May 4, 2009
Comfortable with Uncertainty
Are stocks in a bull market or is this still a bear market? Frankly, I don't put much energy into that question. The S&P 500 has now corrected about one-quarter of its prior losses. Bear market corrections of about one-third are not unusual, but I wouldn't bank on that. Having failed to do anything effective to mitigate the second wave of foreclosures that is set to begin later this year, and seeing very little sponsorship in trading volume (despite good breadth), my impression is that we most likely are in a strong correcting rally in the context of an ongoing bear market. At the same time, cash-equivalents are yielding next to nothing, so it's unclear to what extent investors will decide that stocks are their only real alternative, which might allow a continuation of this advance.
Presently, the Strategic Growth Fund is well-hedged, but with enough call options to allow us to gradually and somewhat automatically reduce our level of hedging in the event that this advance continues. In other words, we are open both to the possibility of a bull market and to a continued bear market. To set an investment position that relies on the certainty of one outcome or the other would be courting trouble, in my view.
In his book On Being Certain, neurologist Robert A. Burton quotes F. Scott Fitzgerald – “The test of a first rate intelligence is the ability to hold two opposed ideas in the mind at the same time and still retain the ability to function.” Buddhist teacher Pema Chodron calls it “being comfortable with uncertainty” – being willing to take every aspect of reality as the starting point, without wasting energy wishing things were different, without denying reality as it is (even if your next step is to work toward changing things), and without needing to know what will happen in the future. “The truth you believe and cling to makes you unavailable to hear anything new. The best thing we can do for ourselves is to be open to an unknown future.”
Burton offers the same advice. Tolerating the unpleasantness of uncertainty, he writes, “is the only practical alternative to cognitive dissonance, where one set of values overrides otherwise convincing contrary evidence. Each position has its own risks and rewards; both need to be considered and balanced within the overarching mandate: Above all, do no harm. Science has given us the language and tools of probabilities. We have methods for analyzing and ranking opinion according to their likelihood of correctness. That is enough. We do not need and cannot afford the catastrophes born out of a belief in certainty.”
Our objective is always the same – to outperform the S&P 500 over the complete market cycle, with smaller periodic losses than a passive investment strategy. To that end, we spend much more effort identifying market conditions and their associated return/risk profiles than we spend on predicting them. The difficulty in the bull/bear distinction is that bull and bear markets don't actually exist in observable reality, only in hindsight, and it is futile to base an investment position on things that can't be observed.
What we can observe is that valuations are now in the high-normal range on the basis of normalized earnings. Stocks are no longer undervalued except on measures that assume that profit margins will permanently recover to the highest levels in history (in which case, stocks would still only be moderately undervalued). For instance, the price-to-peak earnings multiple on the S&P 500 is only about 11, but those prior peak earnings from 2007 were based on record profit margins about 50% above historical norms, largely driven by the excessive leverage that has since sent the economy reeling.
On normalized profit margins, valuations are above the historical average, and prospective long-term returns are below the historical average. Overall, I expect the probable total return on the S&P 500 over the coming decade to be about 8% annually, provided we don't observe much additional deleveraging in the economy. At the 1974 and 1982 lows, based on our standard methodology, the S&P 500 was priced to deliver 10-year total returns of about 15% annually. While it has become quite popular to talk about 1974 and 1982, the stock market is presently not even close to those levels of valuation.
Meanwhile, market action in recent weeks has been excellent from the standpoint of breadth (advances versus declines), uneven from the standpoint of leadership (where much of the strength has been focused on speculation in companies with extraordinarily poor balance sheets), and rather uninspiring on the basis of trading volume.
From an economic standpoint, the main argument for an oncoming recovery is simply that the knuckles of investors and consumers are no longer absolutely white. A backing-off from extreme risk aversion is certainly helpful, since it puts banks at less risk of customer flight, but the underlying assets of banks are still deteriorating. For the time being, the recent revision in accounting rules has prevented balance sheets from showing negative capital and revealing insolvency, but the reality is that the mortgages underlying bank assets are still defaulting. If this was simply a temporary problem of fluctuating asset values that would recover over time, the problem would not be serious. As T. Boone Pickens once said, “I have been broke three or four times, but fortunately for me I'm not an MBA, so I didn't know I was broke.” But the assets Pickens owned moved in cycles, and regularly recovered in step with the price of oil. In the case of mortgages, once the loan goes into foreclosure, there's an asset sale, the loss is taken, and the game is over.
