. Even if my opinion was that this rally would be sustained, we would not invest on that opinion because it would contradict the prevailing Market Climate we identify. In practice, my opinions are never inconsistent with the prevailing Market Climate because that climate takes precedence over alternative indicators. For now, the Market Climate is solidly unfavorable. That doesn't imply that Monday's rally has to fail. But it does mean that we will not expose ourselves to market risk until more favorable evidence emerges.
Sunday May 12, 2002 : Hotline Update
Press "Reload" on your browser to access the latest update file
The Market Climate remains on a Warning condition. Once again, the hallmark of last week's action was distribution without any particular accompanying news. As I frequently note, market action conveys information held by other traders that cannot be observed directly. So despite the lack of specific bad news, the news last week was evidently bad.
Now, if all traders in the market are rational, and it is common knowledge that they are all rational, then any attempt by one trader to buy or sell can be taken as a pure information signal. The mere willingness to trade reveals privately held information. In that kind of market, prices quickly and fully reflect all information whether public or private, and the market is "efficient." But it is also true that every academic theorem asserting market efficiency is accompanied hand-in-hand by something called a "No-trade theorem." In an efficient market, no trading takes place. Price quotations change in response to new information, but no trading occurs at those prices. So when the market starts moving up and down on bid-ask changes but without volume, it's time to buy an index fund. Until then, we've got to take market action as a "noisy" signal, containing both information and uninformative noise.
This, by the way, is why a stock that looked great at $40 isn't necessarily a buy at $20. The decline from $40 to $20 may represent more attractive valuation, or it may mean that traders have new, negative information about the future prospects of the company. How one distinguishes information signals from noise is essential to interpreting such a price movement. A sharp price decline might mean one thing for say, Bristol Myers, and another for Enron, depending on the precise features of market action accompanying the decline.
The analysis of trend uniformity is one proprietary method we use to separate the signal from the noise. With respect to the overall market, we got a nice momentum signal between the September low and late December, and left as much as 20% of our holdings unhedged on that basis. But we have since observed a failure of the market to recruit any kind of favorable uniformity. That suggests that there remains an underlying aversion to risk. And in an overvalued market where risk premiums are very thin to begin with, small shifts in risk aversion can have sudden and devastating results. Accordingly, we remain fully hedged here. We will shift to a more constructive position when the market recruits favorable trend uniformity, but we have no forecast of when that will eventually occur.
In the meantime, last week's action was disturbing. On Monday, we saw the 10-day average of the trading index (TRIN) move above 1.5. The TRIN is calculated by dividing the ratio of advances to declines by the ratio of up-volume to down-volume. Often, a 10-day TRIN of 1.5 or higher occurs just before a capitulation in prices, often representing important lows. This occurred both before the March 2001 low and the September 2001 low. However, Wednesday's explosive rally served to let off the steam, so that the market was not able to develop an extreme oversold condition. This was followed by fresh weakness, in the classic style of bear market rallies - fast, furious, and prone to failure. There is a disturbing persistence in all of this distribution, as well as the ability of the market to work off oversold conditions as it declines. This behavior may make it more difficult for the market to mount a sustained recovery without yet further deterioration. Not a forecast, but certainly a concern.
Moreover, sentiment indicators remain very complacent, with the CBOE volatility index nowhere near levels typically seen near important lows, while the Investor's Intelligence figures report that investment advisory bearishness remains under the important 30% figure. Elsewhere, brokerage analysts continue to advise nearly the highest allocation to stocks on record, historically a reliable contrary indicator.
In the fixed income arena, my impression is that the yield curve is likely to flatten considerably in the weeks ahead, with short term yields pressured somewhat higher while long-term yields move down. That's a somewhat odd expectation, but it derives from expectations of oncoming economic weakness, combined with increasing (and myopic) pressure to swap long-term debt into short-term debt to relieve debt service costs. As always, we don't invest on expectations, but on the prevailing Market Climate. In the fixed income area, that climate appears favorable for medium- and long-term bonds, as it has for several weeks.
In all, we've got extreme overvaluation, particularly in the blue-chip "growth" area (as reviewed last week), unfavorable trend uniformity, persistent distribution, complacent sentiment, and important weakness in the dollar and corporate bonds suggesting fresh economic weakness. Not an environment in which we find market risk inviting. Our stock holdings remain fully hedged.
Thursday Morning May 9, 2002 : Special Hotline Update
Press "Reload" on your browser to access the latest update file
The Market Climate remains on a Warning condition. Except when the market is very overbought in a negative Market Climate, or very oversold in a positive Market Climate, I rarely have any expectation regarding short-term direction. It is not, however, unusual to see fast, furious rallies during negative Market Climates in order to clear an oversold condition. I would place Wednesday's rally in that category.
While we still hold less technology and substantially less financials than the market indices, I do view some technology stocks much more favorably than I have in recent years. A number of telecom related companies remain worthless in my estimation, but a few tech stocks have finally approached the price/revenue valuations that I articulated in the January 2001 issue of Research & Insight (it's a fun letter to read in hindsight). I noted that Cisco was worth about $18 3/4, Sun Microsystems $4 1/2, EMC $10, and Oracle $6 7/8. Of course, at the time the market prices were substantially higher. For example, EMC was trading near $80 a share, coming off of a high of $105. Alan Abelson was kind enough to print that analysis, so I received my share of hate mail from a few Barron's readers ("... get out of the investment business..."), as well as some derisive comments by the guys on Squawk Box. I still wouldn't touch Cisco because I no longer trust its management, and because we calculate it as virtually worthless based on our measures of discounted free cash flow (Note to tech bulls: spare me the hate mail). I do consider the others appropriately priced here. (Note to tech bears: spare me the hate mail). All still fail to exhibit favorable market action or signs of persistent accumulation, but at least a few of the glamour techs are no longer absurd on a valuation basis.
In short, technology is not out of the woods as a group, but the opportunities are increasing. Financials continue to appear vulnerable though, so a hedged approach that is light on tech and financials doesn't exactly do the Mambo when those groups lead the market over the short-term. Over time, however, our returns are driven by favorable valuation and market action across a wide range of stocks, and are not particularly dependent on the leadership (or lack of leadership) by specific industry groups.
