Are Stocks Cheap? A Review of the Evidence

Friday, May 10th, 2013

Are Stocks Cheap? A Review of the Evidence
Fernando Duarte and Carlo Rosa , New York Fed

May 8, 2013

We surveyed banks, we combed the academic literature, we asked economists at central banks. It turns out that most of their models predict that we will enjoy historically high excess returns for the S&P 500 for the next five years. But how do they reach this conclusion? Why is it that the equity premium is so high? And more importantly: Can we trust their models?
The equity risk premium is the expected future return of stocks minus the risk-free rate over some investment horizon. Because we don’t directly observe market expectations of future returns, we need a way to figure them out indirectly. That’s where the models come in. In this post, we analyze twenty-nine of the most popular and widely used models to compute the equity risk premium over the last fifty years. They include surveys, dividend-discount models, cross-sectional regressions, and time-series regressions, which together use more than thirty different variables as predictors, ranging from price-dividend ratios to inflation. Our calculations rely on real-time information to avoid any look-ahead bias. So, to compute the equity risk premium in, say, January 1970, we only use data that was available in December 1969.

Let’s now take a look at the facts. The chart below shows the weighted average of the twenty-nine models for the one-month-ahead equity risk premium, with the weights selected so that this single measure explains as much of the variability across models as possible (for the geeks: it is the first principal component). The value of 5.4 percent for December 2012 is about as high as it’s ever been. The previous two peaks correspond to November 1974 and January 2009. Those were dicey times. By the end of 1974, we had just experienced the collapse of the Bretton Woods system and had a terrible case of stagflation. January 2009 is fresher in our memory. Following the collapse of Lehman Brothers and the upheaval in financial markets, the economy had just shed almost 600,000 jobs in one month and was in its deepest recession since the 1930s. It is difficult to argue that we’re living in rosy times, but we are surely in better shape now than then.

The next chart shows a comparison between those two episodes and today. For 1974 and 2009, the green and red lines show that the equity risk premium was high at the one-month horizon, but was decreasing at longer and longer horizons. Market expectations were that at a four-year horizon the equity risk premium would return to its usual level (the black line displays the average levels over the last fifty years). In contrast, the blue line shows that the equity risk premium today is high irrespective of investment horizon.

Why is the equity premium so high right now? And why is it high at all horizons? There are two possible reasons: low discount rates (that is, low Treasury yields) and/or high current or future expected dividends. We can figure out which factor is more important by comparing the twenty-nine models with one another. This strategy works because some models emphasize changes in dividends, while others emphasize changes in risk-free rates. We find that the equity risk premium is high mainly due to exceptionally low Treasury yields at all foreseeable horizons. In contrast, the current level of dividends is roughly at its historical average and future dividends are expected to grow only modestly above average in the coming years.

In the next chart we show, in an admittedly crude way, the impact that low Treasury yields have on the equity risk premium. The blue and black lines reproduce the lines from the previous chart: the blue is today’s equity risk premium at different horizons and the black is the average over the last fifty years. The new purple line is a counterfactual: it shows what the equity premium would be today if nominal Treasury yields were at their average historical levels instead of their current low levels. The figure makes clear that exceptionally low yields are more than enough to justify a risk premium that is highly elevated by historical standards.

But none of this analysis matters if excess returns are unpredictable because the equity risk premium is all about expected returns. So…are returns predictable? The jury is still out on this one, and the debate among academics and practitioners is alive and well. The simplest predictive method is to assume that future returns will be equal to the average of all past returns. It turns out that it is remarkably tricky to improve upon this simple method. However, with so many models at hand, we couldn’t help but ask if any of them can, in fact, do better.

The table below gives the extra returns that investors could have earned by using the models instead of the historical mean to predict future returns. For investment horizons of one month, one year, and five years, we pick the best model in each of the four classes we consider together with the weighted average of all twenty-nine models. We compute these numbers by assuming that investors can allocate their wealth in stocks or bonds, and that they are not too risk-averse (for the geeks again, we solved a Merton portfolio problem in real time assuming that the coefficient of relative risk aversion is equal to one). The table shows positive extra returns for most of the models, especially at long horizons.

At face value, this result means that the models are actually helpful in forecasting returns. However, we should keep in mind some of the limitations of our analysis. First, we have not shown confidence intervals or error bars. In practice, those are quite large, so even if we could have earned extra returns by using the models, it may have been solely due to luck. Second, we have selected models that have performed well in the past, so there is some selection bias. And of course, past performance is no guarantee of future performance.

Disclaimer
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

Tags: New York Fed, Stocks, Valuations
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Sam Zell: “The Stock Market Feels Like The Housing Market Of 2006″

Thursday, April 11th, 2013

Instead of the endless procession of “different this time”, “buy-the-dip”, “money-on-the-sidelines” asset-gathering, Muppet-fleecers that CNBC so typically trots out, Sam Zell graced them with his presence and the truth was allowed a voice for a few minutes. Joined by David Rosenberg, who clarifies the insanity that engulfs US equities, explaining in wonderment that it is “not surprising the market rises even in the face of bad ISMs, worse jobs, and worst NFIB data, because Japan and the US are embarking on a gargantuan quantitative easing that is the lynchpin behind the stock market.” It is not about being bullish, or bearish, or agnostic, it is understanding the driver of this market – and that is not the economy, not earnings, “it is the mother of all liquidity-driven rallies.” Maria B, soundbite in hand, is slammed for her “glibness” at not fighting the Fed but it is Sam Zell’s brutal honesty that shocks even the money-honey. “This is a very treacherous market,” Zell explains – thanks to the giant tsunami of liquidity, “the problems of 2007 haven’t been dealt with,” and given the poor macro data and earnings, “we are suffering through another irrational exuberance,” leaving the entire CNBC audience speechless when he concludes, “the stock market feels like the housing market of 2006.”

