No Capitulation

John P. Hussman, Ph.D.
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Over the years, I've noted that bear markets typically involve far greater volatility and far larger short-term advances than investors typically remember in hindsight. The 2000-2002 bear, for example, included three separate advances in excess of 20% from intra-day low to intra-day high, with many more advances in the 5-10% range.

Even with the turbulence of recent months, the S&P 500 has still not declined by 20% on a closing basis, valuations (particularly on the basis of normalized profit margins) remain fairly rich, and the prospect of a recession is still subject to debate. My own view on recession risk has been clear since November, when our best early-warning composite finally turned the corner (having always and only provided warnings during or immediately prior to U.S. recessions).

Part of the reason for the fresh weakness in recent sessions is that the consensus regarding recession is beginning to shift. If investors eventually capitulate to the idea of a U.S. recession, we we are likely to observe prices at substantially lower levels, because much of the "rebound around the corner" optimism about earnings will abate. On a positive note, good capitulations have often provided a base for sustained bear market rallies (even if they eventually fail and the market drops to deeper lows later).

Tradable bear market advances typically feature a) normal or at least only modestly elevated valuations (on the basis of normalized profit margins); b) high levels of investor anxiety as evidenced by spiking advisory bearishness and option volatility; c) falling interest rates - bear market rallies in the face of rising rates should be viewed with great skepticism and; d) strong internals such as lopsided positive breadth on explosive volume very early into the rebound.

Though we've seen a few strong rallies since last year, they've been fairly high-risk advances in that they could very well have gone the other way, because lower-risk conditions weren't generally present. We did observe volatility spikes and falling interest rates at the August, January and March troughs, but valuations remained rich, market action off of the lows was typically not compelling, and investors have been largely in denial about recession risk and the continuing onslaught of foreclosures and credit losses. "Capitulation" would mean investors accepting those risks, and also believing that they will only get worse.

My impression is that we will eventually observe that sort of capitulation, hand-in-hand with broad recognition that the U.S. economy is in recession. That sort of capitulation may provide some opportunity to reduce our level of defensiveness, particularly by removing the short-call option side of our hedge. Still, we should not assume that the next significant capitulation will be the last. Bear markets typically involve a series of them (e.g. initial weakness on no news or only fears about interest rates or inflation, initial earnings disappointments, initial evidence of economic weakness, consensus about recession itself, consensus about the deepening of the recession, and eventually the mother of all bear market lows - complete loss of hope and a panic to cut deepening losses and "just get me out").

From the standpoint of capitulation, last week's decline was actually very orderly, and hardly caused the CBOE volatility index to budge. When we see the VIX spike to the mid 30's or 40's, it may become useful to survey opportunities to assume greater market risk. So far, however, the VIX makes it clear that investors are taking recent losses very casually. The following charts are (with permission) from Carl Swenlin's nice Decision Point site.

(It's worth mentioning that while the S&P 500 is at its lower Bollinger band on the daily chart, it's quite common for the market to "ride" the band lower during persistent declines, so those bands aren't useful buy/sell levels in and of themselves).

We would prefer to see not only a spike in the VIX, but also better valuations before assuming greater amounts of market risk. The market weakness we've observed since last year has been fairly tame in the sense that the S&P 500 has to-date suffered a fraction of the loss that we typically observe in a standard, run-of-the-mill bear. It can be dangerous to attempt trading bear market rallies early into a decline - especially when valuations remain rich. It's useful to remember that the 1929 and 1987 crashes started after the S&P 500 was already down about 14% from its highs.

So emerging panic is not enough - there has to be some basis to believe that a positive shift in investor attitudes toward risk would be sustainable. Again, falling interest rates, moderate valuations, and very strong market action early into the rebound are useful in separating sustainable advances (even sustainable bear-market rallies) from the fast, furious, prone-to-failure variety.

Presently, we don't even see emerging panic. What we do observe, however, is that prices are somewhat oversold on a very short-term basis, so it's reasonable to allow for one of those fast, furious bounces to clear that condition. Not a forecast - particularly because the prevailing Market Climate is unfavorable - but even high-risk markets can produce very strong short-term advances, and investors should not immediately abandon caution when they emerge.

Market Climate

As of last week, the Market Climate in stocks remained characterized by unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully hedged investment stance. As noted above, despite the recent weakness, there is a strange "orderliness" to recent market losses - as if investors are convinced that there is some invisible safety net that will keep stocks in a trading range and prevent any sustained price erosion. That complacency may become costly. Still, stocks are somewhat oversold from a very short-term perspective, so again, we can't rule out a fast, furious spike to clear that condition. Suffice it to say that the Market Climate remains unfavorable and the Fund remains fully hedged.

I expect that fresh credit losses will put a reasonably quick halt to the prospect of any near-term Fed rate hikes, but it's possible that Fed will be more reluctant to sent a message that "the spigots are wide open" when those fresh losses do emerge. The real test for the Fed would come in the event that stocks break their March lows. At that point, we're likely to see the Fed abandon any remaining discipline and offer up some emergency rate cut or "liquidity facility." But then, if the Fed could do everything it has done and the market still breaks the March lows, investors may take much less confidence from any new initiatives. So if the market fails to hold those lows, the Fed is likely to lose much of its credibility. Along with that credibility would go much of the faith in the Fed's omnipotence.

In bonds, the Market Climate last week remained characterized by relatively neutral yield levels and modestly unfavorable market action. The spike in 10-year Treasury yields to about 4.25% prompted us to add a bit of duration there, as well as in the 2-year Treasuries, so the Strategic Total Return Fund has a duration closer to 2 years at present. Still fairly defensive, but having appropriately sought the defense of short-term Treasury bills during the recent yield spike, we're starting to see more opportunities to extend our maturities a bit. Meanwhile, fresh economic concerns have helped our foreign currency positions, which continue to represent just over 15% of assets in the Strategic Total Return Fund.

New from Bill Hester: Anchored Inflation Expectations and the Expected Misery Index

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The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

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Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 reflect our standard valuation methodology, focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle (see for example Investment, Speculation, Valuation, and Tinker Bell, The Likely Range of Market Returns in the Coming Decade and Valuing the S&P 500 Using Forward Operating Earnings ).