Erasers (Hussman)

Tuesday, August 7th, 2012

by John Hussman, Hussman Funds

August 6, 2012

I’ve never been very popular in late-stage bull markets. Defending against major losses and achieving our investment objectives over the complete bull-bear market cycle (bull-peak to bull-peak, or bear-trough to bear-trough) requires us to maintain an investment exposure that is essentially proportional to the expected return/risk ratio that is associated with each given set of market conditions. When prevailing market conditions are associated with a sharply negative expected return/risk ratio, as they are at present, and either trend-following measures are negative or several hostile indicator syndromes are in place (what we call Aunt Minnies), we will typically be fully-hedged, and will raise the strike prices of our put options toward the level of the market, in order to defend against steep market losses and indiscriminate selling. At present, we expect an average 10-year total return on the S&P 500 of about 4.7% annually in nominal terms, on the basis of rich normalized valuations. Based on a much broader ensemble of evidence, and considering horizons between 2-weeks and 18-months, we estimate the prospective return/risk ratio of the S&P 500 to be in the most negative 0.6% of all historical observations.

Moderate losses may be a necessary feature of risk-taking, but deep losses are erasers. A typical bear market erases over half of the preceding bull market advance. It is easy to forget – particularly during late-stage bull markets – how strongly this impacts full-cycle returns. The most obvious example, of course, is the 2008-2009 decline, which erased not only the entire total return of the S&P 500 since its 2002 low, but also erased the entire total return of the S&P 500 in excess of Treasury bill yields (its “excess return”) going all the way back to June 1995 – making all of the benefit from risk-taking during the late-1990’s completely for naught. Similarly, the 2000-2002 bear market wiped out the excess return that investors had enjoyed in the S&P 500 all the way back to February 1996. The 1990 bear market wiped out the excess return of the S&P 500 all the way back to January 1987.

Recall that at the 1987 peak, the S&P 500 had quadrupled (including dividends) from the secular low of August 1982. The 1987 crash – which in terms of size was a fairly run-of-the-mill bear of -33.51% from peak to trough – was enough to wipe out nearly half of that preceding total return (do the math: [(4*(1-.3351)-1]/(4-1)-1 = -45%), and slashed the excess return that investors had enjoyed since 1982 by even more than half. This chronicle of unpleasant arithmetic can be extended indefinitely over market history. Regardless of whether stocks are in a secular bull market or a secular bear market, the mathematics of compounding are brutal where large losses are concerned.

It’s instructive that $1 invested in Strategic Growth Fund at its inception, near the beginning of the 2000-2002 bear market was worth 2.72 times the value of an equivalent investment in the S&P 500 by the end of that bear market. Likewise, $1 invested in the Fund at the beginning of the 2007-2009 bear market was worth 2.09 times the value of an equivalent investment in the S&P 500 by the end of that bear market (see The Funds page for complete performance information). Performance gaps that can arise in the overvalued but still-advancing part of the full market cycle can be dramatically recovered by defensive strategies in the declining part of the cycle, which is why we don’t pay excessive attention to short-term tracking differences when market conditions are hostile.

Of course, there’s no assurance that we’ll always achieve our objective of outperforming the market with significantly smaller drawdowns over the complete market cycle. Though we’ve certainly had far less volatility and drawdown than the S&P 500 over the most recent cycle, Strategic Growth Fund lagged the total return of the S&P 500 by just shy of 13% cumulative from the 10/09/2007 peak in the S&P 500 to its most recent peak on 04/02/2012. This outcome primarily reflected my insistence on making our hedging approach robust to Depression-era data (an effort that caused us to miss returns in 2009-early 2010 until we achieved a robust solution using ensemble methods), and the smaller issue that purchasing actual put options has been less effective in periods where central banks have seduced investors to place their faith in “Bernanke puts” and “Draghi puts.” Our 2009-early 2010 miss was not “strategic” in that we would not be similarly defensive in future cycles if presented with identical conditions and evidence. But the fact is that our present defensive stance, particularly since early March, is something that we can be expected to establish over and over again in future cycles if presented with the same evidence.

