July 6, 2015
Judging the Future at a Speculative Peak
“I know of no way of judging the future but by the past.” – Patrick Henry
With valuations still extreme and deterioration in market action continuing to indicate a shift toward risk-aversion among investors, we are less concerned about specific factors such as Greece than about much more general pressures that threaten to force an upward spike in compressed risk-premiums. We’ve often noted that a market collapse is nothing other than that phenomenon: razor-thin risk premiums that are then pressed abruptly to higher levels. Undoubtedly, any worsening of Greek credit strains could contribute to the timing of such a spike. But until we observe a firming of market internals coupled with a fresh narrowing of credit spreads, it’s important to recognize that downside risks are much more general, and not are confined to any particular news item.
A rather classic feature of speculative peaks is the eagerness of speculative companies to issue equities to the public while the getting is good. On that front, fully 78% of the initial public offerings over the past 6 months are companies that have negative earnings; a percentage that eclipses both the previous record of 76% at the height of the tech bubble in 2000, as well as the second-highest extreme of 65%, which was set, not surprisingly, in April 2007 during the distribution phase that preceded the 2007-2009 market collapse. Likewise, private equity firms have been dumping their ownership stakes at a record pace.
Of course, in equilibrium, somebody has to buy these same shares, and so one has to ask – who was heavily accumulating stock at the very peaks of the equity bubbles of 2000, 2007 and at present? Unfortunately, some of the most aggressive buyers at equity market peaks have been corporations themselves, via debt-financed stock repurchases. In recent weeks, the pace of these repurchases has eclipsed the previous peak that was set (again not surprisingly) at the 2007 market extreme. What’s rather disturbing is how seemingly resistant investors are to an examination of how these episodes have repeatedly ended.
Among the frequent remarks on financial television that make us wince here is the idea that because rich market valuations, heavy issuance of speculative IPOs, Greek debt concerns, private-equity divestitures and other factors have been openly discussed, these risks must also be fully discounted in the market. The theory seems to be that once a risk is widely known, it is no longer a risk. Even the most cursory review of the last two bubbles should disabuse investors of that idea. One might, for example, refer to the February 11, 2008 issue of Business Week, well before the market collapsed in earnest, which showed a bright red graphic of a melting house, with the headline “Meltdown – For housing, the worst is yet to come.” That cover appeared a few weeks after Newsweek ran a cover titled “Road to recession.” Both concerns would be realized over the following year as the worst economic collapse since the Great Depression.
Now, we’ll be the first to agree that when such covers emerge on popular magazines after historically reliable valuation measures have moved well beyond historical norms, they can be a useful confirmation of overdone sentiment. But extreme valuation measures are what tell you that the risks have been discounted, or that optimism has been fully embedded in prices. The magazine covers and other sentiment measures are simply confirmation of the risk-seeking or risk-averse attitudes that have produced those extremes. The idea that risks vanish as soon as they are broadly discussed is merely wishful thinking.
For our part, we remain focused on the lessons of a century of history. The most historically reliable valuation measures continue to project zero total returns for the S&P 500 over the coming decade, and that conclusion is quite robust to assumptions about interest rates and nominal growth (whose effects on actual subsequent market returns have historically been closely related, and highly offsetting). It’s quite true that the Federal Reserve has encouraged speculative yield-seeking in recent years. It’s also quite true that valuations are not a terribly useful guide to market outcomes over horizons shorter than a complete market cycle. What best distinguishes the advancing portion of the market cycle from the declining portion is the attitude of investors toward risk. The best measure of investor risk-preferences, in turn, is not Fed policy per se, but rather the behavior of market internals, credit spreads, and other risk-sensitive measures. This has been true in market cycles across history, even during the half-cycle since 2009 (see A Better Lesson Than “This Time Is Different”). Once investors have shifted toward risk-aversion following extreme valuation and an extended period of overvalued, overbought, overbullish conditions, the markets have not reliably responded even to aggressive Federal Reserve easing. One can verify this by examining the 2000-2002 and 2007-2009 collapses, when the Fed was aggressively easing the whole time.