Maria B:

“So don’t fight the Fed?“

Rosenberg:

“That’s a pretty glib comment for what is going on. You could have fought the Fed in 2000 and 2009 and done quite well… [thanks to the Fed] the market will tend to drift up - until something breaks.”

Zell:

“We’re debasing our currencies around the world.. which ultimately translates into a lot of inflation.”

“What we are seeing here is like a giant tsunami of liquidity.”

“People look at the market and think things are better. The level of uncertainty has reached a point where people are just throwing money [at risky assets] because they don’t know what else to do with it.”

“I would not be adding money to the stock market. This is a very treacherous market.”

“Yes, it’s gone up every day. Yes, you’re not supposed to fight the Fed, but sitting on the sidelines is preferable.”

“In our businesses, we are not seeing strong conditions.”

“The problems leading up to 2007 haven’t been dealt with.”

Then at 6:00

Zell:”The current stock market feels like the housing market of 2006. Everybody can’t afford to miss it.”

Maria B: “That’s a scary comment.”

Zell: “Why? Every single day it goes up. What were the headlines in 2006 – housing prices going up every day. What are you talking about every day now – new high in stocks every day!”

“We are suffering through another irrational exuberance.”

Tags: Housing Market, Sam Zell, Stock Market, Valuations
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Begging for Trouble (Hussman)

Monday, August 13th, 2012

Begging for Trouble

by John P. Hussman, Ph.D., Hussman Funds

With the daily focus on European crisis and the hope of central bank intervention, one of the essential features of the investment climate – at least for long-term investors – is easy to lose in the shuffle. That feature is valuation. It’s an easy concern to overlook, because with corporate profit margins close to 70% above historical norms (largely because of unsustainably large government deficits coupled with low private savings rates – see Too Little to Lock In), Wall Street is quite happy to look at the ratio of prices to near-term earnings estimates and conclude that valuations are satisfactory. But stocks are not a claim on one year of earnings. They are a claim on a very long stream of cash flows that will actually be delivered into the hands of investors. Unfortunately, the conclusion that stocks are appropriately valued rests on the implicit assumption that profit margins will remain elevated into the indefinite future.

We presently estimate a projected 10-year total (nominal) return for the S&P 500 of less than 4.6% annually. Nothing in recent years, much less the past decade, indicates any material change in the relationship between actual market returns and expected market returns as we estimate them using a range of fundamentals including normalized earnings. Indeed, the 5.1% total return of the S&P 500 over the most recent 10-year period has been right on target (see also my July 7, 2002 comment). It’s notable that even without compelling valuations a decade ago, we lifted 70% of our hedges several months later in early 2003, at what turned out to be the start of the next bull market – something to remember for those who misunderstand our two-data sets issue of 2009-early 2010 and assume that we’ll never lift our hedges until the market is deeply undervalued.

I anticipate that a decade from now, the S&P 500 will have achieved a total return that is very weak from a long-term perspective. Remember also that you don’t “lock in” a 10-year return. You ride it out. I continue to expect that investors will have numerous opportunities to accept risk in the coming years in expectation of much better prospective returns than are presently likely.

Of course, with the yield on the 10-year Treasury bond at just 1.6%, one might argue that a prospective 10-year return of nearly 4.6% on stocks is still very good by comparison, and should be enough to prevent any substantial adjustment to lower prices and higher prospective returns. To inform that argument, I’ve added the 10-year Treasury bond yield to our standard chart below. Note that the correlation between 10-year S&P 500 returns and 10-year Treasury bond yields (which reflect both expected and actual 10-year returns, provided no default occurs) is just 0.1. There is virtually no relationship at all, with the exception of the early-1980’s, when the prospective and actual returns were quite high for both as a result of inflation shocks.

While the simultaneous rally in both stocks and bonds from the early 1980’s through the late-1990’s gave the illusion that the 10-year bond yields and forward operating earnings yields had a precise point-for-point relationship, spawning an unfortunate little cottage industry of adherents to the “Fed Model”, this model is based entirely on the relationship between stock yields and bond yields during a specific 16-year period of sustained disinflation, and there is no evidence – or even sound theory – supporting that spurious one-to-one correlation more generally.

Why aren’t the 10-year returns of stocks and bonds (prospective or actual) more closely related? The reason is simple, really. 10-year bonds have an effective duration of only about 7-8 years, depending on the coupon, which means that your ending wealth is nearly completely determined within that horizon. In contrast, stocks are very long-term assets, with an effective “duration” roughly equal to the price/dividend ratio*, which means that changes in valuation dramatically affect the terminal value of your investment even for horizons out to 30-40 years, and sometimes longer when valuations are rich and yields are low.

[*Geek’s note: You can derive this by differentiating the Gordon growth model P = D/(k-g) with respect to k, and calculating the elasticity of price to changes in the gross return: (dP/P)/{dk/(1+k)}].

Consider investors who bought stocks back in 1999 when the price/dividend ratio was 70. Those investors were assured that the value of their investment would be dramatically affected by even very small changes in yields. The S&P 500 has now underperformed Treasury bills for over 13 years – even when recent market advance is included. If the S&P 500 indeed achieves a total return of 4.6% annually over the coming decade, those investors will have achieved a 23-year total return of just 3.2% annually. But even if the S&P 500 achieves a 10% annual return over the next decade, the 23-year total return for those investors would still only work out to 5.6% annually. When investors commit funds at rich valuations, the inevitable return to more normal valuations matters, and it matters for a very long time.