Our measures of prospective return/risk became steeply negative in early March (see Warning: A New Who’s Who of Awful Times to Invest). Since then, market conditions have satisfied a restrictive set of criteria that have been similarly negative in a very small percentage of historical observations. At present, Strategic Growth Fund is fully-hedged, with most of our index put option strikes raised within about 4% of prevailing market levels, at a cost of less than 2% of assets in time premium looking out toward late-2012. This time premium will decay if the market remains unexpectedly resilient in the coming months and we observe no shift in presently negative market conditions. That said, with an angry army of negative indicator syndromes in place, I don’t expect speculation – even on hopes of further central bank intervention – will be significantly or durably rewarded here.

Suffice it to say that our present defensiveness is an intentional and repeatable aspect of our investment strategy. There are certainly some extraordinary factors that we had to address in the most recent market cycle as a result of the credit crisis and government attempts to defend bad debt, avoid restructuring, and to extend, pretend, and print at all costs. I believe that we can manage a continuation of that policy environment well over time, though periodic frustrations may be more frequent due to short-lived “risk-on” advances. In any event, I have no belief that central bank operations (which do little more than purchase a fraction of the new additions to the mountain of global government debt and replace them with currency and bank reserves) are actually capable of making recessions, bear markets, or the basics of arithmetic things of the past.

Economic Notes

Friday’s headline non-farm payroll employment gain (establishment survey) of 163,000 jobs was surprisingly positive, but far less informative about economic prospects than investors appeared to assume. The household survey, which is used to calculate the unemployment rate, actually showed a drop in civilian employment of 195,000 jobs in July. The increase in the unemployment rate would have been greater if not for the fact that another 150,000 people left the labor force altogether and were therefore not counted as unemployed. The picture was particularly weak for workers 20 years of age and older (where 213,000 jobs were lost), but was slightly rescued by a gain of 18,000 jobs among 16-19 year-olds. While the difference between the establishment and household surveys was unusually large, these disparities aren’t entirely uncommon, and don’t have a great deal of predictive value for either series. It’s probably most accurate to say that the July employment figures were mixed.

Even focusing on the bright spot, which is the establishment survey figure, one immediate fact to note is that year-over-year growth in non-farm payrolls fell below 1.4% back in April, following a brief excursion above that level, and has remained weak since then. As the chart below indicates, a decline in year-over-year payroll employment growth below 1.4% has occurred just before, or already into, each of the past 10 recessions, with no false signals. As usual, we’re skeptical of drawing inferences from a single indicator, and this instance may be different. But given the collapse in new orders and other measures of economic activity across numerous Fed, ISM and global surveys (and a continued decline in the most leading signal that we infer from our unobserved components models), there seems to be little reason for that expectation.

Keep in mind, as we’ve noted regularly over the years, that employment is a lagging economic indicator. The “stream of anecdotes” school of economic analysis may treat every economic report as having equal weight in determining the course of the economy, but the actual sequence is generally as follows: falling consumption growth and new orders -> falling production -> falling employment. The latest employment report appears to be little more than the wagging tail of an already sick puppy, and the tail is not likely to wag that dog to health.

In contrast, the latest JP Morgan global manufacturing report observes that “production and new orders both fell for the second month running in July, with rates of contraction gathering pace.” The chart below presents the global purchasing managers index (PMI), which has now weakened to levels last seen during the last two recessions.

With regard to Europe, it’s interesting how the semantics of the phrase “everything necessary” has been used to obscure the differences between Euro-area countries when it comes to monetizing bad debt. The distinction can be seen in a comment last week by German government spokesman Georg Streiter: “The ECB president said that the ECB will do everything necessary to preserve the euro and the government will do everything politically necessary to preserve the euro.” As long as the phrase is shortened to “everything necessary,” everyone is in agreement. The differences are in the subset of actions that constitute “everything.” For the German government, it is everything politically necessary. For Finland, it is everything necessary provided that collateral is pledged for every loan. For the German courts, it is everything legally necessary. While everyone can be unanimous about their commitment to doing “everything necessary,” it’s important to recognize that “everything” means something different to each party.

