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 September 29, 2002 : Hotline Update
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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Just a note: The October issue of Bloomberg Personal Finance has an outstanding article by Bill Hester (p. 54, Getting Past the Wreckage) that includes some of my work, and a number of charts that are probably familiar to readers of these updates. Not only did Bill get the facts and analysis right, he captured the subtlety of the arguments from a lot of excellent analysts, some whom I've seen only loosely quoted in the past. Pick it up if you get a chance.
The Market Climate in stocks remains on a Warning condition, characterized by both unfavorable valuations and unfavorable trend uniformity. We continue to hold a fully hedged position, with the full value of our favored stocks hedged against the impact of market fluctuations.
In bonds, the Market Climate is also unfavorable, characterized by low yields and generally upward yield pressures, particularly in inflation, but a number of important yield pressures remain downward, which allows for the possibility of further declines in long term interest rates. Unfortunately, the risk of speculating on such a decline is unacceptable when the level of yields is already quite low. So while we do hold a very small quantity of intermediate Treasury bonds, the majority of our fixed income investments are in short maturities, with modest additional diversification in precious metals shares, foreign government debt (mainly short-term Euro area securities), and a few select utilities.
In short, this is a very risky financial environment, and we are taking these risks seriously.
Much of my observation on the current market is captured in last week's update. My only additional thoughts are, #1 the duration problem at Fannie Mae continues to appear as bad as I thought, and #2 don't believe every opinion you read.
Long-term readers of these updates know by now how often I italicize the word opinion, in order to differentiate it from evidence. Our investment positions are not driven by anybody's opinion, including my own. The distinction between opinion and evidence is that evidence can be observed in real-time, and has a certain amount of testable, factual weight. In this regard, the so-called "Fed model" of stock valuation (dividing the prospective earnings yield on the S&P 500 by the 10-year bond yield) is opinion, in the sense that "overvaluation" or "undervaluation" on the basis of that model has zero statistical relationship with subsequent market returns (even including a few good "calls" from extreme readings in 1974, 1982 and 1987 which were apparent even using the raw P/E). This is not to mention the fact stocks currently have a duration in excess of 40 years, which makes it a laughable notion that anybody would think of pricing them off of a 10-year Treasury with a duration of less than 8.
Thus, when one reads an op-ed piece from Thursday's Wall Street Journal entitled "The Market's P/E is Low, Not High", it doesn't take much looking to find the hook in the carp's mouth. And there it is, in the description of how the author "properly adjusted" the P/E for the level of interest rates: "This adjustment is accomplished by dividing P/Es by the inverse of the 10-year Treasury yield."
Now, normally, one might recognize that dividing by the inverse of a number simply means multiplying by that number. But of course, that would have led to the much less compelling title "The Market's P/E, multiplied by the 10-year Treasury yield, is low, not high."
Which goes to show that like Keynesian economics, an appealingly simplistic model, once popularized, is very difficult to dislodge.
Sunday September 22, 2002 : Hotline Update
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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Just a note - last week's market action prompted a couple of special updates (Wednesday and Friday). If you missed them, you can find them directly after the current posting.
As of last week, the Market Climate for stocks has shifted back to a Warning condition, characterized by both unfavorable valuations and unfavorable trend uniformity. In the fixed income area, the Market Climate for bonds is also unfavorable, characterized by low yields and upward yield pressures on balance. Over the short term, rising default risk in the corporate arena and frantic buying of Treasuries by Fannie Mae (see below) may help to support the bond market. But such factors are fairly speculative, and the risk is that when bond yields turn, they may do so in a hurry. We continue to hold relatively short maturities in the Strategic Total Return Fund, with diversification into foreign government notes, precious metals shares, and a few select utilities.
At present, the Strategic Growth Fund is fully hedged, with the intent of removing the impact of market fluctuations from our portfolio.
In stocks, this is not a forecast or a statement about expected market direction, particularly over the short term. The stock market is currently oversold, and bear markets have a general tendency to produce explosive rallies to clear such conditions before moving lower ("fast, furious, and prone to failure"). Such a rally should not be ruled out here, nor should it be counted upon. As always, once we identify a particular Market Climate, we make no attempt to forecast, "time," or speculate on short term market movements within that Climate.
In short, our fully hedged position should not be interpreted as a forecast of oncoming weakness in stocks, but as a simple statement that market risk has generally not been well rewarded in the current Market Climate on average. Accordingly, we have attempted to remove market fluctuation as a source of portfolio risk. No forecasts required.
When we carry a fully hedged position (and 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 favored stocks we hold and the market indices that we use to hedge (mainly the Russell 2000 and S&P 100 indices). As I frequently note, the potential for our stocks to behave differently than the market is a source of risk, but it is also our primary source of expected return when we are fully hedged.
The performance of a fully hedged portfolio (long stocks, short the same dollar amount in market indices) is approximately equal to: the total return on the stocks owned by the portfolio, minus the total return on the indices sold short as a hedge, plus the risk free interest rate earned on the short sale of those indices (technically about 80% of the broker call rate), minus any expenses. So for example, if the portfolio stocks fall by 12%, the market indices fall by 20%, and expenses and interest earned are roughly equal, a fully hedged portfolio would gain about (-12 minus -20) = +8% in value despite the market decline. In contrast, if the portfolio stocks were to fall by 12% while the market indices fall by only 5%, a fully hedged portfolio would lose about 7% in value. Similar calculations hold when one or both components advance. In short, the return on a fully hedged portfolio is not driven by market direction, but by the performance of stock selection relative to the market.
While the rally off of the July lows has failed, it did generate favorable trend uniformity very quickly, and placed us in a constructive position until deteriorating price/volume action prompted us to cover larger and larger portions of that position. Driven largely by evidence related to weak financial stocks and other measures of risk premium pressure, trend uniformity is again negative. As I've noted before, bear market rallies usually fail by producing a blowoff rally, followed by subtle internal deterioration which shifts trend uniformity negative. That's also how both bear market rallies in 2001 failed (March-May, Sep-Dec).
In the recent instance, however, volume never expanded significantly. Nearly a century ago, Dow Theory proponents like William Peter Hamilton and Robert Rhea noted that rallies should be treated with great skepticism when trading volume is dull on advances and expands on declines. The recent rally had precisely that feature, and frankly was one of the most unsatisfying bear market rallies I've ever seen. For an outstanding review of recent volume action, see the excellent article in this week's issue of Barron's.
Trading volume is often looked at as a "technical indicator" and accordingly gets very little attention in academic research. Finance researchers typically overlook trading volume because their theories, in large part, imply that it should not exist. Seriously. Indeed, every academic theory implying market efficiency has a corollary (its evil twin) called a "no-trade theorem" asserting that trading volume should be identically zero.
Of course, trading volume is not identically zero, and markets are not tightly efficient. Instead, the markets provide profit opportunities for trades that move the market toward efficiency, and thereby keep the market in a neighborhood of efficiency. Sometimes, as in the recent bubble, this neighborhood is the size of Minnesota, but the most reliable profit opportunities are generally those that drive the market back toward efficiency - either by providing support through the purchase of undervalued stocks that would otherwise be driven lower, or by providing resistance through the sale of overvalued stocks that would otherwise be driven higher. I cannot stress enough that market action - both price and volume - conveys information. At present, this information suggests more trouble ahead.
Increasingly, newspapers and magazines are publishing "What we've learned the hard way" articles, outlining lessons learned from the decline. Among these lessons are items like "Tune out the hype." While this is desirable, "tuning out" is impossible for most investors when hype is, in fact, making money. This is like asking squirrels to tune out nuts. In order to tune out the hype, investors need some objective anchor that provides, to use J.K. Galbraith's words, "a durable sense of doom" when valuations are unreasonable.
Another apparent gem of wisdom is "Focus on long-term, not short-term returns." This is poorly defined lip service, encouraging investors to hold onto stocks based on past long-term returns achieved through a long and unsustainable increase in stock valuations, rather than recognizing the still disappointing future long-term returns which stocks are currently priced to deliver as valuations stabilize or regress toward their historical norms. As I wrote in the May 2001 issue of Research and Insight "Investing is about the long term... Which is exactly why investors should get the hell out of stocks."
The fact that these articles are coming out as if the bear market is over, means that investors haven't learned a thing. The most important lessons to learn? Stocks are simply a claim to a future stream of free cash flows that will be delivered to investors over time. Free cash flow is equal to operating earnings, minus interest, minus taxes, minus capital investment over and above what is required to replace depreciation in order to provide for future growth, minus required increments to working capital to support revenue growth, minus the value of share dilution through option and stock grants to employees and management. These cash flows must then be discounted to present value at a rate of return appropriate for a very long duration security. The fact that investors have still not learned this lesson is evident from their continued focus on operating earnings as a measure of corporate performance, from their uncertainty as to whether options costs should be deducted from reports of financial performance to shareholders, and from the frightening tenacity with which they cling to poorly valued stocks under the delusional rationale "I'm a long-term investor."
Quite simply, stocks remain priced to deliver total returns of about 7.6% annually over the long term if current valuations are sustained into the indefinite future, and substantially less than 7.6% if valuations return to historical norms even a decade or two from today.
In other news, Fannie Mae revealed last week that their duration gap has plunged to a negative 14 months. Which begs the question, "What's a duration gap?" Having seen how inaccurately it has been explained in the press, all I can say to my former finance students is "I feel your pain." The following discussion is going to gloss over a few details, like call features, modified duration, convexity, and inverse floaters, but here is the basic idea:
As you can read in the Prospectus of the Hussman Strategic Total Return Fund, the price of a debt security is just the present value of the future payments that the security will deliver to investors. The "duration" of a fixed income security is the average date at which it makes those payments, weighted by their present values. So for example, the duration of a 10-year zero coupon bond is simply 10 years (100% of the payment stream is received in year 10). In contrast, the duration of a 10-year, 6% coupon bond priced at par is just 7.8 years. The coupon bond has a shorter duration because part of its payment stream is received as coupon payments much earlier than its 10 year maturity date, and these coupon payments shorten the bond's duration.
Importantly, duration measures not only the "average" date at which a bond makes its payments; it also measures the price sensitivity of a bond to interest rate changes. So now things get interesting. To an approximation, a bond with a duration of 10 years will fluctuate about 10% in price based on a 1% (100 basis point) change in interest rates, while a bond with a duration of say 4 years will fluctuate only about 4% in price on that same 1% change in rates.
So here's the payoff. The duration gap of a financial company is equal to the duration of assets minus the duration of liabilities. For Fannie Mae to have a duration gap of -14 months means that the duration of liabilities exceeds the duration of their assets by 14 months. This is because Fannie Mae makes mortgage loans, and as interest rates have declined, more and more individuals have refinanced or shortened their borrowing horizons. So these mortgages (assets of Fannie Mae) are now substantially shorter in duration than Fannie's liabilities. Since -14 months is -1.17 years, this means that a 1% drop in interest rates would cause Fannie Mae's loan portfolio to lose about 1.17% in value. Now, that doesn't sound like a lot. Until you realize that Fannie Mae has leveraged its equity 40-to-1 (the highest leverage ratio in its history), and that its annual return on this portfolio is just 0.65%.
In short, a further drop in interest rates of even 0.50% here would cause an overall portfolio loss equal to about (1.17 x .50 x a leverage factor of 40 =) 23% of Fannie Mae's book value, or equivalently, about (1.17 x .50 / .65 = ) 90% of Fannie Mae's annual earnings. Accordingly, Fannie Mae appears to be scrambling to buy long-term Treasury bonds (thereby lengthening the duration of its assets) in an attempt to shore up its duration gap. This is no small problem, and is behind the substantial plunge in long-term Treasury interest rates we've seen in recent weeks.
... Thus explaining my comment last year that I don't understand why Fannie Mae trades without a substantial haircut for risk. As I've written many times, there are three features common to nearly every financial debacle: 1) extreme leverage, 2) a mismatch between assets and liabilities, and 3) lack of disclosure. In this regard, it's difficult to exclude Fannie Mae from concern. We don't own any stock in the company. And while I have no concern over the debt quality of Fannie Mae's bonds, we don't own them either, because even tiny changes in risk premiums demanded by investors can generate meaningful price fluctuation.
More generally, we remain intentionally light on financials - a position driven by objective valuations and market action, but underscored by emerging news like this, as well as recent troubles at J.P. Morgan and Citibank.
Finally, it's interesting that J.P. Morgan has done away with its casual dress code and is now requiring business attire. This is reminiscent of the "hemline indicator" that was popular in the late 60's. The theory held that as hemlines went, so went the market, since liberal and conservative fashion trends seemed to mirror broader trends in economic prosperity. Thus, "Happiness is a stock that doubles in a year" - a book on my shelf from the Go-Go years of the 1960's - dedicated an entire chapter to the subject, optimistically noting that mini skirts were taking the fashion world by storm. It will be interesting to see what happens to business casual if the economy continues to stagnate.
Friday Morning September 20, 2002 : Special Hotline Update
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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Just a note: I am pleased to introduce the no-load Hussman Strategic Total Return Fund. The Fund will trade under the ticker symbol HSTRX. For a Prospectus detailing the Fund's strategy, including fees and expenses, please visit our website www.hussman.net. Please read the Prospectus carefully before you invest or send money.
As of last week, the Market Climate remained characterized by unfavorable valuations, while trend uniformity remained favorable by the most tenuous margin possible. We report shifts in the Market Climate with a one-week lag. Suffice it to say that much has changed since last week. When the market failed to enjoy a sustained rally following the news that Iraq would allow unconditional inspections, and finance stocks began to swoon early this week, it became clear that risk premiums were no longer on the decline. Apparently, the market anticipates a variety of troubles in the near future.
With regard to very short-term conditions, the market is substantially oversold. Bear markets have a tendency to generate explosive rallies in order to clear such conditions before heading lower. We never rule out such action, regardless of the Market Climate we identify, but we certainly would not position ourselves in the hope for such a bounce.
