April 30, 2007
A quick note on day-to-day performance. Though our correspondence lately has been dominated by expressions of confidence, encouraging that we maintain our discipline despite short-term speculative pressures, I can't help but imagine that it has also been uncomfortable to see the Fund pull back a few cents on several days when the market has hit marginal new highs. In recent weeks, the stocks held by the Fund have lagged the market's advance by about 1%. That's not very significant, but that alone can produce a small pullback in Fund value because the implied interest from our hedges does not accrue fast enough over the short-term to offset the performance difference.
I expect that this will quickly wash out over the full cycle. The Strategic Growth Fund remains only about a percent from its own all-time high - including reinvested distributions it has more than doubled since 2000, while the S&P 500 has earned a total return of less than 2% annually. And assuming we maintain our hedge and our stocks neither outperform nor underperform the market during a general decline (which would result in overall Fund returns close to T-bill yields), even a minimal one-year bear market of 20% would put the Fund ahead of the S&P 500, with far less risk, for every standard performance horizon (1, 2, 3, 4, 5, 6, 7 years, and since inception). As noted in the most recent semi-annual report, I expect that it would take a far smaller pullback to put the Fund ahead of the S&P 500 for the period from 2004 to the present.
Still, there is no question that our willingness to hedge risk in overvalued, overbought, overbullish conditions can be uncomfortable at times. That's particularly true here, during a short-squeeze / speculative blowoff in a late-stage, mature bull market where investors are focused on leveraged, cyclical and smaller companies - ones that only tend to abruptly show their vulnerability after the fact.
As I've noted before, these points of overvalued, overbought and overbullish conditions are often followed, at least over the short-term, by further gains of a few percent, but invite deep and abrupt declines that can erase weeks or months of upside progress in a few days. So while I unfortunately can't rule out the possibility that my investment decisions will prompt somewhat more short-term discomfort, I do believe that there is a strong case for both a hedged investment position and a focus on stocks with high quality (on the basis of revenue, earnings and balance sheet stability) and reasonable valuations.
Holding a portfolio of stocks that do not tightly match the "market" is ultimately the only way for a hedged position to achieve strong returns without taking net long or short positions in the market, and I do believe that our overall position here is well suited to the likely return/risk profile of the market that has typically followed similar conditions.
In recent weeks, investors have been enthralled with the idea that stocks are being supported not only by earnings surprises, but also by heavy repurchases, as if these are two separate effects.
As I've noted before, repurchases are already reflected in the calculation of the S&P 500 index and index fundamentals such as earnings and dividend figures. To assume that repurchases are a separate source of "return to investors" is double counting.
A little index math (just skim the next 4 or 5 paragraphs if figures make your eyes glaze over):
Suppose that the total market capitalization of the S&P 500 is $12,000 (billion), and that the index divisor is 8 (billion). Then the S&P 500 Index would be $12,000 / 8 = 1500. Now suppose that companies in aggregate reduce their shares outstanding by 5%. Assuming (only for simplicity) no immediate price impact, both the market cap and the divisor would be reduced by 5%, producing an index value of $11,400 / 7.6 = 1500. The index is the same because we assumed no price impact. Had prices increased or declined, the market cap would have changed by more or less than the 10% change in the divisor, producing a change in the index.
Now consider dividends and earnings. Suppose that total dividends for companies in the index were $200 (billion) and earnings were $650 (billion). Given the original index divisor of 8, the "index" dividends would be 200/8 = $25 and the "index" earnings would be 650/8 = $81.25. Regardless of whether we used total dollar values or index values, the dividend yield would be 200/12,000 = 25/1500 = 1.67%, and the P/E would be 12,000/650 = 1500/81.25 = 18.46.
Following the repurchase of 5% of all shares outstanding, the divisor drops to 7.6, but unlike market cap, which is reduced by the repurchases, total dividends and earnings on the index remain the same. So per-share dividends and earnings rise.
In this case, the $200 billion in total company dividends now represent an "index" dividend of 200/7.6 = $26.32, while the $650 billion in company earnings now represent "index" earnings of 650/7.6 = $85.53. As a result of the repurchases, per-share dividends and earnings have increased by 5.26%.
Notice that the calculation of the S&P 500 already fully reflects the impact of the repurchase on both the level and the growth of per-share earnings and dividends. Investors are emphatically mistaken if they double-count repurchases as a separate or additional "distribution" to shareholders.