The most controllable determinants of investment returns are the level of valuation at which investors choose to initiate their investment and the level of valuation at which they choose to terminate their investment. Once you choose to initiate your investment at a rich level of valuation, you require a rich terminal valuation at some point in the future – and the good fortune to sell at that point – in order to achieve an acceptable long-term return. At present, rich valuations promise a very challenging decade for stock market investors, regardless of any fleeting short-term relief that monetary policy might provide.

Keep this in mind – when the market is deeply oversold and market internals are demonstrating positive divergences and recruiting favorable breadth, it can be sensible to accept market risk despite uncompelling valuations, as we did in early 2003. But speculating in a richly valued market where internals are showing increasing divergences, and the environment features an exhaustion syndrome and other historically dangerous conditions (see An Angry Army of Aunt Minnies) – is just begging for trouble.

Begging for Trouble

Investors remain so addicted to the temporary high of monetary intervention that they continue to ignore very real downturn in global economic indicators, to an extent that we have not seen since the 2007-2009 recession. This is particularly evident in the deterioration of new orders and order backlogs, which are short-leading indicators of production, which in turn is a short-leading indicator of employment.

Trading volume has been unusually low, while a 14-handle on the CBOE volatility index also suggests unusual complacency.  It’s understandable that people are reluctant to place trades in a weakening economy, yet one where quantitative easing is widely expected. Wall Street is scared to death of being out of the market when the perceived salvation of QE3 is announced, and at the same time is increasingly encouraged by negative economic data in the belief that this will accelerate delivery. In short, investors are practically begging to be shot, mauled by dogs, and diced by a Veg-O-Matic so they can get their next fix of pain-killers.

The chart below shows the average standardized value (mean zero, unit variance) of the overall, new orders, and order backlogs components of numerous regional surveys from the Federal Reserve and the Institute of Supply Management (ISM). We observe the same sustained deterioration in economic data across the world, including Europe and China (where the absolute values are higher, but the standardized values are similarly bad). The overall pattern reflects what Lakshman Achuthan of ECRI often describes as the “three P’s” – pronounced, pervasive, and persistent. Those three P’s help to distinguish signals from noise. Presently, our own noise-reduction methods suggest that a global recession is at hand.

One problem with the widespread faith in QE3 is that quantitative easing has had very weak and temporary effects on real economic activity or employment. Regional Fed governors like Eric Rosengren (Boston), John Williams (San Francisco) and others have increasingly advocated another round of quantitative easing, feeling extreme pressure for the Fed to “do something” about the economy. But as I’ve asked before, suppose that Ben Bernanke announces that he is going to stop spitting watermelon seeds into a can. Should we all become concerned that the Fed is suddenly not doing enough to stimulate the economy? Well, only if you think that spitting watermelon seeds into a can is stimulative.

Unfortunately, the impact of QE has been almost exclusively restricted to marginal changes in interest rates that have little effect on economic activity, and provoking temporary speculative bouts in the financial markets. This ineffectiveness has been predictable, not only because of the very weak relationship between GDP growth and stock market changes (a 1% change in stock market value has historically been associated with just a 0.03-0.05% change in GDP), but also because – drumroll – with trillions of idle reserves already sloshing around in the banking system, QE doesn’t relax any constraint that is actually binding on the economy.

The typical effect of QE-induced speculative runs has been little more than to help the stock market recover the decline that it experienced over the prior 6-month period (see What if the Fed Throws a QE3 and Nobody Comes?). In effect, QE is a policy that has negligible effects on the real economy, and is effective only in suppressing spikes in risk premiums and supporting the stock market after hard declines. We should not be surprised if it turns out to be fairly ineffective in lowering risk premiums when they are already depressed, reducing interest rates that are already near record lows, or supporting stock prices that are already quite elevated. Needless to say, the Fed is virtually certain to initiate another round of QE3. But the fact that it is needless to say this should be of some concern, because it suggests that the intervention is already fully discounted.

The suspended animation of the market here is very reminiscent of the similar suspension that occurred in 2008, as the markets eagerly awaited the near-certain passage of the Troubled Assets Relief Program (TARP). If you recall, within one minute of the passage of that bill by the House of Representatives, the stock market entered a free fall. Buy the rumor, sell the news.

Given the spike in risk premiums across Spanish and Italian debt, it is clear that a round of massive bond purchases by the European Central Bank would come as quite a relief to those debt markets and the European stock market. So massive ECB purchases would almost certainly have greater short-run impact than another round of QE by the Fed. But ECB monetization of distressed European debt is a policy that is still vehemently opposed by stronger European countries, and even what has been done already dabbles at the very edge of German constitutional law.

I continue to expect that the Euro will eventually break apart, and that it would be least disruptive for the stronger countries (Germany, Finland, Holland, etc) to exit first, allowing the remaining countries to print money and depreciate the Euro as they desire. The reason is that existing contracts in Euro could still be honored, without the massive corporate and private defaults that would occur if peripheral countries had to revert back to their previous national currencies and yet have to honor contracts in a dramatically stronger currency.

In my view, it is unwise to dismiss the possibility that the stronger European countries will split off either into their pre-Euro currencies, or into a new common currency with a more restricted membership. That is essentially what the sovereign bond markets foreshadow. Government bonds in Finland, Germany, Holland and several other countries are presently sporting negative interest rates, with German yields reaching record negative levels just last week. As Ray Dalio of Bridgewater recently wrote, “we think that there are good reasons to doubt that European bank and sovereign deleveragings will be prevented from progressing to the next stage in a disorderly way, without a viable Plan B in place. This fat tail event must be considered a significant possibility.”

For the United States, the main force of policy here should be on measures to ensure that the financial system is as immunized as possible from deterioration in the European banking system. On that front, Reuters reported last week that major banks have been directed to develop plans in the case of a renewed credit crisis.

