March 13, 2006
Reversal of Fortune
In March 2000, near the stock market's bubble peak, the median price/earnings ratio on the largest 50 S&P 500 stocks was 35.6, while the median P/E on the smallest 50 S&P 500 stocks was just 10.1. Currently, the median P/E ratios on the largest and smallest 50 stocks in the S&P 500 are 17.3 and 20.3, respectively. So while the valuation multiples of the largest stocks have dropped by over 50%, the valuation multiples of the smallest stocks have more than doubled. The same is true if we examine price/book and price/revenue ratios.
That, in a nutshell, is the explanation for 3 facts:
1) Small and mid-cap stocks have performed well since 2000 not because of any powerful, inherent advantage over large stocks, but primarily because they've enjoyed a massive (and at this point excessive) rebound in valuation relative to large caps;
2) Because of this performance streak in small and mid-cap stocks (which make up the majority of stocks, but not the majority of market cap), breadth measures based solely on advance-decline statistics have not yet picked up the deterioration in sponsorship that's evident if we examine other market internals such as industry group action, interest-sensitive securities, and trading volume; and,
3) The Hussman Strategic Growth Fund has gradually shifted from smaller to larger capitalization holdings in recent years, not out of any necessity due to Fund size (at the Fund's current asset level, we could easily populate the Fund with mid-caps if it was optimal to do so), but precisely because large stocks generally carry the best relative valuations.
If we examine median price/earnings ratios of different groups in the S&P 500 at the 2000 market peak and at current levels, we observe the following pattern:
Notice that in 2000, valuation multiples were highest for the largest stocks and lowest for the smallest stocks. The situation is exactly reversed at present, with valuations monotonically increasing as we move from the largest stocks to the smallest. Clearly, we've experienced a major shift in relative valuations in recent years, with smaller stocks moving to substantially richer valuations.
It's important to emphasize that I don't view any of these groups as "undervalued" - even the largest stocks are above historical norms of valuation (with various individual exceptions), and even apparently "low" P/E multiples should be evaluated critically since they're on record earnings. In any case, smaller stocks will probably be most vulnerable to earnings shortfalls in the coming year or two, stemming from either slower economic growth, rising real wage costs in excess of productivity growth, or most likely, both.
So should investors pile into the largest of the large caps (without hedging their market risk)? Not exactly. As Walter Deemer recently (and correctly, I think) pointed out, leadership tends to change during down markets, and "telegraphs its intentions by generating relative strength during a bear market." That's really what happened with small cap stocks during the 2000-2003 decline: small stocks still declined substantially, but they declined by less than the more overvalued large-cap stocks.
The same is likely to be true for large-cap value stocks here. While the largest S&P 500 stocks account for a good portion of the index capitalization (making it harder for them to strongly outperform the index itself as a group), it is still likely that a diversified portfolio of good, stable values chosen from the index will hold up better in a bear market than the index itself. As for upward leadership, Deemer also notes that small stocks, being more volatile, typically surge in the early part of a new bull market. So investors looking for large-cap value stocks to lead strongly on the upside will probably have to wait roughly until the year after the next bear market is over.
As a rule, the Strategic Growth Fund doesn't get terribly "cute" with its hedges - for example, even though I expect smaller indices to perform poorly in the next bear market, I'm not about to hedge a portfolio of larger cap stocks by hedging primarily in small cap indices. That would open the Fund up to substantial "basis risk" and would, in my view, be a poor use for our risk budget. In my view, our comparative advantage lies in stock selection, not in timing one index against another. So when the Fund is fully hedged, our primary risk (as well as our primary source of expected return) is the potential for our stock holdings to perform differently from the major indices, be they the S&P 500 or the Russell 2000.
In short, I believe that we're well positioned by holding our present, broadly diversified portfolio of stocks, and hedging their overall market exposure with an offsetting short sale in the S&P 500 and Russell 2000 (using a proportion that reasonably reflects the capitalization profile of our long positions).
