December 15, 2008
Recognition, Fear and Revulsion
In the 11 trading sessions from November 20 to December 8, the S&P 500 gained 20.9% based on end-of-day closing values. It certainly has not felt as if the market enjoyed an advance in excess of 20% from its November low to last Monday's close, but it has been a material gain (from which some retracement is quite possible).
I continue to view the market as undervalued, but clearly 20% less so than a few weeks ago. Of course, a 20% difference is material. While our investment stance remains modestly constructive on the basis of valuation, we have somewhat less exposure to market fluctuations than we had a couple of weeks ago when prices were extraordinarily compressed. What bothers me about the recent rebound is the tepid volume and general lack of leadership. We certainly don't observe market action from any industry group that reveals investor expectations for an economic recovery. The advance we've seen is better characterized as a short squeeze, and a period where investors have "stepped back" from extreme panic, rather than something that reflects investors "looking across the valley to the eventual recovery."
Our early measures of market action turned favorable a couple of weeks ago, allowing us to participate in a good portion of the recent advance, but those early measures are somewhat demanding in requiring follow-through from wider measures of breadth, trading volume, leadership and other factors. It's still possible that the market will recruit that evidence, but every session that passes without it makes us more skeptical about the tolerance of investors for risk. Our investment strategy is to always align our investment positions with the evidence available from valuations and market action, without forecasting where the market is headed, or how long our investment position will be constructive or defensive. Our discipline is to change our investment positions as the evidence changes (or fails to change as much as we need in order to maintain a constructive position).
My guess, and it's only a guess, is that the general tenor of the market may remain tepidly positive for a few more weeks, but that we will ultimately observe another frightening leg down in the first part of next year - possibly to re-test the November lows, possibly to new lows, depending on the evolution of economic conditions. The problem isn't that stocks are expensive - they're not. The problem is that the U.S. economy will probably not see the beginnings of a recovery until the second half of 2009, and while we've seen a good deal of fear, the stock market tends to go through a great deal of sideways action after panics like we've observed. It's likely that stocks will trade in a very wide 25-35% range for months. We have to be particularly observant as stocks approach the higher end of that range.
Bear markets tend to experience a series of separate lows on what I'd call recognition, fear, and revulsion. The first selloff of a bear market is on "recognition" - the growing awareness among investors that "boom" economic conditions are in question. Investors generally continue to deny the likelihood of a bear market or a recession, so the phrase "healthy correction" usually comes up a lot. Unlike true "healthy corrections," however, these periods tend to begin from untenable valuations, overbought conditions, generally rising interest rates, and deteriorating market internals.
Strong intermittent advances are typical during bear markets, and can often achieve gains of 20% as we've seen in recent weeks, and sometimes substantially more. But the very existence of bear market rallies can be a problem for investors, because they clear the way for fresh weakness. The scariest declines in bear markets are typically the ones when investors think they are making progress and recovering their losses, only to see stocks go into a new free-fall.
The "fear" lows in a bear market are probably the most variable because they are the most tied to actual economic news and events. These lows are generally associated with distinct negative developments in earnings, the economy, or in 2001 for example, world events. The fear-type lows are damaging to the long-term discipline of many investors, because the negative news encourages them to question the viability of the economy itself. In 2001, the idea that "nothing will ever be the same" permeated discussions about the economy and investing, much like it did in 1982 and much like it does now.
Those "fear" lows are typically followed by powerful bear market rallies, which then clear the way for fresh declines. My impression that investors experience such declines as if they are additional major losses, even if they result in only modest new lows. In other words, if the market declines by 20%, followed by a 15% advance, and then by another 20% decline, the second drop may be experienced with the same pain as the first one was, even though it's little more than a retracement.
That cycle of decline, followed by hope, followed by fresh losses, is really what ultimately puts a final low in place. The final decline of a bear market tends to be based on "revulsion" - a growing impatience among investors who conclude that stocks are simply bad investments, that the economy will continue to languish, and that nothing will work to help it recover. Revulsion is not based so much on fear or panic, but instead on despair and disillusionment. In a very real sense, investors abandon stocks at the end of a bear market because stocks have repeatedly proved themselves to be unreliable and disappointing.
As it happens, that sort of revulsion can be very helpful to investors who pay attention to market action. Unlike panic lows based on indiscriminate selling, which generally characterize lows that occur within a bear market, the final lows of a bear market tend to exhibit a lot of "positive divergences." Though some of the major indices may register new lows, it's usually the case that not all of them do. Unlike earlier lows, the final lows tend to be accompanied not by a spike in trading volume, but by diminished, almost exhausted volume. Some industry groups may hold up relatively well, and the number of of new lows tends to be smaller than on prior declines. In short, there is less negative information conveyed by a "revulsion" low, which is a useful signal that at least some investors are, in fact, finally "looking across the valley" toward a recovery.
On the subject of valuations, I believe that the peak level of earnings seen in the past market cycle was somewhat high, so I'd agree with Bill Gross at PIMCO in the sense that we're not likely to see that level of earnings as the "norm." Prior peak earnings were, indeed, an artifact of unrealistically high profit margins and return on equity, driven by large amounts of debt-financed leverage. That is a point that I repeatedly made during the past cycle.
Where I depart from Gross is that while he believes that the economy in the future will diverge from the norms of the past, I believe that the economy of the past 15 years has itself been the outlier, and that we're likely to observe profit margins, returns on equity, and economic performance in the next several decades that are much more reminiscent of the longer-term historical record. That is an environment that investors should be very comfortable with, because it will be one based not on financial alchemy, but on real businesses that do real things. Despite the difficulties with old-line, capital-intensive manufacturing, I still believe that the U.S. economy has a promising future. Even if the cash flow assumptions of investors become more realistic, the fundamentals of disciplined, value-conscious investing will not change.