With regard to the preparation of the U.S. financial system, I remain skeptical, but am somewhat more hopeful than I was a few years ago. Part of the Dodd-Frank act was the creation of an Orderly Liquidation Authority (OLA) to resolve too-big-to fail banks (Systemically Important Financial Institutions or SIFIs). The objective is to preserve large financial firms as going concerns in the event of insolvency, while ensuring that shareholders and creditors bear all the losses and customers and depositors are protected. The mechanics: following receivership, a temporary bridge company would be created, the FDIC would write down the assets to market value, old equity would be written off, and liabilities would be transferred by seniority (senior secured debt first) until the  bridge company had 10% equity. Remaining debt would be exchanged for equity in the new company.

The JP Morgan resolution plan provides a good example of how this would work. Notably, JP Morgan’s illustration suggests that an after-tax loss of $50 billion (just 2.2% of total assets) could be sufficient to take the company to insolvency, driving the company to a negative $16 billion equity position (h/t DailyBail). How could that happen? The example presented by JPM assumes two additional driving changes: a deposit run of 20%, which would be a substantial reduction in deposits, but certainly not unprecedented in other banking crises; and a $150 billion mark-down of asset values by the FDIC upon creation of the bridge company. Now, I’ve been quite critical of the 2009 FASB ruling that removed the need for banks to mark their assets to market, but a difference of $150 billion between the reported value of assets and the value that would be recognized in a reorganization? That would represent about 80% of the equity presently reported by JPM. One hopes that this figure has no relationship to reality.

Market Climate

As of last week, our estimates of prospective return/risk for stocks remained in the most negative 0.6% of historical observations, based on a blend of horizons from 2-weeks to 18-months. Strategic Growth remains fully hedged, with a “staggered strike” position that raises the strike prices of the put side of that hedge closer to market levels, presently representing about 1.6% of assets in time premium looking out toward year-end. Strategic International also remains fully hedged. Strategic Dividend Value is hedged at 50% of assets – it’s most defensive position. In Strategic Total Return, we used the spike in yields last week to very slightly increase the duration of the Fund to about 1.8 years. About 10% of assets remain in precious metals shares, with a few percent in utility shares and foreign currencies.

Copyright © Hussman Funds

Tags: Amp, Cash Flows, Central Bank Intervention, Corporate Profit, Daily Focus, Dalio, Earnings Estimates, Government Deficits, Hedges, Hussman, Hussman Funds, Implicit Assumption, Investment Climate, Material Change, Norms, Private Savings, Profit Margins, Shuffle, Target, Term Earnings, Term Investors, Valuations
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CASSH-ing In

Wednesday, August 8th, 2012

Last fall, I introduced the concept of investing in the CASSH countries– Canada, Australia, Switzerland, Singapore and Hong Kong. This theme has played out well year-to-date, and I still believe these smaller countries are likely to outperform broader global benchmarks over the long term. Let me explain why.

First, while larger developed countries have struggled with anemic growth and high debt burdens, the CASSH countries are in much better condition with relatively low debt, small deficits, and less traumatized labor markets.

Despite the outperformance, the CASSH countries still exhibit valuations generally below the larger developed regions. On both a price-to-book and price-to-earnings basis, the CASSH countries are, on average, about 10% cheaper than the average valuation of the United States, Europe, and Japan.

In addition, for investors looking for income, a basket of CASSH countries provides a respectable dividend yield. The average dividend yield on the CASSH countries – which is an equal weighted average of all the CASSH countries — is roughly 3.50% based on Bloomberg data as of July 31. That is about 1% higher than the average rate on the larger developed regions.

One objection we sometimes hear is the assertion that the CASSH countries are just a commodity play. However, while Canada and Australia both have large weights to commodity-driven sectors, this does not hold true for the group as a whole. Hong Kong and Singapore are largely driven by financials, and Switzerland has a significant weight to defensive sectors, specifically pharmaceuticals and consumer staples.

A strategy that I like to use is to underweight some of the larger developed regions, particularly southern Europe, and use that to fund a long-term overweight to the CASSH countries.

For investors seeking exposure to these countries, I would suggest looking at the iShares MSCI Australia Index Fund (NYSEARCA:EWA), or the iShares MSCI Canada Index Fund (NYSEARCA:EWC), the iShares MSCI Hong Kong Index Fund (NYSEARCA:EWH), the iShares MSCI Singapore Index Fund (NYSEARCA:EWS) or the iShares MSCI Switzerland Index Fund (NYSEARCA:EWL).

Source: Bloomberg

The author is long EWA, EWC, EWH, EWS and EWL

Russ Koesterich, CFA is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog. You can find more of his posts here.

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Securities focusing on a single country may be subject to higher volatility.

Index returns are for illustrative purposes only and do not represent actual iShares Fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. For actual iShares Fund performance, please visit www.iShares.com or request a prospectus by calling 1-800-iShares (1-800-474-2737).

There is no guarantee that dividends will be paid in the future.

Tags: Assertion, Australia Index, Canada Australia, Canada Index, Consumer Staples, Debt Burdens, Developed Countries, Dividend Yield, Ewa, Ewc, Global Benchmarks, Index Fund, Ishares Msci, Koesterich, Labor Markets, Outperformance, Southern Europe, Switzerland Singapore, Valuations, Weighted Average, Year To Date
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Erasers (Hussman)

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.

Economic Notes

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.

Market Climate

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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Equity Implications for a Modest-Return World

Monday, July 30th, 2012

by Andrew Pyne, PIMCO

• Equity valuations appear reasonable, but volatility is likely to remain elevated amid slowing global economic growth and macroeconomic risks.
• As macro events drive markets, the probability of fundamental mispricing increases, providing opportunity for active managers to add value.
• Investors should consider increasing exposure to emerging markets, deploying downside-risk and volatility-mitigation, emphasizing dividends and focusing on active share.