For those investors who are relatively new to our approach, is essential to understand that every Market Climate we identify includes some periods of strongly advancing prices, as well as periods of declines. On average, market risk has been rewarded to some degree in all but the most negative Market Climate (unfavorable valuations, unfavorable trend uniformity). But even the most negative Climate experiences occasional periods of rising prices, sometimes substantial ones. Once we identify a particular Climate, we make no attempt to predict short-term moves within that Climate. When the Climate is negative, our main imperative is to remove the impact of market fluctuations on our portfolio of favored stocks. These hedges are not a "bet" that the market will decline, and they do not imply anything about short-term movement.
On the fixed income front, the 10-year bond yield is now at the lowest level since 1960. Investors fleeing stocks to take an indiscriminate position in bonds are moving out of the frying pan and into the fire. The rate of inflation now exceeds short-term Treasury yields. At this point, the most favorable trend remains the widening spread between corporate yields and Treasury yields, suggesting further economic weakness. While this does exert some pressure for Treasury yields to fall further, investing in longer term Treasuries on this basis presumes the ability to liquidate prior to a rebound in yields. Unfortunately, such rebounds tend to be fast and unpredictable when yields are at very low levels. For that reason, long-term Treasuries are not safe havens, but invitations to trouble. If, for example, the 10-year Treasury yield moves up by 1% from current lows over the coming two years, the 10-year bond will deliver a negative total return over that period.
Meanwhile, corporate bonds remain a minefield, and mortgage backed securities, though widely viewed as "safe", are simply uncomfortable propositions in a housing market overridden by debt and foreclosure risks. For a variety of reasons, short-term Treasuries, callable agency notes (other than mortgage pass-throughs), European government notes, certain utility stocks, and precious metals shares all appear much more attractive on a return/risk basis than the typical bond fund fare of medium-term Treasuries, corporates and mortgage backed bonds.
In short, this is not a market where taking unhedged, long-term risks is likely to be rewarded in either stocks or bonds. Fortunately, there is a wide palette of attractive and less hazardous risks available among which to diversify. It is simply false to believe that investors have no alternatives except high-risk positions in stocks and bonds simply because Treasury bill yields are low. The only reasonable risks are those that are associated with an attractive expected return.
Wednesday Morning September 18, 2002 : Special Hotline Update
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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The stock market continues to behave in a way that suggests upward pressure on risk premiums - a shorthand way of saying that the Market Climate is likely to shift back to a fully defensive posture in short order. We've taken opportunities to increase our level of hedging, but we will not establish a fully defensive position until and unless the evidence confirms a negative shift in trend uniformity. In the meantime, even tenuous or negative Market Climates can admit powerful short-term rallies. Despite my growing skepticism about market conditions here, the market has experienced enough downside losses that an explosive rally should not be ruled out. I never try to predict this sort of thing. We simply align ourselves with the prevailing Climate - which at this point remains positive by the slightest margin.
My opinion is that stocks are vulnerable to a negative shift in the Market Climate. While I have discretion as to how much market risk to take on at present, our discipline does not allow the discretion to be fully hedged when trend uniformity is favorable (however tenuously). In any event, we continue to have a slight exposure to market fluctuations here, but conditions have already broken down enough to keep that exposure fairly minimal.
In bonds, the Climate has shifted to a fully negative condition. This should not be confused with a forecast about the future direction of bonds. As always, a negative Climate indicates that expected returns are not sufficient to justify prevailing risks, and that a defensive posture is appropriate. Recognition of this sort of condition does not require predictions about the size or extent of future market movements. One of the only favorable prevailing trends in the bond market is the widening in risk premiums between corporate bonds and default-free Treasuries. Widening risk premiums are typically associated with oncoming economic weakness. Other things being equal, this is generally favorable to Treasury bond returns. The issue here is that other things are not equal. Bond yields are so low that much of this potential economic weakness is discounted already. A low level of yields is generally unfavorable for bond returns regardless of prevailing trends. The reason is that even if low bond yields fall further, the subsequent rebound is typically sharp and unpredictable. In short, rather than being a safe haven against falling stocks here, a blind rush to hide in long-term bonds simply invites further trouble. Fortunately, there are alternatives. A well-hedged portfolio is one. We'll announce another in the coming week.
A final note - Richard Russell of Dow Theory Letters, notes that Fannie Mae and Freddie Mac broke down hard Tuesday, while lumber futures hit a new low. If this kind of market action doesn't cry "danger" regarding the housing market and mortgage quality, I don't know what does.
Sunday September 15, 2002 : Hotline Update
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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As of last week, the Market Climate remained characterized by unfavorable valuations and tenuously favorable trend uniformity. I suspect that this favorable trend uniformity will be lost in the coming weeks, but we don't act until we have evidence in hand. Until that shift actually occurs, we'll stay at least modestly constructive. As of last week, our holdings were about 24% unhedged (with the remaining 76% hedged against the impact of market fluctuations).
If the market loses favorable trend uniformity in the coming weeks, there are two probable ways that it could occur (each equally plausible). One would be a further decline that creates further damage to market internals (a 4% decline in the major indices from current levels on a weekly closing basis would almost surely trigger a negative shift). The other possibility, and slightly preferred, would be a broad blowoff market advance followed by a brief period of stagnation during which internals suffer more subtle deterioration. In other words, a negative shift would probably be triggered either by an obvious downside failure, or by a subtle failure following a sharp rally. The subtle shift is more typical for bear market rallies, but in the current economic/political climate, a more abrupt shift can't be ruled out.
Economic evidence remains conflicting on the surface, but the essential features of the economy are still solidly unfavorable. The U.S. current account remains at the deepest deficit in history, which largely rules out the possibility that U.S. consumption and investment will grow quickly as they typically do during the initial years of an economic recovery. The key help wanted and capacity utilization data remain floored near the lowest levels of this recession, suggesting that despite mild stability in survey readings such as the Purchasing Managers Index, demand for employment and capital is still weak. The main risks remain tied to the U.S. dollar. The extreme current account deficit implies that even current levels of U.S. consumption and investment are dependent on large and continuous inflows of foreign capital. U.S. dollar weakness would be an ominous signal that the supply of foreign capital is slowing, and that would place even current levels of economic activity at immediate risk.
Credit spreads (the difference between risky corporate yields and default-free Treasury yields) continue to widen, suggesting further potential for defaults. But at least the widening is being driven by falling Treasury yields instead of surging corporate yields. That fact suggests that the potential for defaults is largely due to generalized economic risk, not any perception by the market that specific defaults are imminent. So while rising yields (particularly corporates) would be a negative, the main indication to watch is potential weakness in the U.S. dollar.
In any event, the current Climate for stocks is modestly favorable on balance, but so tenuously that conditions can hardly be distinguished from completely neutral. Despite substantial overvaluation, however, it's difficult to characterize the current environment as "bearish." That may change even a few days or weeks from now, which is why predictions in this environment are ill-advised. For now, we remain modestly but tenuously constructive, and we'll take additional evidence as it emerges.
Sunday September 8, 2002 : Hotline Update
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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As of last week, the Market Climate remained characterized by unfavorable valuations and tenuously favorable trend uniformity. Following Tuesday's poor market action, the market showed reasonable improvement late in the week. That said, the present condition of trend uniformity is so vulnerable that as of Friday's close our position was about 24% unhedged. That figure may seem odd - essentially, we were 40% unhedged early in the week, but covered 40% of that 40% on the late-week rally, leaving us with 24% unhedged. That "40% rule" is usually the best way to deal with ambiguous signals. In this case, it's not ambiguous that trend uniformity remains favorable (there are specific criteria for this), but the status is so tenuous that it cannot be trusted with a significant amount of market risk. The bulk (76%) of our stock holdings remain hedged with an offsetting short position in the S&P 100 and Russell 2000 indices. Nevertheless, we will remain at least slightly constructive until trend uniformity shifts to a fully negative condition. At present, we are still more constructive than we were at any time between August 2000 and August 2002.
Quick comment about Friday's unemployment report. In general, about 150,000 workers enter the labor market each month. Job creation at less than this pace is not healthy. The decline in the August unemployment rate was almost entirely the result of weak labor market entry, not an increase in jobs. Again, the best confirmation of an improving job market would be a sustained surge in the help wanted advertising index. Currently, that index remains at the lowest point of this recession.
Bonds no longer appear to offer favorable valuation. Barring a substantial reduction in the growth of government entitlements (a primary driver of secular inflation), any further decline in interest rates from here will be based only on speculative merit. There are certainly some trends that are favorable to a further decline in yields, the main one being that risk spreads are widening (the risk spread is the difference between yields on corporate bonds and Treasury bonds). Widening risk spreads tend to be followed by lower yields because they presage general economic weakness. That said, the present steepness of the yield curve (long term rates higher than short term rates) is the product of low short-term rates, not value in the long maturities.
Why is this important for stocks? Because most of the "fair value" calculations tossed about by Wall Street analysts are predicated on the 10-year Treasury bond yield. If the 10-year Treasury yield is low, analysts generally assume that stock yields should be similarly low (and that P/E multiples should be high). Indeed, this is the whole basis of the so-called "Fed model." I've frequently noted that despite a few good "calls" based on extreme outliers in 1982 and 1987, the historical data taken as a whole shows zero correlation between the "overvaluation" or "undervaluation" indicated by the Fed model, and the actual subsequent return for the S&P 500. That's zero to about 4 decimal places, mind you. Completely useless.
Still, analysts are suckers for visual evidence that confirms their hopes, and charts of the Fed model look as if the indicator is useful, entirely because of those outliers. But current readings are nowhere close to being one of those outliers.
In any event, a depressed 10-year bond yield, predicated on unusually depressed short term yields and a weak economy, should not be used as the basis of for pricing stocks. If you look at a 10-year Treasury bond, the duration (the average date at which the bond delivers its payments) is about 8 years. But if you look at equities, their duration is currently well above 40 (it's not straightforward to derive this, so I'll just state the fact). In terms of their price sensitivity (which is also linked to duration), a 10-year coupon bond would currently fall by very roughly 8% in response to a 1% increase in the yield to maturity. But the stock market would have to fall by about 40% if investors were to demand a 1% increase in the long-term return provided by stocks. A 40-plus-year risky asset should not be priced as if it should deliver a constant risk premium over an 8-year default-free asset. For this reason, the long-term return on stocks is much less sensitive to fluctuations in interest rates than most analysts seem to believe.
At present, stocks remain overvalued, in the sense that they are priced to deliver a long-term return of only about 7.6% if valuations remain constant here while fundamentals grow at historical peak-to-peak rates. If valuations instead move back modestly toward their historical average over the next decade as fundamentals grow (e.g. to a 2% dividend yield instead of 1.6%), the S&P 500 will deliver a total return of less than 6%. If the S&P 500 dividend yield was to move to 2.65% over the coming decade (the same level seen at the 1987 peak), the S&P 500 would deliver a total return, including dividends, of less than 3% annually. For more detail on where these estimates come from, see Estimating the long-term return on stocks on our Research & Insight page.
The wild card is not the long-term (where returns are nearly certain to be unsatisfactory from current levels), but the short-term. Here, trend uniformity is clinging tenuously to a favorable condition. There's no sense guessing whether this will persist. As any successful floor trader will tell you, the proper response to uncertainty is not to hold the same size position, curl up in a ball and hope (or worry), nor do you toss your trading cards into the air and run screaming out of the Exchange toward LaSalle Street. The proper response to uncertainty is to reduce your size, widen your spread, and keep trading. For us, that means leaving a somewhat smaller portion of our portfolio unhedged, and to require larger overall market movements in order to change that position further. Preferably, the next unfavorable shift in trend uniformity will occur on a market rally that shows subtle signs of internal weakness, rather than on a sharp market drop that forces the shift. But we've already responded to the increased risk of a negative shift, and as usual, that leaves prediction unnecessary. For now, we remain slightly constructive, with most but not all of our holdings hedged against the impact of market fluctuations.
Wednesday Morning September 4, 2002 : Special Hotline Update
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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What a difference a day makes. Tuesday's action calls for a special update. While the Market Climate is still in a modestly favorable condition, Tuesday's impact was quite negative. As I've noted many times, market action conveys information. Most of this information is contained not in what the market does, but what it does that differs from what it ought to do. This is why I regularly discuss important divergences in various measures of market action.
Very simply, Tuesday's decline was out of context for a favorable Market Climate, and far out of line with the "nothing" news of a flat Purchasing Managers Index. Market action is the combined verdict of millions of investors acting on both public and private information. This information need not be "insider" information - it may be as simple as Sally Douglas getting some new orders and deciding to invest the extra income in the market. Or Joe Perkins losing his job and deciding to sell some stock to reduce his risk level. The combination of millions of such actions drives the market.
A day like Tuesday suggests that there may be something much more nefarious going on than simply a flat Purchasing Managers Index. I have no idea what that might be. Possibly credit problems and a few high profile bankruptcies (particularly with the financials so weak). Possibly international risks. But there's trouble somewhere. At this point, a continued favorable Market Climate requires a substantial rebound for the remainder of this week. Otherwise, a negative shift in the Market Climate is threatened, and I am quite alert to the possibility.
In short, the Market Climate remains modestly favorable for now, and we remain largely though not fully hedged. Stocks have declined to a relatively oversold condition. In general, oversold markets in favorable Market Climates tend to produce sharp advances. If the Climate is to remain constructive, the market must do so here. Tuesday's action was simply too far out of line with the prevailing Climate and current news. Unless strong market action in the coming days quickly proves Tuesday's decline to have been noise, we'll have to prepare for the possibility that some relatively unattractive shoe is about to drop.
For now, the evidence holds us to a modestly constructive position. It remains to be seen how brief or durable this condition will be, but we'll take our evidence as it comes, and act on it accordingly.
