August 22, 2011
As of last week, the S&P 500 has declined to the point where we now expect 10-year total returns averaging about 5.7% annually on the index. This is certainly higher than the 3.4% prospective return we observed earlier this year, but is still a prospective return more characteristic of market peaks than of long-term buying opportunities. Wall Street analysts continue to characterize stocks as cheap on the basis of completely specious approaches like "forward operating earnings times arbitrary P/E multiple," or worse, "forward operating earnings yield divided by 10-year Treasury yield." Unfortunately, despite a few anecdotal successes, there is no correlation between "valuation" on these measures and actual subsequent market returns.
There are numerous reasons why these toy models based on forward operating earnings are misguided, but the four most important ones today are 1) forward operating earnings presently carry the embedded assumption that profit margins will achieve and indefinitely sustain the highest profit margins observed in U.S. history; 2) the duration of a 10-year Treasury bond is only about 8 years, while the duration of the S&P 500 is about 42, meaning that any given yield increase implies 5 times more loss for stocks than it does for bonds, and there is no reason in the world why investors should treat those risks as equivalent; 3) the current conformation of evidence strongly suggests the likelihood of an oncoming U.S. recession, and forward earnings expectations tend to be stunningly off-base in those instances, and; 4) the norms typically applied to forward operating earnings are artifacts of the recent period of bubble valuations, and use norms for "trailing net" as if they are equally applicable to "forward operating." In fact, the correlation between forward operating P/Es and other normalized P/Es having far longer history suggests that a forward multiple of even 12 is quite rich.
As it happens, forward operating earnings, when used properly, can actually be very informative about prospective market returns (see Valuing the S&P 500 Using Forward Operating Earnings ). However, the phrase "used properly" can't be emphasized enough. Here and now, our forward operating earnings model delivers nearly identical prospective return estimates for the S&P 500 as our standard methodology. Stocks are emphatically not undervalued here on any reasonably long-term horizon.
At the same time, we have a menu of prospective returns that is simply dismal here. Three-month Treasury bills are literally yielding less than one basis point annually. 10-year Treasury bonds are yielding just 2.1% (which makes one wonder what Ben Bernanke can possibly hope to accomplish with further attempts to distort the investment opportunity set). Corporate bonds yield just 3.4%, providing dangerously little compensation for volatility or default risk - particularly since corporate yields have typically shot to about double that level or higher during recessions, even when Treasury yields have been contained. By our estimates, utilities have 10-year prospective returns around 6.6%, which is enough to justify a modest exposure to this sector in Strategic Total Return, but even here, the durations are well over 20, so they have the potential for price weakness if debt concerns accelerate.
Despite prospective long-term returns that remain quite thin on a historical basis, some segment of investors may be willing to accept market risk in stocks and utilities based on comparative returns in an environment where Treasury yields are abominably depressed and distorted. On a long-term basis, I think that significant exposure is an mistake, because it relies on risk premiums to stay compressed indefinitely. Even so, on a near-term basis we've observed enough of a decline to taper our disdain for market valuations at least modestly. On the technical side, short-term market action is extremely compressed and oversold. Also, we saw a variety of "non-confirmations" last week - downside leadership eased, trading volume tapered off, new lows in more volatile indices such as the Nasdaq and Dow Transports were not confirmed by new lows in the S&P 500, Dow Industrials, or Dow Utilities, and so forth.
The overall picture is clearly tenuous, but may be enough to support at least a few weeks of consolidation. Any material market break would quickly reverse that hope, particularly if it featured a breakdown in balance-sheet sensitive sectors such as corporate bonds and utilities. We're willing to extend a benefit of the doubt to the coupled improvement in valuations and internals, but we're holding very close to the vest.
For our part, on Friday's weakness, we covered about 20% of our hedges in Strategic Growth, but retained a very strong line of defense a few percent below current levels using index put options. We also covered about 20% of our hedges in Strategic International Equity, but are again keeping a fairly tight leash on our willingness to accept market risk.
Suffice it to say that we continue to anticipate an oncoming recession and the potential for substantially deeper market losses over the next 12-18 months. At the same time, however, the ensemble of evidence on a variety of fronts has shifted our return/risk expectations, probably temporarily, above the zero line, allowing us to accept a small amount of market exposure, as we've briefly done on a handful of occasions this year.
Ideally, present conditions will be associated with what we've observed historically - a few weeks of moderate advance to clear the deeply oversold condition of the market, most likely followed by a fresh shift to a defensive stance. Given that the expected return/risk profile has just peeked above zero, we would prefer not to immediately experience the market's version of "Whack-A-Mole," but are prepared for that possibility as well. A break below the area around 1050 on the S&P 500 would put us in a situation much like 2008, where nearly every expectation of short-term stabilization was promptly dashed. For now, we don't see the sort of uniform breakdown that we observed then. A break to fresh lows by numerous indices, an explosion of new lows in individual issues, and steep weakness in utilities or corporate bonds would quickly change that assessment, and we will respond accordingly.
A few common questions and answers:
Are we bullish or bearish here? We really don't think in those terms. Our investment approach is to align our investment exposure in proportion to the return/risk profile that we expect at any point in time, given observable market conditions and the distribution of market outcomes that has historically accompanied that set of conditions. Based on our present methods, the expected market return/risk profile has been generally negative since about April 2010 with a few exceptions, including a slight traversal into positive ground this week. Our muted response is proportional to that. We are open to a shift toward a larger or sustained constructive position if the data supports it, but my guess is that the present shift will be fairly transitory. Again, the evidence of an oncoming recession is now compelling. This carries weight in our market analysis, but is not by itself enough to rule out periods of positive expected returns.
