January 7, 2008
Minding the Hinges on Pandora's Box
I've used the word "warning" far more than I would like in recent months. For an investment manager who tries to maintain a fair amount of equanimity about market direction, I don't take this lightly. Importantly, our present defensive investment stance is not based on any forecast of a substantial bear market decline - we don't need to make such forecasts. The fact that market has historically lagged Treasury bills in similar environments, on average, is sufficient basis for our current defensive stance (which is not net short, just fully hedged).
Still, I am emphatic that investors should evaluate their risk exposures and tolerances now, in order to allow for substantial further market weakness. Market conditions presently feature a Pandora's Box of rich valuations, vulnerable profit margins, rising default risk, rapidly deteriorating market internals, failing support levels, and accumulating evidence of oncoming recession. As I noted in my December 17 comment, "there is one particular scenario that would be ominous in my view. That would be if we see a relatively uninterrupted series of declines that breaks cleanly through the August and November lows, followed by a one-day advance of 200-400 Dow points. That's a script that markets tend to follow pre-crash. Though it's not a strong expectation or forecast, it's something worth monitoring, because we've started to see the pattern of abrupt jumps and declines at 10-minute intervals that is often a hallmark of nervous markets."
Among various stock indices, the Value Line Composite and the equal-weighted S&P 500 indices broke cleanly through the August and November lows last week. Several capitalization-weighted indices held just above those lows on a daily closing basis, but on the basis of weekly closing values (which we generally ascribe more weight), even the S&P 500 and Dow Industrials broke their prior lows.
The stock market is oversold short-term, which invites the potential for a spectacular "clearing rally" of the typical variety - fast, furious, and prone to failure. While such an upward spike might be embraced as some sort of message that the market has "fully discounted" negative conditions and mark a successful "test" of prior lows, the data suggest that underlying market and economic conditions are rapidly deteriorating. In that context, a spectacular short-term rally (particularly a one-day barn burner) could provide a setup for concerted selling. As usual, I have no intention of encouraging investors to depart from well constructed investment plans, but investors should recognize that a 30% market decline is only a standard run-of-the-mill bear. It's a good idea to evaluate your investment portfolio to ensure you could tolerate that outcome, should it occur, without abandoning your discipline.
Economic slowdowns, even short of recessions, typically feature substantial contraction of profit margins. Given the solid wage inflation numbers we're observing, and the fact that the extremely elevated profit margins of recent years have been driven primarily by a suppressed wage share, it is clear that earnings shortfalls are likely to run well beyond financials.
On the mortgage front, it is important to reiterate that the swell in mortgage refinancings only began in October, and will continue well into 2009. Though Treasury yields have plunged, market lending rates such as LIBOR, commercial paper, BAA rates and so forth have been much stickier, so it is not at all clear that the rush to the safety of Treasuries (and the inevitable willingness of the Fed to align the Fed Funds rate lower in response) will result in meaningfully lower refinancing burdens. In the typical foreclosure event, there is first a burdensome reset, followed by several months of attempted payments, followed by several months of delinquency, and only then by foreclosure action. Given that the heavy resets only started in October, we are still about two or three quarters away from the really serious credit losses, foreclosures and writedowns.
To imagine that financial companies can simply "come clean" and "just put their cards on the table" assumes that lenders actually know which loans are facing default, and how many. But lenders are still months away from even finding that out. Meanwhile, publicly traded financials face a double-edged sword if they boost loan loss reserves too much in advance, because the SEC discourages it as a potential method of "managing" and misrepresenting ongoing earnings. Finally, with funding sources becoming more risk averse, my impression is that major banks will inevitably be forced to sharply cut their dividends in an attempt to maintain capital. This possibility is increasingly being discussed, but is not fully discounted as a fait accompli.
On the economic front, as I noted in November, the data already indicate the likelihood of a U.S. recession. Last week's poor ISM and employment reports add further confirmation to this expectation, particularly given that total non-farm employment has grown by less than 1% over the past year, less than 0.5% over the past 6 months, and the unemployment rate has spiked 0.6% from its 12-month low (all of which have historically indicated oncoming recessions). The ECRI Weekly Leading Index is now clearly contracting as well. The expectation of oncoming recession may be gaining some amount of sponsorship, but it is still far from the consensus view, and is therefore most probably far from being fully discounted in stock prices.
