August 20, 2012
Confidence and Enthusiasm
The present confidence and enthusiasm of investors about the ability of monetary policy to avoid all negative outcomes mirrors the confidence and enthusiasm that investors had in 2000 about the permanence of technology-driven productivity, and in 2007 about the durability of housing gains and leverage-driven prosperity. Market history is littered with unfounded faith in new economic eras, and hopes that “this time is different.” Those periods can be difficult, at least for a while, for investors who are less willing to abandon evidence and lessons of history, not to mention basic principles of economics and valuation. We endured similar discomfort in periods like 2000 and 2007, before hard reality set in.
The recent market cycle has required two changes to our hedging approach. One was in 2009, when our existing approach was dramatically ahead of the S&P 500, but I insisted on making our methods robust to the worst of Depression era data. The other was earlier this year, when we imposed criteria to restrict the frequency of defensive “staggered strike” option positions in Strategic Growth Fund, requiring not only strongly negative expected returns, but also either unfavorable trend-following measures or the presence of unusually hostile indicator syndromes. There’s little doubt that massive central bank interventions have pushed off economic and market difficulties that might have occurred more quickly. The tighter criteria help adapt to that reality, without foregoing the benefit that defensive option positions would have historically had over the course of the market cycle.
These hedging changes would clearly have altered many of our investment positions during the most recent cycle, particularly during the 2009-early 2010 period, but would not alter the strongly defensive position we’ve maintained since early March (see Warning: A New Who’s Who of Awful Times to Invest). Based on a blend of investment horizons from 2 weeks to 18 months, we presently estimate the prospective return/risk profile of the market as being among the most negative 0.5% of historical instances. On the technical front, the S&P 500 is either at or just short of its upper Bollinger band on nearly every resolution (daily, weekly, monthly), while numerous divergences are already in place, including the failure of many sectors and indices to confirm the recent high.
Valuations remain unusually rich on our measures, and only seem benign to Wall Street because profit margins are nearly 70% above their historical norms as a result of depressed savings rates and unsustainable government deficits (see Too Little to Lock In). On that note, it should be of some concern (though it is clearly not) that the price/revenue multiple of the S&P 500 is now above any level seen prior to the late-1990’s market bubble. Prior to that time, the highest post-war peaks were in 1965 (which was not followed by a deep or immediate decline, but marked the onset of what would ultimately become a 17-year secular bear market), and 1972, just before the S&P 500 lost nearly half of its value. Stocks are emphatically not a claim on next year’s projected earnings. They are a claim on a very long-term stream of cash flows that will be delivered to investors over time, and however speculative hopes or fears might move prices in the short-term, the factors that drive long-term prospective returns have remained durable for a century.
We presently estimate that the S&P 500 is likely to achieve a 10-year total return (nominal) of about 4.5% annually, but that alone is not what concerns us. We generally target an exposure to market risk that is proportional to the expected return/risk profile of the market on a blended horizon of 2 weeks to 18 months. Valuations exert a significant effect on those estimates, but numerous other considerations such as broad market action, trend-following measures, and a variety of indicator syndromes (e.g. overvalued, overbought, overbullish) also have significant effect. It is the full combination of evidence that concerns us.
As a side-note, our exposures are generally not directly proportional to the prospective 10-year return that we estimate on the basis of valuations alone. The difficulty with setting an exposure proportional to the 10-year prospective return is that there is little to stop a 10% prospective return from turning into a 15% or even 20% prospective return as a result of much steeper market losses (which we saw in the 1930’s, 1950’s, 1970’s and early 1980’s). Indeed, in 1931, the stock market’s dividend yield exceeded 6%, the Shiller P/E was well below prior and subsequent historical norms, and the market’s prospective 10-year return was above 10% annually, by our methodology. Yet this did not stop the stock market from losing two-thirds of its value over the following year, for an overall Depression-era loss of about -85%, taking the stock market – on a total return basis – to one-seventh of its 1929 level. That said, we certainly don't require clear undervaluation in order to reduce hedges and establish a constructive position. Absence of severe overvaluation coupled with a shift to favorable market action on our measures is typically sufficient, as was the case in 2003, and might have been possible in 2009 had we not faced the "two data sets" uncertainty.
