Posts Tagged ‘Syndromes’
Tuesday, August 7th, 2012
by John Hussman, Hussman Funds
August 6, 2012
I’ve never been very popular in late-stage bull markets. Defending against major losses and achieving our investment objectives over the complete bull-bear market cycle (bull-peak to bull-peak, or bear-trough to bear-trough) requires us to maintain an investment exposure that is essentially proportional to the expected return/risk ratio that is associated with each given set of market conditions. When prevailing market conditions are associated with a sharply negative expected return/risk ratio, as they are at present, and either trend-following measures are negative or several hostile indicator syndromes are in place (what we call Aunt Minnies), we will typically be fully-hedged, and will raise the strike prices of our put options toward the level of the market, in order to defend against steep market losses and indiscriminate selling. At present, we expect an average 10-year total return on the S&P 500 of about 4.7% annually in nominal terms, on the basis of rich normalized valuations. Based on a much broader ensemble of evidence, and considering horizons between 2-weeks and 18-months, we estimate the prospective return/risk ratio of the S&P 500 to be in the most negative 0.6% of all historical observations.
Moderate losses may be a necessary feature of risk-taking, but deep losses are erasers. A typical bear market erases over half of the preceding bull market advance. It is easy to forget – particularly during late-stage bull markets – how strongly this impacts full-cycle returns. The most obvious example, of course, is the 2008-2009 decline, which erased not only the entire total return of the S&P 500 since its 2002 low, but also erased the entire total return of the S&P 500 in excess of Treasury bill yields (its “excess return”) going all the way back to June 1995 – making all of the benefit from risk-taking during the late-1990’s completely for naught. Similarly, the 2000-2002 bear market wiped out the excess return that investors had enjoyed in the S&P 500 all the way back to February 1996. The 1990 bear market wiped out the excess return of the S&P 500 all the way back to January 1987.
Recall that at the 1987 peak, the S&P 500 had quadrupled (including dividends) from the secular low of August 1982. The 1987 crash – which in terms of size was a fairly run-of-the-mill bear of -33.51% from peak to trough – was enough to wipe out nearly half of that preceding total return (do the math: [(4*(1-.3351)-1]/(4-1)-1 = -45%), and slashed the excess return that investors had enjoyed since 1982 by even more than half. This chronicle of unpleasant arithmetic can be extended indefinitely over market history. Regardless of whether stocks are in a secular bull market or a secular bear market, the mathematics of compounding are brutal where large losses are concerned.
It’s instructive that $1 invested in Strategic Growth Fund at its inception, near the beginning of the 2000-2002 bear market was worth 2.72 times the value of an equivalent investment in the S&P 500 by the end of that bear market. Likewise, $1 invested in the Fund at the beginning of the 2007-2009 bear market was worth 2.09 times the value of an equivalent investment in the S&P 500 by the end of that bear market (see The Funds page for complete performance information). Performance gaps that can arise in the overvalued but still-advancing part of the full market cycle can be dramatically recovered by defensive strategies in the declining part of the cycle, which is why we don’t pay excessive attention to short-term tracking differences when market conditions are hostile.
Of course, there’s no assurance that we’ll always achieve our objective of outperforming the market with significantly smaller drawdowns over the complete market cycle. Though we’ve certainly had far less volatility and drawdown than the S&P 500 over the most recent cycle, Strategic Growth Fund lagged the total return of the S&P 500 by just shy of 13% cumulative from the 10/09/2007 peak in the S&P 500 to its most recent peak on 04/02/2012. This outcome primarily reflected my insistence on making our hedging approach robust to Depression-era data (an effort that caused us to miss returns in 2009-early 2010 until we achieved a robust solution using ensemble methods), and the smaller issue that purchasing actual put options has been less effective in periods where central banks have seduced investors to place their faith in “Bernanke puts” and “Draghi puts.” Our 2009-early 2010 miss was not “strategic” in that we would not be similarly defensive in future cycles if presented with identical conditions and evidence. But the fact is that our present defensive stance, particularly since early March, is something that we can be expected to establish over and over again in future cycles if presented with the same evidence.
Our measures of prospective return/risk became steeply negative in early March (see Warning: A New Who’s Who of Awful Times to Invest). Since then, market conditions have satisfied a restrictive set of criteria that have been similarly negative in a very small percentage of historical observations. At present, Strategic Growth Fund is fully-hedged, with most of our index put option strikes raised within about 4% of prevailing market levels, at a cost of less than 2% of assets in time premium looking out toward late-2012. This time premium will decay if the market remains unexpectedly resilient in the coming months and we observe no shift in presently negative market conditions. That said, with an angry army of negative indicator syndromes in place, I don’t expect speculation – even on hopes of further central bank intervention – will be significantly or durably rewarded here.