Unfortunately, investors are currently engaged in wild-eyed double counting, imagining that higher per-share earnings figures and higher repurchases are separate effects, when they are one in the same. The truth is that a significant portion of the higher per-share figures is the result of repurchases, and the higher repurchases are the result of a paucity of alternative uses for the cash.
To put some numbers on this, Bill Hester notes that according to Bloomberg, among S&P 500 companies reporting to-date, the average surprise on operating earnings (cough) per-share has been 9.66%, while the average surprise on operating earnings on a total dollar basis has been 5.85%. Of course, the average is skewed by a few extreme outliers (for example, Hasbro reported operating EPS of 19 cents, versus an estimate of just 1 cent). The median surprise, which is a more robust measure, has been 2.94% in operating earnings per share, and just 1.93% in operating earnings themselves.
It is wrong to hail an increase in per-share earnings as if it is an "earnings surprise" - as if it reflects an improvement in corporate operating conditions, when it is in fact an expenditure of existing earnings on shares instead of on business investments. When such repurchases are done at rich valuations, they are a signal that the company lacks other productive business opportunities and is instead propping up per-share earnings by disposing of what it does earn.
Why haven't investors figured this out? The story constantly repeated on CNBC is that companies low-balled their earnings guidance in order to surprise investors with better than expected earnings (with the implication that the market will rise forever because companies can continue to do this indefinitely). A good part of the true story is that analysts made their forecasts of per-share earnings based on old, higher share counts, so the juiced per-share figures resulting from repurchases are now showing up as "earnings surprises."
As Standard & Poors itself warned last year,
"S&P has concern as to the extent that some equity analysts incorporate share changes into their analysis. If a higher share count is used in the calculation of an estimate, the result would be an under estimation of the EPS. This could lead to an initial assumption of a positive earnings surprise when the actual EPS is announced, since the announced value is higher than the estimated value. The discovery that the variance is due to share change, however, would not take long, resulting in any initial upward price movement being negated."
Valuations and credit spreads
But, one might argue, doesn't this eagerness to retire stock mean that valuations are cheap?
There are several responses. First, we observe no such eagerness to buy company stock in the insider purchase statistics - that is, company executives buying their own stock with their own money. We continue instead to observe unusually high insider selling.
Second, a good portion of the repurchases are being made to offset the grant of shares to executives and employees. It's true that we're observing net repurchases overall, but they're well below the volume of gross repurchases.
Third, the statistical correlations between repurchases and valuations or subsequent returns are small at the individual stock level, and are even weaker for the market as a whole. There is simply no evidence to support anything close to the confident cause-effect statements regularly offered by analysts on CNBC.
Indeed, if we measure net stock issuance or retirement (including through corporate buyouts and the like), one of the better explanatory variables seems to be the spread between corporate bond yields and Treasury bond yields. The blue line in the following chart is the estimated change in the S&P 500 divisor attributable to net issuance or retirement of stock (as a percentage of shares outstanding), while the red line is the spread between the yield on the Dow Jones Corporate Bond Index and the 10-year Treasury yield.
Clearly, even the retirement of stock in recent months is not fully explained by credit spreads, but we've seen that in the past as well. Interestingly, although it's generally true that heavy issuance of stock by new companies (i.e. IPO activity) tends to be concentrated at overvalued market tops, stock valuations don't help much to explain net issuance by existing companies, once credit spreads are taken into account. And though we observed high issuance prior to the 2000-2002 bear market, we've also observed high issuance at a number of excellent times to purchase stock, and net retirement (negative issuance) prior to poor periods for the market.
For example, we observed heavy net retirement of equities in early 1980, followed immediately by a market drop of over 12% in a month. Similarly, we observed net retirement in late 1989. While the market remained stable for several more months, it was down substantially a year later despite continued retirement of stock.
Suffice it to say that the retirement of stock we're observing lately is far more related to credit spreads than it is to any attractiveness of valuations here. There is no evidence that such periods have had useful implications for subsequent stock returns.
Scarcity (Get 'em while they last!)
In addition to the theme of earnings surprises, there is a growing belief that stocks are becoming "scarce" because of private equity transactions, and that this puts a "bid under the market." Unfortunately, we've seen this belief before:
"Anyone who buys our highest-class rails and industrials, including the steels, coppers, and utilities, and holds them, will make a great deal of money, as these securities will gradually be taken out of the market. "
- George R. Dyer of Dyer, Hudson & Company, 1929
"Investment trusts have provided stocks with a new scarcity value."
