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April 17, 2006

Market Action and Information

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

One of the notions of the “efficient markets hypothesis” is that stock prices are always “fairly valued” and reflect all information available to investors. Of course, that result is built on the assumption that all investors are rational (meaning that they process information optimally, statistically speaking, and that any two investors, faced with the identical information, would arrive at identical conclusions). You also have to assume that it's “common knowledge” that investors are rational (so I know you're rational, you know I'm rational, I know you know I'm rational, you know I know you're rational, and so on…) The other assumption is that the only motive for trading is an expected profit based on available information (e.g. no trading just because you need the money, just got paid, face job insecurity, etc).

Under those assumptions, prices will be efficient because the mere willingness of another investor to buy or sell is a signal that the investor has favorable or unfavorable information, so other investors will adjust their bids or offers until the informed trader is no longer willing to trade. For example, as long as some investor is willing to buy at the quoted offer, the other investors will pull their existing offers and quote even higher ones, until the informed investor is indifferent between buying and not buying. At that point, the market price reflects the information held by the informed investor, even though nobody else actually saw that information.

Note that the other investors simply adjust their (non-binding) bids and offers – no stock actually trades – because no rational but uninformed investor would actually trade against another rational but informed investor whose only motive is an expected profit, based on information that, if observable, would lead the uninformed investor to the same conclusion as the informed one (which we've assumed).

The bottom line is that in an efficient market, prices convey all information, all traders agree, and there's zero trading volume.

Hmm.

Needless to say, if you make somewhat less restrictive assumptions about perfect rationality and so forth, you can arrive at other plausible, more realistic looking “markets” where prices convey much (but not all) information, investors do have differences of opinion, and trading volume is not zero. In those markets, even though prices don't perfectly reflect all private information, variables generated by the market such as prices, trading volume, common movements in securities, divergences between securities, and so forth, are all useful information because they help to convey, however imperfectly, the information held by other investors.

For example, suppose that a stock looks absolutely wonderful based on the latest income statement and balance sheet. Looking at market action, however, you notice that even though that company's industry group is holding up well, and the market is holding up well, the stock you're considering is dropping like a rock. Most likely, you can comfortably assume that somebody knows something you don't. The income statement and balance sheet are no longer reliable sources of information unless you also factor the observed market action of the stock into your judgments. So a proper investment decision now requires you to consider both valuation and market action (that sounds familiar…)

More generally, unless one actually believes that prices convey all information and the market is perfectly efficient, there are very sound reasons for investors to pay attention to things like market action, breadth (advances vs. declines), leadership (new highs vs. new lows), industry group behavior, interest rate spreads, and other market-generated data.

Presently, the valuation of the market remains unusually rich (see recent weekly comments especially as they relate to price/earnings ratios here). Meanwhile, interest rate action is unfavorable, and we've seen a long period of “distribution” and gradually deteriorating internals. For example, fewer and fewer stocks have been participating in each successive (marginal) new high in the major indices, as measured by the number of stocks above their 10-week averages, the McClellan Oscillator (a measure based on market breadth), the number of stocks achieving new highs, and so forth.

In a richly valued market with upward interest rate pressures, it's a particularly unfavorable sign when within just a few days of new highs in the major indices, leadership “flips” so that the number of individual stocks achieving new 52-week lows actually exceeds the number achieving new 52-week highs. That's exactly what happened last week. The S&P 500 achieved a fresh bull market high on April 5th , at 1311.56, yet new lows have already flipped above new highs.

Equally important, the number of new lows and new highs have both been relatively large, which is an indication of wide internal divergences among individual stocks. Last week, 189 NYSE stocks hit new highs and 280 hit new lows, both representing more than 5% of issues traded. Much of this can be traced to interest-sensitive stocks such as utilities and preferred stocks, but as I've noted before, early breakdowns in bonds and utilities were the main precursors of the 1987 and 1990 market plunges.

Hindenburgs

I've noted often that a great deal of the information conveyed by markets is contained in “divergences” between securities. While investors shouldn't read too much into any indicator, there's an interesting signal that has enough validity as a measure of divergence that it's worth mentioning here. Think of it as slightly more than entertainment value but far less than a reliable guide to investment.

The signal is based on new highs and new lows, and is cheerfully called a Hindenburg (the actual name given to it by Kennedy Gammage is the “Hindenburg Omen” but that strikes me as far too, well, ominous, because it's certainly not a sufficient condition for a market decline). Even based on the looser criteria that many analysts use, it's a relatively unusual event that has often preceded fairly substantial market declines with a fairly short lead time (usually within 30-60 days, including declines in 1987, 1990, 1998, 2000 and 2001), but has sometimes proved to be meaningless or insignificant as well (such as a cluster of signals in September 2005, among others).

The basic elements are 1) the market is in a rising trend, defined as the NYSE Composite being above its 10-week average, 2) both daily new highs and new lows exceed 2.2% of issues traded, and 3) the McClellan Oscillator is negative – meaning that market breadth as measured by advances and declines is relatively weak (there's some dispute, which I will not join, as to whether the Oscillator has to be negative that day or turn negative later). Peter Eliades added a couple of other conditions to eliminate signals occurring in clearly strong markets: 4) new highs can't exceed new lows by more than 2-to-1, and 5) 2 or more signals occur within about a month (he uses 36 days) of each other. Eliades' criteria reduce the number of "confirmed instances" to a smaller set with fewer false signals.

As it happens, we observed a Hindenburg on April 7th (just 2 days after the market high) and another one on April 10, so those elements seem to be in place here. We'll see whether anything comes of it this time around. In the context of current valuations and market action, we're already well hedged, so this arcane little signal has no impact on our investment positions. At the same time, it's at least interesting to report this signal because it comes at a point when the prevailing Market Climate does hold us in a defensive and well-hedged position.

Again, this is only mentionable because it's instructive about some of the ways that others look at market internals, not because it has any impact in our own work (we're hedged anyway, and something like this wouldn't move us to hedge if our own measures were constructive). If nothing else, it gives us something to watch in an otherwise indecisive market.

Market Climate

As noted above, the Market Climate for stocks remains characterized by unusually unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a well-hedged (about 95% hedged) position in stocks. In bonds, the Market Climate remains characterized by unfavorable valuations and unfavorable market action, holding the Strategic Total Return Fund to a roughly 2-year duration in bonds. While bond yields are approaching levels where we may increase Fund duration modestly, interest rate action (and particularly the inflation rate implied by TIPS prices) does suggest some amount of further inflation pressure ahead.

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