April 3, 2006
It's an old truism of investing that bull markets typically end with a speculative phase. While this doesn't always prove true in sentiment figures (for example, the percentage of investment advisors who are bullish or bearish), we do generally observe growing "divergences" in the internal action of the market. Basically, instead of showing a healthy "uniformity" that lifts all boats, a weakening bull market tends to lift a gradually narrowing group of speculative darlings, while a growing number of laggards begin to sink.
Some of this shows up in a "heaviness" of price/volume characteristics - a tendency for dull trading volume on market advances, or if volume is heavy, for the advances to be small, and for an increasing number of deep or high-volume declines to occur. All of these contribute to a general effect of dullness on the upside and heaviness on the downside, which is something we've been observing for several months now.
In general, bull markets have historically ended with investors showering their affection on speculative darlings that seemed to offer a ticket to sure money, fast money, or preferably both.
These were "... the garbage stocks that everyone could make money on just so long as, and no longer than, everyone could continue to hold his nose and avert his eyes and imagine that the garbage was actually nourishing and palatable." (John Brooks, The Go-Go Years, 1973)
Without prejudice to my usual message - that nothing in these weekly comments should be taken as short-term forecasts about coming market action - it's disconcerting to see how far investors are taking their affection for garbage stocks today.
Trash on the Move
Let me start this section with thanks to Bill Hester, who dug into a trove of Standard & Poor's quality rankings to support this piece. In its coverage of individual companies, S&P produces an appraisal of the "quality" of company fundamentals, based on growth and stability of earnings and dividends, as well as long-term trends and sensitivity to economic cycles.
Among stocks belonging to the S&P 500, those rated "A" or "highest quality" have gained just 1.01% year-to-date. In contrast, companies rated "B -" or "lower quality" have gained 10.17% year-to-date. At the bottom of the quality barrel, those S&P 500 companies rated "C" or "D" for "lowest quality" (or in reorganization) have gained a striking 16.90% year-to-date.
The pattern is the same in the Russell 2000, where the highest, lower, and lowest quality stocks in the index have posted average year-to-date gains of 7.38%, 13.03% and 20.09%, respectively.
In the Strategic Growth Fund, I don't explicitly restrict our stock holdings by these quality measures, but because a good portion of my valuation work focuses on discounted future cash flow, the Fund generally invests in stocks that have relatively identifiable and at least somewhat predictable long-term fundamentals. One of my goals is to manage an asset for shareholders that represents a diversified, properly valued claim on relatively dependable long-term cash flows, not just a batch of lottery tickets. Shareholders can observe how that stock selection approach has performed versus the major indices in the Fund's latest semi-annual report.
Not all stocks with low quality ranks are poor investments, and I don't mean to suggest that these stocks should be shunned from further analysis. However, when the market rewards low quality in such a lopsided way, it's a good bet that investors aren't doing much of that analysis at all.
The affection for junk comes at the peril of unusual losses once that affection is lost. Looking at the bear market period from March 15, 2000 to March 15, 2003, those S&P 500 stocks with the highest quality rank actually gained an average of 16.08%. Those with the lowest (C or D) quality ranks at the start of that period went on to suffer average losses of -63.96% during the bear market. For rated stocks in the Russell 2000, the performance spread was an average gain of 6.88% for high quality versus an average loss of -71.07% for stocks in the lowest quality ranks. The quick lesson is that investing in low quality stocks works great until it doesn't.
One need not predict an abrupt end to this low-quality rally to recognize that it's dangerously mature. Over the past 3 years, the average price/revenue and price/book ratios of the lowest quality stocks have virtually doubled (from 1.26 to 2.57 times revenues, and from 1.67 to 3.15 times book value). In contrast, the valuations of the highest quality stocks have remained constant or actually decreased (from 2.16 to 2.17 times revenues, and from 3.95 to 3.64 times book value).
When the market treats the average dollar of low quality, post-recovery, highly cyclical, potentially bankrupt revenue as worth more than the average dollar of high quality, stable and dependable revenue, something is seriously wrong with investors' judgments. Essentially, investors are not only relying on the revenues of low quality companies to be stable, they're assuming those revenues will grow faster and amount to more over the long-term.
As always, it's generally an investing mistake to pay high multiples on elevated but cyclical fundamentals. Never confuse growth that represents recovery from a cyclical trough with growth that reflects a stable long-term trend. What matters is the full cycle - whether you're analyzing earnings from economic peak-to-peak or analyzing investment performance from market peak-to-peak.
Breadth and Quality
The behavior of high and low quality stocks goes a long way to explaining why market breadth has appeared deceptively good even though other measures of internal market action are failing.
The chart below tracks four advance-decline lines over the past 12 months. The green line is the advance-decline line of the largest 50 stocks in the S&P 500 by capitalization. The blue line is the advance-decline line of the S&P 500 stocks with the highest quality rankings. Notice that these lines move very much together, and are more stable, despite their somewhat lagging performance over the past year.
The orange line is the advance-decline line for all stocks on the New York Stock Exchange. As I've noted in other weekly comments, this line is heavily influenced by smaller capitalization stocks.
As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and relatively neutral market action. At present, risk-free interest rates near 5% represent a substantial hurdle for stocks to compete with over the coming, say, 5 year horizon. Even assuming continued earnings growth along the peak 6% trend for the S&P 500, a price/peak-earnings multiple of just under 16 at the end of that 5-year horizon would be sufficient to hold the total return on the S&P 500 below 5%. It would be dangerous to assume that rates need to rise much further to draw demand away from stocks.
At present, the Strategic Growth Fund is over 90% hedged against the impact of market fluctuations. Depending on day-to-day market action, the Fund may increase or moderately decrease the extent of that hedge, though my impression is that - barring a substantial market decline that improves valuations - the Fund is unlikely to carry less than a 70% hedged investment stance in the near future.
In bonds, the Market Climate remains characterized by unfavorable valuations and unfavorable market action. My impression is that core inflation and wage pressures are likely to persist. Moreover, the continued prospect of a weaker dollar translates into upward price pressures on the import side.
While market participants and even Ben Bernanke continue to view inflation as if it is a variable that the Federal Reserve can actually choose, I very strongly believe that inflation is an outcome of fiscal policy and to a lesser extent, credit conditions (bankruptcies, defaults and the like). On the fiscal side, the choice for higher inflation in the coming years has largely been made. Bernanke only gets to decide whether the public will hold a continuing flood of government liabilities in the form of bonds or in the form of money. That choice makes far less of a difference on inflation than it might seem.
So far, China and Japan have forestalled the need to choose, since they've been willing to absorb as much of our government liabilities as we can dish out. That situation is likely to change, and as it does, the only remaining determinant of inflation will be the tolerance of we Americans to absorb the liabilities of our government. If the economy falters and credit defaults or bankruptcies accelerate, the public may very well run for government liabilities as a safe haven. Barring that, my impression is that there is far more inflation baked into the cake than investors will comfortably palate.
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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