That said, it is important to emphasize that nothing in our measures of trend uniformity have improved. Specifically, I continue to view market conditions as precarious, particularly for large-cap stocks in the consumer and financial areas among others. Stocks such as 3-M, Citigroup, Bank of America, Merrill Lynch, American Express, Bed Bath & Beyond, Kohls, Home Depot, Lowe's, Target, Wal Mart, Procter & Gamble, Pepsico, Johnson and Johnson, United Health, and Tenet Healthcare all appear strenuously overvalued. This is a broad but certainly not exhaustive list, and the profile of overvaluation suggests that technology is no longer the real problem. The difficulty for the S&P 500 really is a blue-chip, nifty fifty type of overvaluation overhang that remains unresolved.
In any event, we continue to be fully hedged based on the current profile of valuations and market action. This position does not require any forecast of market direction. The observable data is sufficient to keep us defensive for now.
Tuesday Morning May 6, 2002 : Special Hotline Update
Press "Reload" on your browser to access the latest update file
The Market Climate remains on a Warning condition. I trust that prior updates have sufficiently underscored the seriousness of current conditions, particularly the relentless evidence of large-cap distribution, and fresh breakdowns in the U.S. dollar, corporate bonds, and various elements of trend uniformity.
Most striking about Monday's decline is that it occurred with no apparent catalyst. As I frequently note, market action conveys information. And the divergent market action (the hallmark of unfavorable trend uniformity) conveys unfavorable information. We already have sufficient evidence to be fully defensive. Only later will we read in the headlines exactly why this defensive position was warranted. From the behavior of the dollar and corporate bonds, my inclination is to believe that we are on the cusp of fresh economic weakness, and unexpected bankruptcies or some other financial crisis. There is no need to speculate about this however, since our positions are always built on observable evidence rather than scenarios.
Until the past few days, banks, consumer stocks, paper and cyclical stocks have kept the major indices from plunging, despite relentless weakness in technology, health and transports. At this point, those previously strong industry groups are the ones to watch. The profile of industry group weakness is likely to tell early stories about what the news will reveal much later.
On the subject of valuations, suffice it to say that the S&P currently trades at 20 times peak earnings, the highest multiple to peak-earnings seen in any prior market cycle, matching the levels seen at the 1929, 1972 and 1987 peaks.
In short, market action conveys information. Market action is clearly unfavorable here.
Sunday May 5, 2002 : Hotline Update
Press "Reload" on your browser to access the latest update file
The Market Climate remains on a Warning condition, freshly deteriorated and notably hostile.
I've noted frequently that a plunge in the U.S. dollar would likely be the first indicator of oncoming economic weakness. Over the past two weeks, the dollar has declined forcefully. Meanwhile, corporate bonds have encountered sudden pressure. This is very dangerous.
I've also written about the persistent distribution evidenced by surging downside volume even on days where advances widely outpace declines. We saw this again on Thursday and Friday. Vickers notes that sales by corporate insiders have surged to a 5-to-1 lead over insider purchasers. Again, these signs are very dangerous.
Here is a very unpopular, almost unheard-of position. I believe that the recession in the U.S. economy is not over, that capital spending will fail to rebound measurably, and that corporate bankruptcies are about to surge. I would prefer to be wrong about this. In the past few weeks, there has been a pronounced shift toward credit tightening, and an eagerness by banks to step away from providing backup lending facilities to companies encountering difficulty in the commercial paper market. The recent announcement to this effect by J.P. Morgan is part of a broader trend.
The cheerleading position on the economy is that with the labor market showing weakness, the Fed will certainly put off raising rates. At the same time, the cheerleaders note that unemployment is a lagging indicator, and that recent weakness is due to extended unemployment benefits that raise the level of claims. So the general view, as I understand it, is that the weakness in the labor market is important and unimportant at the same time. It must be convenient to hold views so unencumbered by consistency.
As I've noted in recent months, there are really two indications which would have to improve in order to confirm expectations of sustainable economic strength. One is the level of Capacity Utilization, and the other is the Help Wanted Index. Both are languishing, with the Help Wanted Index actually declining in the latest report. This weakness in labor demand underscores the high rate of new claims for unemployment. The argument regarding extended unemployment benefits strikes me as a kernel of truth being used to explain away the whole field of corn. It certainly doesn't address the weakness in job creation, the failure in the Help Wanted Index, and the persistently downward revisions in prior job creation figures. In short, while the unemployment rate is certainly a lagging indicator, the broader trends in employment indicators cannot be so casually dismissed.
There are many individual stocks that remain attractive as long as their market risk can be hedged away. At present, we remain fully invested in such stocks, and fully hedged against their market risk. We expect to be compensated by the difference in performance between those favored stocks and the market indices which we use to hedge (primarily the Russell 2000 and the S&P 100). We view smaller stocks as attractively valued only relative to large ones. All classes of stocks are broadly overvalued in our estimation, and small stocks tend to fall harder in bear market declines, so any preference for small versus large stocks is largely moot at this point. We build our portfolio strictly stock by stock, with no inherent preference here for large versus small. As long as we can find favorable value, market action, and sufficient liquidity, we couldn't care less about market capitalization.
In an overvalued market such as this, I would expect that we could expand our approach to the $3 billion range without any significant change to our management technique. In a more attractively valued market with a larger number of favorably situated large-cap stocks, the carrying capacity of our approach would rise to many times that amount. Needless to say, I have no concern regarding our ongoing ability to execute our strategy, even in a market that remains peculiarly overvalued.
On the subject of gold stocks, I should note that we completed some liquidations on Friday. I certainly believe that the U.S. dollar has a long distance to decline, and that this will tend to support gold over a more extended period. But gold stocks are remarkably volatile, and the best time to hold such stocks is when both valuations and macro trends are firmly aligned. Gold stocks have run up to the point where I believe that they are vulnerable even to a slight upward correction in the U.S. dollar (even if the overall trend in the dollar remains down as I expect).