- Professor Irving Fisher, 1929
"Why is this market so unshakable? It must be because 1) so many people have so much surplus money to invest; 2) that hundreds of thousands of newcomers have watched others make money in the market, and are determined to do likewise; 3) stocks are scarce in relation to total demand; 4) the specter of inflation makes common stocks widely sought; 5) corporate earnings are rising. This roaring market shows no signs of slackening its pace."
- Ira Cobleigh, 1968 (near the end of the "Go-Go" market).
This will end badly. In recent weeks, we've started to observe what people used to call "shooters" back in the 60's and 70's - stocks that rise by 30-40% or more in a single day. That sort of action is characteristic of a speculative blowoff. The difficulty is that such blowoffs can continue over the short-term, but also tend to end abruptly. I have no strong view about the very short-term, except that we're observing an instance of fairly extreme overvalued, overbought, overbullish conditions, which have typically been followed by deep and abrupt losses (but usually only after some period of short-term continuation in the range of 1-3%).
Are earnings dividends? Should risk premiums be zero?
Another insidious result of the emphasis on operating earnings and buyouts has been the quiet appearance of a belief among investors that earnings are dividends. Earnings themselves are talked about as if they are distributions to shareholders, and even as if they are paid out in addition to growth. This is reminiscent of the old Dow 36,000 argument, which was based on the idea that earnings were actually dividends and could grow at 6% annually absent any new investment in capital, and that stocks should be priced without any risk premium.
The fact is that much of the repurchase activity in recent quarters has actually been financed by new debt. The Economist quotes Barclay's Capital that " this equity-buying splurge is almost exactly matched by the corporate sector's financial deficit - in other words, companies are borrowing money to buy back shares. This gearing up of the balance sheet is occurring when profit margins are at their highest level since the 1950s."
In a little piece of hubris published in the Financial Times by Jeremy Siegel (who is increasingly becoming a modern-day Irving Fisher), investors were told:
"Since the long-term real growth of per share earnings is also only about 2 per cent, pessimists project real returns of only 4 per cent in the stock market, well below the 6.5 to 7 per cent average real returns that the historical data have indicated."
"Real returns can be estimated from the earnings yield, the reciprocal of the more popular price-earnings ratio. Since stock earnings are based on real assets, the earnings yield provides a good estimate of the real return on the stock market."
"In the US , the long-term average p/e ratio has been 14.4 times, which corresponds to a 6.9 per cent earnings yield. This is extremely close to the historical average real return on equities. 2007 estimates for earnings on the S&P 500 Index range from $87 to $91 per share. With the index at 1,450, this leads to a current p/e ratio of between 15.5 and 16.5 times and a corresponding earnings yield - and hence real return - of 6.0 to 6.5 per cent on S&P 500 stocks. Even though current returns on stocks look good, future stock returns may even be higher."
Let's look at this argument closely. First, why does Siegel say that the earnings yield is an estimate of the real return on stocks? Think of it this way. Reported earnings subtract out depreciation, which is another way of saying that earnings are reported as if the company reinvests only enough to replace depreciation and keep its stock of productive assets constant over time. If the company were not to invest anything for growth, it would theoretically be able to pay out all of its net earnings as dividends. If earnings on the fixed stock of capital could grow at the inflation rate by virtue of monetary factors alone, you would get zero real earnings growth. Then holding valuations constant over time, the earnings yield would be a measure of the real return on stocks. Fine if you believe the assumptions. Now let's look at the data.
The first problem is that in order to produce 2% real annual growth in earnings per share, companies have historically devoted about 50% or more of their earnings to reinvestment and repurchases - over 300 basis points of that earnings yield to get 200 basis points of real growth. That's a tip-off that historically, competitive pressures have prevented earnings from simply growing at the rate of inflation without new investment. You had to invest new money to get your earnings growth up to the inflation rate. In general, once your return on invested capital falls to the point where you're willing to buy your own stock instead of making new investments, the simple earnings yield overstates probable long-term real returns (especially if the yield is based on record earnings). In fact, about 1% of the long-term real return on stocks has come from an increase in the overall level of valuation in recent decades. Absent that increase in valuations, the real return on stocks would actually have been at least 1% less than the average long-term earnings yield.