Monday September 2, 2002 : Hotline Update
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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As of last week, the Market Climate remained characterized by unfavorable valuations and favorable trend uniformity. This is a modestly favorable condition for taking market risk, and we currently have about 40% of our stock holdings exposed to market risk (the remaining 60% is hedged with offsetting short sales in the Russell 2000 and S&P 100 indices). My opinion continues to be that stocks remain in a bear market, and that the recent rally is a counter-trend move. But I have no opinion about when the current, modestly favorable Climate will shift, or how far the market might move in the interim.
It remains possible that this Climate may shift as the result of a sharp, broad market decline. But it is more likely that any negative shift will be preceded by something of a "blowoff" advance. Last week's decline certainly didn't take the market to an oversold condition, but it did relieve an overbought condition. Given a modestly favorable Market Climate, the lack of an overbought condition is reasonably conducive to a further rally. For that reason, my opinion (which we don't trade on and neither should you) leans more strongly toward a sharp rally than a sharp decline here. But we'll take our evidence as it comes. We don't actually invest on the basis of such forecasts, nor on my opinions about the existence of a bear market versus a bull market. Bull and bear markets can't be identified except in hindsight. Instead, we align our positions with the prevailing, identifiable Market Climate. When that Climate shifts, we'll shift our position. At present, a 40% exposure to market risk is about right. This position takes into account the risks from overvaluations and weakening economic conditions, and also the speculative merit due to an increased willingness of investors to take risk.
Selling by corporate insiders has declined sharply in recent weeks, and corporate bonds continue to firm. I still expect further debt problems ahead, but both are healthy indications of an improved speculative condition. Unfortunately, Treasury yields have been falling even faster than corporate yields, meaning that despite the improvement in corporate bonds, credit spreads have been widening. That is an economic negative. But matters would be worse if corporate bond prices were falling, and they are not - at least for now.
In contrast, the Help Wanted Index has plunged to 44 (the worst level to-date in this economic downturn), while capacity utilization has stagnated. The U.S. current account deficit has also deteriorated to another record. These are very strong signals that economic improvement should not be anticipated in the near future. If the Chicago Purchasing Managers Index is any indication, the national Purchasing Managers Index appears likely to show an increase when it is reported on Tuesday morning. That would probably revive claims that there is a "disconnect" between the economy and the market. But such evidence from the PMI is unreliable when it is not accompanied by indications of stronger demand for labor and capital (namely help wanted and capacity utilization). Recall 1980. Indeed, a substantial weakening of the U.S. dollar at this point would signal a probable deepening of this recession.
I say "this recession" of course, because I do not believe that it is over. Despite widespread assertions to the contrary, the view that the economy is in recovery is based largely on hope and superstition. Yet analysts talk about an economic recovery as if it was fact, without questioning whether the indicators they are citing are even valid. As G.K. Chesterton wrote a century ago, "the fact without the truth is false." For instance, if an analyst suggests that Fed cuts are "in the pipeline", it is reasonable to ask how these cuts transmit their effect to the economy, and whether these mechanisms are working. In this case, the entire increase in the monetary base in recent years has been drawn off as currency in circulation. Bank reserves have actually declined. To believe that Fed cuts have created more bank reserves and more lending is counterfactual. To believe that "Fed injections of money into the economy are still in the pipeline" is superstition. If there was such a pipeline, trust me, these analysts wouldn't be doing interviews on CNBC. They'd be out there with a plunger and a bag.
As for the presumed "disconnect" between the market and the economy, one can do no better than to quote William Peter Hamilton, one of the early Dow Theorists, who wrote in 1922: "The market has ... often seemed to run counter to business conditions, but only for the reason which represents its greatest usefulness. It is then fulfilling its true function of prediction. It is telling us not what business is to-day but what the future course of business will be... To those who profess themselves dissatisfied that the major stock market movements are not always immediately adjustable to the various current business charts, it may be said that the fault is not in our barometer. That is universal, and takes note of international facts where those tabulations do not. If, therefore, they inadequately confirm our deductions, so much the worse for them."
In short, as I argue relentlessly, market action conveys information. This is not to say that valuation levels are always correct, but rather that market changes reflect far more information than is held by any analyst, and this action should never be ignored when forming opinions about economic prospects. Notably, Richard Russell (Dow Theory Letters) notes that stocks remain in a bear market from the standpoint of Dow Theory. Though our own discipline doesn't require the notions of bull and bear markets at all, I suspect that in hindsight, the current period will in fact be seen as a countertrend rally within an ongoing bear.
In the meantime, no determination has been made that the recession is over. The NBER Business Cycle Dating Committee will not convene to date the official end of this downturn until the prior economic peak is surpassed. This is their standard policy - the dating committee is not a forecasting body but an arbiter of historical starting and ending dates.
Even without further economic deterioration, a number of industries are already at very high risk of immediate bankruptcies. The airlines are the most vulnerable (particularly AMR). Further economic weakness would open this list to a wider set of companies, including not only the usual suspects (Nortel, Emmis, Nextel, Cox, Broadwing, etc), but also autos (particularly Ford) and a number of large financials.
So we've got an economy at risk of further weakening, a market still priced to deliver unsatisfactory long-term returns, but a favorable speculative Climate at present (which may last a week, a month, or a year - no forecasts required). That is a mixed bag, and justifies a modest exposure to market risk - neither strongly defensive, nor strongly aggressive. This is not a "bullish" position however. We have to recognize that trend uniformity could shift at any time, and be willing to move to a strongly defensive posture if that occurs.
A few side notes. Alan Greenspan gave a speech last week, hoping to disavow responsibility for the recent market bubble. Greenspan indicated that the Fed really does not have much power to stop bubbles. I basically agree, except that I would take it further. As I've argued at length in prior issues of Research & Insight, Federal Reserve open market operations are actually irrelevant in determining the volume of lending in the banking system. This is largely due to a change in the treatment of bank reserves in the early 1990's (they now apply only to checkable deposits, which are a minuscule source of funding for bank loans). The Fed really only has two useful functions. One is to adjust the monetary base (currency and bank reserves) in response to changes in demand for cash, as it did in response to Y2K concerns. This function is crucial during bank runs and other panics, but has marginal economic impact otherwise. The other function is purely psychological, giving investors a sense that somebody is in control of the volume of bank lending (a sense that is now totally illusory, but still persists). On that mark, the Fed failed miserably in late 1998. Its surprise easings were among the primary drivers of the market's final speculative frenzy. As I wrote at the time, this was irresponsible of the Fed. The surprise easings in late-1998 represent Greenspan's most serious mistake. Until that mistake is widely recognized, the markets will be at risk of similar mistakes in the future.
In an environment of increasing finger-pointing, some financial stations are now running ads for law firms hoping to sue brokers for investment malpractice. One ad gives its pitch while showing a chart of a portfolio falling precipitously in value from 2000, to 2001, and through 2002. While it is certainly reasonable for investors to hold advisors accountable on the basis of fraudulent or unauthorized behavior, and I never thought that the widespread bullishness of investors in recent years was particularly smart, it is shameful to display a graphic of what is essentially the 3-year performance of the overall market as if it is evidence of broker malpractice. This is ambulance-chasing, and continues to divert investor attention toward scapegoats, and away from what would ultimately help them. Most notably, investors would benefit from a deeper understanding of investment value, and of the cash flows that investors actually claim by virtue of share ownership.
Finally, a number of companies including Fidelity, Schwab and Legg Mason have launched new funds that aim to be either market neutral, or flexible in their exposure to market risk. Barron's reports that Fidelity's offering follows a strategy that aims to beat Treasury bills by 3-4% annually (the Treasury bill yield is currently 1.65%). It will charge an expense ratio of 3.99%.
Now, come on.
Sunday August 25, 2002 : Hotline Update
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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Just a note - the annual report of the Hussman Strategic Growth Fund has been posted to the website. As of Friday, the expense ratio for the Fund has been reduced to 1.45% (our third such reduction since June), reflecting growth in the Fund assets beyond a number of breakpoints, and other economies of scale. This ratio may change with asset levels. Also, for those who have asked, the current asset base (just over $350 million) is not remotely close to what I consider to be the carrying capacity of our approach.
As of last week, the Market Climate remained characterized by unfavorable valuations and favorable trend uniformity. Though my opinion remains that this is a rally within a continuing bear market, that opinion doesn't affect our position. Based on prevailing conditions, we remain modestly constructive but still reasonably hedged (60%), with about 40% of our portfolio value exposed to market fluctuations.
Market action continues to be somewhat suspect, particularly on account of dull trading volume. Bear market rallies are dangerous because they can fail quickly (and sometimes spectacularly). But quick failure is usually a characteristic of rallies during periods of unfavorable trend uniformity. Now, it's possible that the Market Climate could shift back to a strongly unfavorable posture based on sharp, broad, abrupt decline. But typically, bear market rallies showing favorable trend uniformity give some amount of warning before failure. In general, negative shifts in trend uniformity involve subtle action rather than abrupt reversals. They are often preceded by a broad, blowoff surge with little follow-through, while important market internals quietly deteriorate over a period of a few weeks. Just as a sharp market advance is not required for a positive shift in the Market Climate, a sharp decline is not required for a negative shift. I have no idea when a shift will actually occur until it actually occurs.
This is why I rarely have a short-term forecast, regardless of the Market Climate. The only time I have an opinion about short-term action is when the market is very overbought during a negative Climate (which tends to produce vertical drops), or when the market is very oversold during a positive Climate (which tends to produce leaping advances). At other times, it's not very useful to form short-term opinions about the market. Importantly, it is certainly not generally useful to sell an overbought market during a favorable Climate. Nor is it generally useful to buy an oversold market during an unfavorable Climate. Market timers typically attempt both, which places far too much faith on technical overbought/oversold conditions in isolation.
It's probably accurate to think of the market as "hovering." More like a glider on a warm wind than a rocket on propellant. It has neither the valuations nor the economic fundamentals that could reasonably be expected to drive a sustainable bull market. Nor does it have the unfavorable trend uniformity or increasing risk aversion that typically drives powerful selloffs. There's little investment merit in taking market risk, and little chance that stocks will enjoy a runaway bull market advance. Still, investors have become somewhat less averse to risk in recent weeks, and that tendency is robust enough to give the market modest speculative merit. Accordingly, we remain modestly exposed to market fluctuations. When that evidence shifts, so will our position. And as always, no forecasting is required.
Sunday August 18, 2002 : Hotline Update
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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Just a note: Based on some helpful feedback from shareholders, I've slightly adjusted the plan for special intra-week updates. Special updates will occasionally be posted the morning after the Dow has moved at least 150 points, but only when recent events or market action are very unusual or important from the standpoint of the prevailing Climate.
As of last week, the Market Climate remains characterized by unfavorable valuations and favorable trend uniformity. This keeps us in a modestly constructive position, with about 40% of our favored stocks unhedged and exposed to market fluctuations. That's about as much market exposure as I believe is prudent in view of valuations and economic conditions.
I've received a few comments wondering how trend uniformity could have turned favorable so quickly off the recent low. The reason, as I've noted many times, is that trend uniformity does not measure the extent or duration of a market advance (or decline, for that matter), but instead measures its quality. Without revealing anything proprietary, quality is essentially an issue of information content.
The information content of market action is found not in what the market does, but what it does that departs from what it ought to do. For example, suppose I give you a series of numbers, and ask you to calculate the average. If the average so far is 25, and the next number is 25 as well, there is no new information in that data. But if the next number is say, 30, your average changes, because the data is different from what you would have expected. In other words, information is contained in the forecast errors. This is why stocks move not on earnings reports but on earnings surprises. This is why I spend so much time talking about divergences within market action - credit spreads, U.S. dollar action, market breadth, and so on.
When I talk about high-quality market action, I'm talking about market action that conveys a great deal of information. A couple of weeks ago, we got a favorable shift in trend uniformity, because even though market action was lousy, it was lousy in a very high-quality way.
The August 19th issue of Barron's has an excellent interview with Ned Davis. He has an interesting response to investors who have been waiting for a series of Lowry's-type "90% down-days" to signal a solid market bottom: "If you look at the up and down volume and what percentage of it is in advancing stocks and declining stocks, you'll find what we call a waterfall decline: two days or more in which 90% of volume is on the down side and two on the up side. The New York Stock Exchange data didn't show it, but our own database of the 1,500 largest companies showed we had two 9-to-1 down days and then two 9-to-1 up days. That is our definition of a selling climax. We've had record volumes and the market made new lows before turning up. Normally, you would get a new cyclical bull market out of that. This time, we'll see something more like last September, but it will not be a sustained rally."
Davis also notes substantial concerns about a debt bubble and the large U.S. current account deficit - both problems that I've emphasized for well over a year. Aside from a few good articles in the London Economist, the mainstream press continues to overlook the importance of these problems. It's good to see them surfacing in Barron's. Debt - both domestic and foreign, continues to be the greatest obstacle to sustained economic growth. And unfortunately, the only two ways to adjust to excessive debt is to pay it down (which requires a slowing of consumption and investment growth relative to income) or to default on it. Neither of these are conducive to robust economic growth. This is a classic case of the party being over, and still having to pay the piper.
In any event, favorable trend uniformity is a signal that investors, at least for a time, have a robust preference to take market risk. Regardless of valuations or underlying economic fundamentals, favorable trend uniformity indicates that market risk currently has at least modest speculative merit. A 40% exposure isn't aggressive, but it's constructive. And in view of current conditions, I believe that level of exposure is just about right.
Thursday Morning August 15, 2002 : Special Hotline Update
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and
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Just a note: We've changed our update schedule to a single weekly update based on our investment position as of the week just ended. Special updates will also occasionally be posted the morning after the Dow has moved at least 150 points, but only when recent events or market action are very unusual or important from the standpoint of the prevailing Climate. We don't discuss individual investment positions as we are establishing them, and this change formalizes that policy toward our overall market exposure as well. Also, I would like to complete a few substantial writing projects that I believe will be of more lasting benefit to clients and shareholders ("give a man a fish / teach a man to fish"), and this slight change in schedule will release the time to do so. Thanks!