Sharp and sustained rallies in gold stocks generally prefer a rising rate of inflation, falling trends in Treasury bond yields, and a Purchasing Managers Index below 50, none of which are present here. I'm not one to invest on scenarios - adhering instead to observable criteria. But if I was to put together a scenario, my guess would be that gold stocks may pull back until the economy more clearly begins to weaken again. I do expect the Purchasing Manager's Index to decline back under 50, and my suspicion is that that would be a good signal to renew positions in gold stocks. Again though, this is not a forecast. We simply don't have the evidence to continue holding gold stocks based on our own discipline. And we're willing to be wrong about taking profits if we would have to violate that discipline in hopes of getting more.
Long-term Treasury bonds continue to appear attractive, though the level of yield does not allow for a very sustained advance in prices. As a result, the attractiveness of long-term Treasuries would become less compelling if the 30-year yield was to fall below about 5%, which is still some distance away. As for corporate bonds - run. Run like the wind.
Sunday April 28, 2002 : Hotline Update
Press "Reload" on your browser to access the latest update file
The Market Climate remains on a Warning, and fresh breakdowns in several market internals elevate this to a particularly hostile condition. I've noted nearly all year that, barring fresh breakdowns in other market internals, even a small further advance in the S&P 500 would have been enough to recruit favorable trend uniformity. At this point, much more significant reversals would be required. Recent breakdowns in market action (the U.S. dollar not being the least of these) mirror those from which prior market plunges have emerged. The risk of a substantial downside break and fresh economic weakness should not be glossed over.
As usual, this is not a forecast - it is an identification of current conditions. On a technical basis, the market actually appears somewhat oversold. It is important to understand that the market can respond to oversold conditions with fast, furious rallies to clear the oversold condition. But when valuations and trend uniformity are negative, these rallies are also prone to failure.
Trend uniformity is not concerned with the extent or duration of an advance. It is concerned with the quality of market action. On the basis of the models currently in use, that quality typically emerges very quickly in legitimate bull markets. Negative shifts can also occur at precise high of indices such as the S&P 500, as was the case at the August 1987 shift, as well as the September 1, 2000 shift. Without revealing anything proprietary, the quality of market action is measured using market internals which are imperfectly correlated, and driven by substantially different aspects of market information.
As I've noted before, if X = A + B, an Y = A + C, then even if you can't observe A, B, and C directly, you can make inferences from the uniformity or divergence of X and Y. If both X and Y are pushing uniformly higher, you can infer that A is probably rising, though that inference is imperfect. If on the other hand, X is rising but Y is falling, the divergence suggests that C is weaker than B, even though you can't directly observe either. In short, uniformity and divergence conveys information about things that cannot be observed directly.
For a simple example of informative divergence, take a look at Dow Theory. Here, only two indices are essential - the Dow Industrials, and the Transports. But even these two indices contain the essentials: they are both affected by important common factors, but they are also affected by important idiosyncratic factors. The failure of the Transports to confirm the Industrials in recent months, for example, suggests that the economy is facing some sort of threat, either because the inventory buildup in the first quarter isn't being matched by final demand (and associated shipments), or energy prices are posing risks of their own.
The convergence and divergence of a wide array of market variables is really what "trend uniformity" is about. We're not compelled to grade trend uniformity as favorable just because, gee, the Nasdaq, S&P and Dow are all up from their September lows. There's too much correlation in those indices to get a measurement about investor risk preferences, economic conditions, international capital flows, default probabilities, and a host of other factors that are essential.
For now, we identify trend uniformity as unfavorable, and suffering fresh breakdowns. We view stocks as strenuously overvalued as well. That means that we are completely unwilling to take on the market risk associated with our favored stocks.
Every stock is driven by three factors: fluctuations due to the specific company (its valuation, its growth, its industry, and so on), fluctuations due to the overall market, and fluctuations due to day-to-day randomness. We can certainly find many stocks that appear favorable based on their own specific valuations and businesses, so we are willing to take on the company specific risk of those stocks. But we are currently fully hedged against the market specific risk of our stocks. We try to mute the effect of day-to-day randomness of individual stocks through wide diversification. We also try to take opportunities from that day-to-day randomness by selling lower ranked holdings on short-term strength, and buying higher ranked candidates on short term weakness.
In all, it's a discipline that leaves us entirely unconcerned about what the market may do next. If and when trend uniformity becomes favorable, we will take on a moderate amount of market risk. Until then, we will continue to focus on our individual stock selection and the day-to-day opportunities that the market offers.
The Market Climate is hostile here. Please, please, do not aggressively risk your financial security to the hope of a strong economy. Even if the economy grows strongly, there is no reliable implication that the market must follow. Particularly not at current valuations, and not while labor is scarcer than capital (which shifts the gains from economic growth to wages instead of profits). This is still a market valued at a higher multiple to peak-earnings than in 1929, 1972 and 1987. With trend uniformity negative and the dollar weakening notably, this is also a market that could crash. That's not a forecast. Caution doesn't require forecasts. It requires only the willingness to consider risk.
Sunday April 21, 2002 : Hotline Update
Press "Reload" on your browser to access the latest update file
"There can be little doubt that prospects have brightened."
- Alan Greenspan, April 17, 2002
"We have yet to see any significant evidence of a rebound in economic
activity in the United States."
- Scott Davis, CFO, United Parcel Service, April 18, 2002
Frankly, given the terrible record of consensus economic forecasts, particularly those of central bankers, I'm more inclined to go with the observations of the people who actually ship the packages.
In recent weeks, I've noted my concern regarding the Dow Transportation average, emphasizing its failure to confirm the recent high in the Dow Industrials (an observation noted by a few other analysts, most notably Richard Russell of www.dowtheoryletters.com). At the risk of seeming quaint, archaic, and out of touch with the New Economy, I take this nonconfirmation seriously. At this point, the evidence suggests that the recent firming in economic activity represents little more than inventory rebuilding, rather than final demand.