Suffice it to say that our present defensiveness is an intentional and repeatable aspect of our investment strategy. There are certainly some extraordinary factors that we had to address in the most recent market cycle as a result of the credit crisis and government attempts to defend bad debt, avoid restructuring, and to extend, pretend, and print at all costs. I believe that we can manage a continuation of that policy environment well over time, though periodic frustrations may be more frequent due to short-lived “risk-on” advances. In any event, I have no belief that central bank operations (which do little more than purchase a fraction of the new additions to the mountain of global government debt and replace them with currency and bank reserves) are actually capable of making recessions, bear markets, or the basics of arithmetic things of the past.
Friday’s headline non-farm payroll employment gain (establishment survey) of 163,000 jobs was surprisingly positive, but far less informative about economic prospects than investors appeared to assume. The household survey, which is used to calculate the unemployment rate, actually showed a drop in civilian employment of 195,000 jobs in July. The increase in the unemployment rate would have been greater if not for the fact that another 150,000 people left the labor force altogether and were therefore not counted as unemployed. The picture was particularly weak for workers 20 years of age and older (where 213,000 jobs were lost), but was slightly rescued by a gain of 18,000 jobs among 16-19 year-olds. While the difference between the establishment and household surveys was unusually large, these disparities aren’t entirely uncommon, and don’t have a great deal of predictive value for either series. It’s probably most accurate to say that the July employment figures were mixed.
Even focusing on the bright spot, which is the establishment survey figure, one immediate fact to note is that year-over-year growth in non-farm payrolls fell below 1.4% back in April, following a brief excursion above that level, and has remained weak since then. As the chart below indicates, a decline in year-over-year payroll employment growth below 1.4% has occurred just before, or already into, each of the past 10 recessions, with no false signals. As usual, we’re skeptical of drawing inferences from a single indicator, and this instance may be different. But given the collapse in new orders and other measures of economic activity across numerous Fed, ISM and global surveys (and a continued decline in the most leading signal that we infer from our unobserved components models), there seems to be little reason for that expectation.
Keep in mind, as we’ve noted regularly over the years, that employment is a lagging economic indicator. The “stream of anecdotes” school of economic analysis may treat every economic report as having equal weight in determining the course of the economy, but the actual sequence is generally as follows: falling consumption growth and new orders -> falling production -> falling employment. The latest employment report appears to be little more than the wagging tail of an already sick puppy, and the tail is not likely to wag that dog to health.
In contrast, the latest JP Morgan global manufacturing report observes that “production and new orders both fell for the second month running in July, with rates of contraction gathering pace.” The chart below presents the global purchasing managers index (PMI), which has now weakened to levels last seen during the last two recessions.
With regard to Europe, it’s interesting how the semantics of the phrase “everything necessary” has been used to obscure the differences between Euro-area countries when it comes to monetizing bad debt. The distinction can be seen in a comment last week by German government spokesman Georg Streiter: “The ECB president said that the ECB will do everything necessary to preserve the euro and the government will do everything politically necessary to preserve the euro.” As long as the phrase is shortened to “everything necessary,” everyone is in agreement. The differences are in the subset of actions that constitute “everything.” For the German government, it is everything politically necessary. For Finland, it is everything necessary provided that collateral is pledged for every loan. For the German courts, it is everything legally necessary. While everyone can be unanimous about their commitment to doing “everything necessary,” it’s important to recognize that “everything” means something different to each party.
Even Mario Draghi had to resort to oxymorons to explain why the ECB did not initiate bond purchases last week despite what investors had taken as a pledge to do so, saying that the endorsement of bond purchases among ECB council members was “unanimous with one reservation” (he then left to enjoy some jumbo shrimp in a plastic glass, but they were found missing, leaving Draghi and his broken fix for an enduring Euro alone together in the deafening silence).
My impression regarding the Euro remains unchanged – liquidity will not durably counter insolvency, and the solvency problem among peripheral European countries is too great to be addressed without debt restructuring. ECB purchases of distressed sovereign debt would most likely have to be permanent purchases, and would therefore represent a fiscal transfer at the expense of stronger countries that would prefer to use the proceeds of money creation for the benefit of their own citizens. Doing those purchases indirectly – the ECB buying the debt of an ESM with a banking license, and the ESM buying distressed debt – does not change the arithmetic. Very reasonably, Germany is only willing to mutualize the debts of its neighbors if it can exert centralized authority over their fiscal policies – in Angela Merkel’s words “liability and control belong together.” But while Europe is geographically united, it is culturally and politically diverse, and a surrender of national sovereignty to the required extent is unlikely.
