March 19, 2012
An Angry Army of Aunt Minnies
As of Friday, the S&P 500 was within 1% of its upper Bollinger band at virtually every horizon, including daily, weekly and monthly bands. The last time the S&P 500 reached a similar extreme was Friday April 29, 2011, when I titled the following Monday's comment Extreme Conditions and Typical Outcomes . I observed when the market has previously been overbought to this extent, coupled with more general features of an "overvalued, overbought, overbullish, rising yields syndrome", the average outcome has been particularly hostile:
"Examining this set of instances, it's clear that overvalued, overbought, overbullish, rising-yields syndromes as extreme as we observe today are even more important for their extended implications than they are for market prospects over say, 3-6 months. Though there is a tendency toward abrupt market plunges, the initial market losses in 1972 and 2007 were recovered over a period of several months before second signal emerged, followed by a major market decline. Despite the variability in short-term outcomes, and even the tendency for the market to advance by several percent after the syndrome emerges, the overall implications are clearly negative on the basis of average return/risk outcomes."
As it happened, April 29, 2011 turned out to mark the exact high of the S&P 500 for the year, and was followed by a steep intermediate market plunge. My impression is that despite the recent run of speculation the market has enjoyed - largely reflecting a reprieve in European debt concerns and what appears to be a drawing-forward of jobs into the first quarter due to unseasonably favorable weather - the extended implications of present market conditions remain decidedly negative.
If you examine the components of the S&P 500 individually, you'll quickly find that the majority of those stocks are also at or through their own upper Bollinger bands. In overvalued, overbought, overbullish, rising-yield conditions, those extensions are often resolved in unison, which is what produces the characteristic "air pocket" where the index can give up weeks or sometimes months of upside progress in a handful of sessions (though we often see a knee-jerk reaction to buy that initial dip before more serious follow-through occurs).
In recent weeks, the market has faced what I've called an "angry army of Aunt Minnies" (see for example Warning: A New Who's Who of Awful Times to Invest and Goat Rodeo), These are indicator syndromes that are generally (and sometimes singularly) followed by steeply negative market outcomes. When I present these in the weekly comments, I'll often give specific thresholds (such as a Shiller PE of 18, 27% bearish sentiment, and so forth) in order to give an idea of where the "border" of a given cluster of data tends to be, but these aren't magic numbers. The objective is to capture a syndrome of conditions that is characteristic of some particular diagnosis, but the outcomes are generally robust to small variations in how they are defined. For example, with as few bears as we have at present, there's little distinction between say, 45% bulls and 44% bulls. As I noted last May:
"We can define an 'overvalued, overbought, overbullish, rising-yields syndrome' a number of ways. The more general the criteria, the better you capture historical instances that preceded abrupt market weakness, but the more you also encounter 'false positives.' Still, as long as the criteria capture the basic syndrome, we find that the average return/risk profile for subsequent market performance is negative, almost regardless of the subset of history you inspect."
The steepest market plunges on record (e.g. those following the 1973-74, 1987, 2000 and 2007 peaks, among others) have generally followed an overvalued speculative blowoff coupled with divergent interest rate pressures. This is why we take the "overvalued, overbought, overbullish, rising yields" syndrome so seriously. Indeed, the outcomes are usually negative on average even without rising yields, but the yield pressures tend to add immediacy. Notably, the emergence of this syndrome has provided accurate warning of oncoming losses both historically, and also as recently as 2010 and 2011.
These syndromes are useful because the combination of several conditions often carries far more information than any of them individually. To ignore syndromes like the ones we've increasingly observed in recent weeks is like having nausea, sudden lower-right abdominal pain - especially following a period of dull pain in the upper abdomen, coupled with an inability to even consider jumping, and shrugging it off as a stomach ache instead of recognizing that, in all likelihood, your appendix has just burst.
Two concepts of risk - market risk and tracking risk
Our approach has always been to accept the risk of market fluctuations in proportion to the average return that we can expect per unit of risk, given prevailing market and economic conditions. So we are willing to take a higher exposure to market risk when the prospective return/risk profile is favorable (as it was in 2003 for example). In contrast, we limit our exposure when the profile is weak, and hedge very tightly against market risk when we are confronted with classic signs that have almost invariably preceded major market setbacks (such as the "overvalued, overbought, overbullish, rising-yields" syndrome we observe today). That word "average" is important - our exposure to market risk tends to be proportional to the average return that we expect from that risk, given market conditions. From a full-cycle investment perspective, this is actually optimal strategy.