In short, if the potential negatives such as profit margin contraction and credit problems turn out to be only passing, minor events, then it might be true that the market has fully discounted them. We can certainly allow for that possibility, because we are not net short in any event. However, my impression is that the scope of these problems is likely to be much broader than anticipated at present, and that the combination of worsening outcomes and a growing consensus could result in substantially more weakness than we've observed thus far.
With regard to the "news" that the Federal Reserve will conduct $60 billion in term repos during January, note that $30 billion of those will be auctioned on Monday January 14, settling on Thursday January 17. The other $30 billion will be auctioned on Monday January 28, settling on Thursday January 31. It should quickly occur to shareholders that these will simply be rollovers - though factoring in other expiring actions, perhaps a net $10 billion or so of the new repos will represent a legitimate increase in the total quantity of repos outstanding.
The belief that these "injections" represent new money is a testament to the unwillingness of Wall Street to look at data. Recall the observation in my December 24 Market Comment (Vanishing Act - Are the Fed and the ECB Misleading Investors About "Liquidity"?): "As a side note, we can already predict that at least one of the "term auction" repos that will be announced in January will have a settlement date of January 17. Why? That's when the first term repo expires." It should be no surprise that the other term-auction repo the Fed initiated in December will mature on (you guessed it) January 31.
That said, I should note that discount window borrowings have increased to nearly $6 billion. While this is virtually nothing in relation to a $12.7 trillion banking system, it does represent the largest level of discount window borrowings since 2001. To some extent, then, the Fed can't be criticized for its efforts - it's doing more than it typically does. The problem is that the Fed is a lot like a sparrow working very hard to put out a forest fire by dropping water from its beak. You can't criticize the effort, but if the sparrow holds itself out as having the power to actually put out the fire, it would be wise to measure how much water is being dropped before taking the poor thing at its word.
What does seem clear is that the FOMC will be cutting its rate targets. Based on normal spreads between the Federal Funds rate and nearly all other market rates including both Treasury and corporate yields, as well as clear evidence of economic weakness, it's probable that the Fed Funds rate will be lowered to about 3% in the coming year. Although dollar weakness and inflation pressures may restrain the speed of this a bit, ultimately the FOMC tends to be very sensitive to avoiding blame for economic weakness, and this impulse to "first do no harm" will ultimately trump any tendency to maintain inflation credibility (not that I think that monetary policy determines inflation - fiscal policy does - monetary policy just determines whether the government's liabilities will foisted onto the public in the form of Treasury debt or base money).
In any event, the progressive cuts in Fed Funds toward 3% will be a predictable, lagging effect, not a cause of anything. To the extent that Fed meetings occur in the perimeter of oversold conditions, the consistent knee-jerk exuberance of investors in response to Fed cuts may allow us some modest speculative opportunities by say, briefly covering some of our short call options and then selling them out on rallies. But unless we observe more compelling evidence from valuations or market action, I certainly don't intend to remove put option defenses in anticipation of likely Fed cuts.
Valuations based on PE multiples, and particularly forward operating earnings multiples, remain misleading because they continue to be based on the implausible assumption that recent record profit margins will be sustained indefinitely despite very real and observable economic pressures to the contrary. As Bill Hester noted in his price/sales piece a few weeks ago, even if the prior historical peak for the P/S ratio (about 1.0) will now serve as the historical trough, the current $940 figure for S&P 500 revenues - itself boosted by oil company revenues - should give investors pause versus an index over 1400.
Though P/E multiples have come down a bit, they are still very rich on the basis of normalized profit margins. The notion that rich valuations on record profit margins can be overlooked, and will not be followed by sub-par long-term returns, is a speculative idea that runs counter to all historical evidence. It is an iron law of finance that valuations drive long-term returns. As testament to that fact, the S&P 500 is now behind Treasury bills on a total return basis for the 9.5 years since August 1998, and the present cycle has not even experienced a bear market.
