March 8, 2010
The Rubber Hits the Road
In the January 11th comment Green Shoots Weak Roots, when the S&P 500 was slightly higher than it is at present, I noted
"Despite the high level of bullishness here, the market has gained only a few percent beyond its September highs. Most of what we are seeing now is a tendency to make marginal new highs, back off slightly, and then recover that ground enough to register another marginal new high. As I've noted frequently, when market conditions are characterized by unfavorable valuations, overbought conditions, overbullish sentiment, and upward yield pressures, the market's tendency is exactly that - to make continued marginal new highs for some period of time, followed by abrupt and often steep losses virtually out of nowhere. Being defensive in that situation can make each slight new high feel excruciating, even if the market is not making much net progress. I remember that my own patience with this process was tested in mid-2007, when I quoted Wallace Stevens - "Does ripe fruit never fall? Or do the boughs hang always heavy in that perfect sky?"
At present, my impressions haven't changed much. Following a brief retreat in prices and advisory bullishness, both are back to the same tenuous conditions (see Mark Hulbert's recent note on sentiment, which notes that his index of advisory bullishness jumped last week to the highest level since the 2007 peak). The market remains in an "overvalued, overbought, overbullish, yields rising" syndrome, particularly given the subtle yield pressures we're seeing. More on that below. Still, I think it's equally important to stress the second part of my comments from that Green Shoots update:
"Given this context, the next few months are likely to be extremely important. The present overvalued, overbought, overbullish, yields-rising conformation holds us back from accepting market risk here in any case. But the market is quite likely to clear this condition in one way or another over the next few months, most likely with an abrupt decline. Meanwhile, the next few months will also afford us better clarity with respect to the actual condition of the delinquency/foreclosure situation, as well as a look at the off-balance sheet entities that, per FASB rules, must now be disclosed on the balance sheet of financial institutions (where Freddie Mac has already warned the accounting change will significantly impair its solvency).
"The combination of greater clarity, and hopefully, better valuation, should offer us much more flexibility to accept market risk, without the "two data sets" issue that has plagued us in recent quarters. My concern is still very much that the outcome of this clarity will not be favorable for the financial markets or the economy. But once you know the environment you are in, it is much easier to work with the details, good or bad."
The upshot is that we are now in the time window where the rubber hits the road, so to speak. From the pattern we observed during the round of sub-prime resets, delinquencies tended to follow the resets within about 3 months, and foreclosure actions within about 6 months. Although the 2010 peak in the Alt-A / Option-ARM reset schedule doesn't occur until July, with a much larger peak in mid-2011, a small initial round of resets is already in progress, having started about November of last year. I would expect that if we are indeed at risk of a second wave of mortgage defaults and credit strains, it will show up first as a surprising jump in 30-day mortgage delinquencies in the data we see over the next 2-4 months. I do not expect quarters upon quarters of uncertainty. It may take longer to observe the full effect of continued mortgage delinquencies and foreclosures, but we are at about the point where the data would depart from the market's "all clear" expectations if credit pressures are likely to resume with force.
The simple answer is that we will respond in line with historical precedent. A deleveraging cycle is much like a secular bear market in that the market experiences a great deal of volatility, but tends to establish a sequence of troughs, each at lower levels of valuation (even if not at lower absolute prices). In that environment, there is significant risk of abrupt spikes in risk aversion (which implies abrupt price spikes to the downside), so you can't trade with "hot" valuation or market action criteria. It should be no surprise that Graham and Dodd wrote Security Analysis following the post-credit crisis period of the 1920's and 1930's. If there's one lesson from those environments, it is that valuations and the idea of a "margin of safety" takes precedence over all other considerations.
In post-war data where investors have not been concerned about credit and banking crises (and especially since the mid-1990's), valuations have been a less reliable investment guide except over the complete bull-bear cycle. Even in the face of valuation bubbles and pertinent risks that have predictably harmed investors over the longer term, investors have demonstrated themselves to be quite willing to ignore those risks and speculate. While there has always been this element in post-war data, it has become very exaggerated in the past 15 years. An important feature of post-war cycles is that when credit crisis is not a concern, you've generally been able to cut losses before the real damage is done by paying very strict attention to market internals. Risk aversion doesn't spike as abruptly. In contrast, the losses in a credit crisis can slam investors from left field.
Basically, trends, technicals and market internals have played a larger role in post-war data, and particularly since 1995, allowing the market to periodically tolerate valuations that would have collapsed much sooner in earlier times. Still, valuations have remained important in determining the extent to which market returns are durable. Ultimately, valuations have determined long-term returns regardless of what portion of history you examine. Speculative advances in richly valued markets are invariably surrendered later.
The S&P 500 is still below where it was a decade ago, and even with the benefit of its recent advance, has underperformed Treasury bills for nearly 13 years. The reason is that investors could not have cared less about valuations during the late-1990's, and failed to recognize that they were still inappropriately rich between 2004-2007 (as they are again today). Speculators can get all kinds of enticing advances going over the short-term, but over time (complete market cycles and longer), regardless of whether one looks at post-war data or pre-war data, valuations determine the long-term returns that investors achieve in stocks.
