May 24, 2010
Don't Mess with Aunt Minnie
Over the years, I've noted that certain subsets of market conditions - occurring together - are associated with very specific outcomes, such as oncoming recessions, abrupt market weakness, strength in precious metals, and so forth. Such indicator subsets, or Aunt Minnies, are essentially "signatures" that often have very specific implications. In medicine, an Aunt Minnie is a particular set of symptoms that is “pathognomonic” (distinctly characteristic) of a specific disease, even if each of the individual symptoms might be fairly common. Last week, we observed an Aunt Minnie featuring a collapse in market internals that has historically been associated with sharply negative market implications.
Of the 3257 issues traded on the NYSE last week, 2955 declined and just 275 advanced. The S&P 500 has now abruptly erased nearly 8 months of progress. Moreover, we observed a "leadership reversal" with new 52-week lows flipping above the number of new 52-week highs. Our broader measures of market action deteriorated to a negative position as well. Historically, we can identify 19 instances in the past 50 years where the weekly data featured broadly negative internals, coupled with at least 3-to-1 negative breadth, and a leadership reversal. On average, the S&P 500 lost another 7% within the next 12 weeks (based on weekly closing data), widening to an average loss of nearly 20% within the next 12 months - often substantially more when the Aunt Minnie occurred with rich valuations and elevated bullish sentiment.
The most recent instance was November 9, 2007, which was followed by a market loss of more than 50%, but the instances also include September 22, 2000, prior to a nearly two-year bear market decline; July 14, 1998 prior to the "Asian-crisis" mini-crash; July 27, 1990, at the beginning of the pre-Gulf War plunge; October 9, 1987, just prior to that market crash; July 2, 1981 at the beginning of the 1981-82 bear market and again in May 21, 1982, following a strong rally during that bear market, leading into a steep decline to the final lows; November 9, 1973 (just after a swift rally during the 1973-74 bear market, and leading into the main portion of that loss); and November 21, 1969, at the beginning of the 1969-70 bear market.
Given my aversion to market "forecasts," I hesitate to interpret this record as a hard prediction of what will occur in this particular instance. This is particularly true because in a handful of instances (2/9/68, 9/12/75, 10/20/78 and 4/30/04), the outcomes were fairly benign. Still, the average outcome has been awful. For that reason, the combination of unfavorable valuations and collapsing market internals is a sharp warning to examine risk exposures carefully here.
I haven't used the word "warning" for some time, and I certainly don't want to be alarmist. If your asset allocation is reasonable and you are following a well-defined discipline, do nothing. There is wisdom in ignoring the views of others and staying the course, provided that your investment strategy is in fact based on a well-defined discipline. That said, I disdain when analysts advise "staying the course" when the subtext is to disregard risk. Probably the best advice I can offer is to reprint the following segment from the November 12, 2007 comment, which roughly mirrors my sentiments at present:
"My intent here is not to encourage disciplined investors to deviate from carefully considered investment plans. But if a recession or a bear market would produce unacceptable losses or would force you to abandon your investment plan, it is best to begin altering your investment position immediately (even if not entirely at once) toward a position that you can maintain regardless of market outcomes. If your position is inappropriate, do not wait for an “ideal” opportunity to change it. Begin changing it immediately, and continue to change it in steps – larger steps when you can get favorable prices, smaller steps when you have to do it at adverse prices. The important thing is to start immediately and decide in advance to move step-by-step over a reasonably limited period of time, until your position is appropriate.
"I should also emphasize that I have no intention of encouraging short-selling or bearish speculation about potential market weakness. Our investment position is fully hedged, but the dollar value of our shorts never materially exceeds our long holdings. It can be very costly to bet on market declines because the “tracking risk” is intolerable – it's one thing to gain only moderately when the market gains, but it's entirely another thing to lose predictably and continuously as the market advances. You simply can't maintain the discipline if the market makes a sustained move against you.
"In short, my intent is to prod investors to carefully think about their risk exposures, and to make any needed changes in a step-wise fashion. Make larger changes when prices are advantageous, and smaller changes when prices are adverse, but start immediately and keep moving step-by-step until your position is correct. The inability of investors to extract themselves from speculative positions destroyed the financial security of many investors in 2000-2002. At the same time, I don't recommend “bearish” investment positions except as a hedge against long exposure that would otherwise be inappropriate."