Over the past several weeks, there has been a great expectation from short-sellers that Wednesday's deadline for CEO's to certify financial reports would be accompanied by a rain of "other shoes" dropping. I suspect that Tuesday's decline was more related to that fear than to disappointment over the lack of a Fed move. When no shoes dropped on Wednesday (other than UAL's bankruptcy warning after the close) that thesis was disproved and shorts ran for cover. The rally was on uncomfortably low volume given the size of the move in the major indices. It is still important for volume to expand on rallies. Until that begins to occur with regularity, this advance will remain somewhat suspect.
Even in the event that this rally is simply a counter-trend advance in a bear market (which is my opinion), the S&P 500 could advance by nearly 20% without moving above its 200-day moving average (which is a typical resistance point during bear markets). That's certainly not a forecast of such a rally. But advances of even that magnitude are not unusual for extended bear market declines. Even during this bear market, the March-May 2001 advance was 19% in the S&P 500, and the September-December 2001 advance ran slightly over 21%. Again, that's not a forecast, but it is a reminder that even substantial rallies can be consistent with ongoing bear markets.
Fortunately, our approach doesn't require us to forecast or speculate about the duration or extent of this rally. In fact, it doesn't even require us to forecast a rally at all. The relevant issue is the prevailing condition of the market. With valuations still unfavorable but trend uniformity favorable, we remain in a modestly constructive, but still 60% hedged position.
Wednesday Morning August 14, 2002 : Special Hotline Update
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and
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The Market Climate remains characterized by unfavorable valuations and favorable trend uniformity, holding us to a modestly constructive position - fully invested in favored stocks, with about 60% of their value hedged against market fluctuations.
The FOMC left the Fed Funds rate unchanged and shifted the "bias" toward a view of the economy more at risk of weakness than of inflation. Hopefully, the Fed will leave it at that and opt not to cut rates in upcoming meetings. It would simply do more harm than good. Tuesday's market reaction was fairly poor, with market breadth heavily dominated by declining issues and downside volume swamping upside volume. But we've still got a favorable indication from trend uniformity, and we'll remain constructive as long as that is true.
Again, our investment discipline is not one of prediction but identification. The fact that trend uniformity is favorable should not be mistaken for a forecast that the market will move higher. This may seem bizarre, but it works like this: when valuations have been unfavorable and trend uniformity has been favorable, as reflected in the current Market Climate, stocks have historically advanced at an average rate of about 15% annualized. Now, this looks fairly impressive until you realize that it averages to only about 0.3% per week. Meanwhile, the weekly volatility (standard deviation) of returns in this Climate has been about 1.6% a week. So that average weekly gain is swamped by random volatility, and is not statistically significant even on the weakest criteria. Since we have no forecast as to when a given Climate will shift, or how long it will prevail, there is no statistically significant forecast that we can attach to any Climate. So apart from a small, unreliable, and statistically insignificant tendency for the market to advance over the coming week, we have absolutely no expectation for future market direction at all. Yet we know exactly how much market risk we are willing to take here.
Again, this may seem bizarre, but as I've said before, our investment approach is a lot like sailing a boat. The destination is not acheived by forecasting the future direction of the wind, but by adjusting to the prevailing one.
For now, we remain constructively positioned, with about 40% of our stock holdings exposed to market fluctuations. That's certainly not an aggressive stance, but it is appropriate to the prevailing Climate that we identify.
Sunday August 11, 2002 : Special Hotline Update
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and
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The Market Climate remains characterized by unfavorable valuations and favorable trend uniformity. While unfavorable valuations suggest unsatisfactory long-term returns and a lack of compelling investment merit for major indices like the S&P 500, favorable trend uniformity suggests that investors are becoming somewhat less averse to risk - a condition which produces sufficient speculative merit to take a modest amount of market risk here.
So while our portfolio of favored stocks is currently 40% unhedged and exposed to market fluctuations, this is not an indication that I view stocks as a "value" or a "buy." Our Market Climate approach does not require forecasts but identification. I spend virtually no time trying to predict market moves or "time" rallies or declines - the effort is to properly identify the prevailing Climate. Any tendency for our shifts to look like "market calls" is incidental. If you're sailing a boat, you can go anywhere you wish simply by adjusting the sails to the prevailing wind. When the wind changes, you change the tack again. No forecasting is required in order to do this. What is required is the ability to properly identify the prevailing wind, and to recognize shifts as they develop.
In view of last week's favorable shift in trend uniformity, it was amusing to see news reports attributing the rally to "hopes of a Federal Reserve rate cut." It is much more accurate to say that stocks rallied because investors had become less averse to risk. But falling risk aversion doesn't make good headlines, and unless you've got good tools to identify falling risk aversion, you don't know that it's happening except in hindsight. From the standpoint of our investment discipline, we identified a shift toward lower risk aversion last week. When investors are willing to take on greater amounts of market risk, valuations become temporarily irrelevant. This is how a modestly overvalued market was able to become breathtakingly overvalued between 1995 and 2000.
In my opinion, the recent shift is more likely to represent a bear market rally rather than a sustainable bull move, but we don't trade on that opinion. Until we observe an unfavorable shift in trend uniformity, we'll hold to a modestly constructive position, regardless of my opinions about economic fragility.
Though I would still prefer to see much stronger volume on advances, it is notable that the percentage of bearish investment advisors in the Investor's Intelligence figures has moved above the percentage of bulls in recent weeks - the first time since a 3-week period near last September's lows. Lowry's turned positive late last week based on its own price-volume studies (though these signals can be of a fairly short-term nature). We're also seeing fewer news stories that take a bull market and an economic recovery as givens. Until very recently, the news media preferred to choke, gag and turn vibrant shades of purple rather than spit out the phrases "bear market" or "double dip." The fact that they're using these phrases now suggests that the "recognition" phase of the bear market may be complete.
Bear markets tend to be broken into several phases, each punctuated by counter-trend rallies. Typically, the final phase of a bear market is marked by a sizeable majority of bears and "revulsion" for stocks by investors. We're not at such a point here, but there's no requirement that such a situation has to occur on any particular time schedule. An opportunity to buy stocks for outstanding investment merit may be months away, or it may be years away. But it is nearly certain that long term investors will see such a point before the "long term" actually arrives. Regardless of favorable speculative merit at present, stocks are likely to produce very disappointing returns between now and the eventual point that they become outstanding values. I say this to underscore the point that the current, modestly favorable Climate is not an indication of compelling long-term investment merit.
On the subject of Fed rate cuts, I noted my opinion a few weeks ago that Greenspan has become more reactive since 1998, buying short-term crisis resolution at the cost of increased long-term economic instability. I was impressed, however, that he did not announce a surprise cut at the depths of the recent selloff. This also makes me hopeful that the FOMC has gained enough clarity to leave rates unchanged this week.
As I've noted over the past year, rate cuts in the current environment do not sponsor new bank lending. Nearly all of the increased monetary base produced by the Fed (the only aggregate the Fed directly controls) has been drawn off as currency in circulation. The only function of lower short term rates has been to shift portfolio preferences toward greater holdings of currency, in an amount which must exactly absorb the increased supply. If anything, lower short-term rates at present would further reduce the "opportunity cost" of holding currency, which would actually work against greater bank lending because the cash balances in people's pockets are not intermediated to borrowers. Over the past decade, Japan's near-zero interest rates also did little to spur bank lending. Instead, those low rates decimated the willingness of the Japanese to save in the form of bank deposits. Before the Fed compounds its errors, it would be helpful to consider the potential for such unintended consequences.
Friday Morning August 9, 2002 : Special Hotline Update
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and
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The Market Climate remains characterized by unfavorable valuations and favorable trend uniformity, holding us to a modestly constructive stance - fully invested in favored stocks, with about 60% of their value hedged against the impact of market fluctuations.
That said, the past few days were not very representative of returns that can be expected from a constructive position. We've gained ground overall, but I suspect that new shareholders may be scratching their heads that our returns have not more closely tracked the market (given that we removed 40% of our hedge position on Monday).
Here's what's going on. Our holdings are still about 60% hedged against market fluctuations. I frequently note that when we are hedged, our main source of risk is the potential for our stocks to perform differently than the market does. Of course, that difference in performance is also our primary source of return when we are hedged (provided that the long-put/short-call combinations we use have identical strike prices and expirations), and is essentially what has driven our performance for the past couple of years.
Occasionally, however, our favored stocks may underperform the market. Over the past two days, this has been due to a lopsided concentration of market gains in two industries: financials and technology. Since these groups demonstrate relatively poor value and market action on our measures, we hold smaller weights in these groups, relative to the major market indices. This difference in weights is intentional. But on days when market performance is driven by these groups in a very lopsided way, even a partially hedged position comes under a bit of pressure (as techs and financials lift the indices that we are short, without an equivalent gain in our portfolio).
So while lifting 40% of our hedge doesn't seem to have done much for us at first glance, it has in fact reduced the negative impact that this unbalanced market action would have otherwise had on our performance.
What am I doing to "correct" our portfolio based on the short-term strength in techs and financials over the past few days? Nothing. Our discipline is very clear: align our portfolio with the currently identified Market Climate, attempt to sell lower ranked holdings on short-term strength, and attempt to purchase higher ranked candidates on short-term weakness. Over the past several days, we've taken exactly these actions, as we do every day. Aside from a somewhat increased exposure to certain semiconductor stocks that we established early in the week, we're still underweight in tech and financials, and will be until they demonstrate more favorable valuation and/or market action on the measures that we emphasize.
I honestly believe that the key to success in anything is daily action: finding a set of actions that you believe will produce great results if you follow them consistently, and then following them consistently. I don't measure success by whether our approach gained or lost ground on a given day. I measure success on any given day by the extent to which I took those actions. Those actions are ultimately the source of our performance. On that basis, we had a very successful day on Thursday, as we do every day.
Thursday Morning August 8, 2002 : Special Hotline Update
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The Market Climate remains characterized by unfavorable valuations and favorable trend uniformity, holding us to a modestly constructive position; fully invested in favored stocks, with about 60% of their value hedged against market fluctuations.
Wednesday had a bit more dispersion than I'd like to see in a favorable Market Climate, mainly because the late-day rally in large cap stocks didn't spill over rapidly to the smaller caps. For instance, the S&P 100 gained about 2.4% on Wednesday, while the Russell 2000 lagged with only a 0.7% advance. Since we are fully invested in favored stocks and short both the Russell 2000 and the S&P 100, large disparities in market action make our returns unusually sensitive to the precise composition of our favored stocks versus our hedge. So it's not accurate to expect our daily returns to be a straight 40% of what the indices do, even though we're 40% unhedged. Still, there's not nearly enough disparity to threaten the favorable Market Climate at this point, and there's no reason to expect the disparities to persist. Patience.
It's often useful to think of the market in terms of both buyers and sellers, and to consider what each is thinking. In fact, the recognition that each share bought is also sold is the only way to see through the ridiculous notion that money ever goes "into" or "out of" the market. Very simply, markets don't move because money goes "in" or "out" on balance. They move because buyers are more eager than sellers, or vice versa. Every dollar that goes in goes out, and every share that is bought is sold. Money "on the sidelines" stays on the sidelines in aggregate. The markets are a place where money and shares are exchanged, not a balloon that expands with so-called "money flows." (see our November 2001 issue of Hussman Investment Research & Insight for more detail on stock market equilibrium).
Currently, my impression is that there are four basic groups operating in the market here: patient bulls, skittish bulls, patient bears, and skittish bears. The skittish groups are very emotional and react to whatever move is in progress. The patient groups are value-driven: the bulls attempt to buy into declines, and the bears attempt to sell into advances.
The result has been a great deal of volatility. The patient bulls are a persistent buying force, but on rallies skittish bulls and skittish bears also rush to buy, and prices have to move high enough for this demand to be satisfied by the patient bears. In contrast, the patient bears are a persistent selling force, but on declines, the skittish bears and skittish bulls also rush to sell, and prices have to fall low enough for this supply to be absorbed by the patient bulls.
With trend uniformity now positive, my opinion is that investors are becoming substantially more tolerant of market risk. This substantially increases the ranks of patient bulls and reduces the ranks of the other groups. Now go through the same mental exercise. The result is that one would expect a larger volume of buying interest, requiring much larger price advances in order to find willing sellers. In contrast, one would expect a smaller volume of selling interest, requiring much shallower price declines in order to find willing buyers. If this occurs, short sellers who have had great success at selling into rallies may suddenly find that this luck has run out.
As I have noted frequently, I am usually skeptical of rallies that produce expanding volume on declines and dull volume on advances. Dow Theorists knew this to be true even in the late 1800's. In my view, it is important for the market to produce a strong and very high-volume advance in the near future if this rally is to be trusted (interestingly, Richard Russell of Dow Theory Letters has expressed the same view). We'll see.
For now, we remain modestly constructive, with about 40% of our holdings unhedged. That's certainly not an aggressive stance, and I don't suspect that the market is in either a new bull market nor an economic expansion. But favorable trend uniformity is a signal of speculative merit, even when fundamentals are unappealing. A modest exposure to market fluctuations remains appropriate.
Wednesday Morning August 7, 2002 : Special Hotline Update
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and
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The Market Climate remains characterized by unfavorable valuations and favorable trend uniformity, holding us to a modestly constructive position. We remain fully invested in favored stocks, with about 60% of their market value hedged against the impact of market fluctuations.
As I've noted before, favorable trend uniformity is essentially a signal that investors have an increasing preference to take market risk. Given the high level of fear and distrust in recent weeks, it's not surprising that investor's risk aversion seems to be settling down a bit. I have no ability to predict how far or how long this will continue, but as always, we'll act on any shift in the Market Climate at the point that it occurs, not before. No forecasting required.