Even Mario Draghi had to resort to oxymorons to explain why the ECB did not initiate bond purchases last week despite what investors had taken as a pledge to do so, saying that the endorsement of bond purchases among ECB council members was “unanimous with one reservation” (he then left to enjoy some jumbo shrimp in a plastic glass, but they were found missing, leaving Draghi and his broken fix for an enduring Euro alone together in the deafening silence).

My impression regarding the Euro remains unchanged – liquidity will not durably counter insolvency, and the solvency problem among peripheral European countries is too great to be addressed without debt restructuring. ECB purchases of distressed sovereign debt would most likely have to be permanent purchases, and would therefore represent a fiscal transfer at the expense of stronger countries that would prefer to use the proceeds of money creation for the benefit of their own citizens. Doing those purchases indirectly – the ECB buying the debt of an ESM with a banking license, and the ESM buying distressed debt – does not change the arithmetic. Very reasonably, Germany is only willing to mutualize the debts of its neighbors if it can exert centralized authority over their fiscal policies – in Angela Merkel’s words “liability and control belong together.” But while Europe is geographically united, it is culturally and politically diverse, and a surrender of national sovereignty to the required extent is unlikely.

As a result, the Euro is likely to be pulled apart, and the tensions will probably be greatest across geographic and socioeconomic fault lines. From a geographic perspective, Finland (which insists on good collateral even for EFSF actions) and Italy (where popular sentiment against the Euro is strongest) have the greatest divide. From a socioeconomic standpoint, Germany (which is strongly anti-inflation and more oriented toward free enterprise) and the southern European states of Greece, Italy, Spain and Portugal (which have high debt ratios, heavily socialized economies, and very fragile banks) seem to be the furthest apart. The real question is who will get the Euro if the wish-bone snaps – the stronger more solvent states, or the weaker more inflation-prone states. Until the answer is clear, it will be difficult to anticipate the future direction of the Euro’s value. I would expect the least amount of systemic disruption in the event of an exit from the Euro by the stronger European countries, but that would also be associated with the maximum amount of Euro depreciation as the remaining members are left to inflate as they (and the ECB) please. All of this will be extraordinarily interesting, but it will not be easy.

Market Climate

As of last week, the Market Climate for stocks remained among the most negative 0.6% of historical observations, holding us to a tightly defensive stance. Strategic Growth remains fully hedged, with a staggered-strike position that raises the strike prices of the put option side of our hedge within a few percent of prevailing levels, at a cost of less than 2% of assets in time premium looking out to very late-2012. The Fund’s day-to-day returns can be expected to primarily reflect changes in the value of this time premium and day-to-day performance differences between the stocks held by the Fund and the indices we use to hedge. Strategic International also remains fully hedged. Strategic Dividend Value remains hedged at about 50% of the value of its stock holdings. Strategic Total Return continues to carry a duration of about one year in Treasury securities, with about 10% of assets in precious metals shares, and a small percentage of assets in utility shares and foreign currencies.

Copyright © Hussman Funds

Tags: Aunt Minnies, Bear Market, Bull Bear, Bull Markets, Erasers, Excess Return, Going All The Way, Horizons, Hussman, Hussman Funds, Investment Objectives, John Hussman, Market Advance, Market Losses, Naught, Necessary Feature, Risk Ratio, Syndromes, Treasury Bill, Trough, Valuations
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Are Investors Worried About the Right Risk?

Monday, July 30th, 2012

by Seth Masters, Chief Investment Strategist, AllianceBernstein

Individual and institutional investors alike have been shifting their capital from stocks to cash and bonds at a rapid rate in recent years, despite extraordinarily low interest rates. But if investors stop to weigh the importance of two different types of risk, they’ll see they still need stocks.

