April 24, 2006
Historically, the worst outcomes for stocks have typically emerged when valuations were rich and there were well-defined upward pressures on interest rates and other yields. The tendency for bad outcomes to be born of such conditions is so established that our investment discipline virtually demands that we hedge when they are present.
At the same time, the elements just mentioned virtually assure that a defensive position will look ridiculous for some amount of time. Specifically, rich valuations imply that the market will typically have done well in recent months or years, and that it will probably still be establishing marginal new highs (until, of course, it doesn't). Likewise, upward pressures on interest rates and other yields typically imply concurrent economic strength and strong consumer confidence. So at the most compelling times to hedge risk, the market will be achieving fresh highs and the economy will appear strong. Hedging under those conditions is often accompanied by foregone short-term gains that are made irrelevant by subsequent market weakness.
Conversely, the best outcomes for stocks have typically been born of depressed valuations and well-defined downward pressures on interest rates and other yields. This combination typically emerges after stocks have done terribly in recent months or years, and are still probably establishing fresh lows, while the economy appears unusually weak and consumer confidence is plunging. Aggressive investment under those conditions is often accompanied by disappointing short-term losses that are made irrelevant by subsequent market strength.
The upshot is that the points where defensive or aggressive investment positions are most effective are also typically the points where one will, at least briefly, look like an idiot for taking them.
Over the long-term, the market's tendency to reward appropriate risks and punish inappropriate ones has worked out well enough that I'm comfortable being occasionally considered out of touch with "obvious" trends and popular wisdom. It's performance and risk management over the complete market cycle that matters. Everything else is entertainment.
Not surprisingly then, for the better part of the past 6 years, the following bit has been part of our Fund information page:
"It is important for shareholders to understand that we place a rigid emphasis on disciplined strategy. We believe that the key to superior long-term returns is to take investment opportunities when the evidence suggests high return/risk tradeoffs on average, and to avoid situations when the evidence suggests low return/risk tradeoffs on average ... we do not try to 'time' specific market advances and declines, or alter our position based solely on adverse short-term movements."
I'll start this section by emphasizing that it is not the nature of our investment approach to make short-term forecasts, and no short-term forecasts are intended here. We don't rely on specific predictions, but on the law of large numbers. Just like you can't predict the flip of a coin, but expect that after many, many flips your average will be about 50% heads, we take investment positions, again and again, based on the average return/risk profiles we've observed in any given Market Climate. We can't predict the specific outcome for any specific period. We just expect that risk-taking will be rewarded better, on average, in some Climates than in others.
I've noted before that a fully hedged investment position earns implied interest (generally somewhere between the 3-month Treasury bill yield and the broker call rate - currently just over 5% annualized), so that hedging will typically increase investment returns in periods when the market's total return falls short of risk-free interest rates, even if the market's total return is positive.
On that note, investors should recognize that since the 1960's, when the 10-year Treasury yield, the 3-month Treasury bill yield, and the Consumer Confidence index have all been rising (say, above their levels of 6 months earlier), the S&P 500 has followed by underperforming risk-free T-bill yields by -5.13% annualized, on average.
But it gets worse.
If we look at periods since 1975 when the Philadelphia Gold & Silver Index (XAU) was also above its level of 6 months earlier, it turns out that the S&P 500 has followed with annualized losses of -12.37% on an absolute basis (nearly a -20% shortfall versus risk-free Treasury bill yields). All four conditions are true today.
Since Consumer Confidence is actually a lagging indicator that improves based on past changes in employment, factory use, and so forth, we can also look at periods when an economic expansion was already reasonably mature. Examining periods of upward yield pressure (on the conditions above) when factory capacity utilization was also above 80% (as it is now), the subsequent annualized total return for the S&P 500 drops to -19.00%.
You can mix-and-match these pressures to your heart's content. The more conditions required, the smaller the subset of events, but generally the poorer the returns.
Even a couple of these pressures will do. For example, if we look at periods when the 10-year Treasury yield and the XAU were each above their levels of 6 months earlier (a condition that has prevailed about 24% of the time since 1975), we find that these pressures alone were enough to hold the annualized total return on the S&P 500 -1.62% below the risk-free T-bill return. If you include rising T-bill yields among the criteria, the shortfall drops to -6.78%.
Note that the historical compensation for stock market risk-taking under these conditions remains tepid even if we exclude the month of the October 1987 crash from the calculations (not that there's any good reason to ignore that event, which itself was a completely legitimate outcome of rich valuations coupled with rising interest rates and commodity prices).
Simply put, the stock market has generally not rewarded risk-taking when interest rates, commodity prices, and consumer confidence have been trending higher. That's not a huge surprise to data monkeys who spend their time analyzing such historical outcomes. Still, my hope is that these simple observables will provide some understanding of why I believe that a fully hedged investment position is appropriate here, despite hopeful consumers, optimistic investors, and even the occasional marginal new high.
As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and unfavorable market action. Note that our measures of market action contemplate far more than simply the behavior of the major indices. If the major indices were all that mattered, our analysis of market action would represent little more than trend-following. The benefit of market action is that it reveals internal divergences and pressures that aren't apparent in the major indices. The point is that the conclusions will sometimes contradict what an investor would observe by looking only at prevailing trends.
With regard to internals, I should note that there were 570 new highs and 317 new lows on the NYSE last week. Such figures for both new highs and new lows is an indication of internal dispersion that has typically been a clear (though sometimes early) negative for stocks. Given current valuations and yield pressures, the overall Market Climate warrants a fully hedged investment stance here.
In bonds, the Market Climate remained characterized last week by unfavorable valuations and unfavorable market action. Despite the recent rise in yields, the shape of the yield curve remains consistent with a further, possibly substantial, parallel rise in yields at all maturities. That sort of forecast isn't required, however, and prevailing, observable yields and market action are sufficient to hold us to a 2-year duration in the Strategic Total Return Fund. On the basis of further strength in precious metals shares, I trimmed the Fund's exposure in this group again last week, to maintain the Fund's position to about 10% of assets in gold shares and other mining stocks.
[Technical note: in the calculations above, for conditions observed at time t, the corresponding returns are always measured for period t+1. So, for example, if a condition is true as of March 31st, our analysis would be focused on, say, the market's April returns, not on the coincident March returns. Our objective is to set the current investment position in response to currently observable evidence, not in anticipation of future evidence, or in expectation that the current evidence will necessarily continue].
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
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