PIMCO’s secular outlook calls for slowing global economic growth, a world that is still multi-speed, and unresolved macroeconomic risks that are likely to result in continued heightened volatility. While our view on the economy is a cautious one, overall equity valuations appear reasonable, and corporate fundamentals, as measured by earnings, margins and balance sheets, are relatively attractive. The outlook for equities, then, can be expressed as a tug of war between these macro headwinds and micro fundamentals.

What does this mean for equities, which are still the dominant risk in investor portfolios? Overall, we believe that continued policy confusion and economic fundamentals that are trending in a negative direction will create headwinds. As the developed world continues to delever, we expect global equities to experience a modest-return environment.

Challenges and solutions

The clear implication is that this creates a challenge for investors. Most investors historically have relied on equities to help achieve their target portfolio returns. In this environment, though, beta is unlikely to deliver the returns required. We believe that investors should consider the following:

• Increase exposure to faster-growing economies. Many portfolios should be more global with higher allocations to emerging markets.
• Incorporate downside-risk and volatility-mitigation to address the higher probabilities of negative macro events.
• Emphasize dividends, which will likely be a more important component of equity total returns.
• Take greater active risk and focus on active share. In a modest-return world, if beta doesn’t get the job done, then alpha may be a significant percentage of an investor’s equity returns.

Multi-speed world

The key risk to the global economy is Europe, which given significant structural challenges and policy uncertainty is facing prolonged subdued growth and the risk of recession. Why then do we suggest equity portfolios be more global? The answer lies partly in the way equities have traditionally been categorized. Companies are often classified by their country of domicile, but we think they are better defined by their end-markets. Despite significant risks at home, many European multinationals have meaningful exposure to emerging markets. If we find businesses with stable cash flows, high dividend yields, strong end-market growth – and with valuations that discount home-market risks – these can be attractive investment opportunities.

In addition, we believe most investors, particularly those with a home-market bias, would benefit from increased direct exposure to emerging markets. While emerging markets are certainly not immune to the struggles of the developed world, emerging markets and developed markets face very different economic scenarios. We expect emerging markets to continue to gain share of global GDP, but most investors are still underweight the asset class. We expect emerging markets to account for more than 50% of global GDP in purchasing power parity terms over the next three to five years. They already are about a third of global equity market caps. Yet emerging market equities represent only about 7% of the average investor’s portfolio.

Managing macro risks

Our second suggestion is to prioritize downside- and volatility-mitigation in equity portfolios. Correlations among stocks have increased meaningfully over the past few years; they’ve tended to spike around negative macro events and decrease as uncertainty subsides (see Figure 1). This suggests that the “risk-on/risk-off” sentiment that drives stock prices is often governed by macro news flows, not company fundamentals.

There are two takeaways for investors. The first is that macro does impact stock prices, and so while equity investing has traditionally been thought of as a bottom-up endeavor, we believe managers need to consider both bottom-up and top-down views as part of their research process.

The second takeaway is that because there are unresolved macro risks, investors must recognize that, given the way returns compound over time, protecting on the downside could be a critical contributor to long-term returns. Part of the solution may be increasing allocations to active mandates from passive. Although investors could lose more with an active approach, by definition traditional indexes will capture 100% of down-market performance.

We believe protecting on the downside requires a very active approach. Strategies including low-volatility and dividend-focused investing, tail-risk hedging, and flexibility to short stocks or raise cash, may result in improved risk mitigation compared with a passive strategy.

Dividend income

Dividend income, a significant portion of historical equity returns, is likely to be even more important in an environment of slower growth. Of course, if we were expecting broad multiple expansion and strong global growth – as we saw in the ‘80s and ‘90s – then the message simply would be “buy equities and enjoy the ride.” As Figure 2 shows, however, dividends often have been a substantial portion of total equity performance during periods of modest returns. While many investors’ assumptions and expectations for equities were formed by the 20-year bull market of the ‘80s and ‘90s, the ‘40s, ‘60s and ‘70s may be more instructive for the period ahead.

We also believe the opportunity for dividend-paying stocks is more of a global story than a U.S. one. Given demand from U.S. investors for income, traditional dividend-paying sectors in the U.S. – telecom, utilities, Real Estate Investment Trusts (REITs), and Master Limited Partnerships (MLPs) – are generally quite expensive, whereas select non-U.S. equities, including emerging markets, remain attractive sources of yield.

Essential alpha

Two points outlined above – the notion that macroeconomic news flow influences stock prices and the expectation for modest returns – each reinforce the importance of alpha in helping investors achieve their goals. As macro events drive markets, the probability of fundamental mispricing increases, providing opportunity for active managers to add value. The key is to be highly selective, identifying the long-term winners even as the markets are indiscriminate in the short term.

For many investors, the importance of alpha should prompt a reconsideration of the mix of passive and active equity allocations. At the very least, we believe investors should ensure that their active managers are truly active, with high active share a prerequisite for inclusion in their portfolio (please see Equity Investing: From Style Box to Global Unconstrained, May 2012).

Revisiting equity portfolios

In an environment of fatter tails, there is always the possibility of a right-tail event. Enactment of comprehensive and bipartisan policies to address structural problems in developed markets, for example, would be welcome news and would likely lead to broad multiple expansion and higher returns in the equity markets. However, absent such developments, economic fundamentals suggest more modest returns.

Many investor portfolios may not be positioned for a lower-return world, particularly those that were structured during a higher-return equity environment. We believe investors would be well served to take a fresh look at their equity allocations. If beta will not suffice, then investors should work to ensure their portfolios have the characteristics needed to succeed.