Indeed, as noted in the latest issue of Hussman Investment Research & Insight, the gaping U.S. current account deficit provides strong reason to believe that consumption and investment will grow substantially slower than in the typical economic rebound. Historically, economic recoveries have started with a substantial surplus in the U.S. current account (essentially, a trade surplus). This means that the U.S. was producing enough to satisfy its own domestic consumption and investment needs, with enough left over to make net exports abroad. In this kind of situation, there is a great deal of room for consumption and investment to soar, while the current account moves from surplus (exporting goods and services on balance) to deficit (net imports from abroad). There is no question that the most powerful and prolonged U.S. expansions and investment booms have been largely fueled by the ability to import goods, services and capital from foreign countries, which shows up as an increasing current account deficit. The problem here is that we already have a monster deficit. The probability of consumption and investment growing sustainably faster than GDP (as it did for most of the past decade) is nearly zero.
I also believe that the U.S. housing market is in a bubble. Greenspan suggested on Wednesday that the relative illiquidity of housing made it immune to bubbles, which is absurd. The valuations that produce a bubble are always determined by the transactions between the marginal buyer and the marginal seller, not by the ease or difficulty of turning over the entire stock. So long as existing owners define their wealth by the prices determined by the marginal buyers and sellers, the impact of a bubble in housing prices is no different from the impact of a bubble in equities.
I noted in Research & Insight that weakness in the dollar would be the first sign that foreigners might be starting to pull back on sending capital to the U.S. Last week, the dollar broke recent support, hard. This is a dangerous sign, in my estimation. Moreover, lumber futures also broke hard last week, which is of further concern regarding housing. When divergent market action starts telling stories that nobody wants to hear, it's often worth paying attention. As always, this is not a forecast so much as an indication to be alert. It is worth watching for any persistence in these divergences, and for other confirmations such as fresh weakness in the stock prices of homebuilding companies.
We continue to hear comments by analysts on CNBC, in SmartMoney, and elsewhere about "money on the sidelines" that has to "come into the market" due to low T-bill yields. This is like saying that apples are bigger when they are made of grapefruit - a statement that is neither true nor false, but simply reflects a completely invalid view of the world.
In equilibrium, the desired ownership of every security must exactly equal the outstanding supply, or the price of the security changes until it does. Suppose that there are 1000 units of a security that we call "cash", and 100 units of a security that we call "stock." Now, suppose that the people with the cash decide that they would rather hold stocks, so they try to "put their money into the market." Well, urgent demand for stocks might very well cause stock prices to rise, but this is because the eagerness to buy exceeds the eagerness to sell. Some people who held cash will now hold stock, and some people who held stock will now hold cash. After the trades take place, there will still be 1000 units of cash outstanding and 100 units of stocks outstanding. There will still be identically the same amount of "cash on the sidelines" as there was before. The size of the cash position itself is neither bullish nor bearish.
Look. If people decide that cash at current yields is not interesting, cash becomes a hot potato. Since, in equilibrium, all securities including outstanding cash must be held, we require either the return on cash to increase, or the competing return on other investments to fall. Now, if demand is urgent for alternatives to cash, stock and bond prices may increase, lowering their prospective future returns (since prices and returns move inversely), reducing their attractiveness relative to cash, and restoring equilibrium. But there is still the same amount of cash as there was before.
In short, the argument that there is "enormous cash on the sidelines" is incoherent. The proper way to frame this argument, if you want to make it, is to argue that short-term interest rates are too low to create equilibrium in the short-term money markets.
Now if you believe this, the least plausible implication is that stock prices must rise. To argue for an increase in stock prices, one requires the additional assumption that stocks are currently priced to deliver an attractive rate of return - something which we've argued endlessly against. At present, there are three far more plausible ways to bring the money markets into equilibrium (if you assume they are not).
1) An increase in bond prices (i.e. a decline in long-term interest rates).
This is another way of saying that people would
be more comfortable with low money-market yields if the yield curve was
flatter at the long end.
2) An increase in short term interest rates - remember that market
yields on T-bills and commercial paper are not actually determined
by the Fed, and often move opposite to Fed-controlled rates.
If investors don't want to hold cash at current low interest
rates, the simple solution is to demand higher yields. This isn't
happening yet, which suggests that there is still enough risk aversion
that investors are comfortable holding safe cash.
3) An acceleration of inflation. If cash is a hot potato and nobody
really wants to hold it at current yields, there is a tendency for
cash to lose value relative to goods. That's another way of saying that
inflation rises.
In short, whatever money is on the sidelines will, by virtue of equilibrium, stay on the sidelines, though possibly in the hands of somebody else. If investors are dissatisfied with low returns on cash, the most plausible outcomes would be inflation and an increase in short term interest rates, which would naturally flatten in the yield curve. If investors were really aggressive in their distaste for cash holdings, the yield curve might even flatten by long-term rates falling (bond prices rising). In practice, when money creation is excessive, we tend to see inflation, rising short term interest rates, a flattening yield curve, and a falling dollar all happening in tandem, which is the market's way of screaming that the Fed is too loose.
But at current stock valuations, the last way that disequilibrium in the money markets would express itself would be a rally in stocks. In any event, there would still be the same amount of cash on the sidelines, but the profile of prices and yields in other markets would be sufficient to make people comfortable holding that cash. Those who argue that "money on the sidelines" must shift "into" the stock market are not simply making a statement that is true or false. They're talking complete gibberish.
At present, we remain defensive based on the current unfavorable profile of valuations and trend uniformity. As I've noted in recent weeks, we have no forecast regarding how long trend uniformity will remain negative, but until and unless it improves (which could be in a week or could be in a year), we'll remain defensive. We are fully hedged at present.
Wednesday Morning April 17, 2002 : Special Hotline Update
Press "Reload" on your browser to access the latest update file
The Market Climate remains on a Warning condition here. It is impossible to guess whether or not the market will recruit favorable trend uniformity in the weeks ahead. Several developments, including a rally in the S&P 500 index to about 1200, could act as a sufficient trigger. But other developments, such as a slight deterioration in the corporate bond market, could prevent it. This very tentative condition of market internals suggests that even trend uniformity reasserts itself, it would not be difficult to whipsaw back to a negative condition.
Of course, that possibility poses no difficulty at all to our investment approach. We align ourselves with the prevailing Climate, and we have a modest amount of discretion regarding how quickly we execute those shifts. At present, a favorable shift in trend uniformity would cause us to remove as much as 40% of our hedges. So even if we got a whipsaw from negative to positive and back to negative again, we would not have a substantial amount of exposure to downside risk.