It may seem overly cautious that I demanded that our hedging models should perform well in cross-validation (“holdout”) data from both post-war data and more extreme Depression-era periods. My view is that the arithmetic of deep losses is devastating to long-term returns, and the behavior of the market and the economy in 2008 and early 2009 was simply out-of-sample from a post-war perspective. I don’t share the confidence and enthusiasm of investors about the ability of central banks to make recessions, debt crises, and major market losses a thing of the past. Again, while the resulting changes in our methods (ensemble models, more restrictive criteria on staggered-strike positions) would have produced substantially different investment positions over the most recent cycle than we took in practice – particularly during the 2009-early 2010 period – the fact is that our defensive stance here is fully intentional, and the “heat” that we experience during points of investor enthusiasm is something that this same discipline would have occasionally experienced in numerous prior cycles.
In Strategic Growth Fund, part of the setback in recent months has been due to hedging costs, and part has been due to a modest lag in our stock holdings, relative to the indices we use to hedge. Neither outcome is extremely rare, or even particularly deep relative to the volatility regularly experienced by a passive buy-and-hold approach, but it’s uncomfortable to experience erosion in both aspects of our approach at the same time. That said, I doubt that this fairly run-of-the mill setback – especially since March - would feel nearly as uncomfortable if it did not blend in with our “miss” of 2009 through early-2010 (which I would not expect to be repeated in future cycles even under identical conditions).
In any event, I believe that the challenges we experienced during the recent, extraordinary cycle have been addressed. We’ll always work to learn new things and to bring new knowledge into practice, but unless we go back to the South Sea Bubble or the Dutch Tulip Mania, there isn’t a great deal of historical context available to augment what we’ve already incorporated into our methods. On the question of whether I believe our present methods require additional stress-testing or remediation, the answer is no, because I am satisfied that these methods would have strongly navigated not only the most recent cycle, but also post-war data, and also Depression-era data (without the exposure to significant periodic losses that our pre-2010 methods would have experienced during the Depression). On the question of whether I believe it was necessary to make our methods so robust to extreme outcomes and economic risks, my answer unfortunately remains an emphatic yes. I believe that investors should be prepared for far greater turbulence than present valuations and complacent sentiment seem to envision.
In my view, this time is not different. It may be more drawn out, but it bears repeating that the 2008-2009 market decline, when it arrived, wiped out the entire total return that the S&P 500 had achieved, in excess of Treasury bill returns, all the way back to June 1995. Regardless of any immediate relief from the Federal Reserve or the European Central Bank (both which I suspect are largely priced into the markets, and leave investors vulnerable to disappointments), I expect that stocks will achieve weak overall returns over the next few market cycles, and I am confident that we are well-prepared to navigate the full course of those cycles, if not always shorter segments (particularly the richly valued portion of mature bull advances, which is where I believe we are today).
What Merkel actually said
What’s fascinating about the present confidence and enthusiasm about central bank intervention is that investors have stopped actually listening for fact, and are increasingly hearing only what they want to hear. A good example of this is the notion last week that German Chancellor Angela Merkel now supports a major round of distressed debt purchases by the European Central Bank. As background, recall that ECB head Mario Draghi indicated a few weeks ago that the central bank was prepared to do “everything” to support the Euro, “and believe me, it will be enough.” Yet immediately after these words, the ECB had a meeting in which it initiated – nothing.
Germany’s position on ECB purchases of distressed country debt (Greece, Spain, Italy) has always been that this support must be conditional on the imposition of centralized control over the fiscal policies of those countries. This is what Germany calls “political" action, and that is why when Germany talks about its willingness to do everything necessary to save the euro, it typically uses the phrase “everything politically necessary.” Merkel’s most concise summary of this position – “Liability and control belong together.”
Fast-forward to last week, when Merkel was in Canada discussing trade issues. There, she gave a statement that was widely reported as suggesting that ECB action is “completely in line with what we’ve said all along.” That phrase was then reported as if Merkel was endorsing a massive and unconditional ECB intervention, which is what Wall Street now seems to be anticipating.
The problem is that here is what Merkel actually said: “The European Central Bank, although it is of course independent, is completely in line with what we’ve said all along. And the results of the meeting of the central bank and their decisions, actually shows that the European Central Bank is counting on political action in the form of conditionality as the precondition for a positive development of the Euro.”