As a result, the Euro is likely to be pulled apart, and the tensions will probably be greatest across geographic and socioeconomic fault lines. From a geographic perspective, Finland (which insists on good collateral even for EFSF actions) and Italy (where popular sentiment against the Euro is strongest) have the greatest divide. From a socioeconomic standpoint, Germany (which is strongly anti-inflation and more oriented toward free enterprise) and the southern European states of Greece, Italy, Spain and Portugal (which have high debt ratios, heavily socialized economies, and very fragile banks) seem to be the furthest apart. The real question is who will get the Euro if the wish-bone snaps – the stronger more solvent states, or the weaker more inflation-prone states. Until the answer is clear, it will be difficult to anticipate the future direction of the Euro’s value. I would expect the least amount of systemic disruption in the event of an exit from the Euro by the stronger European countries, but that would also be associated with the maximum amount of Euro depreciation as the remaining members are left to inflate as they (and the ECB) please. All of this will be extraordinarily interesting, but it will not be easy.
As of last week, the Market Climate for stocks remained among the most negative 0.6% of historical observations, holding us to a tightly defensive stance. Strategic Growth remains fully hedged, with a staggered-strike position that raises the strike prices of the put option side of our hedge within a few percent of prevailing levels, at a cost of less than 2% of assets in time premium looking out to very late-2012. The Fund’s day-to-day returns can be expected to primarily reflect changes in the value of this time premium and day-to-day performance differences between the stocks held by the Fund and the indices we use to hedge. Strategic International also remains fully hedged. Strategic Dividend Value remains hedged at about 50% of the value of its stock holdings. Strategic Total Return continues to carry a duration of about one year in Treasury securities, with about 10% of assets in precious metals shares, and a small percentage of assets in utility shares and foreign currencies.
Copyright © Hussman Funds
Tags: Aunt Minnies, Bear Market, Bull Bear, Bull Markets, Erasers, Excess Return, Going All The Way, Horizons, Hussman, Hussman Funds, Investment Objectives, John Hussman, Market Advance, Market Losses, Naught, Necessary Feature, Risk Ratio, Syndromes, Treasury Bill, Trough, Valuations
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Monday, July 2nd, 2012
by John Hussman, Hussman Funds
In the first week of March, the U.S. stock market established a set of conditions placing it among the most negative 2.5% of historical observations (see Warning: A New Who’s Who of Awful Times to Invest) – a short list that includes the major peaks of 1972-73, 1987, 2000, and 2007. Since then, we’ve seen an increasing set of indicator syndromes that are associated with historically hostile market outcomes, maintaining us in a hard-defensive stance that is as rare as it is imperative. Last week, the market reconfirmed the “exhaustion syndrome” that I discussed several months ago (see Goat Rodeo). Prior to 2012, there were 112 weeks in post-war U.S. data where our investment strategy would have encouraged a similarly defensive position with that syndrome in place. Following those instances, the S&P 500 plunged at an average annual rate of -47.5%.
The trend-following components of our market action measures remain negative here, but it is important to note that those components are moderately – probably a small number of positive weeks – away from an improvement that could shift us from such a tightly defensive stance. While our outlook would not become bullish by any means, this shift would rein in the “staggered strike” put option hedges we presently hold in Strategic Growth. These positions (which raise the strike prices on the long-put portion of our hedges) substantially improve performance during market plunges, but make us vulnerable to the loss of put option premium during “risk on” advances such as we saw last week. That is uncomfortable even if the puts only represent a very small percentage of assets (as they do here).
Suffice it to say that we are most likely a single number of weeks away from either substantial market losses, or enough stabilization in market action to ease our defensiveness. In any event, we will not maintain our present stance indefinitely.
So far, hopes for massive bailouts and monetary interventions have allowed the market to forestall the more violent follow-through that it experienced in 1973-74, 1987, 2000-2002 and 2007-2009 from similar conditions. Yet the market impact from various monetary actions has become progressively weaker, and the exuberance from various “agreements” out of Europe has become progressively shorter. More importantly, in data spanning more than a century, including Depression, two world wars, rapid inflation, credit crisis, and numerous bubbles and crashes, we’ve seen that relevant global events show up in observable data such as market action, credit spreads, valuations, economic indicators, sentiment, and specific syndromes of conditions. As a result, we don’t need a “Euro breaks up” indicator, or a “Bernanke bubble factor” in our data set, nor do we need a live feed showing constantly refreshed CT-scans of Angela Merkel’s spine.