Moreover, given the very extended nature of this advance (particularly in the Russell 2000 - our major hedging vehicle), our immediate move would probably follow our "40% rule" - whenever an investment change is required, we do 40% of the change immediately, without speculating about possible direction or regret. We then attempt to complete the remainder of the change relatively quickly, as market opportunities present themselves.
So our immediate response to a favorable shift in trend uniformity would probably be to lift 40% of 40% of our hedges - that is, 16%. That would leave 84% of our portfolio still hedged. A quick whipsaw in conditions back to a negative Climate would not pose any concern at all.
In short, we'll respond to shifts in the Market Climate as they emerge. For now, we remain fully hedged and defensive.
Tuesday's rally was substantially different from recent rallies. While total volume was not strikingly large, up volume strongly outpaced down volume. It would be good to see this sort of market action on a more extended basis. That would make any favorable shift in trend uniformity more convincing.
Keep in mind that there is a distinction between speculative merit and investment merit. Even though fundamentals remain awful and stocks remain overvalued, we would be happy to establish a moderate exposure to market risk if the evidence was sufficient. Most of the advance from 1995 through 2000 took place in an overvalued market with favorable trend uniformity. We certainly would not be unhedged or aggressive in this environment, but we wouldn't stay fully hedged if investors exhibited a robust preference to take on market risk.
We had the opportunity to increase our exposure to technology and even some select telecom stocks in the past couple of weeks, but the broad market is strenuously overbought. With so many small stocks hitting new highs, we should not be surprised by a concerted pullback from those highs. Though I have no forecast about whether or not trend uniformity will shift in the weeks or months ahead, I am never thrilled when stocks are overbought in a negative Market Climate. This is particularly the case with small stocks here. Our discipline of selling lower ranked stocks on short term strength leaves us with a portfolio that is not similarly overextended, so this prospect is not of great concern, but it's worth mentioning.
On the subject of fundamentals, The Wall Street Journal quotes John Lonski, chief economist at Moody's, saying "the debt repayment capacity of corporate America has dropped to its lowest level in years. You're not going to come back to those higher levels of cash flow to debt or cash flow to net interest expense that held during the capital spending boom of the 1990s any time soon. That by itself is reason to expect at best a modest recovery in capital spending." The Journal also reports that as of last week, Moody's downgraded the credit rating of 5.7 companies for every one it upgraded, adding "It was the highest ratio of downgrades to upgrades since the credit rating agency began tracking the figures in 1986."
Needless to say, I would expect any renewed speculative climate, if it emerges, to be short lived. But that sort of view does not feed into our willingness to take market risk in response to favorable trend uniformity. It only affects the aggressiveness of that response.
The bottom line is simple. We remain fully hedged here. We strongly distrust the fundamentals underlying the stabilization in the market and the economy. A shift to favorable trend uniformity, if it occurs, would prompt us to leave as much as 40% of our holdings unhedged, but we would initiate just under half of that move if the market was still overbought at the point of that shift. All of these considerations are derived from a very specific discipline. For now, that discipline holds us to great caution.
Sunday April 14, 2002 : Hotline Update
Press "Reload" on your browser to access the latest update file
The Market Climate remains on a Warning condition here. It is an absolutely open question as to whether or not the market will recruit favorable trend uniformity in the weeks ahead. We make no forecast in that regard. If the market does so, we would expect to reduce our hedge by as much as 40%, still leaving the majority of our holdings fully hedged, but taking a moderate speculative exposure to the market risk inherent in the favorably valued stocks we already own.
Specifically, we currently hold a fully invested position in about 100 stocks that we believe exhibit some combination of favorable valuation and market action (price-volume characteristics that convey persistent accumulation by other market participants). Those stocks have two sources of fluctuation. In part, they fluctuate due to overall market fluctuations, and they fluctuate due to characteristics specific to those individual companies. When we are fully hedged, we are willing to take the company specific risk, but attempt to neutralize the market risk of those stocks. When we lift a portion of our hedges, it isn't necessarily a statement that we "like" the overall market. It simply means that we are willing to take more of the market risk inherent in stocks we already own. Subtle distinction, but important, because a fully invested position in our favored stocks, leaving 40% unhedged, is a dramatically different position than simply being 40% invested in some market index.
For now, we remain fully hedged. My opinion is that this market is far more extended than most investors seem to imagine. While we've actually had some opportunities to increase our exposure to a few technology stocks (we still won't touch Cisco because we don't trust its management), the broad market is actually more overextended than it was at the 2000 peak. We don't trade on opinion, of course, but we're comfortable with a full hedge here.
With regard to the big picture, probably the best phrase to describe both the economy and the markets is this: delayed recognition of impairment. What we have is a situation where the fundamentals, particularly in terms of balance sheets, are terrible. But there are mechanisms at work to delay the recognition of this impairment.
In the housing market, for example, balance sheets continue to deteriorate. Mortgage debt has soared to record levels relative to household income. Sub-prime defaults are spiking higher. And home owners have withdrawn so much cash when they refinance that equity as a percentage of total home value is now less than 55%, compared to 70% little more than a decade ago. But homeowners are focused on the nominal interest rate on mortgages, which is fairly low, failing to understand that with inflation low, the real interest rate, and thus the real burden of mortgages in terms of purchasing power, has rarely been higher on a historical basis. It is that burden that eventually shows up in default rates.
In the banking sector, the past several years have seen a dramatic increase in securitized loans. What happens here is that banks make loans, package them into a security, and then sell them off on the bond market. As a result, these loans go off of the balance sheet, and if they fail, they don't show up in the banking statistics. As Charles Peabody notes in Kate Welling's excellent Welling@Weeden, "a lot of these structured products are sitting out there with significantly impaired values - CLOs or CBOs or CDOs, collateralized loan obligations of one flavor or another. Essentially, that's what PNC had created with their special purpose entity, for instance. But as assets become impaired in those vehicles, they're not recognized immediately in the P&L or in the equity accounts of these banking organizations. Eventually, these CLOs will be renamed CLOWNs, for 'collateralized loan obligations worth nothing.'"