So look at the “results of the meeting of the central bank, and their decisions” that Merkel mentions. The ECB decided to do nothing. No unconditional bailout. No liability without control. That result was indeed completely in line with what Germany has said all along. It just wasn’t what investors wanted to hear, so they heard something else entirely.
Meanwhile, nonperforming loans in Spanish banks surged from 8.96% in May to a record 9.42% in June. There remains an urgent but fully-denied need for broad receivership and restructuring of undercapitalized Spanish banks. It is important to recognize that bailing out the debt of insolvent entities is not a loan, because it is money that can’t be paid back. It is either a direct fiscal expenditure or it is permanent money creation – which is effectively indirect fiscal expenditure since the proceeds of money creation could otherwise be used to finance new government spending. The simple way to understand the Euro crisis is to understand that countries like Germany and Finland expect to be paid back, and failing that expectation, they are unwilling to transfer more fiscal resources than they already have. As the German finance minister said over the weekend, "It is not responsible to throw money into a bottomless pit." That's hardly a tone that indicates a willingness to accept unconditional ECB bailouts. All of this will remain very interesting, and most likely very turbulent. In any event, my impression is that the confidence and enthusiasm about easy central bank fixes is sorely misplaced.
As of last week, our estimates of prospective stock market return/risk on a blended horizon from 2 weeks to 18 months remains in the most negative 0.5% of historical instances. It’s easy to blur our present defensiveness in response to extreme conditions we’ve observed since early March into a much longer period of defensiveness: two intentional and strategic segments (our defensiveness in the correct anticipation of the 2008-2009 credit crisis, and our defensiveness since April 2010, where our present criteria would have limited the use of staggered-strike positions, but would otherwise have still avoided market risk), and one segment comprising our 2009-early 2010 stress-testing "miss." That blur may make our present concerns appear to be simply "more of the same". The fact is that on our measures, present conditions correspond to less than half of one percent of historical observations going back nearly a century.
The issue now is what we should do going forward. In my view, we’ve wholly addressed the “two data sets” problem that we faced in 2009, and as a result, I am convinced that our approach is well-suited to navigate both run-of-the-mill and very extreme market behavior over the course of future market cycles. I also believe that investors should not easily dismiss conditions that are more negative than over 99% of market history, particularly when they are accompanied with evidence of emerging global recession, overbought conditions at the upper band of daily, weekly and monthly Bollinger channels, and a variety of historically hostile indicator syndromes (Aunt Minnies such as “overvalued, overbought, overbullish” conditions, and evidence of technical divergence and exhaustion).
There is no reason to expect that the Fed will refrain from periodic interventions aimed at encouraging transitory bursts of speculation. But the effect of previous rounds of quantitative easing have typically been restricted to little more than a recovery of decline in stock prices over the preceding 6-month period, and I am doubtful that we will see much effect when the market is already near the top of its Bollinger channels (2 standard deviations above 20-period moving averages at daily, weekly and monthly resolutions). I am even more doubtful that Fed purchases of Treasury securities to create an even deeper ocean of zero-interest currency and reserves - when banks hold trillions of idle currency and reserves already - will have any material effect on a global recession that we view as already quietly in progress. In any case, our approach is always focused on the average outcomes associated with a given set of market conditions, and individual instances may deviate from the average. Suffice it to say that we continue to adhere to our investment discipline here.
We are presently in an environment that has historically been associated with the overvalued segment of late-stage bull markets. This segment of the market cycle has been frustrating for us before, and that frustration may not be over. Yet in each instance, our defensiveness was overwhelmingly vindicated. The drum-beat of investors is that “this time is different.” Simply put, I doubt that this time is different.
Strategic Growth Fund remains fully hedged, with a staggered-strike position representing about 1.6% in additional option premium cost (versus a standard matched-strike long-put/short-call hedge), looking out to year-end. Strategic International remains fully hedged. Strategic Dividend Value fund remains hedged at close to 50% of the value of its stock holdings (its most defensive stance), and Strategic Total Return carries a fairly conservative duration of about 1.8 years in Treasury securities, with about 10% of assets in precious metals shares, and a few percent of assets in utility shares and foreign currencies.
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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