Past performance is not a guarantee or a reliable indicator of future results. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Dividends are not guaranteed and are subject to change and/or elimination. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. Entering into short sales includes the potential for loss of more money than the actual cost of the investment, and the risk that the third party to the short sale may fail to honor its contract terms, causing a loss to the portfolio. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.

The correlation of various indices or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.

The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. The S&P 90 (prior to 1957) was a value-weighted index based on 90 stocks. It is not possible to invest directly in an unmanaged index.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

©2012, PIMCO.

Tags: Active Share, Balance Sheets, Downside Risk, Economic Fundamentals, Emerging Markets, Global Economic Growth, Global Equities, Headwinds, Impo, Mitigation, Negative Direction, PIMCO, Policy Confusion, Portfolio Returns, Pyne, Target, Tug Of War, Valuations, Value Investors, Volatility
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4 Reasons to Like China

Thursday, July 12th, 2012

Last month, in my Investment Directions monthly commentary, I predicted that we’d see further stimulus from China this yearas officials try to keep Chinese growth at a respectable rate ahead of a fall 2012 leadership transition.

And as I suggested would happen, the Chinese central bank last week announced its second surprise rate cut within a month. The action from the central bank was an acknowledgement that the world’s second largest economy is slowing. In the first quarter, China’s growth decelerated to 8.1% year over year, the slowest pace since the summer of 2009 as a slowing United States and ongoing European sovereign debt crisis took a toll on Chinese exports.

Still, despite China’s economic slowdown, I continue to hold an overweight view of Chinese equities for the following four reasons:

1.)    Valuations: Chinese stocks are selling at a significant discount to both other Asian emerging market countries and to their own history, especially when you consider that Chinese inflation is decelerating. In addition, current discounted valuations appear to be already reflecting the risk of a hard landing, which I don’t believe is the most likely scenario for China.

2.)    Growth Expectations: While China is experiencing a slowdown, it’s important to put China’s growth in perspective. I expect second quarter Chinese growth to come in around 8%, a level consistent with a soft landing scenario, and not anywhere near the United States’ truly slow 2% growth. In addition, the preponderance of evidence – and the few bright spots among weak recent economic data — still suggest that China can engineer a soft landing and even if China ends up growing at 7% to 7.5% next quarter, Chinese equities still look cheap.

3.)    Economic Policy: That China lowered interest rates twice within a month suggests that Beijing is refocusing on, and is willing to go the distance to stabilize, growth. In fact, I continue to expect more stimulus from China as it tries to ensure a smooth upcoming leadership transfer and as cooling inflation in the country gives the government more room to focus on growth. In addition, the gradual liberalization of the financial industry is also a plus for long-term growth.

4.)    Relatively Low Risk: Based on my team’s analysis, China is not one of the 15 riskiest markets. In addition, China enjoys a relatively stable currency, which reduces the volatility of its USD returns.

To be sure, Chinese equities, along with other risky assets, are still vulnerable to the fortunes of the global economy, and an exogenous shock, such as a worsening eurozone crisis, could certainly knock China off of its trajectory. But in the absence of such an event, most evidence suggests that China can engineer a soft landing and its outlook seems more positive than investors may be discounting. I prefer to access Chinese equities through the iShares MSCI China Index Fund (NYSEARCA: MCHI) and the iShares MSCI China Small Cap Index Fund (NYSEARCA: ECNS).

Source: Bloomberg

Russ Koesterich, CFA is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog.  You can find more of his posts here.

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country and investments in smaller companies may be subject to higher volatility.

Tags: Acknowledgement, Chinese Central Bank, Chinese Exports, Chinese Growth, Chinese Stocks, Debt Crisis, Economic Data, economic policy, Economic Slowdown, Emerging Market Countries, First Quarter, Growth Expectations, inflation, Investment Directions, Leadership Transition, Preponderance Of Evidence, Sovereign Debt, Stimulus, Surprise Rate, Valuations
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Run of the Mill (Hussman)

Monday, June 4th, 2012

by John Hussman, Hussman Funds

Since late-February, our estimates of the market’s prospective return/risk tradeoff (over a set of horizons from 2 weeks to 18 months) have persistently held in the worst 0.5% of all historical observations. It’s always important to emphasize that we try to align ourselves with the average return/risk profile that has historically accompanied the particular set of investment conditions we observe at each point in time, but that the outcome in any specific instance may not reflect the average return, and may even fall outside of what we view as the likely range of outcomes. That said, the awful behavior of the market in recent weeks is very run-of-the-mill in terms of how similarly unfavorable conditions have usually been resolved historically, and there is no evidence that this awful prospective course has changed much. The chart I included three weeks ago in Dancing at the Edge of a Cliff presents similar periods for historical perspective.

It’s probably needless to say that last week’s decline improved valuations modestly – we presently estimate prospective 10-year total returns (nominal) for the S&P 500 about 5.5% annually, based on our standard methodology. Most bear markets have historically ended only after prospective returns moved above 10% (including bear markets in periods of very low interest rates, and also including 2009). Moreover, regardless of whether interest rates have been high or low, extended secular bear markets have ended – and secular bull market advances have begun – only when prospective 10-year returns have reached about 20% annually (see Too Little To Lock In for a chart on this). So it won’t come as a surprise that we don’t view a 5.5% annual prospective total return as having much investment merit. You don’t “lock in” prospective stock market returns – you ride them out, and holding on for the expectation of a 5.5% prospective annual return is likely to involve a very bumpy 10-year ride.

Investors with most of their assets already invested and unhedged should hope that prospective market returns move no higher than about 8% through the completion of the present cycle, since even touching a prospective return of 10% in the interim would require an S&P 500 in the mid-800′s. Though I think it’s plausible that we’ll establish prospective returns consistent with the start of a secular bull market at some point in the next few years, actually quoting the associated level for the S&P 500 would only strain credibility here. Investors have forgotten so much after just 3 years time that it seems fruitless to talk about secular lows that only occur every 30-35 years (even if the last secular low was all the way back in 1982).