From a price-volume perspective, it is a real problem that valuations are rich at the same time that technical measures are breaking down. This is inconvenient because if something makes a given trader want to sell, the price must move in a way that either removes that impulse or induces another trader to buy. There is no other option. As I noted in Zen Lessons In Market Analysis, "if you've got an overvalued market which then loses technical support, the outcome can be extremely negative, because technical investors are prompted to sell, but fundamental investors have weak sponsorship at that point, so large price declines are required to induce the fundamental investors to absorb the supply."
Finally, as longer-term readers of these comments know, I have a lot of respect for Richard Russell, who publishes Dow Theory Letters and is as close as one can get to having William Peter Hamilton - who wrote for the Wall Street Journal in the early part of the 20th century - still writing. While our views certainly don't always agree, you won't find a more informative, if colorful, observer of market action than Russell. At present, Dick suggests "If I read the stock market correctly, it's telling me that there is a surprise ahead, and that surprise will be a reversal to the downside for the economy, plus a collection of other troubles." Speaking in reference to one of his key measures of market internals, he observes "In 50 years, this is the most decisive top I can ever remember... the damage and cost of this reversal will run into the trillions."
We can't rule out a recovery in market internals that would allow a further extension of market gains, but the historical record provides little basis for that expectation. Take risk seriously here. That is not advice to abandon all exposure to risk, but it is important to accept only the risks you can actually tolerate in the event that further problems materialize.
Savage the Innocents or Restructure the Debt
The ultimate survival of the Euro relies on the ability of its member nations to maintain tightly controlled fiscal deficits, and on the ability of the ECB to avoid creating more of the currency (through its purchases of European debt over time) than is consistent with price stability. Unfortunately, some of those member nations have no history of deficit restraint, nor any reasonably near-term prospect of acquiring it. It is one thing to buy more time, at some cost, to resolve a situation that will gradually self-cure. It is another to throw good money after bad in order to kick the can down the road.
Providing Greece (and possibly some of its neighbors) a graceful exit from the Euro requires greater courage but lower ultimate cost - particularly to the citizens of Greece itself - than a policy of forcing heavy austerity, dislocations, and internal deflation within Greece. The effect of austerity policies will be to damage the revenue side of the Grecian economy enough to leave the deficits little changed in any event. One would like to go back a decade in time and choose different policies that would have allowed Greece to maintain the Maastricht deficit limitations, but it is far too late to push a full-grown genie back into an itty-bitty bottle.
As I've constantly emphasized (possibly to the point of exhaustion, yet it remains worth emphasizing) - in a situation where the probable amounts repaid by borrowers cannot meet the required debt service on the bonds (or mortgages), one has two choices: either savage the innocents in order to defend the bondholders (and create new government debt or print money to do so), or restructure the debt. For Euro-area countries, the stronger member countries (which are already running fiscal deficits) are being asked to run even larger fiscal deficits to bail out the weaker members. This itself would undermine the Euro. The alternative bailout is for the ECB to effectively print the money, which has the same effect of undermining the Euro by levying an eventual "inflation tax" on the holders of Euro-denominated assets.
The natural fear of restructuring is that if the debts of Greece (or any other debtor for that matter) are not made whole, then there are probably other leveraged financial institutions that hold that debt, who will be forced to mark down assets, and might themselves become insolvent. The proper response to this fear is "And?" The management of those institutions took risks, for which they stood to gain, and those risks were poorly taken. Likewise, the bondholders that lent to those institutions took risks, for which they stood to gain, and those risks were poorly taken. Who should bear the costs of those actions? Precisely those individuals and entities.
It is helpful to remember that only about 60% of the liabilities of the global banking system represent deposits. The rest is money that was knowingly provided to these institutions through stock or bond purchases, in pursuit of returns. If an institution takes bad bets, the investors in the institution, not the public, should lose money.