Moving on to the corporate sector, the Wall Street Journal ran a chart on April 4th, showing how dramatically tangible assets have declined in recent years as a percent of all business assets. Corporate balance sheets are increasingly built on intangibles and goodwill that can be highly subjective.
In effect, the stock market and the economy are built on increasingly fragile balance sheets - questionable assets on one side, huge debt on the other. Confidence is based not on underlying asset values, but on the trend of income and reported cash flows. The problem is that as long as these reports are upbeat, investors refuse to look deeper. This lack of vigilance results in a time lag between impairment of assets and the recognition of this impairment in market prices. It is this lag - this air - that many stocks are trading on here.
With an active slate of earnings reports due this week, investors will undoubtedly be urged to focus their attention on operating earnings and cash flow once again. This is really a request to ignore the balance sheet.
Take for example the argument that strong cash flow indicates "high quality" earnings. When people talk about "cash flow" this way, they're not talking about cash flow = net earnings + depreciation, depletion and amortization. Financial statements don't even include that number. When people talk about cash flow being an indicator of earnings quality, they're talking about the first figure on the Statement of Cash Flows: "Net Cash Provided by Operating Activities."
Now in theory, if you're reporting earnings and you can show the cash in your hot little fist, then yes, the earnings report can probably be taken at face value. But net cash provided by operating activities doesn't show this at all. Most of this cash disappears as unspecified "investments" and other uses of cash flow that make it unclear that the cash flow was ever legitimate in the first place. Often these "investments" are simply expenses that have been purposely misclassified. The investments are then written off later as "extraordinary losses", keeping them entirely out of the calculation of operating earnings, and allowing the game to continue.
Much of this can be demonstrated by analyzing the financial statements of a randomly selected company. Let's see. Oh, here's one. Enron.
In its 2000 annual report, Enron reported strong net income, and backed it up with "Net cash provided by operating activities" of $4.779 billion. Now, few reading the report knew of the accounting fiasco underneath this company. Nor did they have to. The funky cash flow number was enough.
See, if you go over to the balance sheet and the footnotes, you discover the source of much of this "cash flow." From 1999 to 2000, Enron's receivables roughly tripled, increasing by $8.203 billion. Payables shot up by $7.167 billion, the company ran off $1.336 billion in inventories, and it otherwise ran down its working capital (net short term assets) by 1.469 billion. Now, anything that allows Enron to hold onto more cash (including deterioration in the timeliness of payments, depleted inventories, and reduced working capital) boosts "Net cash provided by operating activities." For instance, the increase in payables means that Enron owed others $7.167 billion that had not yet been paid out of the cash account. That's actually booked as a "source" of cash flow, as is the rundown in inventory (since no cash had to be laid out to obtain the energy that was sold). In all, these "changes in components of working capital" added 7.167 + 1.336 + 1.469 - 8.203 = $1.769 billion to Enron's year 2000 "cash flow". Nice.
Any risk-averse investor would be put off by that big jump in receivables, as well as the six-fold increase in "assets from price risk management activities" from $2.21 billion to $12.01 billion, a corresponding surge in similarly-named liabilities, and an absence of discussion of what these "activities" actually entailed. In short, you didn't even need to know that there were accounting irregularities. The published financial report, as it stood, was bad enough.
Bad enough for anyone willing to look past the garbage about beating analyst expectations and "huge cash flow." You're going to hear more of that garbage this week. So be prepared to go to the web sites of the companies, and actually look at the reports - particularly the balance sheet and the statement of cash flows.
In general, you want to look for 1) big jumps in receivables - an indication that customers aren't paying in a timely manner, 2) big jumps in payables - an indication that cash flow is larger than it would otherwise be, and the company may be strapped for cash, 3) big jumps in inventories - an indication that products aren't selling, 4) big declines in inventories - an indication that cash flow from operations is higher than it would otherwise be, 5) huge numbers in any category labeled "other", 6) footnotes about option costs and associated tax deductions - figures that often reveal that option grants actually exceeded net income, 7) notes about "accounting changes" - always ask "Why?", and 8) four paragraphs in the auditor's opinion rather than three - the fourth paragraph (which would occur after the one saying "In our opinion..." may be nothing of importance, but it can sometimes contain information about some aspect of the financial report that caused fights between the auditors and management.
Should be an interesting week.
Friday Morning April 12, 2002 : Special Hotline Update
Press "Reload" on your browser to access the latest update file
Just a note: the latest issue of Hussman Investment Research & Insight is now available on the Research & Insight page of www.hussman.net.
The Market Climate remains on a Warning condition. Once again, the main feature of market action is heavy distribution. Downside volume exploded higher on Thursday, outpacing advancing volume by more than 10-to-1. I hesitate to take that as predictive, but this persistent distribution is really not the kind of action you tend to see in sustained bull markets. Bull markets tend to generate strong volume on upside moves, while declines only briefly generate high volume. Indeed, the ebbing of downside volume on declines and new highs on large upside volume is typical of the sustained buying interest that characterizes bull markets. We don't see that here at all.
For now, we remain fully hedged. When we are fully hedged,(and provided that the long-put/short-call combinations we use have identical strike prices and expirations), our performance is not particularly driven by market fluctuations, but instead by the difference in performance between the portfolio of stocks that we own, and the market indices we use to hedge. We are certainly willing to take stock-specific risk in companies that exhibit favorable valuation and market action, but we are being very defensive in hedging away as much impact from market fluctuations as possible.
Thursday Morning April 11, 2002 : Special Hotline Update
Press "Reload" on your browser to access the latest update file
The Market Climate remains on a Warning condition. For several months now, the easiest way for the market to recruit favorable trend uniformity has been for the S&P 500 to advance about 5% on a weekly-closing basis. If we can generate that kind of move, without fresh breakdowns in other market internals, that would be sufficient to warrant at least a moderate speculative exposure to market risk (probably leading us to keep about 40% of our stock holdings unhedged, with the hedge maintained on the remaining 60%). Certainly, the broad market has no investment merit at these valuations. Both large and small stocks are looking overextended. But history is full of examples where overvalued markets pushed even higher, provided trend uniformity was evident. At present, however, we have no evidence upon which to hold anything but a fully hedged position.