At this point, the S&P 500 has achieved a cumulative total return of less than 10% since April 2010. Meanwhile, of course, there remains a great deal of faith in the “Bernanke put,” because even though it’s fairly obvious that QE has done nothing durable for the economy or the financial markets over the last couple of years, a hit of QE might at least be good for a few months of “risk on” delirium. If the American public can’t get thoughtful economic leadership, at least Wall Street’s speculative junkies can hope for a little taste of Q from Sugar Daddy.

One of the problems with QE here, however, is that it would essentially represent fiscal policy for the benefit of speculators, at taxpayer expense. To see this, note that the 10-year Treasury yield is now down to less than 1.5%. One wonders how Bernanke would be able to argue, with a straight face, that this is not low enough. Nevertheless, a 10-year bond has a duration of 8 years – meaning that each 100 basis point fluctuation in interest rates is associated with a change of about 8% in the price of the bond. So if you buy the bond and hold it for a full year, an interest rate change of of 1.5/8 = .1875, or less than 20 basis points, is enough to wipe out the annual interest and leave you with a negative total return.

So at this point, if the Fed buys Treasury bonds, it will predictably lose money – after interest – unless interest rates rise less than 20 basis points a year during the period that the Fed holds those bonds. Over the past year, the standard deviation of week-to-week changes in the 10-year Treasury yield has been about 13 basis points, so 20 bips over the course of a full year is nothing. Whether or not a speculator is willing to take a bet on lower yields, it’s highly unlikely that the Fed could buy Treasury bonds here at a yield of 1.5% and ever expect to unload its portfolio later at even lower yields, because yields would shoot higher merely on the anticipation of Fed liquidation.

As a result, Treasury debt purchased by the Fed here would almost certainly result in capital losses, at taxpayer expense, and those capital losses would be an implicit subsidy to speculators who sold those bonds to the Fed at elevated prices. Of course, “sterilized QE” – where the Fed would buy bonds, and then pay banks 0.25% interest to keep the balances on reserve – would involve an even larger subsidy, and would then require only a 15 basis point move to put the Fed into loss mode.

“QE3 – subsidizing banks and bond speculators at taxpayer expense” – there’s a pithy slogan. That doesn’t mean the Fed will refrain from more of its recklessness (which will be nearly impossible to reverse when it becomes necessary to do so), but does anyone actually believe by now that QE would improve the economy, durably elevate risky assets beyond a few months, or materially relieve global debt strains?

Despite the uncertainties, our game plan remains fairly straightforward. As I noted two weeks ago in Liquidation Syndrome, “there may be latitude to take a more constructive stance between the point that any new monetary intervention produces an improvement in our measures of market internals, and the point where we re-establish an overvalued, overbought, overbullish syndrome. Without a material improvement in valuations or market action here, we remain defensive. Undoubtedly, the best outcome would be a strong improvement in valuations, followed by signs of improvement in our measures of market action, which is the typical sequence of events that complete a market cycle and can launch a very favorable investment environment.

Tags: Bear Markets, Decline, Expectation, Historical Perspective, Horizons, Hussman Funds, Investment Conditions, John Hussman, Low Interest Rates, Methodology, Nbsp, Periods, Point In Time, Prospective Course, Risk Profile, Secular Bull Market, Stock Market, Tradeoff, Unfavorable Conditions, Valuations
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Liquidation Syndrome (Hussman)

Monday, May 21st, 2012

by John Hussman, Hussman Funds

May 20, 2012

Over the past two weeks, the S&P 500 has lost months of upside progress in a handful of sessions. This is the very characteristic initial outcome of the overvalued, overbought, overbullish syndrome that has been in place until recently (the decline has cleared the overbought component). The good news here is that we now estimate the 10-year prospective total return on the S&P 500 to be about 5.2% annually as a result of the recent decline. As a rule of thumb, a 1% market decline in a short period of time tends to increase the prospective 10-year return, not surprisingly, by about 0.1%. However, that approximation is less accurate over large movements or over extended periods of time, where growth in fundamentals and compounding effects become important.

The bad news here is that given the sharp deterioration in market internals, and the likelihood of an emerging recession, we have no basis to expect market losses to be contained to such minimal levels. It is important to recognize that the scope of our concerns is on the order of 25-35% market losses over 12-16 months, and those concerns aren’t meaningfully resolved by a 5% decline over the course of a few sessions. A good week in the market is unlikely to change our assessment unless it produces a material improvement in our measures of market internals. The fast, furious, prone-to-failure rallies that often result from short-term oversold conditions aren’t generally enough, and usually reflect short-covering rather than sustainable investment demand. Improved valuations are often supportive of that sort of sustainable demand, but that would require a much larger decline than we’ve seen thus far.

Massive monetary interventions have not done much for the economy, but have proved capable of provoking speculation for several months at a time. As I’ve noted recently, there may be latitude to take a more constructive stance between the point that any new monetary intervention produces an improvement in our measures of market internals, and the point where we re-establish an overvalued, overbought, overbullish syndrome. Without a material improvement in valuations or market action here, we remain defensive. Undoubtedly, the best outcome would be a strong improvement in valuations, followed by signs of improvement in our measures of market action, which is the typical sequence of events that complete a market cycle and can launch a very favorable investment environment.

In the meantime, however, a bad week is unlikely to change our assessment unless that bad week includes a market crash. Last week was not a crash, though a free-fall appears increasingly possible, as the reality of emerging recession (and all that it implies for fresh credit risks, sovereign defaults, fiscal imbalances, banking strains and other problems) will likely smash against the consensus view of economic expansion in next few months.

