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May 22, 2006

Textbook Warnings

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

In the early 1980's, I spent much of my time carrying stacks of computer punch cards back and forth to Vogelback, a short, dimly lit building on the Northwestern University campus that housed a massive VAX computer with blinking lights and huge cases of magnetic tapes reeling back and forth. There I punched cards full of COBOL or FORTRAN computer code, along with thousands of bits of historical data on the financial markets, and then carefully carried my stack up to a work-study student, who would plop it into a chute at the top of the computer.

About a half hour later, my stack would be returned, tucked into one of a hundred rectangular mail slots, wrapped with a green and white striped printout and held together by a rubber band. Moment of truth. I'd pull that rubber band off, whispering hopefully to the paper, “come on, come on…” Sometimes it would be just a page or two, with nothing but fatal errors, which meant you had to trace the error, resubmit the stack, and then attend to the bruises you got from banging your head against the wall. But at least some of the time, the result would be pages and pages of good output. It amazes me that the same work takes a fraction of a second these days on an inexpensive PC running Excel or Matlab, but back then, it seemed awesome to get answers from that huge computer, despite the hours of waiting.

Some of those early lessons are ones that I've stared at and replicated so many times that I think of them as laws of investing – “canonical” or “textbook” truths about favorable and hostile markets that seem to hold true within nearly every subset of history and across international markets as well.

Among the simplest truths is that market risk tends to be unusually rewarding when market valuations are low and interest rates are falling. For example, since 1950, the S&P 500 has enjoyed total returns averaging 33.18% annually during periods when the S&P 500 price/peak earnings ratio was below 15 and both 3-month T-bill yields and 10-year Treasury yields were below their levels of 6 months earlier. Needless to say, there are a variety of ways to refine this result based on the quality of other market internals, but it's a very useful fact in itself.

The “canonical” market bottom typically features below-average valuations, falling interest rates, new lows in some major indices on diminished trading volume, coupled with a failure of other measures to confirm the new lows, and finally, a quick high-volume reversal in breadth (usually with an explosion of advances over declines very early into a new advance).

Similarly, market risk tends to be poorly rewarded when market valuations are rich and interest rates are rising. Since 1950, the S&P 500 has achieved total returns averaging just 3.50% annually during periods when the S&P 500 price/peak earnings ratio was above 15 and both 3-month T-bill yields and 10-year Treasury yields were above their levels of 6 months earlier. Again, there are a variety of ways to refine this result, but note that anytime the total return on the S&P 500 is less than risk-free interest rates, a hedged investment position increases overall returns (since hedging instruments are priced to include implied interest).

The “canonical” market peak typically features rich valuations, rising interest rates, often a reasonably extended and “flattish” period where, despite marginal new highs, momentum has gradually faded while internal divergences have widened, and finally, an abrupt reversal in leadership, from a preponderance of new highs over new lows (both generally large in number) to a preponderance of new lows over new highs, with the reversal often occurring over a period of just a week or two.

Though our investment position doesn't by any means rely on it, my impression is that recent market conditions fall very much into that description of a canonical peak.

As I've noted before, for an investor looking to capture all the market's long-term returns with substantially less downside risk, it would actually have been enough, historically, to simply step out of the market on a price/peak multiple of 19 and then wait for a 30% plunge before repurchasing stocks, even if that meant staying out of the market for years in the interim. (As I've also noted, this is not a practical or optimal strategy by any means, since it has far too much tracking risk and would have required implausible levels of patience, but it's an enlightening fact nonetheless).

It doesn't help the case for stocks to argue that, for example, earnings growth is still positive, because it turns out that the year-to-year correlation between stock returns and earnings growth is almost exactly zero. It doesn't help to argue that consumer confidence is still high, because consumer confidence is actually a contrary indicator, as are capacity utilization, the ISM figures, and other factors being used for bullish fodder. It doesn't help to argue that the Fed will stop tightening soon, because the end of a tightening cycle has historically been followed by below-average returns for about 18 months. It doesn't help that 10-year bond yields are still lower than the prospective operating earnings yield on the S&P 500 (the “Fed Model”), not only because the model is built on an omitted variables bias (see the August 22 2005 comment), but also because the model statistically underperforms a simpler rule that says “get in when stock yields are high and interest rates are falling, and get out when the reverse is true.”

Once stocks are richly valued, then, the burden of proof is on the case for staying in, not getting out (or in our case, hedging). Once interest rates are rising, that burden of proof ticks up. Once internals show “heavy” price/volume behavior, more burden. And once you get a huge leadership reversal, as we've seen over the past week, it's time to watch for falling rocks.

Our fully hedged investment position in stocks doesn't require any forecasts here – the prevailing combination of valuations and market action has historically produced unsatisfactory returns on average – and this is sufficient reason to be defensive. That said, I strongly encourage investors to evaluate their exposure to market risk here. The Strategic Growth Fund is fully hedged, so I don't have concerns about general market direction on the Fund, but for other investments that are more linked to general market movements, if you could not accept or financially tolerate a market decline of 20-30% in the value of those holdings, you're probably not being realistic in terms of the risks you're taking.

It's only been 10 trading days since the S&P 500 registered 5-year highs and the Dow hit 6-year highs. The S&P 500 has since declined by just 4.43%, is oversold, and could very well be due for a short-term bounce. On that basis, the preceding comments may seem overwrought. Nevertheless, current conditions strike me as so unfavorable that they demand some additional emphasis of the risks involved. We don't rely on negative market outcomes here. But we shouldn't be surprised if the next few months are substantially more difficult for the major indices than anything investors have observed in recent years.

Market Climate

As of last week, the Market Climate for stocks was characterized by unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully-hedged investment position. Short-term conditions are very oversold, which invites the typical fast, furious, prone-to-failure bounce that often clears that condition in unfavorable Climates. Still, oversold conditions don't produce reliable buying opportunities when the Market Climate is not constructive or favorable. If the Market Climate is unfavorable and interest rates are falling, it's sometimes possible to trade oversold conditions effectively. But when rates are rising and we've just observed an abrupt reversal in leadership (new lows suddenly dominating new highs), it's not worth the gamble - the average return tends to be negative, and the volatility also tends to be unusually high. Yes, that high volatility does admit the possibility of a big short-term jump, so we can't rule that out, but it also admits the possiblity of further - possibly profound - weakness.

In bonds, the Market Climate was characterized by relatively neutral valuations and unfavorable market action, holding the Strategic Total Return Fund to a relatively limited duration of about 2.5 years. On weakness in the precious metals sector, I added a small amount to the Fund's precious metals positions, raising its overall exposure to a higher but still limited 10% investment position.

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