When the observable data shifts, so will our investment stance. We certainly struggled in 2009 and early 2010 to ensure that our methods were robust to Depression-era data, and the repeated bouts of monetary intervention have narrowed our criteria for establishing staggered-strike hedges, becoming more sensitive to trend-following factors than was necessary prior to 2009. The past few years would have been more comfortable if these adaptations had not been necessary, but they also leave us well-prepared to weather a broad range of potential outcomes, in the expectation of returns that resemble what we’ve achieved in other complete market cycles (e.g. peak-to-peak 2000-2007, trough-to-trough 2002-2009). Both the internet bubble and the housing and credit bubble offered plenty of temptation to believe in a “new era” where historically important market factors were irrelevant. The same temptation exists today despite accelerating global economic challenges. We remain just as unwilling to shift our investment discipline away from testable evidence, or to rely on a blind faith in policymakers to make risk simply go away.
Anatomy of a Bear
Last week, the market re-established the “exhaustion syndrome” that we observed several months ago. The associated rally was uncomfortable, not only because banks and financials advanced (where we hold very little exposure), but also because the advance took our staggered strike put option hedges from in-the-money to out-of-the-money while the CBOE volatility index dropped to just 17. It is easy to forget that we experienced much the same thing near the 2000 and 2007 market peaks. As I noted in the March Who’s Who piece: “A word of caution… When we look at longer-term charts like the one above, it’s easy to see how fleeting the intervening gains turned out to be in hindsight. However, it’s easy to underestimate how utterly excruciating it is to remain hedged during these periods when you actually have to live through day-after-day of advances and small incremental new highs that are repeatedly greeted with enthusiastic headlines and arguments that ‘this time it’s different.’ For us, it’s particularly uncomfortable on days when our stocks don’t perform in line with the overall market, or when the ‘implied volatility’ declines on our option hedges.”
Though our level of defensiveness will remain sensitive to any improvement in our measures of market action, my opinion remains that the global economy is entering a new recession, and that stocks are already in the beginning of a bear market. Because bull and bear markets can only be confirmed in hindsight, we prefer in practice to focus on the broad set of observable evidence at every point in time. Our investment stance is based on that evidence, not my views about recession or bear market status.
As veteran market analyst Richard Russell has noted, investors often equate the concept of a bear market with the expectation that prices will continuously fall. Indeed, if you think back to the 2000-2002 bear, or the 2007-2009 bear, that is probably the memory that those bear markets invoke. In fact, however, those bear markets can be seen on a smaller scale as a constant process of hope and disappointment, with periods of risk-seeking abruptly punished by fresh waves of risk-aversion. This can make it very difficult to live through a bear market day-after-day with a clear sense of the larger picture.
In an attempt to reinforce this picture, the following charts present the initial the 1973-74, 1987, 2000-2002, and 2007-2009 bear markets, respectively. For each period, the initial portion of the bear market is on the left side, while the complete decline is on the right side. Those complete declines represented market losses of about 50% from the highs, except for 1987 which was more abrupt but somewhat less extensive. The final chart shows the S&P 500 from early March through last week. Notably, each of those previous bears started from conditions that match the “Who’s Who” syndrome we observed in March of this year. The feature to notice about these early bear markets is that in each case, despite a hard initial decline, the market recovered within a few percent its bull market high at some point between 2-9 months after the bear market had already started. In effect, investors mounted an “exhaustion rally” despite already deteriorating market internals and rich valuations.
The unusually bad outcomes of similar historical precedents help to convey why we retain such a durable sense of doom, even after last week’s scorching “risk on” advance. Again, a moderate continuation of constructive market action would likely be sufficient to move us to soften our presently hard defense by retreating from a “staggered strike” option hedge. At present, conditions remain aligned with those that have preceded some of the most negative consequences in market history.
On Europe’s Plan to Have a Plan to Have a Memo of Understanding
The following is Friday’s statement from the EU (emphasis added):
“We affirm that it is imperative to break the vicious circle between banks and sovereigns. The Commission will present Proposals on the basis of Article 127(6) for a single supervisory mechanism shortly. We ask the Council to consider these Proposals as a matter of urgency by the end of 2012. When an effective single supervisory mechanism is established, involving the ECB, for banks in the euro area the ESM could, following a regular decision, have the possibility to recapitalize banks directly. This would rely on appropriate conditionality, including compliance with state aid rules, which should be institution-specific, sector-specific or economy-wide and would be formalised in a Memorandum of Understanding. The Eurogroup will examine the situation of the Irish financial sector with the view of further improving the sustainability of the well-performing adjustment programme. Similar cases will be treated equally.
