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October 15, 2007

Warning - Examine All Risk Exposures

John P. Hussman, Ph.D.
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The S&P 500 registered a record high last week, exactly 5 years after the market registered its bear market low in 2002. With the last bit of the 2000-2002 bear market now removed from the 5-year window, the past 5 years comprise a pure trough-to-peak market advance, without an intervening bear market decline, nor even a 10% pullback in the S&P 500 (on a daily closing basis). This is entirely unrepresentative of what an investor can expect over the long-term. Ironically, the brutal 2000-2002 bear market has now moved out-of-sight and out-of-mind at just the time that investors would benefit most from its memory. The completion of the current market cycle may be closer than investors think.

I generally try to avoid near term forecasts of market direction. The predictable amount of market return over a one-week period is overwhelmed by short-term volatility, and forecasts based on longer time horizons implicitly assume that the Market Climate we identify will not change over the forecast period. Moreover, if we partition history into “buckets” according to the Market Climate that was prevailing at the time, and look at how the market performed over say, the next week, month, or quarter we find that every bucket includes periods that were followed by advances, as well as periods that were followed by declines.

In other words, we can rarely predict that the market will reliably advance or decline over the next week or month or quarter. What we can say is that the average return/risk profile varies substantially across buckets. Given observations over at least one complete market cycle, we regularly find that the strongest average return/risk profile was associated with periods that one could identify in advance as having favorable valuation and (already) favorable market action, and that the poorest subsequent return/risk profile was associated with the bucket of periods having unfavorable valuation and unfavorable market action. Over the complete market cycle, this knowledge has generally been enough to achieve strong full-cycle returns with moderate risk.

It's not difficult to find various indicators that have been positive in recent years. But you don't find useful market indicators simply by looking at an advance and asking what conditions accompanied the advance. Nor do you find useful indicators simply by looking at a decline and asking what conditions accompanied the decline. Suppose that 100% of the people who have the flu are positive on a given test. Even if you test positive, you still don't have any information about whether you have the flu. What you also need to know is how many times the test was positive, and people didn't have the flu. The counter-examples are essential. It is also important to base the diagnosis on more than one factor – are there muscle aches? Chills? General fatigue? The more the symptoms fall into a well-defined syndrome the better the accuracy of the diagnosis.

For example, though investors are convinced that successive cuts in the Discount Rate are good for stocks, you will find that nearly all of the historical instances occurred when stocks were well into bear market declines, and valuations were already depressed. Indeed, the exceptions when stocks did not respond well to successive Discount Rate cuts were precisely those where valuations were still rich and stocks were not far from their highs at the time. Again, you have to look at the overall syndrome of conditions, and ask whether there are any informative counter-examples.

As I noted in prior comments about Bayes' Rule, there is one particular syndrome of conditions after which stocks have reliably suffered major, generally abrupt losses, without any historical counter-examples. This syndrome features a combination of overvalued, overbought, overbullish conditions in an environment of upward pressure on yields or risk spreads. The negative outcomes are robust to alternative definitions, provided that they capture that general syndrome (for instance, Treasury yields need not be obviously rising – an absence of strong downward pressure on yields is sufficient).

Presently, the price/peak earnings multiple of the S&P 500 is at 18.4 even without normalizing the level of profit margins. The S&P 500 is at a record high, is clearly overbought, and is pushing the upper Bollinger band at every horizon (daily, weekly, and monthly). Treasury yields provide no assistance, with the 10-year yield about the same level as 6 months ago and well off of its lows, while Treasury bill yields are also well off their lows. Sentiment readings from Investors Intelligence indicate 60.2% bulls and just 18.3% bears. Finally, we have what has historically been a sharply negative additional feature: our measures of market action are unfavorable (this is in contrast to points earlier this year, when we could infer the risk of abrupt corrections despite constructive internals).

There are only a handful of historical periods that fall into this syndrome of conditions: December 1972, August 1987, July 1998, July 1999, December 1999, March 2000, and October 2007.

All of the prior instances were followed by steep market losses. When the declines were not abrupt, they were protracted. There is not a single counter-example. This is clearly a small sample of events, but it is some sample. Note that even the 1999 instances were followed by separate declines of at least 10%, even before the 2000-2002 bear market began. Could October 2007 be the first exception? Sure. But for investors to ignore present risks, they would need very strong “prior beliefs” that reduce the weight that they place on this set of observed evidence.