As we move through the coming months, resolving the "two data sets" issue will help us to determine which set of historical precedents is relevant. If the current economic environment produces fresh credit strains similar to previous periods of credit difficulty in the U.S., Japan and elsewhere, valuations and margin of safety will remain the most important consideration in determining investment positions. If the economic situation reveals itself to be more like typical post-war cycles, valuations will still be an important consideration, but we'll be better able to assume that speculation (provided sufficient evidence from market internals) will be reliable even in the absence of clear fundamental support from valuations.
I certainly don't expect that the mortgage securities in bank portfolios and at agencies such as Fannie Mae and Freddie Mac will ultimately be made whole by cash flows paid by homeowners. But we can't fully reject the possibility that the Fed and Treasury have kicked the can down the road far enough, and that the FASB has obscured disclosure sufficiently, that we'll just gradually make mortgage securities whole over a period of years through bloated fiscal deficits and quiet bailout of these lenders. If we get through the next several months without a material shift in credit conditions, we'll gradually revise our assumptions to reflect a "typical" post-war economic environment and set our investment exposures consistent with that. This doesn't mean ignoring valuation, but it does mean being more responsive to speculative pressures and strategies that have been effective in post-war data.
Can we rely on investor myopia?
Over the past decade, it has been an uncomfortable lesson to accept that investors can be relied on to behave in ways that are ultimately unsustainable and destructive to their wealth, as long as market internals are temporarily supportive. It's one thing to say, "From every historical precedent, we know that this is going to end badly, and investors will lose a great deal of their wealth, but for now, they are speculating anyway." It's another thing to add, "and since they are, we are actually going to rely on investors to continue behaving dangerously, and join them." Even though we've substantially outperformed the S&P 500 with smaller periodic losses over complete market cycles, there is no denying that periodicaly riding the coattails of speculators, so to speak, would have made our margin of outperformance even greater.
It's unlikely, given the seriousness I place in being a fiduciary to shareholders (in some cases to their life savings), that I'll ever completely submit to the idea of relying on the speculative impulses of investors, but I do recognize that we can probably accept a greater level of speculative risk going forward than we were willing to adopt coming off of a valuation bubble and a credit crisis with a latent second-leg still looming. I expect that clarity about the underlying economic conditions here will be helpful in striking that balance.
In post-war data, subtle deterioration in various measures of market action has generally provided an indication that investors are becoming more skittish toward risk. But what if investors change their behavior, and finally learn to stop ignoring pertinent risks (which, as we've seen over the past decade, ultimately translate into actual losses)? How would we know that riding the coattails of speculators was now a dangerous approach?
I've thought about this a great deal, and I suspect that just as the experience of patients is determined by the quality of information they get from their doctors, the behavior of investors is likely to be only as sound as the quality of the discourse and advice they receive from investment professionals. In reflecting on why the past 15 years have been so riddled by irresponsible speculation, it is impossible to ignore the rise over that same period of widely-viewed financial programming that is equally riddled with cartoonish content that encourages short-term thinking and speculation (buy-buy-buy! sell-sell-sell! boo-yah!). When we observe a clear change in the quality of analysis on the financial news, and the departure of its more speculative elements, I suspect we'll also see greater emphasis on fundamentals and better allocation of capital, while speculation will be less effective in the face of overvaluation.
During the late-1990's bubble, it struck me that the discourse on CNBC was remarkably similar to the sort of discourse that I had read from news archives preceding the 1929 crash. As I wrote at the time, what was surprising was the extent to which investment professionals, who ought to have known better, were fully endorsing valuations that were clearly inconsistent (at the time, and certainly in hindsight) with prospective cash flows - even if one assumed that economic activity, earnings, and dividends would achieve and sustain the highest growth rates ever observed in history.
Many investment professionals have developed a habit of forming expectations based on nothing more than extrapolation of short-term trends in the data, even when those extrapolations are inconsistent with market history or well-established economic relationships. This was a key element in creating the housing bubble - no price was too high and no bubble was recognized, because all that mattered was that prices were rising. The focus of analysts on the short-term ups and downs of economic and earnings reports has become such a mainstay of financial news that it's not at all clear to me that investors even recognize how devoid the current financial discourse is of real analysis.
To analyze a company or the market, you have to think carefully about the long-term stream of cash flows that investors actually stand to receive, and how they should be discounted to arrive at an appropriate price. Instead, the only question today is whether earnings and economic reports are delivering "surprises" versus what "the Street" estimated the day before the data was released. The quality of earnings, the cyclicality of profit margins, dilution from option and stock grants, the implied total return reflected in the stock price, the return on retained earnings, cost of entry, competitive structure, market saturation, the potential for organic growth from reinvested capital - all of those things matter over the long run. But to watch a half hour of CNBC today is like watching an old episode of Gomer Pyle ("Well, surprise, surprise, surprise!").