I received a number of comments on Tuesday. A few of these were to the effect that since the source of our recent shift to favorable trend uniformity couldn't have been an improvement in market breadth, other factors must have driven the shift, and can I list these factors? Unfortunately, I can't without revealing proprietary elements of our approach. As much as I try to explain the basis of our decisions, discussing these specifics would weaken whatever competitive advantages we enjoy, and by extension, the competitive advantages of our shareholders. Suffice it to say that risk aversion seems to be abating, and that various features of market action support this conclusion.
For now, the Market Climate is positive enough to leave about 40% of our portfolio unhedged and exposed to market fluctuations. This is certainly not an aggressive position, but it will give us a greater sensitivity to market movements than we've had in recent months. The reason we are willing to take modest risk in this Climate is because it has historically been rewarded, on average. Market conditions do not warrant an aggressive stance. Nor do they warrant a fully-hedged and defensive one. At present, a modest exposure to market fluctuations is ideal.
Tuesday Morning August 6, 2002 : Special Hotline Update
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and
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The Market Climate is characterized by unfavorable valuations and favorable trend uniformity. This represents the first shift in the Market Climate since December, and takes the stock market off of a Warning condition. In response, we removed just over 1/3 of our hedges on Monday's market decline. The majority of our holdings remain hedged against market fluctuations.
How could you get a positive signal in a down market?
As I've written frequently, our measures of trend uniformity are not based on the extent or duration of a rally, but on the quality of internal market action across a wide variety of measures. Simply put, recent market action has been lousy in terms of the major indices, but high quality in terms of factors that we use to define "uniformity."
Should this be interpreted as a major buy signal?
No. The core of our market approach is to position ourselves in line with the prevailing, identifiable Market Climate at every point in time. Until Monday, we held a fully hedged position. We now hold a mostly-hedged position. So while the current Climate instructs us to take a modest amount of market risk, there is no forecast attached to this shift. It should not be considered a "buy" signal, nor should we be counted as "bullish." The proper interpretation is that the current Market Climate, defined by valuations and trend uniformity, is one in which market risk has historically been rewarded on average. This Climate may persist for a week, a month, or a year. I have no idea when it will shift. And for that reason, I have no forecast of market direction ahead, except for a very general expectation of positive market returns on average while this Climate remains in effect.
What do you mean by "on average"?
Every Market Climate we identify has its own average return/risk profile, but that average includes both advances and declines, often substantial ones. Even the most negative Climate we identify can and does include occasional periods of strongly advancing prices. Once we align ourselves with a given Climate, we make no attempt to forecast short-term direction within that Climate. So while the current Climate can be considered "modestly favorable," I have no particular expectation that the market will or must rally in the short term. It could just as well decline profoundly. But on average, the current Climate has historically produced reasonably attractive returns when it has been in effect. Given high valuations and a risky economic environment, however, there is a risk that this Climate could be short-lived. The proper response is to accept a modest amount of market risk here.
What would the market have to do to reverse this signal?
Preferably, we'll see a reversal due to internal breakdowns in market action following an advance to higher levels. But nothing rules out a further market decline. I suspect that a decline of about 6% from current levels (on a weekly closing basis) would produce enough internal breakdowns to place the market back on a Warning condition. At our current level of market exposure, we expect to experience about one-third of the market's fluctuations, both up and down. We take that risk, of course, because we expect to be rewarded for doing so.
Have you changed your views about the economy or long-term market prospects?
Currently, stocks are priced to deliver something less than 8% annually even if above-average market valuations are sustained indefinitely. If they are not sustained indefinitely, stocks could very well underperform T-bills over the next decade. So stocks are not a value here, and I doubt that they have established a durable bear market low. My opinion (which we don't trade on and neither should you) is that the economy remains in a recession that is likely to worsen, and that stocks remain in a bear market that is likely to worsen. But evidence of a weak economy takes months if not quarters to be fully recognized, and even the worst bear markets have frequently enjoyed rallies of 20% or more (even the current bear has had two such rallies in March-May 2001 and Sep-Dec 2001). That said, it is lunacy to invest based on whether one believes stocks are in a bull market or a bear market, because they don't exist in observable experience; their existence can only be confirmed in hindsight. Our discipline is simple - we position ourselves in line with the current, identifiable Market Climate. The more favorable the return/risk profile of that Climate, the more market risk we are willing to take. At present, we're willing to take a modest amount of market risk.
So are you a bull or a bear? What's your forecast?
What kind of trees did Christopher Columbus think were planted at the edge of the earth: maples, or pines?
What happened to those call options you held to hedge against the possibility of a signal happening on a rally?
Early last week, the market rallied strongly enough to put most of those calls in-the-money. But we didn't have a favorable signal yet. Since it was not our intent to remove our hedges pre-emptively, and the value of those calls was at considerable risk if the market was to decline, we raised their strike prices, taking in a credit in excess of what we paid for them originally. As in Chess, the two questions we always ask are: "What is the opportunity?," and "What is threatened?" The goal is to take those opportunities that have acceptable risk and sufficient supporting evidence, and to defend what is threatened by unacceptable risk or weak supporting evidence.
So the favorable shift in the Market Climate suggests that a modest, but not aggressive amount of market risk is now acceptable, while this Climate is in effect, but you have no particular forecast regarding short-term direction, and you still believe stocks and the economy face further long-term risks, and your opinion is that this may just indicate a bear market rally of a few weeks or months, but rather than speculate on that opinion, you'll follow the discipline of aligning your investment position with the prevailing Market Climate, and change that position when and if the Climate shifts again?
Yes. It's almost as if I wrote that.
Sunday August 4, 2002 : Hotline Update
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and
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Just a note - this week's update will be available on Tuesday morning, August 6th. Thanks! - JPH
Friday Morning August 2, 2002 : Special Hotline Update
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and
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The Market Climate remains on a Warning condition at present. While it is possible that we will still see a favorable shift ahead, recent market action has not been encouraging.
Thursday's decline underscores why we never make major portfolio changes ahead of legitimate shifts in the Market Climate. At this point, it is a wide open question whether or not we will see such a shift. If the Market Climate does not shift this week, the market must rally strongly next week or we could lose the "window of opportunity" for a favorable near-term shift in the Market Climate altogether. We'll see.
In economic news, the past week has delivered plunges in both consumer confidence and the Purchasing Managers Index. These declines have evidently been a great surprise to analysts, and have thrown the thesis of a new economic recovery into question.
Why does this stuff surprise anybody?
As I noted in our June 26th update, "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."
How would one have expected that? By properly interpreting market action. In the case of the above quote, my expectations for oncoming weakness were based largely on a plunging U.S. dollar and widening credit spreads (the difference between yields on risky corporate debt and default-free Treasury bonds).
As I've noted frequently, every past economic recovery has started with a surplus in the U.S. current account, indicating that U.S. savings were so plentiful that we were sending savings abroad. In this condition, there was always plenty of ammunition to finance big increases in U.S. investment and consumption. In contrast, the U.S. current account has been hitting record deficits month after month, indicating that even our current levels of domestic consumption and investment are heavily dependent on foreign savings. Not to mention mountains of low quality bank credit.
In that context, a widening of credit spreads suggests the potential for important new defaults ahead, and the plunging dollar suggests a sudden reluctance by foreigners to export savings to the U.S. This is not consistent with expectations for strong near term U.S. economic growth.
It's true that a large current account deficit can often be a signal that foreigners have a great willingness to invest in the U.S. The problem is that we normally see these deficits only after consumption and investment have grown rapidly and are about to ebb. Once you've got a record deficit, it's very difficult for that rapid growth to continue. So you never want to see a large deficit when you're hoping for rapid economic growth. The other problem with the "deficits are a good sign" argument is that great eagerness of foreigners to invest in the U.S. is associated not only with a large current account deficit, but with a strong dollar (reflecting strong demand for U.S. assets). When you see huge deficits along with a plunging dollar, it is a sign that past eagerness of foreigners to invest in the U.S. is now in fast retreat. That's a major warning sign.
Recent short-term action in retail stocks has also been very poor, conveying information about a potential retrenchment in consumer spending, and causing just a little bit of turbulence for our own holdings. Still, many consumer sectors such as restaurants and apparel are generally undervalued, and even in a downturn, consumer spending can be expected to be much more resilient than other activity such as capital spending. Indeed, consumer spending has never actually declined in nominal terms on a year-over-year basis (though we would never rule out the possibility). In any event, the action in consumer stocks strikes me less as a negative for these stocks per se, than as a signal that consumer spending is unlikely to support economic growth. Very simply, it is difficult to see how analysts can expect a near-term improvement in the economy, except if they are depending on superstition ("Fed cuts kick in with a lag", "It's always darkest before the dawn").
So in my view, it is not at all clear that the economy is in recovery. Given the recent downward GDP revisions, and the general tendency of the economy to enjoy at least one quarter of positive growth while still in recession, I still lean toward the belief that the U.S. economy remains in recession. I should also note that the NBER Business Cycle Dating Committee has not made a statement to the effect that the recession is over (and typically does not meet to establish the date of the recession low until the prior economic peak is actually surpassed). Given that fact, it is quaint to see charts of economic data in newspapers, showing the shaded "recession" area ending in December. At present, this is simply wishful thinking.
As usual, these views do not map into specific investment positions. With valuations still excessive, a positive shift in trend uniformity would encourage us to take only a modest exposure to market risk (about 40% unhedged, leaving 60% of our holdings still hedged against market fluctuations). But until and unless we actually recruit sufficient evidence, we will remain fully hedged. At present, a positive shift would require the market to hold or expand upon recent improvement in broad market action. Thursday was not encouraging in this regard, but we'll take our evidence as it emerges.
Tuesday Morning July 30, 2002 : Special Hotline Update
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The Market Climate remains on a Warning condition here, but Monday was a good start in delivering the broad advance we would require in order for that Climate to shift to a favorable stance this week. As I noted last week, we have no anxiety about the possibility that the market may rally more strongly before we shift our position. We take our actions when we have sufficient evidence, and not before.
That said, the essence of good hedging is to set up an asset and a liability having similar character and timing. Once the market had plunged sufficiently to create the strong possibility of a near-term momentum reversal, we faced a "contingent liability." Namely, contingent on a strong market rally prior to about mid-August, we would be obligated (by virtue of our investment discipline) to buy market indices in an amount equal to about 40% of assets, to uncover part of our hedge. The appropriate way to manage that somewhat undesirable contingent liability was to create an offsetting contingent asset having the same character. Specifically, we needed an asset that would deliver market indices if a strong rally occurred prior to mid-August, but not otherwise. The appropriate asset in this case was inexpensive, out-of-the-money August call options. We purchased enough near last week's lows to lift off about 40% of our hedges if a powerful rally arrived, at a cost of less than 1% of assets. Importantly, this move was strictly a hedge (or to be oddly accurate, a hedge against our hedge), not a speculation or "bet" that such a rally would actually arrive. Needless to say, if the market rallies further, we will be taken cleanly into a constructive market position, closing out 40% of our hedges. Otherwise, we will remain fairly neutral to overall market fluctuations.
Keep in mind that we are professional stunt men. Don't try this at home.
I continue to have no opinion regarding short-term action. Monday's rally was strong enough to nearly clear the extreme oversold condition of last week. So we are now in an important area, and it is essential for the market to hold onto its gains this week, or to rally even more strongly next week. Otherwise, as I noted on Sunday, the prospect for a favorable near-term shift in the Market Climate may be lost.
For now, we remain well hedged, but about 40% of our hedges are offset with inexpensive call options. This leaves us with a reasonable expectation of participating in any advance that occurs prior to a favorable Climate shift, while also keeping us hedged in the event that the market turns down instead. In all, we remain comfortably aligned with the prevailing Market Climate.
Sunday July 28, 2002 : Hotline Update
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and
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The Market Climate remains on a Warning condition. It is important to emphasize that this Climate has not shifted, and that a favorable shift remains uncertain. We do not materially change our investment position until a shift has actually occurred. At present, we are essentially neutral to market risk. Given this stance, our day-to-day performance is still driven primarily by the difference in performance between the stocks we hold long and the market indices that we use to hedge (Russell 2000 and S&P 100).
Although the market has recently followed a fairly predictable script, market breadth (advances versus declines) has been disappointing on rallies. In order for a shift in the Market Climate to occur in the coming week, the market must advance broadly. Failing that, the market will have to demonstrate even stronger action in the following week or we could lose the "window of opportunity" for a positive near-term shift in the Market Climate altogether.
The Wall Street Journal ran a somewhat disturbing op-ed piece last week by Professor Jeremy Siegel of Wharton. He noted that historically, when investors have endured as much pain as they have in the recent downturn, they have been well rewarded with subsequent returns. Apart from the 1929-1932 downturn, which eventually ran to an 85% decline, the recent downturn is the deepest on record. The problem with Siegel's argument is that it bases the market outlook on the decline from the peak, rather than by the relationship between prices and fundamentals. Although he also suggests that the "fair" P/E for the S&P would be over 20 here, that estimate is based on prior work that he also published in the WSJ, which drew a correlation between P/E ratios and rates of interest and inflation from 1965 to the present. This is a statistical artifact: Siegel has chosen the estimation period to ensure that current interest and inflation rates are the lowest in the sample. Had he used readily available data prior to 1965, the same estimation would generate a "justified" P/E about the historical average of 14 (with a better fit using price/peak-earnings rather than the raw multiple).
In any event, as I've noted before, when you jump out of a plane, the relevant measurement is not how far you've fallen, but where the ground is. The recent decline is unique in having started at a price/peak-earnings multiple about 50% higher than existed at the 1929, 1972 and 1987 peaks. Valuation multiples such as price/dividend, price/revenue, price/book and others were even more extreme.