So there is our investment stance. Defensive based on the current combination of unfavorable valuations and unfavorable trend uniformity. Fully observable conditions. Evidence available at the present time. No opinions or forecasting required.
Want my opinion anyway? My opinion (which I don't trade on and neither should you) is that Wednesday's rally is a standard bear market thrust to clear an oversold condition (particularly in some of the large caps). We may or may not see follow through, but I certainly wouldn't be betting in advance on a favorable shift in trend uniformity.
Probably the most disturbing internal action is the evidence of heavy and persistent distribution. Advances have tended to be on relatively light volume, while picking up on declines. The same thing is true at the individual stock level. For example, on Wednesday's ostensibly powerful rally, 396 stocks in the S&P 500 advanced, while 99 declined (the rest were unchanged). So breadth was good. But looking closer, it turns out that those 396 advancers produced 1.11 billion shares of up volume, while the 99 decliners produced a nearly equivalent 1.06 billion shares of down volume.
On the Nasdaq, the 2113 advancing stocks generated 896 million shares of volume. The 1413 declining stocks generated 1.02 billion shares of volume.
This is a pattern that we have been seeing for several weeks now to varying degrees. Heavy down volume and unimpressive up volume. When this occurs following a bear market rally, it's typically not a good sign. It implies distribution - large holders getting out under cover of the strong averages.
As the brilliant Dow Theorist William Peter Hamilton wrote in 1909 (that's not a typo), "One of the platitudes most constantly quoted in Wall Street is to the effect that one should never sell a dull market short. That advice is probably right oftener than it is wrong, but it is always wrong in an extended bear swing [i.e. an overbought bear market rally]. In such a swing the tendency is to become dull on rallies and active on declines."
Meanwhile, Vickers reports that the insider selling ratio has soared to 3.33 shares sold for every share purchased. This is an unusually high figure.
Again, these are opinions. They will not prevent us from establishing a more constructive stance if the market recruits favorable trend uniformity, and they are not the key factors driving us to be defensive here.
But it certainly is interesting market action. I can hardly wait to see what happens next.
Sunday April 7, 2002 : Hotline Update
Press "Reload" on your browser to access the latest update file
The Market Climate remains on a Warning condition. The last time we held at least a mildly constructive position (as much as 20% unhedged) was late-December, until market breadth lost its favorable momentum off of the September low. Since then, we've been fully hedged, and the S&P 500 has moved lower. As I've written for months, the easiest way for the market to recruit favorable trend uniformity on our measures would be a breakout advance in the S&P 500, which would require a mere 5% rally from current levels on a weekly closing basis, without any fresh breakdowns in other market internals. So far, it has not been able to do so, and that makes me suspect that the rally off the September lows may be exhausted - particularly since a host of sentiment indicators are at levels very characteristic of intermediate tops - the low percentage of bearish investment advisors (28.9), and the depressed CBOE volatility index (21.11) among them. Of course, no forecasts are required. The current, objectively identified Market Climate holds us to a strongly defensive position for now.
A quick note before broader commentary. I've received a number of questions about whether the Fed could manipulate the market, and what impact that would have on our analysis. The answer is first, that I view Fed intervention into the market as having a nearly zero probability. I know enough economists who work with the Fed to believe that such discussions are completely academic. But whatever the source of demand, our approach is highly sensitive to market action. Even if sustained manipulation was possible, the only risk would come from abrupt and random shifts in the conduct of that manipulation. I don't think that's a reasonable risk. More generally, I do believe that large institutions such as investment banks occasionally act in an uncoordinated way to support the market during plunges, and then feed that stock out on rallies. But on this, my views are identical to those articulated by Robert Rhea in 1932: "Manipulation is possible in the day to day movement of the averages, and secondary reactions are subject to such an influence to a more limited degree, but the primary trend can never be manipulated." This is clear from the size and depth of the equity market alone, and it is also obvious from the currency markets, where the attempt by central banks to intervene is openly stated and often intense, but is nearly always of fleeting impact.
Despite the glowing appraisal of market and economic prospects by many analysts, I remain skeptical, largely due to the failure of the market to recruit favorable trend uniformity. This failure leads to a very real concern that the bear market is not over and that a further plunge (even taking out the September lows) should not be ruled out. Certainly, the September lows represented no attractive level of value, so incredulity that the market could break those lows cannot be based on valuation arguments. In a market at such extreme valuations, the arguments for further upside action are speculative ones. And speculative merit is exactly what trend uniformity helps to isolate. Currently, we see none.
Again, this is not a forecast. But I am concerned that investors are ruling out the possibility that this rally could be a secondary reaction in a still-ongoing bear market. One of the symptoms of this is the failure of many investors to reduce clearly inappropriate investment positions on this rally - especially investors near retirement, or otherwise dependent on preservation of capital. There is certainly a lot of distribution going on, but the selling is evidently by the smart money - as reflected by the spike in insider selling. Individual investors aren't lightening up. They want to get back to "even", as if their stocks remember where these investors bought them.
Extreme valuations and unfavorable trend uniformity are the quantitative reasons for skepticism about a sustainable advance. Qualitatively, the decline to the September low didn't seem quite right as marking the end of a bear market either.
As the early Dow Theorist Robert Rhea wrote in 1932, "There are three principal phases of a bear market: the first represents the abandonment of hopes upon which stocks were purchased at inflated prices; the second reflects selling due to decreased business and earnings, and the third is caused by distress selling of sound securities, regardless of their value, by those who must find a cash market for at least a portion of their assets... Each of these phases seems to be divided by a secondary reaction which is often erroneously assumed to be the beginning of a bull market..."
In this context, the rally between March-May 2001 might be identified as the secondary reaction separating phase one and phase two. Though the decline into the September low was sharper than would typically be expected, this was entirely due to the September 11th attacks. Secondary reactions following panics tend to be very powerful, and in general recover between 1/3 and 2/3 of the ground lost since the peak of the previous secondary reaction. In that context, the rally from the September lows looks suspiciously like the rally that would be expected between phases two and three of an ongoing bear market. As it happens, this rally has recovered 2/3 of the ground lost since the peak of the March-May 2001 rally.