As Benjamin Graham and David Dodd wrote following the Great Depression (Security Analysis, 1934),
"The 'new-era' doctrine - that 'good' stocks (or 'blue chips') were sound investments regardless of how high the price paid for them -- was at bottom only a means for rationalizing under the title of 'investment' the well-nigh universal capitulation to the gambling fever… Why did the investing public turn its attention from dividends, from asset values, and from earnings, to transfer it almost exclusively to the earnings trend? The answer was, first, that the records of the past were proving an undependable guide to investment; and secondly, that the rewards offered by the future had become irresistibly alluring ... The notion that the desirability of a common stock was entirely independent of its prices seems incredibly absurd. Yet the new-era theory led directly to this thesis."
At the point we observe a higher quality of discourse from financial professionals, I suspect that the quality of investor behavior will follow. Without that, the amplified effect of speculation we've seen in the past 15 years may turn out to be an ugly but enduring feature of the investment landscape. We'll adapt in any event. For now, I am still very concerned about the potential for abrupt weakness and credit deterioration, but the data over the coming months will help to resolve those concerns one way or the other.
Yield pressures suggest the risk of an "air pocket"
Last week, we observed a subtle shift in yield pressures, which has historically been associated with fairly abrupt "air pockets" in which stocks have typically lost 10% or more within the span of about 6 weeks. As usual, this isn't a forecast, but given that we are already defensive on the basis of broader considerations about overvaluation and the overbought status of the market, the pressures we're seeing on the yield front make our aversion to market risk somewhat more pointed.
Consider the following conditions: 1) market valuations above their historical norm by any amount at all - for example, a dividend yield on the S&P 500 anything less than 3.7%, and; 2) The 10-year Treasury bond yield and the year-over-year CPI inflation rate higher than their levels of 6 months earlier (regardless of whether their absolute levels have been high or low).
If you look at market history since 1940, this condition has been in effect nearly 20% of the time. Yet this set of factors alone has made an enormous difference in the returns achieved by the market. When the above conditions have been in effect at the same time, the S&P 500 has actually lost ground on a price basis, and has delivered an annualized return of just 0.28%. In contrast, when those conditions have not been in effect, the market has advanced at an average annualized rate of 14.94%. Of course, these averages mask a lot of volatility, but it is clear that even the most basic combination of low stock yields and rising yield pressures is hostile to total returns.
To the above conditions, if Treasury bill yields are also higher than 6 months earlier (again, regardless of the absolute level of yields), the annualized return drops to -0.83%. Add a discount rate higher than 6 months earlier, and the annualized return drops to -2.22%.
Now add overbought conditions (say, a 12-month advance in the S&P 500 of greater than 30%), and the annualized return turns sharply negative, to -39.17%. Overvalued, overbought, conditions with rising yield pressures are trouble. Given those conditions, excessive bullishness only worsens the situation. Now, this combination of conditions has never persisted for an entire year, so the actual loss sustained by the market is not so extreme, but suffice it to say that the typical loss has been in excess of 10%. Based on the current overbought status of the market, there are only three similar periods that we can identify in post-war data: August-October 1999 (which was followed by an abrupt air pocket of greater than 10%), September-October 1987 (no comment required), and September-December 1955 (which was followed by a 10% correction, a brief recovery, and a secondary decline to re-test the initial low).
Again, this is not intended as a forecast, but rather to note a historical regularity that seems relevant in a market environment where we are already defensive on the basis of other considerations.
As of last week, the Market Climate for stocks was characterized by unfavorable valuations, overbought conditions, and hostile yield pressures, combining to produce a negative expected return/risk profile and holding the Strategic Growth Fund to a fully hedged investment stance. As noted above, the particular set of conditions we currently observe has generally been resolved by abrupt market losses over a period of about 6 weeks. To some extent, this is fortunate, as the next few months are also the window over which we expect to acquire better clarity about the potential for fresh credit strains.
To the extent that we can both clear the current combination of overbought conditions and overvaluation coupled with hostile yield pressures, a lack of fresh credit strains in the next few months could put us in the position where we could establish greater exposure to the market on the first indication of strengthening in market internals. Alternatively, renewed credit strains would increase the emphasis that we place on valuations, but as I've noted before, the main concern we have is what may occur at the point of recognition in the event that the credit crisis is not in fact behind us. We simply need to get past that point - either through a fresh escalation in credit risks, or by evidence that those risks are not as large as we anticipate. The next few months will be important either way.
A final possibility is that we fail to clear the current combination of overvalued, overbought conditions coupled with hostile yield pressures (or worse, bullish sentiment increases as well). In that case, even strict post-war data would suggest that we maintain a defensive stance until that condition is cleared, since the average return/risk profile of the market in that set of conditions has been negative, regardless of the status of market internals.
In bonds, the Market Climate is presently characterized by relatively neutral yield levels and unfavorable yield pressures. In the Strategic Total Return Fund, we currently maintain a duration of about 4 years, primarily in intermediate term Treasury bonds, as the potential for fresh credit strains remains our primary concern at present.
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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