Though the recent decline in the stock market only represents a moderate correction from a historical perspective, it's interesting to note that on a total return basis, the S&P 500 is already behind risk-free Treasury bills for the past 15 months, since October 2006. Though the specific placement of our strike prices creates a "local" tendency for the Strategic Growth Fund to move slightly counter to market movements of a few percent, our current fully-hedged investment stance does not reflect a net short position (the dollar value of our shorts never materially exceeds our long holdings), and is intended to achieve positive returns regardless of the direction of any extended market movement.
At present, if the Strategic Growth Fund was simply to remain unchanged in the face of a further market decline, the S&P 500 would have to fall by less than 15% to put the total return of the Fund ahead of the S&P 500 for the most recent 5-year period (which excludes the 2000-2002 bear market). To the extent that the stocks held by the Fund perform worse than the indices we use to hedge, the Fund could achieve a negative return despite its hedged investment position, and the market decline needed to place the Fund ahead of the S&P 500 since the beginning of 2003 would be larger than 15%. To the extent that the stocks held by the Fund perform better than the indices we use to hedge (which has in fact been the primary driver of Fund returns since inception), the required market decline from here would be even smaller than 15%.
On the issue of whether the recent correction removes any further potential for market weakness, Jim Stack of Investech notes that prolonged correction-less periods have generally been resolved by much deeper losses than 10%. At 55 months, the period since 2003 has been the second-longest stretch in 80 years without a 10% correction. The record was the 84-month period during the 1990's. Though that instance ultimately led to a series of 10-18% corrections between 1997 and 2000 before the market finally dropped in half, the other most prolonged periods (40 months from Oct 1962 - Feb 1966, and 37 months from Jul 1984 - Aug 1987) were followed immediately by full bear markets.
While I remain very concerned about overall market conditions, I am increasingly enthusiastic about the emerging "dispersion" in valuations that we're starting to observe among individual stocks and industries. In recent years, the market has been so broadly overvalued that it was difficult to create a diversified portfolio of stocks with valuations well below those of the indices we used to hedge. The best we could do was to find stocks that had relatively better valuations than those indices, and the attempt to purchase more deeply undervalued stocks inevitably came at the expense of price-volume action and investor sponsorship. At the same time, the devotion of investors to speculative, cyclical and otherwise low-quality stocks provided our disciplined stock selection with little traction versus the general market.
I've always admitted my unwillingness to invest shareholder assets in speculative stocks whose prices don't appear to be adequately supported by a probable future stream of cash flows. There are many speculative, momentum oriented managers that do this, but such speculation is often followed by spectacular losses, it is outside of our value-conscious discipline, and our strong long-term record of stock selection has not required it.
Fortunately, the growing internal turbulence of the market has recently created opportunities to populate our stock holdings having what I view as reasonable and even favorable absolute valuations. You can observe this dispersion in the fact that equal-weighted market indices have been declining more sharply than the capitalization-weighted indices. This can produce a bit of short-term discomfort because we do use those cap-weighted indices to hedge, but I see it as a very good development in terms of intermediate and long-term prospects for investment returns.
The coming weeks have the potential to be very turbulent, so I think it's an appropriate point to review what I believe are the main drivers of our returns in the Strategic Growth Fund. To that end, I've reprinted a section from a prior market comment below.
Alpha versus Beta (reprinted from the August 20, 2007 Market Comment)
Our investment objective is to achieve long-term capital appreciation, with added emphasis on the protection of capital during unfavorable market conditions. Preferably, to significantly outperform the S&P 500 over the full market cycle, with smaller periodic losses than a passive investment strategy. The Strategic Growth Fund set a fresh high little more than a week ago. Including reinvested distributions, the Fund has achieved a total return of over 120% since its inception in July 2000, while the S&P 500 has achieved a total return of less than 11%. The market may or may not have entered the “bear” portion of this cycle, but has not even declined 10% on a daily closing basis. It would be helpful to keep some portion of the prior bear market in memory until the current bull-bear cycle runs its course.
Achieving gains in a declining market does not require us to carry a significantly negative "beta." In extremely negative conditions, raising the strike prices on index put options side of our hedges can create a moderate negative beta and can help to avoid the impact of indiscriminate selling early in a bear market. But conditions that warrant these "staggered strike" positions are historically infrequent. Notably, our gains during the 2000-2002 market plunge were not due to net short positions or negative betas. Our gains were due to the slow accrual of “alpha,” averaging less than a penny of net asset value per day. It is essential to understand the distinction.