That leaves phase three uncompleted. Again, again, again, this is not a forecast. But in terms of resolving the excesses of the prior bubble, market action so far has been curiously unsatisfying.
As usual, we'll move immediately to a constructive position if and when the market recruits favorable trend uniformity. For now, we remain fully hedged.
Thursday Morning April 4, 2002 : Special Hotline Update
Press "Reload" on your browser to access the latest update file
The Market Climate remains on a Warning condition. In all of the day to day volatility of the market, it's easy to forget that the current Climate is the most hostile we identify, and it warrants a fully hedged position. I try to be very careful in emphasizing that this is not a forecast, but the simple fact is that market risk currently carries neither investment merit nor speculative merit. This Climate doesn't rule out positive returns, but on average returns have been sharply negative. This set of conditions represents a small sliver of market history, but includes every historical crash of note. In short, the present Climate does not forecast a plunge to new lows, but such a plunge should not be ruled out in the weeks and months ahead. Until market action generates sufficient evidence of favorable trend uniformity, market risk simply is not worth taking. We remain fully hedged here.
It may seem almost picky to require favorable trend uniformity from a market is almost universally believed to have reached its low in September, in an economy that is almost universally believed to be in a recovery. But as I've noted before, bull and bear markets exist only in hindsight. Their existence cannot be confirmed or refuted in real-time. They don't exist in present, observable experience. What is absurd is the attempt to invest on the basis of what cannot be observed or confirmed except in hindsight.
In contrast, the dimensions that define the Market Climate are objective and observable. We know that when we look at past market cycles, the bulk of bull market periods have been accompanied by conditions of favorable trend uniformity, while the bulk of bear markets have been associated with conditions of unfavorable trend uniformity. We might do better by being invested only during bull markets and avoiding market risk only during bear markets, but these constructs are not observable. In other words, to invest based on hope or worry about bull market versus bear market is insane, unless those distinctions can be boiled down to criteria that are observable in real-time.
Likewise, the distinctions of recession versus expansion can only be made in hindsight. But we know that historically, when the economy has been in an expansion but both valuations and trend uniformity have been unfavorable, stocks have lost substantial ground. So the question of whether or not the economy remains in recession is irrelevant to our investment approach.
There is a strong statistical basis for our concern with trend uniformity. If the price of a stock declines, it may mean that the stock is a better value, or it may mean that investors know something unfavorable about the stock. The same is true for the market as a whole. The only way to "read" the information content of price action is if you have more than one price to analyze. When the action of two or more price series confirm each other, there is a good chance that there is a common factor driving both of them. When the movement in one price is not confirmed by another, there is a good chance that the movement is driven by uninformative noise.
As the reknown Dow Theorist William Peter Hamilton wrote in 1913, "A new low or a new high made by the one but not confirmed by the other is almost invariably deceptive. The reason is not far to seek. One group of securities acts upon the other... These independent movements, on previous experience, are usually deceptive, but when both averages advance or decline together the indication of a uniform market movement is good."
On the subject of Dow Theory, Richard Russell www.dowtheoryletters.com seems to be the only analyst writing about (and taking seriously) the divergence between the Dow Transports and the Industrials. Though we always defer to our own models, we take that divergence quite seriously as well, and it has widened to the point where a favorable confirmation in the near future is terribly unlikely. This fact is also important for its implications about the economy. As Hamilton wrote, "It seems a clear inference, in a movement where the averages do not confirm each other, that uncertainty still continues as concerns the business outlook..."
Our own measures of trend uniformity remain negative. The favorable breadth momentum off of the September low was also lost in late-December. So we simply have no reason to speculate on market risk, and with valuations extreme, there is certainly no reason to invest in it.
The bottom line is simple: we do not risk money on distinctions that are unobservable except in hindsight. Based on currently observable evidence, the Market Climate remains the most hostile we identify. We'll be quick to become constructive when and if the Climate improves, but at present, we remain fully hedged and defensive.
| Past performance does not ensure future results, and there is no assurance that the Hussman Funds will achieve their investment objectives. An investor's shares, when redeemed, may be worth more or less than their original cost. Investors should consider the investment objectives, risks, and charges and expenses of the Funds carefully before investing. For this and other information, please obtain a Prospectus and read it carefully. The Hussman Funds have the ability to vary their exposure to market fluctuations depending on overall market conditions, and they may not track movements in the overall stock and bond markets, particularly over the short-term. While the intent of this strategy is long-term capital appreciation, total return, and protection of capital, the investment return and principal value of each Fund may fluctuate or deviate from overall market returns to a greater degree than other funds that do not employ these strategies. For example, if a Fund has taken a defensive posture and the market advances, the return to investors will be lower than if the portfolio had not been defensive. Alternatively, if a Fund has taken an aggressive posture, a market decline will magnify the Fund's investment losses. The Distributor of the Hussman Funds is Ultimus Fund Distributors, LLC., 225 Pictoria Drive, Suite 450, Cincinnati, OH, 45246.
The Hussman Strategic Growth Fund has the ability to hedge market risk by selling short major market indices in an amount up to, but not exceeding, the value of its stock holdings. The Fund also has the ability to leverage the amount of stock it controls to as much as 1 1/2 times the value of net assets, by investing a limited percentage of assets in call options. The Hussman Strategic Total Return Fund has the ability to hedge the interest rate risk of its portfolio in an amount up to, but not exceeding, the value of its fixed income holdings. The Fund also has the ability to increase the interest rate exposure of its portfolio through limited purchases of Treasury zero-coupon securities and STRIPS. The Fund may also invest up to 30% of assets in alternatives to the U.S. fixed income market, including foreign government bonds, utility stocks, and precious metals shares. The Market Climate is not a formula but a method of analysis. The term "Market Climate" and the graphics used to represent it are service marks of the Hussman Funds. The investment manager has sole discretion in the measurement and interpretation of market conditions. Except for articles hosted from the web domains hussman.net or hussmanfunds.com, linked articles do not necessarily reflect the investment position of the Funds. |