For our part, we are fully hedged, and would be even on the basis of less extreme conditions. Given my general avoidance of forecasts, there are very few situations when I would state my views about the market as a “warning.” Unfortunately, in contrast to more general Market Climates that we observe from week to week, the current set of conditions provides no historical examples when stocks have followed with decent returns. Every single instance has been a disaster.

We can't rule out the possibility that investors will adopt a fresh willingness to speculate (which we would observe through an improvement in market internals). Such speculation might prolong the current advance modestly, but even this would not substantially alter the risks that have ultimately been associated with overvalued, overbought, overbullish conditions.

Accordingly, investors should consider prevailing conditions as a warning about assuming substantial risk. This includes foreign and developing markets, because correlations between U.S. and foreign markets suddenly become stronger during periods of market weakness than they are in periods of general stability. That doesn't mean investors need to make major changes in their investment exposures. There is nothing wrong with buy-and-hold investing, provided that investors recognize at market highs how strong the impulse is to sell at market lows. Whatever market exposure investors accept today ought to be the same market exposure that investors are committed to maintain for the duration of a bear market, without abandoning their investment plan. Investors with no plan to own stocks through a market decline, holding them only in the hope of selling at market highs, may discover in hindsight that these were them.

Market Climate

As of last week, the Market Climate for stocks was characterized by unfavorable valuations and unfavorable market action. The Strategic Growth Fund remains fully hedged based on this combination of market conditions, which has historically been associated with negative average returns even in the absence of the more extreme syndrome of overvalued, overbought, overbullish conditions that we observe in this particular instance.

While the S&P 500 surpassed its prior July 19 peak last week, the Strategic Growth Fund has also achieved positive returns since that date (indeed, outpacing the S&P 500) which underscores the fact that the Fund is not a “bear fund” or a “short fund.” We currently have a “staggered strike” hedge to provide somewhat stronger protection against any substantial loss that might emerge, but are not positioned in a way that would be expected to produce losses as the result of a further market advance. As always, the Fund does accept the risk that our stock holdings will perform differently than the indices we use to hedge (typically the S&P 500 and the Russell 2000). While a substantial performance shortfall in our stocks could result in a loss for the Fund, the difference in performance between our stocks and those indices has been substantially positive since the Fund's inception, and has been the primary driver of Fund returns over time.

In bonds, the Market Climate last week was characterized by unfavorable yield levels and relatively neutral market action. The Strategic Total Return Fund continues to have a duration of about 3 years, mostly in TIPS, with about 15% of assets in precious metals shares, where the Market Climate continues to be generally positive.

I continue to believe that the best approach to current bond market conditions is to change our durations in response to interest rate changes rather than in anticipation of them. The risks to the bond market include the potential for short-term inflation surprises and potential for disappointing talk from the Federal Reserve regarding interest rate policy (purely psychological as it may be). Against that, my impression is that housing weakness, foreclosures, and credit risks will tend to create ongoing surges of demand for Treasuries as safe-havens. So I would expect to gradually increase our exposure in Treasuries in response to any upward spikes in yields that might emerge, but there still isn't sufficient evidence of economic or credit crisis to warrant heavy bond purchases in anticipation of sustained downward yield pressure.

As a final note, the amount of new "liquidity" provided by the Federal Reserve through reserves and discount window lending continues to be nil (see The Bag Will Not Inflate, and Liquidity Will Not Be Flowing). The heavy volume of repos last Thursday, as expected, were nothing but rollovers of existing repos, not "fresh injections of liquidity." Total bank reserves actually dropped in September, from $44.9 billion to $42.5 billion. Meanwhile, the total amount lent by the Fed to the banking system through the discount window amounts to $257 million.

That said, we're likely to observe a growing amount of what will wrongly be viewed as "cash on the sidelines" and "money creation" in the banking system. The problem is that the commercial paper market has dried up. If savers are not buying those securities as the proceeds come due, and a good portion of the borrowing is still somehow being rolled over, then it must be the case that the savers who used to own commercial paper are now saving in another form, and the borrowers who used to issue commercial paper are now borrowing in a different form. Most probably, banks will be the chosen intermediary, because savers view bank deposits as insured and somewhat safer than unsecured commercial debt.

The upshot is that monetary aggregates like M2 and MZM (money of zero maturity) may well increase in the months ahead, but this will not be the result of Fed "liquidity." Rather, it will be a symptom of ongoing problems in the commercial paper market (as well as other securitized loans). To measure Fed induced liquidity, you have to look directly at reserves, currency in circulation, and discount window borrowings. If you don't see it happening there, the Fed isn't doing it.

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