There is a single cause for every market crash in history: a sharp upward spike in the risk premium demanded on stocks by investors. Having driven the risk premium on stocks to by far the lowest levels in history, investors are now driving this risk premium to higher, more normal levels (requiring lower stock prices). This increase in the risk premium was both predictable and inevitable. Only the specific causes were in question. So while investors and politicians focus on accounting issues, it is worthwhile to remember that once the market had been driven to extreme valuations, investors were already assured of disappointment. The accounting issues are actually a minor sideshow.
Geraldine Weiss of the top-rated value newsletter Investment Quality Trends comments "Is Wall Street corrupt? Certainly not. Yes, there are some corrupt individuals, as there are in any large and diverse group. But the system is safe and solid and the information on which investors base their decisions is largely reliable."
I wholeheartedly agree with this view. After all, it is a testament to the accuracy of corporate accounting in general that the breathtaking valuation extremes of the recent market bubble were so clearly apparent. It is true that corporations and the media were responsible for misleading investors by touting irrelevant New Economy figures such as operating earnings and EBITDA as if they were useful measures of performance for equity investors. But had accounting figures been truly misleading on the whole, it would not have been obvious that stocks were strenuously overvalued, while in fact it was (and to some degree still is). So despite some egregious misclassification issues (e.g. ordinary expenses as "investments" and ordinary losses as "extraordinary" ones), corporate figures in general are useful guideposts to value. The real problem is that investors chose for years to ignore them by focusing only on the trend of operating earnings, while chanting "It's a New Era - the old valuation rules don't matter." Live and learn.
As Jim Stack of Investech notes, "... the 'blame' is being shifted to corporations, accountants, and insiders. Yet the real fault lies with those who created, perpetuated, and then ignored the bubble once it began reaching grotesque proportions. Where was the SEC while all the frothy dot-com IPOs were being dumped on the naive public? Why was the Federal Reserve so silent when 'bubble talk' had become a central topic of their FOMC meetings as early as 1996? And where were Exchange officials when they could have easily raised margin requirements to cool the speculative ardor, or imposed new accounting standards (for listed companies) when pooling-of-interest merger accounting had become the #1 means to boost earnings growth. It's sad to realize that those who could have taken action were fully aware of the consequences of not taking action..."
Stack then quotes a Feb 26, 1997 statement by Alan Greenspan: "History demonstrates that participants in financial markets are susceptible to waves of optimism... Excessive optimism sows the seeds of its own reversal in the form of imbalances that tend to grow over time. When unwarranted expectations ultimately are not realized, the unwinding of these financial excesses can act to amplify a downturn."
[As a sidenote, the foregoing comments illustrate the proper way to recognize the work of others. Use quotation marks, give proper attribution, and add a link for interested readers. This can't really be that difficult.]
In short, investors should focus not on why the bubble burst, but why it was allowed to go unchecked, even encouraged, by Wall Street analysts, the financial media, the SEC, the stock exchanges, and most importantly, the Fed. In my view, stocks were indeed overvalued when Greenspan made his "irrational exuberance" comments in 1996 (though trend uniformity was positive, allowing valuations to be temporarily irrelevant). I don't favor Fed intervention into the stock market, so it would have been improper in my view to hike rates strictly on the basis of valuations. But as I stated at the time, the Fed's surprise series of interest rate cuts in late 1998 was irresponsible and cowardly, resolving a short-term crisis while amplifying the imbalances and long-term misery of the economy and financial markets by an order of magnitude.
Again, while there is a good possibility that the market could recruit favorable trend uniformity in the next week or two, we do not have such a shift yet. If the Climate does shift, it should not be confused as a signal of favorable valuation or investment merit, but strictly as a signal about (possibly brief) speculative merit. A favorable change in the Market Climate this week would require a broad advance. Absent such an advance, or an even stronger one the following week, the prospect for a near-term improvement in the Market Climate may vanish. As usual, I have no short-term forecast. While my opinion still leans toward the possibility of a favorable shift in the Market Climate in the coming weeks, we don't trade on my opinion and neither should you. Until we actually see a shift, we'll remain defensive overall.
Thursday Morning July 25, 2002 : Special Hotline Update
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It's always nice to note on Tuesday that I wouldn't be surprised by a 500 point rally, and then to have the market rally about 500 points on Wednesday...
That said, the Market Climate remains on a Warning condition for now. As I've noted frequently in recent updates, there is a good chance that the Market Climate will shift to a favorable stance in the next week or two. In order for that to occur this week, we'll need much better market breadth than we saw on Wednesday. It was a bit disappointing that advancing issues could only muster a 3-to-2 lead over declining issues, but trading volume was great. Fortunately, when the Market Climate is shifting to a more constructive stance, there is a tendency for explosive moves in large-cap stocks to be followed the next day by much broader follow-through. We'll take our evidence as it arrives.
Now, I realize that it's tempting to pre-empt a positive shift in the Market Climate by just lifting our hedges here and now. But in the historical data, I've seen enough shifts that seemed probable and failed to know that waiting for the evidence is better, on average. And while my opinion is that a shift is likely within two weeks, I assure you that it is the road to ruin to follow anybody's opinion (including mine) in preference to a disciplined approach. So we'll await further confirmation of a breadth reversal here. In the meantime, we're already well prepared for the possibility of cutting our hedges by about 40% in the weeks ahead. (Note to my former finance students: what is the appropriate method of hedging a contingent liability?)
In my opinion, a favorable shift in the Market Climate would suggest a bear market rally rather than a new bull market, but there's nothing wrong with that - a good bear market rally could plausibly take stocks 15-20% higher in a span of weeks. But in any event, I continue to believe that the full scope of defaults and economic weakness has not been seen, and that a durable bear market bottom will probably only occur when investors lose the ability to imagine that the economy can improve. It will probably take months if not quarters for investors to abandon expectations that "the economic rebound is just around the corner."
At present, stocks are priced to deliver a long-term total return to investors of about 8%, assuming that the price/peak earnings ratio on the S&P 500 remains at the current level of 16 indefinitely (the 1929, 1972 and 1987 peaks occurred at 20 times peak earnings, the historical average is 14, the historical median is 11, and the typical bear market low is less than 9). Investors who see 8% as an attractive and sustainable long-term return are absolutely free to consider stocks "fairly valued" here. When you hear analysts saying that stocks are 20% undervalued on the basis of the Fed model or other measures, you have to understand that they are implicitly assuming that stocks should be priced to deliver long-term returns of even less than 8% annually. It is absolutely false to believe that this sort of "undervaluation" has any implication of satisfactory long-term returns in practice.
Very simply, in order for stocks to be priced to deliver higher returns, they would have to sell at substantially lower valuations. Over the short term, there's a good chance that stocks will have enough speculative merit to make valuations temporarily irrelevant. But the hard fact of investing is that long-term returns are tightly linked to valuation levels, and higher valuations imply substantially less attractive long-term returns. We're still not out of the woods on that front.
Tuesday Morning July 23, 2002 : Special Hotline Update
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Just a note. Anybody who knows me well understands the amount of research, care, and genuine concern for other investors that I place in these updates and issues of Research & Insight. There are few things in which I invest more effort. I'm thrilled to see our work accurately quoted and properly attributed. But there are few things that recruit my full force, and employment for my attorneys, more quickly than plagiarism.
As Albert Brooks noted in Broadcast News, "I say it here, it comes out over there."
To those who have evidently had an ethical lapse, it is sincerely in your best interests correct the breach quickly. You can typically reduce or eliminate our enforcement actions by taking the following steps, as long as they are initiated before we contact you:
- Issue a revised version of your work to all original recipients, placing each reference to our work in quotations, and noting that you failed to properly credit the author as "John P. Hussman, Ph.D., Portfolio manager of the Hussman Strategic Growth Fund, (www.hussman.net)."
- Forward a copy, along with evidence that the revised version has been distributed, to Gary E. Cooke, Esq. (gc@cookeslaw.com), 333 N. Michigan Ave, Suite 1320, Chicago, IL 60601.
- A short note of apology is not required, but is probably appropriate.
If instead you want to roll the dice and do nothing because you think I don't mean you personally, all I can say is that you'd really better hope you're right.
By the way, I am very grateful to the many readers of these updates who have forwarded instances of plagiarism to my attention (two separate instances in the past week alone). Infringements include highly similar or identical text, graphics, or point-by-point analysis without attribution - particularly when they include trademark terms such "Market Climate" and "trend uniformity", original indicators such as price/peak-earnings, or columns such as Just for Kids. Your vigilance is the reason I continue these publications.
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The Market Climate remains on a Warning condition here. Again, I realize that the word "Warning" looks odd here, but we've been on this condition since December without regret, so "Warning" it is. That said, it is very possible that the Market Climate will shift to a constructive stance within the next two weeks. This is not a certainty, and until the Climate actually shifts, there is a possibility of further serious losses. But as a practical matter, we're well prepared to lift off about 40% of our hedges on a confirmed Climate shift. About the only thing still required is a strong reversal in market breadth (advances versus declines) over a period of days. And frankly, the oversold condition of this market is so extreme that we could very well see an enormous advance off of the eventual low (a 500 point up-day for the Dow would not surprise me).
For now, however, we remain fully hedged, and we will lift off about 40% of our hedge when and if the Market Climate actually changes. It causes us no distress that the initial rally off of the eventual low could potentially be explosive. Without disclosing actual positions, suffice it to say that I believe the possibilities of a market crash and a market surge are both adequately reflected in our current stance.
Sunday July 21, 2002 : Hotline Update
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The Market Climate remains on a Warning condition here. That said, the market has now satisfied much of the set-up to a potential bear market rally. In general, the "phases" of a bear market tend to be punctuated by bear market rallies that are often sizeable and sustained for several weeks and even months. They are not occasions for substantial risk taking, and they do not imply that stocks have investment merit, but there is enough speculative to take a modest exposure to market risk when certain conditions are present. Last week, market action provided exactly what we needed on the downside. At this point, a solid advance in market breadth within the next couple of weeks would be sufficient to shift the Market Climate to a constructive position.
Now, from the standpoint of our investment approach, it is irrelevant whether I think an advance is a bear market rally or a new bull market. I frequently refer to bull and bear markets when I talk about my opinion, but these concepts are actually irrelevant to our approach. Bull and bear markets simply don't exist in observable experience - at any given moment, the existence of one or the other is always a matter of opinion. Our exposure to market risk at any point in time depends on the prevailing, identifiable status of valuations and trend uniformity. At present, a favorable shift in the Market Climate would prompt us to remove about 40% of our hedges, leaving our fully invested portfolio of stocks about 60% hedged against the impact of market fluctuations, but having at least a modest sensitivity to market direction.
As for my opinion (which we don't trade on and neither should you), I've noted in recent updates, I don't anticipate a clean, quick end to this bear market. Many analysts are hoping for a final capitulation to clear the air and finally give way to a sustained bull market. I doubt it.
In my opinion, valuations remain too high for a durable bottom anywhere near current levels. On the basis of the S&P price/peak earnings ratio, the S&P is now at just over 16 times prior peak earnings. This may not seem so bad, given that the historical average has been about 14. The difficulty is that those prior peak earnings are increasingly suspect. Even at the bull market high, P/E ratios were by far the most generous of all valuation fundamentals. While P/E ratios were about double their historical average, ratios such as price/dividend, price/revenue, price/book, price/replacement cost ("q"), and price/GDP were easily three or more times their historical averages. In other words, while stock prices were high relative to earnings, earnings were also very high in relation to dividends, revenues and book values (this was observed as low dividend payout ratios, high profit margins and high return on equity, respectively). As recent earnings restatements are making painfully clear, those high profitability levels were not simply unsustainable, they were phony. For this reason, we continue to stress that price/earnings ratios are not a reliable basis for valuation here. And even if they were, historical bear market lows have typically occurred at less than 9 times prior peak earnings (these include not only post-1965 market cycles, but pre-1965 cycles when trend GDP growth was higher, and interest rates and inflation were lower than current levels).
In the July 22 issue of Barron's magazine, there is an excellent interview with Jeremy Grantham (who I've long viewed as one of the outstanding value investors in the country). Grantham notes "There could indeed be important rallies, but before the smoke really clears, it's very likely we will overrun to a level below 700 on the S&P and below 1100 on Nasdaq. It's very scary. The overrun is something of a terra incognita. There is no methodology to calculate how much it will overrun. I can calculate how much it will correct to fair value because we have a pretty good read on fair value. We know that has always happened. But the degree of overrun in the market is always different. The only thing you can say with some statistical backing is that there is a strong tendency for the degree of overrun on the downside to be related to the degree of overrun on the upside." This is one of the few articles I've seen that gets it right. Be careful as you read it though. Grantham's point is not that stocks are likely to decline relentlessly. Rather, the point is that the ultimate trough of this bear market may be much lower than widely believed. Nothing in his argument rules out the possibility of strong, intermittent bear market rallies along the way.
There is another reason why I suspect the market is not in the process of setting a durable bear market low: The bad news is not yet out. I continue to expect substantial debt problems and economic disappointments. I've noted for several months now that analysts have failed to allow for the possibility that the economy - and particularly consumer spending growth - may deteriorate rather than improve in coming quarters. These risks are underscored by factors such as the record current account deficit, increasing credit card charge-off rates, a marked slowdown in bank lending (despite Fed easings), and a plunging dollar (see recent issues of Hussman Investment Research & Insight for more detail behind these concerns). A durable bear market low is likely to occur only after these problems are widely recognized, and widely expected to worsen. At good bear market lows, investors lose their ability to imagine that economic conditions will improve, just as investors lost their ability at the 1999-2000 peak to imagine that conditions could deteriorate.
So in my opinion (I can't stress that word enough), this bear market probably has much further to go, and it will probably require a period of months (perhaps even a couple of years), not days or weeks, for the aftermath of the speculative, capital investment, and credit bubble of recent years to be fully expressed. In the meantime, the market is likely to generate a substantial number of false starts and bear market rallies. Some of these will generate sufficiently favorable market action to warrant a modest exposure to market risk. This sort of opportunity may arise in the next week or two, but we do not yet have such evidence at present.