At what level of the S&P 500 will we get a buy signal? Again, we don't think in those terms. Our investment positions are based on a whole ensemble of evidence, so the same valuation level might be accompanied by different investment positions, depending on the surrounding conditions. Valuations are a continuum - today's are slightly better than they were a few months ago, much better than they were at the 2000 bubble peak, not as good as they were at the 2009 low, not even close to where they were in the early 1990's when the Los Angeles Times characterized me as "one lonely raging bull," and a lifetime away from the 20% prospective returns we saw in 1982 when I first began working in the financial markets. I don't believe we have to revisit 1950, 1974 or 1982 type extremes in the present cycle (though I'm fairly certain we'll see them at some point again). But even to achieve a prospective return of 8% a year or two from now, quite a bit of further damage would have to be endured. We prefer not to rule out any particular outcome.
It is important to reiterate, as I've done many times over the past two years, that my reluctance to accept market exposure in 2009 and early 2010 was not driven by a view that stocks were overvalued - our estimates of prospective 10-year returns in early 2009 were well above 10% annually. This is not bad, but even in post-war data, stocks have periodically declined to the point where 10-year prospective returns have reached 20%. Worse, we estimate that prospective total returns for the S&P 500 reached 10% in 1931, yet the market lost another two-thirds of its value before reaching bottom. The problem in 2009 was that market conditions at the time were "out of sample" from the perspective of post-war data. Once we were forced to contemplate other periods of major credit strains, I insisted that our methods should navigate both post-war and Depression era data well, without distinctions that could only be known in hindsight. After struggling with that "two data sets" problem through 2009, we finally reached a satisfactory solution in 2010 using an ensemble approach, which we implemented late in the year. We can see where that approach might have done things differently: being hard-defensive even in late-2008 rather than accepting even the slight exposure to market risk that we did, being more constructive than we were in much of 2009 and early 2010 (largely on the basis of contracting risk premia), but frankly, being just as defensive during the period of QE2 as we actually were.
Will we go long if the Fed initiates QE3? It actually depends on the specific conformation of the data that we observe. I expect that we would be as defensive as we were during QE2 if we observe the identical set of conditions (particularly, similar extremes of overvalued, overbought, overbullish conditions as I detailed in Extreme Conditions and Typical Outcomes ). It is also safe to say that we would not go long because of QE3 - rather, we would accept greater market exposure if we observed a set of observable data that was demonstrably associated with a positive profile of expected return/risk in historical data. We don't have a "Bernanke" indicator or a "QE3" indicator. Instead, we measure factors that have some potential to act as "sufficient statistics" for the things that occupy day-to-day news. These include credit spreads, interest rate variables, monetary variables, economic variables, exchange rates, commodity prices, and so forth. The combination of overvalued, overbought, overbullish conditions that we persistently observed during QE2 was associated with a dangerously skewed return distribution, so we stayed defensive, which was difficult but necessary. As I noted at the time, whatever gains the market might achieve had a high probability of being abruptly wiped out in a handful of sessions. What we've seen in recent weeks is about par for the course.
What did I think of Rick Perry's comments about Ben Bernanke? Frankly, I thought they were unfortunate. Perry suggested that monetary intervention would be "playing politics," which implies that Perry believes the Fed actually has the power to benefit the Obama Administration by improving the economy with its interventions. We certainly differ on that point. In my view, QE2 was an economically baseless attempt to distort the financial markets and force the prudent into taking risk in hopes of substituting speculation for innovation, productive investment, debt restructuring, and sound allocation of capital and resources. Perry gives Bernanke far more credit than I do.
As of last week, the Market Climate for stocks remained characterized by unfavorable valuations, overbullish sentiment, but enough compression and mixed internals in market action to push our estimates of expected return slightly above zero. This is emphatically not a "buy signal" or a "bullish call." It is what it is - a slight turn to slightly positive expected returns, which we will re-evaluate based on new data that may be positive or negative even a week from today. Our approach is to respond in proportion to the evidence we observe at each point in time, so our investment positions are always a "snapshot" of what is in fact a continuous process. As of Friday's close, we had covered about 20% of our hedges in Strategic Growth, but with a continuing line of defense using index put options a few percent below present levels. Strategic International Equity was similarly positioned, also with a modest 20% exposure to market fluctuations.
In Strategic Total Return, we added a few percent to our holdings of utility shares, now just over 4% of assets, and continue holding about 20% of assets in precious metals shares. At present, the ratio of gold prices to the XAU index is among the highest in history. Particularly with the striking weakness in the Philly Fed report last week, we have a set of conditions that has historically been quite positive for precious metals shares. My views on the metal itself are more reserved - it certainly appears that physical gold is overbought, but that in itself does not necessarily correlate with the shares, particularly at present extremes in the ratio of the two. From a trend perspective, it would be beneficial to see physical gold correct significantly. Parabolic moves become very problematic when corrections become increasingly frequent but are also very shallow (something you'll see me refer to as a "Sornette-type bubble"). Suffice it to say that the evidence we observe has historically been quite positive for precious metals shares, but that we would actually somewhat prefer a moderate correction in physical gold in order to clear some of the recent froth.
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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