“We urge the rapid conclusion of the Memorandum of Understanding attached to the financial support to Spain for recapitalisation of its banking sector. We reaffirm that the financial assistance will be provided by the EFSF until the ESM becomes available, and that it will then be transferred to the ESM, without gaining seniority status.
“We affirm our strong commitment to do what is necessary to ensure the financial stability of the euro area, in particular by using the existing EFSF/ESM instruments in a flexible and efficient manner in order to stabilise markets for Member States respecting their Country Specific Recommendations and their other commitments including their respective timelines, under the European Semester, the Stability and Growth Pact and the Macroeconomic Imbalances Procedure. These conditions should be reflected in a Memorandum of Understanding. We welcome that the ECB has agreed to serve as an agent to EFSF/ESM in conducting market operations in an effective and efficient manner.
“We task the Eurogroup to implement these decisions by 9 July 2012.”
The upshot here is that Spain’s banks are undercapitalized and insolvent, but rather than take them over and appropriately restructure them in a way that requires bondholders to take losses instead of the public, Spain hopes to tap European bailout funds so that it can provide capital directly to its banks through the European Stability Mechanism (ESM), and put all of Europe’s citizens on the hook for the losses. Spain has been trying to get bailout funds without actually having the government borrow the money, because adding new debt to its books would drive the country further toward sovereign default. Moreover, institutions like the ESM, the ECB, and the IMF generally enjoy senior status on their loans, so that citizens and taxpayers are protected. Spain’s existing bondholders have objected to this, since a bailout for the banks would make their Spanish debt subordinate to the ESM.
As a side note, the statement suggests that Ireland, which already bailed its banks out the old-fashioned way, will demand whatever deal Spain gets.
So the hope is that Europe will agree to establish a single bank supervisor for all of Europe’s banks. After that, the ESM – Europe’s bailout fund – would have the “possibility” to provide capital directly to banks. Of course, since we’re talking about capital – the first buffer against losses – the bailout funds could not simply be lent to the banks, since debt is not capital. Instead, it would have to be provided by directly purchasing stock (though one can imagine the Orwellian possibility of the ESM lending to bank A to buy shares of bank B, and lending to bank B to buy shares of bank A). On the question of whether this is a good idea, as opposed to the alternative of properly restructuring banks, ask Spain how the purchase of Bankia stock has been working out for Spanish citizens (Bankia’s bondholders should at least send a thank-you note). In any event, if this plan for a plan actually goes through, the bailout funds – provided largely by German citizens – would not only lose senior status to Spain’s government debt; the funds would be subordinate even to the unsecured debt held by the bondholders of Spanish banks, since equity is the first thing you wipe out when a bank is insolvent.
It will be interesting to see how long it takes for the German people to figure this out.
It bears repeating that our present defensiveness is not a reflection of European concerns or even our view that the U.S. economy is entering a recession. We try to align our investment position with the prospective return/risk profile that we estimate on the basis of prevailing market conditions, and those conditions are what keep us tightly hedged here. As noted earlier, a moderate further recovery in market internals would move us to reduce the tightness of our hedge, though it’s fair to say that the required improvement is not simply a stone’s throw away and would likely require at least a small number of positive weeks. Here and now, present conditions remain among the most negative in history from a prospective return/risk standpoint. Strategic Growth Fund remains tightly hedged, with a staggered strike position where the additional put option premium at risk represents about 1.8% of total assets. Strategic International also remains fully hedged, and Strategic Dividend has nearly 50% of its stock holdings hedged (its most defensive stance). Strategic Total Return continues to carry a duration of about one year, with about 14% of assets in precious metals shares, and a small percentage of assets in utility shares and foreign currencies.
Copyright © Hussman Funds
Tags: Action Measures, Anatomy, Defensive Position, Defensive Stance, Defensiveness, Exhaustion, Goat, Hedges, Hussman, Hussman Funds, Investment Strategy, John Hussman, Market Losses, Market Outcomes, Market Plunges, Post War, Put Portion, Rodeo, Substantial Market, Syndromes, U S Stock Market
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Thursday, May 3rd, 2012
by Guy Lerner, The Technical Take
The very erudite Dr. John Hussman is as good as a market researcher as there is, and he defines a set of market conditions that when they come together generally leads to poor equity performance. One of Hussman’s syndromes is the “overbought, over-bullish, overvalued, and rising yields syndrome.”