From a psychological perspective, however, it may not be. Specifically, we've had a number of conversations with shareholders of the following form: "I know that the indicators you're looking at are negative, and I do agree that eventually we'll see a bear market that wipes out a lot of these market gains, but here and now, the market is going up. Can't you take a larger exposure to market risk - not huge - but enough to participate a little bit until things turn down?" The basic answer is, yes we could, but we know from historical evidence that we would not actually expect to add to our net returns over time. Instead, we might gain some amount in the event that the market was to advance further, but we would also expect to lose that amount without any predictable expectation of "locking it in." This is because we would be taking a positive position despite negative expected returns, so there would then be no trigger to sell except at the point where a new downtrend was already established, most likely at similar or lower prices, and very possibly on a large and abrupt decline where good price execution would be difficult.
Still, I recognize that this sort of strategy might be psychologically preferable to some investors - despite not adding anything to long-term returns. Participating some amount during an advance might simply feel better, even if there is no expectation of actually retaining that short-term gain. This is an important issue because it highlights the difference between two kinds of risk - one being market risk itself, and one being tracking risk (the difference between one's own performance and the performance of the market).
Our own investment strategy places very little weight on tracking risk, because we are focused on the complete bull-bear market cycle. Likewise, we don't particularly care whether we take our drawdowns during periods when the market is rising or when it is falling, provided that those drawdowns are relatively muted over the full cycle (particularly compared with the losses of over 50% that the stock market has periodically experienced). Indeed, from a diversification perspective, it's better for us to take our drawdowns when the major indices are not, and vice versa. Accordingly, if a given amount of risk isn't expected - on average - to have a positive return, given prevailing market conditions, we simply don't take it. Yet it's clear, especially at times like these, how uncomfortable it can be psychologically to be defensive during an exuberant rally.
While I am convinced - even adamant - that the present time would be the wrong moment to make any shift toward greater market risk, I do understand the psychological discomfort that tracking risk can create. Reducing tracking risk involves a tradeoff - you tend to move somewhat more in line with the market, but you also tend to experience more frequent drawdowns. It's very difficult to exit with further gains once the average return/risk profile goes negative - even if various trend-following measures are still positive. We're open to refinements in our approach that might reduce tracking risk somewhat - provided that we don't materially increase large drawdowns, or reduce expected long-term returns in the process. But our main objective is always focused on investment returns over the complete market cycle (bull market plus bear market) with significantly smaller periodic losses than a buy-and-hold approach. Within the limits of that objective, we'll work to find ways to diminish the periodic discomfort we ask our shareholders to accept. Again however, I am convinced that now would be precisely the wrong time to give in to that discomfort by accepting greater market exposure.
On the subject of investment performance over the complete market cycle (bull peak to bull peak, bear trough to bear trough), a few observations may be useful. In the Strategic Growth Fund , we view the period from the 2000 market peak to the 2007 market peak (peak-to-peak), and the period from the 2002 market trough to the 2008-2009 market trough (trough-to-trough), as fairly representative of typical full-cycle application of our investment approach. In these complete market cycles, the Fund widely outperformed the S&P 500, with far smaller periodic losses.
As we've discussed in previous weekly comments, annual reports, and briefly below, the 2009-early 2010 period was notably unrepresentative of our typical investment strategy. Unfortunately, as a result of that period, the total return of the Fund from the 2007 market peak (10/9/07) through Friday's peak is - at least temporarily - a cumulative 11.6% behind the S&P 500, though we've experienced much less volatility and far smaller intervening losses.
The simple fact is this. Despite anticipating much of the financial crisis and the accompanying market losses, I misjudged the likely policy response, expecting what I called a "writeoff recession" where reckless lenders would be expected to take losses, rather than a "kick the can" approach - defending bondholders at public expense, changing accounting rules, and mounting massive central bank interventions, all of which promise to create recurring crises for years to come (see the Swedish banking crisis in the 1990's for an example of a proper and durable response). As the crisis deepened, I insisted on stress-testing our hedging approach, with the requirement that it should perform well in validation data from both post-war and Depression-era periods. There was simply no way to "average in" Depression-era evidence without getting consistently negative expected return/risk estimates. Indeed, during the Depression, the same valuations that we saw at the 2009 lows were followed by a further loss of two-thirds of the market's value. Until I was certain that our methods were robust to both data sets, we remained hedged.
