November 14, 2005
Niznaya brodo, nyeh suizio vwodo
There are a few important ways that I distinguish the “Market Climate” approach of the Funds from concepts like “market timing” or “trend following.”
First, there is no focus or attempt to predict which direction the market will, or even “should” move in any particular instance. For example, I have no expectation that the market will reliably decline in the short-term even when the prevailing Market Climate is hostile, nor do I have any expectation that the market will reliably advance in the short-term even when the prevailing Market Climate is very favorable. Rather, I try to align our investment position with the average profile of return and risk that the market has achieved under similar, measurable conditions, while treating the next specific movement of the market as mostly unpredictable.
Second, my evaluation of “market action” is not significantly driven by short-term movements or trends in the major indices such as the S&P 500 or Nasdaq. Rather, my attention is closely on the quality of internal market action across a wide range of measures that, taken together, provide evidence of “sponsorship. “ In other words, I'm most interested in evidence that investors have either favorable information or a robust preference to take market risk. That sort of evidence is not expressed in the movement of a few major indices, but in the joint behavior or “uniformity” of a variety of market internals.
Dispersion and lack of sponsorship in an overvalued market give me the willies, regardless of whether the S&P 500 is rallying or not.
With the S&P 500 at about 19.5 times record trailing net earnings (the average historical multiple on record earnings is about 12, regardless of the particular level of interest rates or inflation), even the recent market advance has failed to exhibit much evidence of sponsorship or favorable information. I reviewed some of the information signals regarding economic prospects in last week's comment. It's also somewhat disturbing that last week, for example, the number of stocks achieving new 52-week lows exceeded the number achieving new highs (298 vs. 249). The fact that both figures were relatively high also speaks about the internal dispersion evident in the market here.
Meanwhile, Lowry's reports that even among operating companies (excluding preferred stocks and the like), “the rally has been increasingly selective.” Lowry's also notes that despite the recent surface strength, “the internal condition of the market may be telling a different story,” with price/volume behavior suggesting that investors are holding back in their commitment to stocks, and “a distinct increase in investors' willingness to exit stocks.” Though I use a different set of measures to gauge the quality of market action, the conclusion is broadly the same.
Again, that's not to imply anything specific about short-term market action. Indeed, there's always the possibility that market internals will fall into gear with the major indices. It's just that this evidence is not in hand, so presently, we have to remain aligned with the hostile Market Climate that the evidence currently identifies. That holds us to a fully hedged position (not net short, but relatively indifferent to broad market fluctuations) in the Strategic Growth Fund.
It is, of course, tempting to look at the recent advance and try to “hitch a ride” as a trend-follower. Aside from going against the present evidence, the problem there is that the “buy” side of that trade would be executed while the market is already overbought, so that the eventual “sell” side would have to be on further strength. That's a hard trade to win. If the sell side were to occur instead on even moderate short-term weakness, it's very likely that the trade would be loser, even if stocks were to rally to some extent first. It's just not good investing style to buy rallies unless that purchase is forced by a well-defined shift in available evidence too. Nothing of the sort is apparent here.
As a result, we're left with a Market Climate that has historically been hostile to stocks, on average, despite reasonably good short-term behavior. To increase our exposure to market fluctuations, based only on the market's short-term behavior, would require us to ignore the substantial risks inherent in more reliable measures of valuation and market action.
All of which underscores some very good advice that a Russian taxi driver recently shared with me – Niznaya brodo, nyeh suizio vwodo.
“If you don't know how deep the river is, don't step in.”
As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and still unfavorable market action, holding the Strategic Growth Fund to a fully hedged investment stance. It's important to emphasize that when the Fund is fully hedged (and provided that our long-put/short-call index option combinations have identical strike prices and expirations), day-to-day fluctuations are mostly driven by the difference in performance between the stocks that the Fund holds in its portfolio, and the indices that the Fund uses to hedge (mainly the S&P 500 and Russell 2000 indices). Though that difference in performance has historically been a substantial and generally consistent contributor to Fund returns since inception, it is not reliably positive over the short term, and can very well be negative over consecutive days, weeks or even months. As also noted in recent weeks, the returns on any particular day can be positively or negatively affected by strong or weak performance in a small handful of stocks. Suffice it to say that while the Fund has generally achieved good returns when it has been in a fully hedged position, that performance should not be viewed as riskless or exquisitely predictable, particularly in the short-term.
In bonds, the Market Climate continues to be characterized by unfavorable valuations and unfavorable market action. The factor most capable of prompting an increase in our portfolio duration (currently about 2 years) in the Strategic Total Return Fund would currently be a substantial widening of credit spreads – the difference between risky corporate yields and default-free Treasuries. That sort of widening would be an important indication of potential economic weakness, credit risk, and dollar risk. For now, the Fund's limited exposure to interest rate fluctuations is comfortable given that the year-over-year rate of inflation still exceeds most Treasury yields along the curve. The Fund continues to carry about 20% of assets in precious metals shares, which I would also expect to benefit from a widening of credit spreads and attendant economic risks.
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