My own research would agree this assessment. The markets tend not to do well when yields are rising and when investor sentiment is overly bullish. These constructs have formed the basis of some of my most basic and robust trading models, and this combination of excessive investor bullishness and rising yields is at the core of my “Will Robinson” signal. Will Robinson was the young boy on the 1960′s TV show, “Lost in Space”, and when he was in danger, his robot friend would exclaim, “Danger, Will Robinson, danger!” So when I see this constellations of market findings, it is usually danger ahead for the equity markets.
So what does this have to do with the current market environment? From this perspective very little as I currently don’t find these conditions in the current market environment. Over the past couple of weeks, bullish sentiment (and market “over -boughtness”) has been unwinding slowly, and as my bond trading is positive (i.e., lower yields), I am not expecting yield pressures to be a factor. Valuations, as measured by the Shiller 10 year P/E ratio or cyclical adjusted PE ratio, remains lofty, yet truth be told, valuations are a poor market timing tool anyways.
But while Hussman is “right” about the “overbought, over-bullish, overvalued, and rising yields syndrome” and market weakness, the opposite set of conditions is probably a market positive. The current market environment shows more bulls than bears (but necessarily extreme) and falling yield pressures. Historically, this combination of factors has been associated with some of the more memorable price runs in recent market history. For example from March, 1995 to February, 1996 under similar conditions, the SP500 gained approximately 30%. There was a repeat from May, 1997 to May, 1998 when the SP500 gained 34%. This set of conditions were also seen at the 2003 market bottom, and the late 2006 through 2007 blow off market top. Needless to say, it does take bulls to make a bull market, and by the way, it does help to have falling interest rates. So maybe this is why investors are currently all lathered up.
But I would contend that you need to be careful for what you wish for as something has happened to the relationship between bonds and stocks over the past 2 years. In 2010 and 2011, falling bond yields have not been beneficial to equities. Rather, falling bond yields, as measured by bullish signals from our bond model, have been a sign of economic weakness, and have led to crushing (i.e., poor) returns in the equity markets. When bond yields were falling and when investors were more bullish than bearish, the SP500 had two draw downs exceeding nearly 15%. From the 1970′s to the late 1990′s it was rare (< 5% occurrence on 70 unique instances) for such market conditions to even have a draw down greater than 6%.
I suspect investors remember those good old days from the 1990′s when the Federal Reserve had the luxury to put the pedal to the metal and keep rates low despite extreme investor enthusiasm and market overvaluations. They don’t have that luxury now, and the only reason for the Fed to continue act in such a fashion is economic weakness. Our bond model is currently positive suggesting lower yields. While investors want to hark back to the “good old days”, I don’t think that is the correct interpretation. I believe this signal suggests economic weakness as it did in 2010 and 2011. This time is different as lower bond yields won’t see a blast off in equity prices.
Copyright © The Technical Take
Tags: Bond Trading, Bullish Sentiment, Constellations, Constructs, Current Market, Danger Will Robinson, Dr John, Guy Lerner, Investor Sentiment, John Hussman, Lost In Space, Market Environment, Market Researcher, Market Timing, Market Weakness, Pe Ratio, Robot Friend, S Tv, Syndromes, Timing Tool, Valuations
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Monday, March 12th, 2012
by John P. Hussman, Ph.D., Hussman Funds
As of last week, the market continued to reflect a set of conditions that have characterized a wicked subset of historical instances, comprising a Who’s Who of Awful Times to Invest . Over the weekend, Randall Forsyth of Barron’s ran a nice piece that reviewed our case (the chart in Barrons has a problem with the date axis, but the original chart is in last week’s comment Warning: A New Who’s Who of Awful Times to Invest). It’s interesting to me that among the predictable objections to that piece by bullish readers (mostly related to our flat post-2009 performance, but overlooking the 2000-2009 record), none addressed the simple fact that the prior instances of this syndrome invariably turned out badly. It seems to me that before entirely disregarding evidence that is as rare as it is ominous, you have to ask yourself one question. Do I feel lucky?
From our perspective, accepting stock market risk is not presently a venture that is priced to achieve reasonable investment returns (we estimate a likely 4.3% annual total return for the S&P 500 over the coming decade, and a great deal of volatility in achieving that return). Nor is market risk attractive on a speculative basis, given present overbought conditions, overbullish sentiment, and growing set of hostile syndromes (what we call Aunt Minnies) that have historically been associated with negative return/risk tradeoffs. Then again, what keeps slot machines spinning all around the world is the hope – despite the predictably and reliably negative average return/risk tradeoff – that this time will be different, and this spin will work out. So you have to ask yourself one question. Do I feel lucky?