The frantic cry is then "But look what happened when we let Lehman fail!!" The response is that the failure of Lehman did not cause dislocation simply because the company went bankrupt, but because there was no mechanism by which a regulator had the authority to step in, cut the operating entity away from the stockholder and bondholder liabilities, and transfer that operating entity as a going concern. Note that in the case of bank failures (such as Washington Mutual), that mechanism is fully functioning. The same is true for European banks. Lehman's failure was problematic because the company had to be sold off piecemeal and unwound in a very disorganized manner. Disorganized unwinding was the problem.
Restructuring does not cause losses to bank depositors, and it does not lay burdens on citizens who had no part in the mismanagement and poor allocation of capital. Instead, it properly places the costs precisely on those individuals who provided capital, in expectation of return, but also with the foreknowledge that those investments could result in losses. When governments change the rules of that process, and teach that any risk is good risk, because bad investments will be bailed out (at least if one has the right friends), what prevents rampant misallocation of capital? Worse, what prevents preferential loans to unqualified recipients, at public expense?
It would be wise for investors to abandon the fear-mongering word "failure" in preference for the instructive word "restructuring." Thinking of credit strains in terms of failure prompts a natural but improper impulse to avoid that failure through bailouts, at the cost of those who had no part in the mismanagement. In contrast, recognizing the need for restructuring places the costs directly where they belong - on those who provided and managed the capital. It also immediately turns attention to proper solutions and negotiations between the borrowers and lenders.
While each situation will have its own outcome, depending on the relative position of each party, the ability to swap debt for equity (i.e. taking partial ownership), and the profile of cash flows over time (which might allow a shift in the timing of payments), the ultimate goal of restructuring is to bring the value debt obligations back in line with the probable cash flows that will be available to relieve them. If we accept a "failure" and "bailout" mentality, lenders will play chicken with governments in a way that puts the costs on ordinary citizens. If instead, the only alternatives are restructuring or receivership, the problems can be properly contained to negotiations between borrowers and lenders.
As of last week, the Market Climate for stocks was characterized by unfavorable valuations and unfavorable market action. We also observed a leadership reversal last week, coupled with lopsided negative breadth, which as noted above tends to be associated with unusually hostile market outcomes. The Strategic Growth Fund is fully hedged here. We closed the bulk of our "staggered strike" position as the implied volatility of options (above 40%) significantly reduces the potential benefit of owning additional time premium, and significantly raises the cost if the market moves sideways or recovers. When our long puts and short calls have matched strike prices and expirations, there is no net time decay in the hedge, and it essentially operates as an interest-bearing short position on the underlying index.
We continue to have modest staggered positions in the Nasdaq 100 and Russell 2000, because the size of the potential losses in these indices, in the event of a further market decline, is still large enough to warrant the additional time premium we are holding (about a half-percent of Fund value). In our current position, the primary driver of Fund returns here is the difference in performance between the stocks held by the Fund and the indices we use to hedge.
In bonds, the Market Climate last week was characterized by moderately unfavorable yield levels and favorable yield pressures. In particular, credit spreads have widened substantially, which as expected, has created "safe haven" demand for Treasury securities as default-free investments. Also, the fear of credit problems has put pressure on commodities, which is why despite our longer-term inflation concerns, we are only gradually building positions in precious metals shares and other inflation-sensitive securities. There is a very strong tendency for investors to associate credit strains and economic weakness with deflation, which tends to pressure securities like precious metals shares and TIPS, even in an environment where central banks around the world are pursuing policies that will produce long-term inflation. So as I've frequently noted, our long-term inflation outlook does not translate into material accumulation of inflation hedges, except to the extent that we observe substantial price weakness.
On last week's selloff, we did shift about 2% more of the Strategic Total Return Fund's assets toward precious metals (now at a still very small 4% exposure), with about 4% of assets in utility shares, and about another 3% in foreign currencies. The bulk of the Fund's assets, of course, are in Treasuries, with a duration of just under 4 years - primarily in straight, intermediate-term Treasury bonds. Most likely, we will have numerous opportunities to shift our investment positions to reflect a longer-term outcome of inflation and generally rising interest rates in the second half of this decade. For now, credit fears are likely to boost demand for default-free government liabilities, holding down inflation pressures and prompting (ultimately incorrectly) less eager demand for commodity-related securities.
NEW from Bill Hester: An Update on International Market Valuations
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