Overall, then, the fundamentals of the market and the economy are not nearly as positive as they are being spun by analysts. Stocks are at best only moderately undervalued if one assumes that profit margins will recover to the historical extremes we saw in 2007, and are otherwise mildly overvalued. The financial system is in cosmetic remission, looking better on the surface, but still deteriorating internally. Still, we can't discard the fact that the extreme risk aversion of recent months has eased. Breadth has been quite strong, but is also overbought (with over 80% of stocks above their 20-day and 50-day averages). The mixed picture offers neither certainty that the bear market will resume, nor that a bull market will emerge.
Still, we are comfortable with uncertainty, and are relying on neither outcome. When we don't have a good basis for accepting market risk, we continue to hold individual stocks, and hedge against market fluctuations with offsetting short positions in the S&P 500, Nasdaq 100, and Russell 2000. Provided that our long-put/short-call index option combinations have identical strike prices and expirations, our returns in those conditions are driven by the difference in performance between the stocks we own, and the indices we use to hedge. That difference has been the source of the Fund's returns year-to-date as well.
Two news articles to mention. The cover story of the May issue of Money magazine includes a nice piece on your faithful fund manager, with a very serious looking photo, suitable for a large wall (the photographer, Nigel Parry and his assistants were very professional and great fun to have in the office).
The second piece of news is something I'm particularly excited about. Those of you who know me personally know that autism is a wonderful and challenging part of my life, and that I have been involved in research in neurobiology and statistical genetics for more than a decade, which is how I spend much of my time not devoted to fund management and family (I am the son of two physicians, so I was prepared for Med School as a zygote, and jumped the track in college). The Hussman Foundation has a close collaboration with the Miami Institute for Human Genomics (MIHG) at the University of Miami, including funding, statistical work, and research planning. The team at Miami is an outstanding group of researchers, is led by a great scientist and friend, Margaret Pericak-Vance, and also collaborates with Vanderbilt University Medical Center, under Jonathan Haines.
Last week, in conjunction with a number of other institutions, we reported the discovery of the first common risk locus for autism on a region of chromosome 5 in a little “desert” (probably a regulatory region) between the genes for cadherin 9 and cadherin 10 – which are neuronal cell adhesion molecules that are involved in maintaining synaptic contact and regulating the maturation of synapses.
Deqiong Ma of the MIHG first reported this finding at the 2008 International Meeting for Autism Research (IMFAR), presenting it as the top hit in a GWAS (genome wide association scan) using family-based data. We then validated it using AGRE (Autism Genetic Resource Exchange) data, and approached the Children's Hospital of Philadelphia (CHOP) under Hakon Hakonarson for collaboration, since they were also doing a GWAS on autism. When all of the data was combined, including case-control data obtained by CHOP, it was highly significant. The results were simultaneously published last Tuesday, in Annals of Human Genetics and Nature.
As a side note, you may see reports that say things like “65% of people with autism share this variant” and so forth. This is something of an overstatement. 65% of people with autism have allele 2 instead of allele 1 at a specific location on chromosome 5 (rs4307059), but the associated mutation in the vicinity of that marker is still to be identified, and not all pieces of genetic material with an allele 2 at that location will carry a mutation. So the proper story is not that there is a single gene that causes autism, or that we've identified the specific mutation, but rather that we've found the first common genetic variant associated with autism, which articulates one of the links by which autism operates, and is a major step forward.
See, I really can write a whole weekly comment without repeating that the bondholders of mismanaged financial companies should be required to accept debt-for-equity swaps or haircuts, with the alternative being government receivership. Didn't even mention it.
As of last week, the Market Climate for stocks was characterized by neutral valuations – modestly overvalued on the basis of normalized earnings, and moderately undervalued on the basis of earnings measures that assume a return to record 2007 profit margins. Market action was also mixed, with breadth being the clearest bright spot, and sponsorship from trading volume being the weakest link. The Strategic Growth Fund remains well hedged, but continues to have about 1% of assets in call options (we trade around this position, and “gamma scalp” the strikes and expiration dates so that we take a portion of the value out on rallies, and add exposure on day-to-day declines). The overall position clearly has a defensive bias, but allows for some amount of participation in further market strength if it emerges.
In bonds, the consensus for an economic recovery has pushed Treasury yields higher on both straight Treasuries and TIPS, while some of the flight-to-safety in precious metals has abated. All of this has contributed to a pullback of a few percent in Strategic Total Return. As might be expected, we responded to the higher real yields on TIPS late last week by moderately increasing our exposure to that area. I would expect that we will bump our precious metals exposure back above 10% of assets on further price weakness if it emerges, particularly if Treasury yields and real yields begin to decline again, but we are comfortable with our position for now. The Fund also has about 10% of assets in foreign currencies, and about 5% of assets in utility shares.
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