I continue to view the U.S. economy as most probably entering a recession that will ultimately be marked as beginning in May or June of 2012. We are very much in agreement with the ECRI on this, though our methods are different, and our conclusions are clearly still seen as “fringe” views by the consensus.

For the financial markets, those risks are compounded by the unbalanced “risk-on” exposure that investment managers and institutions adopted early this year, encouraged by a short-lived burst of economic activity, and faith in a central-bank backstop. When heavy “risk-on” positions established in recent months are forced to squeeze out through a narrow exit, large price adjustments may be needed, since investors who are less tolerant of speculative risk seem unlikely to respond with the requisite demand until improved valuations provide a sufficient incentive.

As John Kenneth Galbraith wrote in 1955, “Of all the mysteries of the stock exchange there is none so impenetrable as why there should be a buyer for everyone who seeks to sell. October 24, 1929 showed that what is mysterious is not inevitable. Often there were no buyers, and only after wide vertical declines could anyone be induced to bid … Repeatedly and in many issues there was a plethora of selling orders and no buyers at all. The stock of White Sewing Machine Company, which had reached a high of 48 in the months preceding, had closed at 11 on the night before. During the day someone had the happy idea of entering a bid for a block of stock at a dollar a share. In the absence of any other bid he got it.”

Illiquidity is a very unpleasant thing when you’ve got an inappropriately speculative position and you’re under pressure to close it out. The very high beta exposure taken by managers and institutions lately (see Unbalanced Risk) strikes me as particularly dangerous in an environment where we continue to estimate the market’s return/risk profile among the most negative 0.5% of historical instances.

Will the Federal Reserve come in with QE3 in an attempt to prop up the market? Maybe. It doesn’t matter to Bernanke that the Fed’s interventions are reckless, promote speculation, distort resources, punish savers, produce only temporary economic effects, and will be nearly impossible to unwind. But the Fed will undoubtedly feel compelled to “do something.” Apart from dollar swap lines (which the Fed is likely to reopen to Europe in efforts to reduce banking strains there), more QE is all the Fed can hope to offer. Let’s face it – when your only tool is a hammer, all the world looks like a nail.

Still, we’ve observed diminishing returns from the Fed’s interventions, there is no political tolerance for the Fed to intervene in securities involving any credit risk that would be borne by U.S. citizens (purchasing European sovereign debt, for example), and the yield on the 10-year Treasury bond is already down to 1.7%, which is far below where it stood when prior interventions were initiated. It seems a hard sell to argue that yields aren’t low enough, and that the Fed needs to intervene to drive them down further. Even so, it’s clear that Wall Street responds to Bernanke like a bunch of Pavlov’s dogs. Provided that renewed Fed intervention is sufficient to improve our measures of market action, I expect we would have some latitude to respond with a more constructive position until an overvalued, overbought, overbullish syndrome is re-established.

Frankly, I doubt that investors will find the third time to be a charm in the event of another round of QE. This is why any willingness to accept risk will far more tied to our longstanding measures of market action and other testable factors than to some novel “Bernanke faith factor” that we have no way of testing historically in any kind of rigorous manner. Yes, the stock market advanced in 2009-2010 when the Fed tripled its balance sheet. But there is no material long-term relationship between the size or growth rate of the monetary base and stock market fluctuations. Rather, QE has had its effect on the markets by essentially starving investors of safe yield and making them feel forced into increasingly speculative corners in search of return. With safe yields already so depressed, I suspect that we will see already diminishing returns become even weaker, because there is little left for the Fed to squeeze.

Liquidation Syndrome

As I’ve  frequently noted in recent weeks, there are numerous ways of defining the basic “syndrome” of a richly valued, overbullish market where favorable internals (breadth, leadership) or other driving factors have fallen away. Presently, the market remains richly valued on normalized earnings, and is coming off of a speculative peak with an abrupt and persistent initial decline. The guys at Nautilus Capital recently noted that just a 5% decline from a nearby peak, coming off of a 25% prior advance, has historically been fairly hostile to forward returns. Bill Hester notes that going back as far as Depression era data, that same behavior coupled with a rich Shiller P/E (anything above the mid-teens) and a preponderance of daily declines in recent data (say down 11 days out of 14) has preceded even worse outcomes – particularly in the context of a weak economic backdrop. I should note that we also saw a “leadership reversal” last week – a shift from a preponderance of new weekly highs to a preponderance of new weekly lows. All of this reflects what might be called a “liquidation syndrome” that is selective for awful drops that began in 1969, 1972, 1987, 2000, 2007, and the more moderate but still steep losses in 1998, 2010, and 2011.

The chart below captures a fairly simple filter of instances when the market lost 5% or more over a 2-week period, from a market peak in the prior 6 weeks (within 5% of the prior 52-week high) that was characterized by a Shiller P/E over 19, more than 50% advisory bulls, and fewer than 25% advisory bears. So the bars simply identify quick initial declines from overvalued, overbullish peaks. But the fact that they coincide with so many important cyclical bull market peaks says something about how those peaks are formed.

It’s important to note that on long-term charts like this one, small distances actually represent weeks of data, including many days where stocks advanced and everything looked just fine on a near-term basis, so we certainly shouldn’t rule out the typical “fast, furious, prone-to-failure” rallies that usually punctuate extended market slides. 

Tags: Approximation, Bad News, Deterioration, Handful, Hussman Funds, Interventions, Investment Demand, John Hussman, Likelihood, Market Decline, Market Internals, Market Losses, Minimal Levels, Rallies, Recession, Rule Of Thumb, Short Period, Speculation, Sustainable Investment, Valuations
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