Investors Intelligence notes that corporate insiders are now selling shares at levels associated with “near panic action.” Since corporate insiders typically receive stock as part of their compensation, it is normal for insiders to sell about 2 shares on the open market for every share they purchase outright. Recently, however, insider sales have been running at a pace of more than 8-to-1. Indeed, some of the weekly spikes have been to levels that are associated almost exclusively with intermediate market peaks, the most recent being the run-up to the 2007 market peak, the early 2010 peak, and the 2011 peak, all of which resulted in significant intermediate corrections or worse. Of course, it’s sometimes the case that insiders are early, and therefore miss part of the tail of a market advance. So it might be worth ignoring the heavy pace of insider selling for a little while. But you have to ask yourself one question. Do I feel lucky?
As disciplined investors who align ourselves with the average return/risk profile that is associated with prevailing market conditions, we don’t believe that this is a good time to take significant market risk in hopes of getting lucky. On an objective basis, we identify present conditions among the lowest 1.5% of historical periods in terms of overall return/risk profile. Maybe investors will get lucky, but the odds are still unfavorable.
It’s likely that for some investors, our defensiveness since 2009 bleeds into a general inclination to take our concerns about risk with a grain of salt. On that subject, it’s important to recognize that our defensiveness in 2009 did not result from unfavorable valuations or hostile indicator syndromes, but from the inability to distinguish prevailing conditions at the time from much of what was observed during the Depression-era. In response to the credit crisis, and what I continue to view as a misguided “kick-the-can” policy response, I insisted that our methods should perform well with reasonable drawdowns not only in post-war data, but also in Depression-era data (when for example, stocks lost two thirds of their value even after they were priced to achieve 10-year total returns in excess of 10% annually).
The resulting ensemble methods allow us to make distinctions that we were not able to make in 2009, but that period of stress-testing also left us with a “miss” (2009-early 2010) when the same indicators and methods that are so hostile today would have been much more favorable toward investment risk. One could ignore that fact, and use our miss in 2009 as a reason to ignore demonstrably hostile evidence today. But one would also have to overlook the fact that the narrow syndrome of conditions we observe today mirrors what we observed at the 2000 peak and the 2007 peak, and very few times in-between (including the 2010 peak and the runup to the 2011 peak – see last week’s comment for a chart). Notably, whatever market returns we missed by being defensive too early in those instances were wiped out in short order anyway during the subsequent declines. Yes, stocks might move even higher before the present bull-bear cycle moves to completion. But you have to ask yourself one question. Do I feel lucky?
A note on extracting economic signals
While investors and the economic consensus has largely abandoned any concern about a fresh economic downturn, we remain uncomfortable with the divergence between reliable leading measures – which are still actually deteriorating – and more upbeat coincident/lagging measures on which public optimism appears to be based.
Much of our research effort in recent weeks has been focused on developing a deeper understanding of this divergence. The historical evidence clearly indicates that such divergences are settled in favor of the leading indicators (see last week’s economic discussion in Warning: A New Who’s Who of Awful Times to Invest ), but since our views are so out of sync with the broad consensus, the issue demands as much additional investigation and research as we can amass. It bears repeating we neither desire a recession, nor have any interest in “pounding the table” about it. We would rather have the data convincingly shift to a condition that eases our recession concerns. But if we’re likely to have a recession, we don’t want to be surprised or lulled into complacency by improvement in what are largely lagging indicators.
Probably the best, if slightly technical, way to understand our reluctance to discard recession concerns is to think about observed economic data as being driven by a series of unobserved “true” states of the economy. For example, suppose that the true underlying state of the economy can be summarized by a single positive or negative number each month, call it X(t), and that each economic indicator we can actually observe is driven by a series of those current and past monthly economic states. So for example, some variable that we can observe might be written as a series of unobserved economic states:
Y(t) = a0*X(t) + a1*X(t-1) + a2*X(t-2) + …. + a “shock” from truly new developments and random noise.
[Geek's note - this is a version of an unobserved components model, of the kind used in nearly every modern signal-processing application. For example, when you go to the hospital to get a CT scan, the picture you see is not actually "taken" directly. Instead, the machine shoots X-rays at you from every possible angle, and then uses all of that sensor data to compute an image that could never have been obtained directly. That's why it's called computed tomography (CT). If signal processing methods weren't applied, every image of an internal organ would be obstructed by artifacts from bone, cartilage and other organs. Similar signal processing methods are used to combine data from multiple sensors in order to navigate anti-ballistic missiles and other objects that can't be directly observed (and of course, to identify meaningful genetic signals in autism data)].