Next, the historical average p/e Siegel cites is based on trailing net earnings, not forward operating earnings. Also, current earnings figures reflect unusually wide profit margins. On the basis of trailing net earnings even modestly normalized for profit margins, the relevant p/e for the S&P 500 is currently above 20, and actually closer to 25. That puts the applicable, normalized earnings yield at about 4-5% here. Give that a 1% haircut as explained in the foregoing paragraph, and assuming that p/e valuations don't contract in the future, you could expect a long-term real return of 3-4% from stocks going forward. Add in inflation of 2-3% and the long-term nominal total return priced into stocks here (say, on a 20-30 year horizon) is probably somewhere between 5-7% annually.
Over a shorter horizon, say 5-7 years, the likely real and nominal returns on stocks will probably be lower. At GMO, Jeremy Grantham estimates (and my work largely agrees) that the real return on stocks over the coming 7 years should be about -2% annually (about zero in nominal terms). GMO calculates its estimates for a wide variety of asset classes, including bonds, foreign stocks, and so forth. Grantham noted last week that "We now show - drum roll - the first negative sloping return/risk line we have ever seen. The process of moving all asset prices to fair value over 7 years (which is how we do our 7-year forecasts) will have resulted in a world where investors are paying to take risk!"
If investors believe that stocks should be priced to deliver long-term returns of 5-7% annually, then yes, stocks might be fairly priced here.
Even optimistic assumptions and alternative models produce only modest changes to long-term expected returns. For example, optimists might take the current earnings yield of 5.5% (a trailing price/peak earnings multiple of over 18) as sustainable, assume that profit margins will never come down, assume all earnings can be paid out as dividends, and assume earnings will achieve nominal 2% growth anyway due to inflation alone. In that case, stocks would be priced to deliver a 7.5% long-term annual return. Alternatively, optimists can assume that earnings will continue to grow along the peak of their historical 6% peak-to-peak earnings channel (a point from which earnings have always been vulnerable to long periods of tepid growth), and that valuations and profit margins will remain permanently elevated. Adding in a further 1.8% dividend yield, they might even estimate stocks to be priced for a 7.8% annual return.
It's very difficult, however, for a reasonable analysis to project long-term returns on stocks much higher than about 7.8% over a 20-30 year horizon. Again, 5-7% is more likely in my estimation, with nominal total returns on stocks close to zero over the coming 5-7 years.
As of last week, the Market Climate for stocks was characterized by unfavorable valuations, favorable (but unusually overextended) price trends, and overall, a combination of overvalued, overbought and overbullish conditions that has historically been associated with stock returns below risk-free Treasury bill yields, on average. The Strategic Growth Fund remains fully hedged at present, with a staggered-strike position that affords somewhat greater local defense against market weakness here.
Presently, we've got overvalued, overbought, overbullish conditions where the quality of market action has not deteriorated enough to suggest that investors have abandoned their speculative posture toward stocks. As is typical in such environments, we would be willing to establish a moderate speculative exposure to market fluctuations (using call options only) if the market pulls back by several percent without much internal deterioration. In an otherwise overvalued market, that willingness to vary our speculative exposure can be enough to allow us reasonable participation even if the market continues to trend higher over time, provided that that trend includes a reasonable amount of fluctuation. However, the imperative to hedge at extreme points also means, frankly, that we will invariably lag at the peak of short-term advances. As usual, our objective remains to substantially outperform the market over the complete cycle (bull market plus bear market) with smaller periodic drawdowns than a buy-and-hold approach.
In bonds, the Market Climate was characterized by unfavorable valuations and unfavorable market action, holding the Strategic Total Return Fund to a duration of about 2 years, mostly in TIPS. The Fund continues to hold just over 20% of assets in precious metals shares. Last week's GDP report provided further support for the theme of weaker economic growth and persistent inflation, which prompted some further weakness in the U.S. dollar. Technicians appear rather concerned about various support levels being broken in both the dollar and in U.S. bonds. Personally, I'm somewhat agnostic about near term direction, but given a Market Climate that is unfavorable for bonds and favorable for precious metals shares, a weak dollar/weak bonds outcome is well within probability. Regardless, our investment positions remain aligned with observable, prevailing conditions in various markets, and will change as those conditions change.
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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