In short, it’s the deterioration in market internals and other risk-sensitive factors, and emphatically not simply elevated valuations alone, that suggests a much different and far more vulnerable environment here than we’ve observed for the majority of the period since the 2009 low. No forecasts are required here. It is enough to align our investment outlook with the market return/risk profile we identify. That outlook will change as the evidence does.
In Honor and Memory of Nelson Freeburg
“I would humbly submit this observation” Nelson would begin; and in his carefully paced Tennessee accent, you could be sure that whatever words followed would make your world larger. Last week, our friend and colleague Nelson Fraser Freeburg passed away at the age of 63. We will miss him exceedingly.
Nelson saw the excellent, the fascinating, and the extraordinary in people and places that others might easily overlook. He saw those things because he looked for them. One could hardly walk into a restaurant with Nelson without learning some little-known detail that linked the place you had entered to history itself; without becoming friends with the waiter and experiencing Nelson’s genuine interest in others firsthand.
He studied philosophy at Memphis University School and Lawrence University, and earned a Master’s degree in International Relations from Columbia University (where he was proud to have studied with Zbigniew Brzezinski, who later became National Security Advisor and brokered several major U.S. peace and human rights initiatives). Nelson was also intrigued by the financial markets, which eventually became his career. Beginning in 1991 he published a report called Formula Research, where he developed and tested scores of analytical investment strategies across decades of historical data. One of his great skills was in joining coherent sets of indicators and market indices to capture major market trends with limited drawdown. He would occasionally publish a flurry of reports within a few weeks, often with months between them. All of us, including many leading hedge fund managers, eagerly awaited his insights.
Nelson and I met in the early 1990’s when both of us were publishing investment research. Though I was a value investor and Nelson focused on market action and cross-market relationships, we instantly found ways to learn from each other because, as he put it, “we find systematic market research so compelling.” Nelson’s focus on drawing signals from multiple measures was an immensely useful kind of signal extraction, and methods he shared were critical in helping us to to capture information from market action, as a way of measuring risk-seeking and risk-aversion among investors.
In 2000, Nelson joined the Board of the Hussman Funds, and regularly shared considerations informed by decades of research. He knew more about market history than anyone I’ve ever met, and was just as focused on the risk of embracing the markets too early in a crash as he was on the risk of missing returns late in a bubble. He was flexible enough to look for new factors that might be more important than in the past, but he viewed the idea that this time is different – the idea that historical evidence can be disregarded – as “eight ounces of freshly mixed Kool-Aid.” Whether the discussion was upbeat or challenging, there’s not a single Board meeting where Nelson didn’t also make a point to compliment something or another he saw as noteworthy. More than all of that, Nelson was one of the most genuinely friendly people one could hope to meet on this earth.
Nelson saw the world, I think, as a tapestry where the extraordinary is woven throughout the seemingly ordinary. He found it everywhere. That was one of his joys. He described the world in superlatives like “stunning,” “truly exquisite,” and “riveting,” and one never doubted for a second that those words were sincere. He loved orchestral music, and would occasionally share his favorites (including Air by Aaron Jay Kernis, Heavy Rain by Normand Corbeil, and the prologue to Kepler by Philip Glass).
His seemingly infinite repository of engaging stories was matched only by his obviously infinite love for his family – his wife Carole, and his three sons, Nelson (Trip), Charles, and Scott. We all watched the boys grow up on the front of every Christmas card. Nelson was never more delighted than when he was introducing his sons or sharing their successes. “Thank you,” he would always add, “for indulging a proud father.”
Those of us who knew Nelson are all too aware that we will never meet anyone like him again. He was at once a brilliant mind and a humble soul; a quiet observer and an animated story teller. He was a wonderful friend, colleague, and family man. Nelson left no doubt that he saw himself as fortunate and blessed. We are equally fortunate and blessed for having known him. He made our world larger.
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. Please see periodic remarks on the Fund Notes and Commentary page for discussion relating specifically to the Hussman Funds and the investment positions of the Funds.
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