Leading indicators essentially place weight on the unobserved true state a few months into the future (allowing that state to be estimated today based on those observed indicators), while coincident and lagging indicators load on previous components. To see what this looks like, the following chart presents the load factors we estimate for dozens of widely followed economic variables, including one-month, 6-month and year-over-year employment gains, new unemployment claims, real consumption growth, ISM data, consumer confidence, quarterly and year-over-year GDP growth, stock returns, credit spreads, OECD leading indices, and a score of other measures. Notice that most of the variables load not on the first (most leading) economic state variable, but instead on the fourth or fifth component. That’s another way of saying that most observed economic variables actually lag the best leading indicators by several months. A good example is year-over-year growth in payroll employment, which trails year-over-year growth in real consumption with a consistent lag of about 5 months.
So what do the unobserved components look like today? In the chart below, the green line shows the average standardized value (mean zero, unit variance) of dozens of economic variables, and provides a very good summary of what can be observed directly. Note that this observable data has enjoyed a clear bounce in recent months. The blue line presents estimates of the unobserved economic states that drive the observable data. Importantly, the extracted signals lead the observed economic composite by several months. This is really simply a reflection of the underlying structure of the data – leading indicators lead, and lagging indicators lag (the full analysis uses data since 1950, but the lead of a few months is hard to distinguish visually on a long-term chart).
The most recent estimates we obtain for the extracted economic signal (most recent first) are as follows:
What strikes me about these estimates is short-lived spike in the implied economic signal between September and November. My thinking on the recent improvement in economic data was that it was primarily driven by the large intervention by the ECB near the end of last year. But even when we estimate the parameters of the model using half the data set, and then run true out-of-sample estimates of the economic signal through the present, we still get that burst of improvement in the September through November period. What’s interesting about that improvement was that it was not driven by any obvious shift in the observable data. Rather, the spike was driven by the failure of the data to deteriorate during that period to an extent that would have been expected, given the trajectory of the economic state (this is similar to shifting your expectation for a bird’s flight path not because it turned, but because it failed to turn as much as expected).
In that context, we can see that the improvement in the observable data in recent months has faithfully followed the improvement in that underlying state, which actually happened months ago. Since then, however, the estimated state has deteriorated to a point that is now worse than it was last July.
This is important, because given the deterioration in the inferred economic condition between October and December, it follows that we would expect to see a clear deterioration in observable economic variables over the next 8-12 weeks. If the trajectory holds, the weakness is likely to emerge slowly and then accelerate. For example, the preliminary expectation would be for continued positive payroll growth in March (roughly 50,000-70,000 jobs) and a shift to net job losses in April.
Equally important, to the extent that we observe economic variables coming in better than expected, the inferred underlying state of the economy is likely to improve sharply, as it did last September. This will take a few months of data, but it’s not going to require quarters and quarters of it. At present, we have to view the economic situation negatively, but on the optimistic side, we should also be able to abandon our own recession concerns if the observable data move off of the trajectory that we’ve imputed to-date. On this, leading measures such as consumption growth and OECD leading indices will be most important in driving our estimates of future prospects, while the employment data over the next few months will be useful in confirming the downturn we’ve seen in the inferred state estimates since November.
As noted above, the Market Climate for stocks remains among the most negative 1.5% of historical instances. This time may be different. We see no reason to expect so other than the hope of being lucky. Still, one thing is certain, and that is that present conditions will be impermanent. With certainty, market conditions will shift in a way that removes the present syndrome of overvalued, overbought, overbullish conditions. We don’t know whether that shift will involve a moderate retreat that removes the overbought and overbullish aspects, or a major decline that removes the overvaluation, or just maybe with a further advance that then corrects enough to clear this syndrome at a higher level than the market is today. Conditions might improve without a major breakdown in market internals, or they may improve by a firming of market internals following an extended period of weakness. But with certainty, market conditions will shift in a way that provides us an opportunity to accept market risk at a positive and favorable expected return/risk tradeoff.
Also, with certainty, the present divergence between leading economic measures and coincident/lagging measures will also be resolved. While the historical likelihood is that the coincident and lagging measures will follow the leading measures, we also know that our estimates of the underlying state of the economy could shift quickly in the coming months simply in response to an economy that achieves moderate positive growth, and thereby deviates from what is now an unfavorable projected trajectory.
For now, Strategic Growth and Strategic International remain tightly hedged. Strategic Dividend Value is hedged in an amount equal to 50% of its equity holdings (which is the largest hedge the Fund can establish, but which also leaves the Fund more exposed to general market fluctuations in both directions). Strategic Total Return also remains relatively conservative here, with a duration of about 3.5 years in Treasury securities, and a very small percentage of assets in precious metals shares, utility shares and foreign currencies.
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