As for next week, I have no short-term forecast, as usual. Nor do we need one. But for the sake of pure idle curiosity, here are some of my thoughts. I've often noted that market crashes are typically preceded by fairly relentless distribution and a very bad late-week decline, which we've certainly seen. So Monday could certainly involve a serious plunge. NYSE Chairman Richard Grasso also notes "Mondays following Friday declines have always been difficult and I suspect tomorrow will be no different." The Reuters Business Report warns "expect no reprieve."
While the bad Friday, bad Monday combination is typical, my "intuition" actually runs contrary to these expectations here. That intuition goes something like this. Too many investors seem to be primed for a "capitulation" (or a set of Lowry's 90% days - see some of my June updates on this) in order to signal an "all clear." I also suspect that the shorts are waiting for one more ugly plunge before they cover their shorts ("Why leave money on the table?") That, in my mind, creates a potential order imbalance rushing to the buy side if the market fails to quickly follow through on Friday's decline. After all, unless investors are acutely aware of lingering valuation and debt issues (and I'm convinced that they are not) it's still possible to look at this market and ask "Are things really that bad?" And the last thing either the bulls or the shorts want is to miss the opportunity to get in at the "bottom."
Meanwhile, I used to have good results anticipating Fed moves by asking the question "What would a thoughtful economist do?" But as Greenspan was abducted by aliens and replaced with a pod-person in 1998, I've since had good results by asking the question "What would a panic-stricken, reactionary, populist, New Era devotee do if he had no concern for anything but the immediate gratification of crisis-avoidance, regardless of long-term economic consequences?" On that basis, there's an outside chance that the Fed will announce a surprise rate cut on Monday morning. The best point for such a rate cut would be very close to the market opening. Again, that's not an expectation, but it is a possibility.
In short, both a crash and an immediate rally are possible here. My intuition (which doesn't even rise to the status of opinion) is that a hard rally is more likely, but in any event, we don't trade on such speculation. We are fully hedged here. If the market can generate action sufficient to shift the Market Climate to a favorable status, we'll lift about 40% of our hedges, leaving our portfolio mostly but not fully hedged. We've done a few interesting things to allow for the possibility of lifting our hedges, but I'm going to pass on describing them since we never comment on individual positions as we're putting them in place.
In any event, the Market Climate remains on a Warning condition for now. We're prepared for the possibility of a favorable shift in the Market Climate in the next week or two, but that remains a possibility at present. We don't need any forecasts here. We'll shift our position when and if the Market Climate shifts.
Friday Morning July 19, 2002 : Special Hotline Update
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The Market Climate remains on a Warning condition. While Thursday's decline was quite negative, this is precisely the kind of action that is required in order to quickly shift the Market Climate to a more favorable condition.
In my opinion, valuations remain far too high, economic prospects too dim, and sentiment too complacent to expect a durable, long-term bear market low and a fresh bull market. But even the most prolonged bear markets have historically been punctuated by strong and sizeable rallies. These rallies tend to separate "phases" of a bear market. We're still in the phase of "optimistic expectations being lowered." Up ahead is probably "really bad news" and then "capitulation." I suspect that analysts hungry for the kind of capitulation that marks a durable bear market low are probably several months off. It will simply take more time for bad news, economic disappointments and credit defaults to convince investors that there is no hope for things to improve. And it's that sentiment that's typically associated with durable bottoms.
In our work, we've found only one characteristic that distinguishes sustainable bear market rallies from the ones that are "fast, furious and prone to failure." That characteristic is trend uniformity. Good bear rallies generally launch when two defining elements appear: 1) falling interest rate trends, and 2) a quick, powerful reversal from an abysmal decline. As I've written before, it's not the extent, or duration of such a reversal, but its uniformity that signals a robust preference of investors to take on market risk. Both of the strong rallies we've seen in this bear market to date (March-May 2001 and Sept-Dec 2001) originated from this kind of reversal. Since we need to see fairly abysmal market action first, Thursday's decline was a good start.
If we do see a shift to favorable trend uniformity in the weeks ahead, I expect to close down about 40% of our portfolio hedge. This will leave us with a fully invested position in stocks, and an offsetting short sale in the Russell 2000 and S&P 100 indices covering about 60% of our portfolio value. So in any event, the majority of our stock holdings will remain hedged against the impact of market fluctuations. It's certainly possible (but rare) that the market could continue lower despite such a reversal, but in that case, we would expect a relatively quick shift back to unfavorable trend uniformity. In any event, our approach is not based on forecasting market conditions but identifying them. If trend uniformity becomes favorable, we'll take a modest exposure to market risk until the Market Climate shifts again. As always, our goal is to take a measured amount of exposure to those risks from which we expect to derive a reasonably strong return.
A note about day to day fluctuations: Our approach will occasionally experience pullbacks, sometimes for several consecutive days or weeks. These should be expected from time to time, and are inevitable in any investment approach that takes risk. My goal for any given day, and my measure of success for that day, is the extent to which I take the specific actions that conform to our discipline. But the inherent randomness and risk in the stock market ensures that even the most consistent set of actions will not produce a measurable, desired result every day, week, month or quarter.
In my view, the key to success (in anything) is to find a set of daily actions that you are confident will produce results if you follow them consistently. Then follow them consistently. I don't measure day-to-day success by whether we had a gain or a loss that day. If I took actions that incorporated new elements of value and strength into the portfolio, the day was a success. Obviously, the up-days are essential in the long run. But the key to success is to focus on what can be directly controlled through daily action, and to trust that the results will arrive. Aside from splitting wood, there are very few activities in which effort leads to results in a direct, linear fashion. In most pursuits like investing, fitness, playing an instrument, and raising kids, your "results" on any given day may jump or stall. But if the underlying daily action is consistent, good results appear quickly enough.
As I frequently emphasize, our approach is built on a very well defined discipline. Part of that discipline involves buying a diversified portfolio of stocks displaying favorable valuation and market action. Part involves the daily practice of selling lower ranked holdings on short term strength, and purchasing higher ranked candidates on short term weakness. Part involves varying our exposure to overall market fluctuations, depending on the Market Climate that we identify at the present moment. We follow all of these practices because we understand how each element is related to total returns.
As I note in various reports on the Research & Insight page, the total return on stocks is driven primarily by the level and change in stock valuations. This is why our approach emphasizes valuations and trend uniformity so strongly. We focus on these factors because they relate directly to total return.
In contrast, we see a lot of analysts investing based on what Buddhism calls attachment to rules: adherence to form without understanding the essence. For example, over the past year, analysts constantly promised that the string of Federal Reserve interest rate cuts were "in the pipeline" and were about to "kick in." They argued that Fed cuts would also drive stocks higher, because history said they would. Unfortunately, they believed this without carefully considering the mechanisms linking Fed actions to economic activity and the stock market. In their eagerness to conclude that Fed rate cuts would stimulate the economy, they overlooked the link between reserves and lending (which no longer exists). In their eagerness to conclude that the cuts would stimulate stocks, they overlooked the fact that the entire market advance in the year following historical Fed rate cuts was driven by expansion in P/E multiples, which was unlikely given that the price/peak-earnings ratio was at 21, rather than the average of about 9 when the Fed eased repeatedly in the past.
Similarly, analysts display an attachment to rules when they believe that a higher Purchasing Managers Index necessarily implies better economic growth ahead. If you look to the essence of economic expansions - consumer demand, capital investment, and job growth - one sees weak capacity utilization, weak help wanted advertising, and a record current account deficit (meaning that domestic savings are insufficient to finance a boost in consumption and investment, and that current levels of spending are already heavily dependent on foreign capital). Every prior economic expansion has begun with a U.S. current account surplus and a strong jump in both capacity utilization and help wanted advertising (i.e. fresh demand for capital and labor).
To follow "rules" without understanding the mechanisms behind them is not investing - it's superstition.
As I wrote in the August 2001 issue of Hussman Investment Research & Insight, "The Federal Reserve is irrelevant. We don't just mean ineffective, though that is certainly likely to be true here. Rather, because of a change in the application of reserve requirements over the past decade, Fed actions have virtually zero impact on lending activity in the U.S. banking system... Last year, we argued that the main danger to the markets would be the combination of overvaluation and relentless erosion of profit margins. Over the coming year, margin pressure will continue, but it will be overtaken by a new concern: debt."
Regardless of whether or not we get a positive shift in the Market Climate and a bear market rally, these larger problems are not yet behind us.
Wednesday Morning July 17, 2002 : Special Hotline Update
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The Market Climate remains on a Warning condition. I realize that using the word "Warning" to describe market conditions here is like crying "fire" across a heap of smoldering embers, but we've been on a Warning since December. One of the features of our investment discipline is that we don't try to forecast short-term market action within the Market Climates we identify. So it's a Warning until it's something else. A market characterized by both unfavorable valuations and unfavorable trend uniformity constitutes a "Warning" condition, regardless of how much damage has been done already, and regardless of whether the market is oversold or overbought.
At present, the market is substantially oversold, which means we should allow for the possibility that stocks could enjoy a fast, furious rally to clear that oversold. But the market is also displaying a combination of relentlessness and complacency, which typically precedes crashes. So we have no forecast of short-term market action. Until either valuations or (more likely) trend uniformity shift to a favorable status, we will remain fully hedged.
I noted on Sunday that if market action is sufficiently brutal in the next week or two, followed by a brief but uniform reversal (particularly in advances versus declines), our measures of trend uniformity would quickly shift to a favorable stance, allowing us to lift perhaps 40% of our hedge (leaving the majority of our position - 60% - still hedged against market volatility). Unfortunately, Monday's decline did nothing to contribute to the conditions required for such a shift.
As the Dow approached its September low within a few points on Monday, it was a natural point for lots of investors to get the same idea simultaneously: "Gee, I could buy the September lows here!" Basically, the vigorous rally off of Monday's low struck me as a bunch of synchronized knee-jerks, kind of like a big Vegas kick line. Wayne Newton would be proud. I really don't believe the rebound was driven by anything more complicated than that. Unfortunately, as Richard Russell of Dow Theory Letters has often noted, a market that rebounds from its lows without actually closing with a gain is essentially "burning up ammo."
While we don't act on the basis of forecasts, my opinion is that Monday's low was not the end of this decline, but merely a natural point to burn up ammo. I suspect that if the Dow violates its September low by dropping below about 8200, the same uniformity of knee jerks will send the market a whole lot lower, quickly. That kind of move could set us up for a good bear market rally. But since the market remains substantially overvalued, and is even more detached from the valuations that typically exist at durable bear market lows (about 8.9 times peak-earnings, compared to about double that level at present), it would be difficult to expect a sustained bull market even from the Dow 7000-8000 level.
Tuesday's action was very hostile to consumer stocks, and the U.S. dollar plunged to a fresh low. I think that this action is very informative, and I continue to expect economic weakness rather than strength in the coming quarters. Still, consumer spending has never actually declined in nominal terms on a year-over-year basis, and consumer stocks remain one of the better valued areas of the market. So while market action suggests that consumer spending is likely to slow considerably, I still prefer consumer-oriented stocks to other sectors more sensitive to economic weakness and default risk, such as technology and financials. Not that we would hold any of these sectors on an unhedged basis at present.
A lot of analysts were hoping Greenspan would suggest that the market is "irrationally depressed" in Tuesday's Congressional testimony. Frankly, I became concerned about Greenspan's judgement after the surprise rate cuts in October 1998, which triggered the most speculative and damaging portion of the tech and capital spending bubble. Still, one has to remember that Greenspan's "irrational exuberance" comments were made in 1996, when the Dow was still in the 6500 area. To suggest that stocks are irrationally depressed at 8500 would make him look like both a lousy market timer, and a fool. He may not fully grasp the extent to which his own actions supported the bubble, misallocated enormous amounts of capital, and ensured long-term damage to the economy (which was predictable even in 1998), but he's no fool - especially in matters where his public image is at stake.
Actually, I believe that Greenspan was right on the money in 1996 - stocks were overvalued at that point. They simply became more so. As I constantly stress, overvaluation does not mean that stocks must fall. As long as trend uniformity is favorable, valuations temporarily do not matter. But once trend uniformity breaks down in an overvalued market (as was the case in April 1998 and again in September 2000), valuations can matter with a vengeance. We are still in that phase, and despite the extent of the decline to-date, stocks are still priced to deliver long-term returns of less than 7.6% annually even in the best case. Analysts who are willing to assume that 7.6% is an attractive and tenable long-term rate of return are free to conclude that stocks are fairly valued here. But I don't believe for a second that both current and future investors will indefinitely be happy to buy stocks priced to deliver 7.6% long-term returns.
In order for stocks to be priced to deliver long-term returns of even 9% annually, stock prices would have to decline by over one-third. That's not a forecast. It's just a statement of unfortunate reality: stocks are currently priced to deliver poor long-term returns. In this sense, they lack investment merit. That said, we will be willing to take a modest exposure to market risk (say 40% of portfolio value) if the market can recruit sufficient speculative merit through a favorable shift in trend uniformity.
We don't have that yet. Until we do, we will remain fully hedged.
Sunday July 14, 2002 : Hotline Update
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The Market Climate remains on a Warning condition here and we remain fully hedged. But things are getting interesting. Last week, interest rates moved back into a downtrend. I've noted in recent updates that sustained bear market rallies (for example, March-May and October-December 2001) typically emerge during periods of declining interest rates, and are initiated by a very sharp reversal in momentum, in which overwhelmingly negative market action is immediately followed by a broad reversal.