“Beta” is a measure of the extent to which a particular security “participates” in a 1% movement in the market. A stock or mutual fund with a beta of 1.0 can be expected to gain 1% in response to a 1% market advance, on average, and to lose 1% in response to a 1% market decline, on average. Though a few stocks, such as precious metals shares, often have a slightly negative beta, several “bear funds” are available that take significant short positions in the market, and establish negative betas over the complete market cycle. These funds can be expected to predictably and continually gain as the market declines, and to predictably and continually lose as the market advances.
In contrast, “Alpha” is a measure of the extent to which a particular security advances, on average, independent of market movements. Alpha is not driven by fluctuations in the market, but “accrues” slowly over time. For example, suppose that the Strategic Growth Fund is fully hedged and has a beta of zero. In order to achieve a 15% total return over a period of a year, the Fund would have to achieve an average daily alpha amounting to slightly under a penny per day in NAV. It is important to understand that alpha does not accrue in response to a given day's market action. That's beta. It is not riskless. That's Treasury bill interest. Alpha involves at least some amount of risk (for us, it is the “basis risk” that our stocks could lag the market rather than outperform), it accrues almost unobservably on a day-to-day basis, but it has been responsible for the majority of the returns in the Strategic Growth Fund over time.
Simply put, the Fund does not establish big negative betas, though raising the strike prices of our index put options can create a moderate negative beta in a small percentage of historically extreme conditions. To position the Fund with a large and continuous negative beta, so that we can achieve a rapid gain on a market decline, would also be to position the Fund to suffer large and continuous losses on any sustained market advance. The “staggered strike” aspect of our hedge has certainly allowed us to experience some "giveback" during sharp rebounds after a market decline, and the Fund may experience losses even in a hedged investment position if our stocks underperform the indices we use to hedge or we experience net time decay on our option hedges. In any event, the dollar value of our hedges does not materially exceed the dollar value of our long stock holdings.
There are bear funds available for investors interested in carrying a large or persistently negative beta. The Strategic Growth Fund is not intended to do this. To the extent that the Fund has achieved gains during periods of market weakness, those gains have most often been attributable to the slow and often imperceptible accrual of alpha. For us, our alpha has generally been the result of holding favorably valued stocks with good sponsorship, that tend, on average, to very slightly outperform the market on a day-to-day basis. It's sometimes possible to observe the accrual of alpha over the course of a few months. It is nearly impossible to distinguish it from random noise on a day-to-day basis.
As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully hedged investment stance. The Fund currently has about 1% of assets allocated to a "staggered strike" option position and other modest option holdings which have the net effect of strengthening our defense against substantial further market losses, but also allow for the potential for a very short-term "clearing rally." Aside from these slight modifications, our essential stance is fully hedged and defensive.
In bonds, yield levels are unfavorable in terms of the return that a bond holder can expect as compensation for maturity risk. The case for Treasury securities as a safe haven for fixed-income investors is fairly strong, but so is the likelihood of further brief inflation surprises. Overall, the general expectation of a trading range continues to be consistent with the evidence - persistent downward yield spikes on growing economic concern, punctuated by brief yield spikes on inflation surprises. This may create something of a "sawtooth" in yields - diagonal declines corrected by vertical spikes. For our part, the Strategic Total Return continues to carry a relatively low duration of about 2 years, mostly in TIPS which have behaved quite well given the downward pressure on real inflation-adjusted interest rates.
In precious metals, the Market Climate appears extremely favorable, featuring downward yield trends, upward inflation trends (and in combination, a very hostile environment for the U.S. dollar), economic weakness evidenced by a weak ISM Purchasing Managers Index among other factors, and a gold/XAU ratio that is well above 4. This combination of conditions has historically generated an unusually strong return/risk profile for precious metals shares. Still, the volatility of these shares and the fact that they have advanced significantly already should restrain overly speculative exposure to this sector. Having increased our positions on prior short-term weakness, Strategic Total Return Fund currently holds just over 23% of assets in these shares, which is a large yet acceptable exposure to this sector in light of the historical tendency of similar Market Climates to generate strong returns for precious metals shares.
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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