A number of investors have asked about the potential for bankruptcies to disrupt the long-term assumptions that we make about earnings and cash flows, especially for the S&P 500. The most important observation is again that the past 10-15 years were an anomaly from the perspective of profit margins and return on equity. We will almost certainly see some departure from those extremes, but the "normalized" figures we use have been well below those figures for quite some time. What's really happening now is that the actual figures are reverting to their norms.
Importantly, even the bankruptcies of the Great Depression did not materially disrupt the long-term earnings growth trend for a diversified portfolio of U.S. stocks (especially a periodically updated one like the S&P 500). My guess is that concern about bankruptcies corrupting the S&P 500 reflects confusion over the concept of "survivorship bias." See, if you look at a list of stocks or mutual funds today, and analyze their historical performance, you'll tend to get a much rosier performance figure than an investor would actually have experienced, because any stock or fund that did not survive will not be part of the list. So if you do your return calculations but ignore the companies or funds that didn't survive, you'll create a survivorship bias.
However, for the S&P 500 itself there is no survivorship bias because the list itself changes over time and the index fully reflects the performance of a failing company up to the point that it is replaced. Every time that a component of the index fails, it is sold out of the index just as an individual would sell it, and another component is then purchased (subject to some reallocations of weight across the other members). So the earnings, dividend and performance figures for the S&P 500 already reflect the impact of companies that did not do well and were subsequently replaced. As a side note, the S&P 500 index also corrects for repurchases by adjusting the share figures (and thereby the dividend and earnings figures) accordingly. To count stock repurchases as if they are some sort of "hidden" payment in addition to dividends is double-counting.
Short answer - I do expect the deleveraging we're seeing here to bring future earnings much closer to their "normalized" values than we've observed over the past 15 years. But no, I don't expect that this economic turmoil will impair the general framework within which we analyze stocks or the market as a whole.
Presently, the price/peak-earnings multiple on the S&P 500 is just over 10, but that is based on peak earnings of about $86 for the Index. If we estimate a conservative level of normalized earnings for the S&P 500 in the range of $65-70, the current level for the S&P 500 would put it at a price-to-normalized earnings multiple of 12.5 to 13.5, which is in the undervalued range, but certainly not near a historical low. A multiple of about 9 times normalized earnings would easily form the base for a powerful multi-year advance in the market, and strong long-term returns. Unfortunately, that multiple would put the S&P 500 at about the 600 level. As I've noted before, I don't expect that we'll observe the 600 level in the current downturn, but we also can't rule it out, and we are very mindful of the potential to "overshoot" to the downside, which has historically occurred even in undervalued markets.
Where do I think the market is headed? I have no forecast, but I'll share my impressions. It's possible that the lows we observed in November were the lowest point that we will observe during this downturn, but I would not invest on that basis. It's possible that market action will improve further, and that we will recruit enough evidence to warrant removing a significant portion of our hedges, but at present, we don't have that evidence. My impression is that regardless of near-term prospects, we will observe a tone of "revulsion" at some point next year, which we should certainly allow for especially during the first half of 2009. At that point, we should not rule out a low that would compete with the November lows and perhaps break them, but we should also expect that the market will be more selective at that point, so there will be many stocks that hold above the lows that have already been set.
As usual, we don't need to forecast at all - simply to constantly align our investment position with the prevailing evidence from valuations and market action. At present, valuations are favorable, while market action is generally unfavorable - we have some tenuous signs of early improvement, but trading volume has been sluggish and the market is no longer oversold or compressed. As I noted last week, ambiguous evidence warrants moderate exposure. The Strategic Growth Fund continues to have a moderately constructive position, but primarily with call options overlaid on an otherwise significantly hedged investment stance.
As of last week, the Market Climate in stocks was characterized by favorable valuations and generally unfavorable market action. We do have some tenuous signs of early improvement, but trading volume has been sluggish and follow-through has been more tepid than we would prefer. Moreover, the market is no longer oversold, and prices are no longer deeply compressed, which opens up some risk of a fresh decline. Accordingly, we tightened our hedges some last week, largely by raising the strike prices on our index hedges. The Strategic Growth Fund can be viewed as being hedged with slightly in-the-money put options, or alternatively, as having a full hedge, plus a position in slightly out-of-the-money index call options (because of how options work, those descriptions are essentially identical). This position provides a significant hedge against major downside risk in the market, but also retains the potential to participate moderately in the event that the market recovers further.
In bonds, the Market Climate was characterized by unfavorable yield levels and moderately favorable yield trends. I continue to view Treasury bonds as having a significant "speculative" component in that Treasury yields are far below levels that long-term investors are likely to accept over maturity, so despite good arguments for low yields on the basis of economic weakness, there is a great deal of price risk in Treasury bonds. TIPS are generally safer, with lower durations, and are priced to deliver real yields in the 3-5% range over multi-year horizons. Even with the prospect of a near-term easing of inflation and perhaps even some negative CPI inflation figures, the combination of strong real yields and principal safety makes these a good harbor for investors who want to sleep nights without accepting untenably low nominal yields (and the high associated durations - which I suspect many investors currently overlook). The Strategic Total Return Fund continues to hold just under 30% of assets in utility shares, foreign currencies, and precious metals shares (where we modestly clipped our exposure in response to very strong price gains in recent weeks).
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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