We ultimately tackled that "two data sets" problem with ensemble methods, which capture distinctions that we were frankly unable to make without them. We were very open about the challenges we faced during 2009 and early-2010 in solving that problem, because the need to properly integrate Depression-era data forced a defensive stance that was not representative of our "typical" investment strategy. In short, the 2009 - early 2010 period is distinct in that it is not indicative of the hedge position that can be expected of our strategy in future market cycles, even under identical conditions and evidence.
These considerations may go some way in understanding why the Strategic Growth Fund remains my largest single investment holding (with nearly all of my remaining liquid assets invested in the other three Hussman Funds).
The S&P 500 has underperformed Treasury bills for what is now a 13 year period, and we certainly expect that future cycles will feature more historically normal valuations and prospective market returns. In that sort of environment, we would expect to take far more aggressive investment positions than we've been able to take since 2000. That said, our investment actions from 2000 through 2008, as well as our actions since early 2010, are representative of what we could be expected to do again under identical conditions and evidence. Frankly, this includes the fact that our investment stance has been largely defensive since early 2010. In that regard, it's notable that the S&P 500 gained no net ground from April 2010 through November of 2011. Of course, the market has advanced significantly in the past few months. Our defensiveness in these recent months has been driven by overlapping syndromes of historically negative evidence, with increasingly extreme warning flags. The day-to-day discomfort that we experience here - being defensive in an overvalued, overbought, overbullish advance where various warning flags abound - may be frustrating, but is fairly typical of what our investment strategy will experience in similar conditions, as we did in 2000, 2007, and prior to the less severe 2010 and 2011 declines.
Undoubtedly, our recent defensiveness would feel less uncomfortable had I realized that we would be forced to contemplate Depression-era data, and had our current ensemble methods been in place to capture significant gains during that 2009 - early 2010 period. It's clearly my job to minimize or eliminate the impact of that "miss" over the present cycle. Again, however, I remain adamant that now would be one of the worst possible times to accept market risk in hopes of "catching up" - when valuations are rich instead of reasonable, prices are strenuously overbought instead of oversold, investor sentiment is exuberant rather than fearful, the growing technical divergences are negative rather than positive, corporate insiders are frantically selling instead of buying, stocks are grasping at speculative highs instead of multi-year lows, and risk premiums are razor-thin instead of satisfactory.
On the economy, our broad view is based on dozens of indicators and multiple methods, and the overall picture is much better described as a modest rebound within still-fragile conditions, rather than a recovery or a clear expansion. The optimism of the economic consensus seems to largely reflect an over-extrapolation of weather-induced boosts to coincident and lagging economic indicators -- particularly jobs data. Recall that seasonal adjustments in the winter months presume significant layoffs in the retail sector and slow hiring elsewhere, and therefore add back "phantom" jobs to compensate. While my remarks on seasonal adjustment have been co-opted by a few conservative blogs, I don't view these adjustments as manipulative. It's just important to understand their impact. It seems likely that particularly in retail and construction, favorable weather has brought forward hiring that would normally occur in the spring months, and the seasonal adjustment factors have added to those anyway. The question - still unresolved - is whether the jobs brought forward from the spring months will take anything out of the job creation numbers we see in the months ahead, particularly in the April-May time frame.
There's slightly more dispersion in various economic Aunt Minnies we track, but the overall picture is mixed at best. On the side of concern is a syndrome that uses the standardized values (zero mean, unit variance) of the OECD US, OECD Total, and ECRI Weekly leading indices. A strong discriminator of actual recessions and recoveries can be defined as follows: When all three are below -0.4, and the average is less than -1, the economy has always been approaching or in recession. Conversely, when at least two of these three improve to -0.2 or better, the economy has always been entering a recovery. It's possible to vary the criteria slightly (e.g. 0.1 tighter or looser), but that seems to invite some false positives or false negatives, particularly due to data revisions. This is still only one measure, and as such should be used as a rule of thumb in the context of dozens of other indicators (which is how we use it in practice). Still, it's an instructive example of the coordinated indicator movements we try to capture with Aunt Minnies. The OECD leading indices were released again last week, as was the latest reading in the ECRI index. The standardized values of all three remain below -0.2. That may change in the weeks ahead, but we have not seen it yet. An improvement on this Aunt Minnie would be helpful in alleviating the concern we presently have about leading indicators, particularly if we see some strength in real consumer spending as well.