Breadth, Volume, and Sponsorship
In recent months, we've observed a gradual deterioration in our measures of market action, indicating flagging investor "sponsorship" of stocks. Among widely followed indicators, we can see some of this in the declining number of individual stocks achieving new 52-week highs when the major market indices push higher, by the tendency for trading volume to become dull on advances and expand on declines (or what is a similar observation, the tendency for the market to make little progress on heavy up-volume and substantial downside progress on light down-volume), and in the recent explosion of insider selling.
The behavior of the NYSE advance-decline line is currently an imperfect measure of the loss of sponsorship evident in other market internals (see the Feb 13 2006 comment - The Information is in the Divergences). This is largely because of the continued strength of small- and to some extent mid-cap stocks, which account for the majority of issues traded, but not of capitalization. An examination of breadth in combination with other information such as new highs, extent of advances and declines, trading volume and other measures yields a less compelling picture of breadth. As Paul Desmond of Lowry's notes, while the NYSE advance-decline line is near its high, "the size of the advances and the intensity of the declines seems to be changing," with each successive market advance producing a smaller percentage of stocks breaking above their 30-day moving averages.
Meanwhile, Vickers notes that during the past week, corporate insiders (executives, directors, etc) in NYSE stocks sold 8.48 shares for every share purchased, with the 8-week average at 6.82 sales for every share purchased - figures that Vickers reasonably characterizes as "ominous."
To some extent, stock market action also implies expectations for slower economic growth, though interest rate signals, such as a flat yield curve, are more suggestive of slow growth than stock market action is, and we've yet to see a substantial widening of credit spreads that would suggest imminent recession.
Suffice it to say that while there remain some bright spots in market action, such as the overall profile of market breadth (as measured by the simple NYSE advance-decline line), as well as bright spots in economic figures, such as Friday's upbeat jobs number and the reasonable behavior of credit spreads to-date, the weight of the evidence is increasingly cautious. That doesn't mean that either the stock market or the economy will or must deteriorate quickly or immediately. Rather, the risks are becoming clearer and more pointed. Accepting market risk in similar conditions has historically been a low-return proposition, on average.
As of last week, the Market Climate in stocks was characterized by unusually unfavorable valuations and slightly unfavorable market action. While the behavior of market action isn't overwhelmingly negative here, it isn't sufficient to warrant a speculative exposure to market fluctuations with stocks so richly valued. Accordingly, the Strategic Growth Fund is now back to a fully-hedged investment stance - meaning that the Fund continues to be fully invested in a broadly diversified group of stocks that appear to have some combination of favorable valuation and favorable market action, while at the same time, the Fund carries an offsetting short position of equal size in the S&P 500 and Russell 2000 indices (using option combinations that mimic short futures contracts) intended to mute the impact of broad market fluctuations on the Fund. See the March 6, 2006 comment (Cost of Hedging) and the April 18, 2005 comment (How Hedging Works) for more detail on the mechanics of a hedged investment position.
In bonds, the Market Climate remained characterized by unfavorable valuations and unfavorable market action. The shape of the yield curve continues to imply a further "parallel shift" upward, with yields rising at all maturities. If the yield curve were to resolve the way that such shapes have historically resolved (our investment positions are not based on such speculation about the future), my impression is that short-term yields have a good chance of pushing to 5%, while long Treasury yields would push to about 5.7%. As usual, we need not make specific interest rate forecasts - the fact that prevailing valuations and market action are unfavorable is sufficient to hold the Strategic Total Return Fund to a relatively muted duration of about 2 years, largely in Treasury inflation-protected securities.
Last week, I also increased the position of the Strategic Total Return Fund in precious metals shares on the substantial price weakness in that group. The Fund currently holds about 15% of assets in precious metals shares.
New from Bill Hester: Inflation Data May Continue to Surprise
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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