The problem at hand is that the "overwhelmingly negative" portion could potentially involve a crash. So we certainly would not attempt to trade in advance of a legitimate and decisive reversal. While we never outline proprietary elements of our approach, suffice it to say that if the market can sustain a few brutal down days in the next week or two, and then reverse sharply off of a spike low (which would probably have to be substantially below current levels), the Market Climate will quickly shift to a constructive stance. It is not the extent or duration of such a reversal, but its quality (primarily breadth) that is essential to a decisive signal. As always, uniformity of market action is the hallmark of sustainable advances. If instead, the market rallies weakly from current levels, or declines without a powerful reversal, the Climate will remain on a Warning condition.
In any event, the next couple of weeks could be important.
It is essential to understand that stocks remain overvalued, and that no market action other than an extreme decline would quickly change that. So even a strong momentum reversal would not make stocks a "value." But much of the 1995-2000 advance occurred in a Climate of substantial overvaluation (poor investment merit) and favorable trend uniformity (reasonable speculative merit). Tradeable bear market rallies have also historically had this character. So we are certainly willing to take a constructive stance on the basis of favorable market action alone.
If the market can recruit a high-quality momentum reversal in the weeks ahead, our most constructive position would be about 40% unhedged. In other words, even in the best case, the majority of our stock holdings (60%) will remain hedged. Furthermore, this sort of shift would not be an indication of "bullishness" or "optimism" about the market. These terms imply a market forecast, and the reality is that we could very well find ourselves shifting back to a fully-hedged position even a week after becoming constructive. Also, while constructive Market Climates have a favorable average return/risk tradeoff, every Market Climate that we identify allows both substantial advances and substantial declines. So it's possible that we could take a constructive position and the market might continue to fall. In that case, we could have 40% of our portfolio exposed to a further market decline until a subsequent shift in the Market Climate. That's a risk we would be willing to take on sufficient evidence.
Shifting to a constructive Market Climate would not imply an end to the bear market, or the attainment of a final, durable low. We make absolutely no forecast of how long any given Market Climate will persist, or when it will shift. As usual, our goal is to identify rather than forecast market conditions. We take a measured amount of market risk in Climates that have historically demonstrated a favorable return/risk profile on average. Otherwise we shut market risk down. There are no specific forecasts that go along with this discipline other than the belief that over the long-term, the risks that we choose to take will be rewarded, on average.
In other news, Standard & Poors made some substantial changes to the S&P 500 Index last week. Among them, S&P ousted Royal Dutch, Inco, Alcan, and Barrick Gold. It added EBay, Electronic Arts, Sungard, Prudential and Goldman Sachs. So out were oil and metals (hard assets), and in were techs and financials. Anybody who knows the history of index revisions knows that they are outstanding contrary indicators. Norman Fosback of the Institute for Econometric Research demonstrated decades ago that stocks kicked out of the Dow, for example, dramatically outperformed their replacements over the following years. This rule certainly held true for the inclusion of stocks like Intel and Microsoft a few years ago. So I suspect that S&P has inadvertently given a somewhat long-term buy signal on hard assets and a sell signal on techs and financials (at least of the genre of EBay and Goldman Sachs).
I continue to believe that the U.S. economy faces risk of substantial weakness ahead, But again, if stocks are brutalized sufficiently in the next week or two, the market could take on a positive speculative tone for a while. As for my personal opinion (which we don't trade on and neither should you), I suspect that such a shift - if it emerges - would be on the order of a bear market rally lasting a couple of months, rather than something more durable. In practice, we'll just take our evidence as it comes. There is no assurance that the Market Climate will in fact shift anytime soon, and we would not attempt to "anticipate" or trade ahead of such a shift at present. In any event, our current position is fully hedged, and we have no inclination to take market risk here.
Thursday Morning July 11, 2002 : Special Hotline Update
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The Market Climate remains on a Warning condition. Year-to-date, the S&P 500 Index has lost 20% of its value. There was a brief period where a 20% decline became the commonly accepted definition of a bear market. That period coincided with the point when the S&P 500 initially hit a 20% loss from its high. As soon as that happened, analysts were eager to call it a bear market so they could immediately shift their attention to the "oncoming" bull market, which was invariably right around the corner.
But actual bear markets are not so kind. As I note in the "Bear Market Insights" article on our Research & Insight page, the typical bear market involves a whole series of 10-20% losses, each punctuated by a sharp rally that gives temporary hope that the low has been set. The 73-74 decline included no less than 7 of these plunges. At each point along the way, investors are hooked into holding. On declines, the hook is "I can't sell now. We might be close to a bounce. I'll lighten up on the next good rally." And when that rally comes, the hook is "Hey! It's coming back! Glad I stuck to my guns!" And then the market breaks to a fresh low.
At a durable bear market bottom, the sentiment is not "Buy the dip." It's "Get me out." The news articles are not about the coming rebound, but are instead about how much worse things are going to get. Look back at prior bear market lows and you'll see exactly that. So far, we see little evidence of panic. No lopsided breadth. No preponderance of bears in the Investors Intelligence survey. And no news headlines telling how much worse things are likely to get. That's a real concern here. Because the current widespread complacency leaves open the possibility that investors will begin to throw in the towel simultaneously.
Major plunges are typically preceded by a period of relentless but "orderly" decline, followed by capitulation. That's why I view the persistent distribution of the past few months (as well as the series of 5 consecutive declines in the NYSE Composite a couple of weeks ago) very seriously. In general crashes are preceded by a bad week capped with a 4-5% loss late in the week (The 9% drop on Black Thursday - October 24 1929, which actually preceded the 17% plunge the following Tuesday, or the 4% Friday decline in 1987 that preceded Black Monday). That kind of decline leaves investors without sleep over an entire weekend. Needless to say, the next couple of sessions are worth watching closely.
I want to emphasize that we are not forecasting or expecting a market crash. But as I've written frequently over the years, market crashes are first and foremost periods when the risk premium on stocks rises quickly from a very low level. Given risk premiums that remain quite low from a long-term perspective, the risk of a spike in the risk premium can't be ruled out.
Given the strong oversold condition of the market, it is equally possible that the market could experience a typical fast, furious rally to clear that oversold condition. So as usual, I have no forecast of market direction here - particularly short term direction. And as usual, we don't need one. The current unfavorable status of valuations and trend uniformity is sufficient to hold us to a fully hedged position, so we are indifferent to market risk here.
The point that should not be missed however, is that a market crash is possible, and investors should not rule out the potential for further losses, possibly substantial ones. Unfortunately, far too many investors are locked into investment positions because they fear regret, even though they are risking their entire financial security if the market fails to rebound.
Once again, here is my "40% rule." If you are currently in an investment position that relies on a market advance, and a sharp further decline would result in unacceptable losses, you have to take immediate action. Determine what part of your investment position is inappropriate (for instance, if you feel comfortable having $20,000 in the S&P, but actually have $45,000 invested, then the inappropriate exposure is $25,000). The rule is simple. Shut down 40% of that inappropriate exposure immediately and without regard to price. When you're holding a position that balances a desired gain against an unacceptable loss, prospective return is no longer the important issue. The immediate issue is risk management. Shut down 40% of the inappropriate exposure. You'll still have the majority of your problem - 60% - that you can work your way out of as opportunities arise. When you do this, it is essential to understand and expect that you will regret it to some extent - either the investment will move up and you'll regret having sold 40%, or it will move down and you'll regret not having sold it all. But you'll be taking that certain, acceptable level of regret in order to avoid any possibility of unacceptable regret. That is always a good trade.
Wednesday Morning July 10, 2002 : Special Hotline Update
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Just a note - We'll be featured in Investors Business Daily on Wednesday (click here).
The Market Climate remains on a Warning condition. As usual, we have no forecast of market action. The market is quite oversold, and that often invites fast, furious rallies - even ones lasting several weeks - to clear such oversold conditions. At the same time, I noted a couple of weeks ago that the NYSE composite had generated 5 consecutive down days, on substantial negative leadership (new lows), in a climate of overvaluation, rising yields on bonds and utilities, and unfavorable trend uniformity. This combination has typically occurred a couple of weeks prior to market crashes and other substantial declines, and we wouldn't rule that out either.
To investors who base their decisions on forecasts, the fact that we allow for both a sharp rally and a crash over the near term must be frustrating. But we don't base our decisions on forecasts. Our investment posture is driven by the Market Climate that we identify at the present moment. When the Market Climate shifts, so too will our investment posture. But here and now, the current conditions of unfavorable valuations and unfavorable trend uniformity are sufficient to hold us to a fully hedged position. If the market bounces over the short term, fine. We do not have any evidence at hand on which to speculate on such a bounce. And we are always willing to endure the possibility of missing out on short term moves when "playing" them would go against our discipline - the same way we would walk past a roulette table in Vegas even though the next spin might be a winner.
That said, the relentless distribution in this market is striking. When the market rallies on dull volume and declines on heavy volume, it's often a sign that large interests are getting out. And despite the depth of the decline, we're seeing new groups joining the downtrend, rather than the "positive divergences" that often foreshadow a positive shift in trend uniformity. The latest group to roll over is mortgage lending, notably Fannie Mae. As usual, I do believe that market action conveys information, and the latest breakdowns are a source of concern because they are particularly abrupt.
I've noted before that I don't understand why Fannie Mae trades at all - at least, why it trades without a very substantial haircut for risk. The company has $775 in debt per share, and earns about 0.65% on total assets. I don't care how well FNM thinks it hedges its interest rate and credit exposures. When you're operating on roughly 40 times leverage against your own capital, the whole enterprise is "non-robust" to small changes in factors you didn't anticipate. That's essentially how the geniuses at Long-Term Capital blew themselves up - they leveraged their capital about 40-to-1, and at that ridiculous level of leverage, a very slight divergence between what they were long and what they were short ate them alive. As I regularly taught my finance students at the University of Michigan, every major financial disaster has three elements 1) extreme leverage, 2) a mismatch in the character of assets versus liabilities, and 3) lack of disclosure. Somehow, Fannie Mae doesn't escape this characterization in our analysis. That's not a forecast of trouble, but it seems to me that Fannie's earnings - consistent as they have been - do not seem particularly robust.
A final note. Much was made this week of Warren Buffett investing about $100 million in Level 3. You'll notice that he didn't buy the stock. He bought convertible bonds. The conversion feature is largely a speculation - like getting a free call option. I suspect that the bond investment is basically an asset play, based on the potential liquidating value of the assets if the company goes into bankruptcy.
Sunday July 7, 2002 : Hotline Update
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Just a note: the latest issue of Hussman Investment Research & Insight is now available on our website. The print version will be mailed to shareholders next week.
Also, even as our work receives welcome attention in major publications, please ignore any text suggesting that our position relies or otherwise depends on forecasts of a market decline. Very simply, our strategy is geared to long-term capital appreciation, with added emphasis on capital preservation during unfavorable market conditions. Our approach is focused on identifying prevailing market conditions, not forecasting future ones. The dollar value of our shorts never materially exceeds our long holdings, and we don't bet on market declines. As much as I try to emphasize in interviews that our strategy is not a "bear" or "short" approach, the fact that we don't fit into a standard category is usually lost on journalists with demanding editors and tight deadlines.
The Market Climate remains on a Warning condition. As usual, this is not a forecast of future direction, but an identification of prevailing conditions. When valuations are elevated and trend uniformity is unfavorable, market risk has historically generated a very poor return/risk profile. Our response is to remove market risk as a source of fluctuation in our portfolio. We remain fully invested in individual stocks, but we are short the Russell 2000 and S&P 100 in the same dollar amount. We are not bearish, but indifferent to the overall market. We recognize the risk of a further and substantial decline, but we do not predict or particularly expect such a decline.
Very simply, there is a whole palette of risks available in the financial markets, only one of which is market risk. We remain fully invested in a widely diversified portfolio of individual stocks, but we have attempted to remove market risk as a source of both risk and return. We are still taking risk, but that risk is not very closely related to market fluctuations. As a result, our performance cannot be usefully interpreted in the context of whether the market advanced or declined on a given day. If we experience a positive return, the proper inference is that our favored stocks generally outperformed the Russell 2000 and S&P 100 that day. If we experience a negative return, the proper inference is that our favored stocks generally underperformed the Russell 2000 and S&P 100 that day. But neither of these inferences has anything to do with whether the market was up or down that day.
On the valuation front, stock prices remain overvalued in the sense that they are priced to deliver a long-term return of little more than 7.5%, and then only if the price/peak-earnings ratio, dividend yield, price/book ratio and other measures remain at current extremes indefinitely. In the slightly more likely event, for example, that the price/peak-earnings ratio returns merely to its historical average of 14 say, a decade from now, and that peak-to-peak earnings grow at the same rate as the past 10, 20, 50 and 100 years, the S&P 500 would deliver a total return of less than 6% annually over the coming decade. Needless to say, stocks are not priced to deliver runaway long-term returns here.
Meanwhile, trend uniformity remains unfavorable, and yield trends are also hostile. This is an unfortunate combination, because hostile yield trends (primarily rising long-term interest rates, corporate yields, and utility yields) prevent any constructive signal from momentum reversal. So even if the market does generate a very broad plunge with declines outpacing advances, even a positive reversal would be unlikely to be sustained until and unless yield trends improve. In short, a positive shift in trend uniformity may take a while. In the meantime, we remain defensive.
In sentiment, Mark Hulbert notes that investment advisors have been very quick to become bullish on rallies, but are very resistant to becoming bearish on declines. This is not typical of durable market lows, and it is one reason that Hulbert does not believe we are at one. While we don't rely on any bearish forecast, it is unpopular enough even to allow for the possibility of a substantial further decline. With valuations and trend uniformity still unfavorable, we simply can't rule one out.
Finally, every now and then, the advertisements on CNBC serve as a sign of the times. At the market top, one of the striking ones was an ad for a jet leasing company saying "You need a bigger private jet." Lately, the one that strikes me is for a law firm. The video shows a little glider sailing happily to freedom as the narrator says "Facing a shareholder class action? Most dismissals. Three years running. Steele, D'Armani & Cruz (I can't remember their real name). The law firm, when your future is at stake."
Nice.
| 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. |