Here's what this particular Aunt Minnie looks like (shown by the regions outlined in red). Actual US recessions are shaded blue. The most recent data would not trigger this syndrome today, but it does not relieve the existing signal either. Our best interpretation is that the leading data is mixed - not deteriorating at present, but certainly not "all clear" yet.
On the brighter side, the recent speculative run does give us fewer recession warning signs from financial market variables like stock prices and credit spreads. Recessions tend to be associated with stock price weakness, widening credit spreads, a reasonably flat yield curve, and fairly tepid ISM readings, among other factors. Generally speaking, we use a 6-month look-back (again, not a magic number, but simply a way to make the syndrome operational). Presently, credit spreads would have to widen by about 40 basis points and the S&P 500 would have to decline by about 15% in order to re-establish this particular syndrome of recession warning conditions, which we observed last summer. Given the unusually extreme stock market conditions and narrow risk premiums here, I certainly wouldn't rule out fresh deterioration in the S&P 500 and corporate debt. But for now, suffice it to say that despite continued concerns from leading economic measures, financial variables would have to deteriorate in order to confirm those concerns more unanimously.
As of last week, the Market Climate for stocks remained characterized by an unusually hostile set of overvalued, overbought, overbullish, rising-yield conditions. The record of steeply negative market outcomes that have followed these conditions has nothing to do with my opinion but instead reflects objective historical evidence. The outcome in this particular instance may be different, and we have no problem with investors who are willing to invest on that expectation. We are not. It's that simple.
At present, we estimate the likely total return for the S&P 500 over the coming decade to be about 4.1% annually (nominal). While this may seem adequate compared to a 10-year Treasury yield of 2.3%, the comparison entirely ignores risk. You don't just "lock in" a 10-year return - you ride it out. The volatility of stocks is dramatically higher than the volatility of a 10-year bond. So the proper question is not whether stocks are priced to achieve a greater 10-year return than bonds, but what happens if investors eventually demand even modestly higher prospective returns. The answer is that the impact of changes in valuation multiples would swamp any reasonable expectation for growth in fundamentals. Satisfactory returns on stocks now require strong assumptions for GDP growth (about 6% nominal annual growth) and sustained profit margins (presently over 60% above the historical norm), in addition to the requirement that valuations remain rich and prospective returns stay indefinitely depressed. This may occur over the short run, but beyond that it strikes us as pure speculation.
Strategic Growth Fund and Strategic International Fund remain fully hedged here. About 50% of the holdings in Strategic Dividend Value are presently hedged - which is the Fund's most defensive stance. In Strategic Growth, our avoidance of "high beta" financial stocks, coupled with some option price decay in our higher-strike puts, does create a moderate tendency for the Fund to move inversely to the market - especially during "risk on" days when financials lead. Given that option volatilities have retreated and we have not been aggressive in raising our put option strike prices, that tendency has declined a bit in recent weeks. Moreover, our stock holdings have a strong record of outperforming the major indices over time, so we remain comfortable with our avoidance of certain sectors. Our present investment position is well-aligned with the return/risk profile implied by the market evidence here, but we'll continue to take opportunities to mute the effect of "risk on" speculation whenever possible. In the meantime, I expect our present sensitivity to these periodic spikes to more a short-term nuisance than a longer-term feature of our investment stance.
In Strategic Total Return, our precious metals position remains at less than 3% of assets, as the defensive shift we saw in the Market Climate has persisted despite the recent price weakness. Likewise, we cut back our duration weeks ago in our Treasury holdings, currently to about 3.5 years. While we would expect Treasury bonds to rebound considerably on any fresh economic deterioration, our present duration is adequate from the standpoint of present evidence - the expected return/risk estimates from our ensembles have not rebounded much despite the recent increase in yields. Overall then, we are maintaining fairly modest risk exposure here across the board.
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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