It’s tempting to give up on stocks after more than a decade of high volatility and low returns from stocks—and lower volatility with higher returns from bonds. But we think that 10 years from now, investors who do so will wish they had stayed in stocks—or added to them.

That’s not to say we think investors don’t need bonds. Despite extremely low current yields, we think bonds should still play their usual roles in the portfolios of most long-term investors: providing income, preserving capital and providing protection in times of stock-market distress (because bond prices tend to rise at such times). Bonds will be especially important if the market outcomes are at the extreme low end of our forecast range of potential outcomes.

But most investors are likely to need stocks to feel confident that they will have enough to live on, despite the high volatility of recent years. Remember that volatility isn’t the only type of risk. There’s also shortfall risk: not having enough money to meet your spending requirements. Investors must weigh both types of risk when making strategic asset-allocation decisions.

If you’re just thinking about market volatility, bond-oriented portfolios may look very appealing, especially today. We estimate there is less than a 2% chance that a portfolio with a 20% allocation to stocks and an 80% allocation to bonds will suffer a 20% peak-to-trough loss at some point over the next 10 years, compared with the 15% chance of such a loss for a portfolio with 60% in stocks (Display, left), as the left side of the display below shows. But if you’re just thinking about shortfall risk, a portfolio with 60% in stocks looks more attractive (Display, right).

We estimate that a 65-year-old retired couple planning to withdraw only 3% of their portfolio, grown with inflation, has a 12% chance of running out of money if they invest in the portfolio with 60% in stocks. That may not sound great, but it is materially better than the 24% odds of running out of money if they invest in a portfolio with 20% in stocks.

Today, uncertain macroeconomic conditions make large stock-market drops more likely than usual, and very low bond yields provide a thinner cushion. As a result, market risk can’t easily be avoided. And trying to avoid market risk is not a good strategy if it increases shortfall risk too much. A 20% loss is certainly painful, but it doesn’t hurt as much as running out of all of your money. Many investors who are currently focused on market volatility should be paying at least as much attention to shortfall risk.

The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Seth J. Masters is Chief Investment Officer for Asset Allocation at AllianceBernstein and Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein.

The Bernstein Wealth Forecasting System,^SM driven by the Capital Markets Engine, uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.

Copyright © AllianceBernstein

Tags: Asset Allocation Decisions, Bond Prices, Bonds, Chief Investment Strategist, Current Yields, Enough Money, Institutional Investors, Low Interest Rates, Market Outcomes, Market Volatility, Portfolios, Rapid Rate, Seth, Shortfall, Stock Market, Stocks, Strategic Asset Allocation, Term Investors, Trough
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From High to Low – A Look at World Markets (Horowitz)

Wednesday, May 23rd, 2012

by Andrew Horowitz, The Disciplined Investor

It has been a wild ride over the past 52 weeks and some markets came out looking good, some not so good.

Clearly the U.S. has the best overall return in 2011 and that shows through on the peak to trough range – and still holding up well.

Europe (ex-Germany) has not had as good as a run. Even with the big uptick due to the LTRO, the markets have been punished.

Asia speaks for itself – Japan is still a mess though…

Copyright © The Disciplined Investor

Tags: Asia, Europe, Germany, Horowitz, Investor, Japan, Nbsp, Trough, Uptick, Wild Ride, World Markets
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Oversold Stocks Piling Up (Bespoke)

Thursday, May 10th, 2012

by Bespoke Investment Group

May 9, 2012

Although the S&P 500 is down less than 5% from its bull market highs, the percentage of stocks that are oversold is really starting to pile up.  Using a boundary of one standard deviation above or below the 50-day moving average as the threshold for being overbought or oversold, 49.4% of the stocks in the S&P 500 are now considered oversold, while just 19.0% of the stocks in the index are overbought.  The chart below shows the daily percentage of S&P 500 stocks that are overbought and oversold.  As shown in the chart, the current level of 49.4% is the highest percentage of oversold stocks in the index since 10/3/11.

Tags: Amp, Bollinger Bands, Bounces, Bull Market, Commodity, Dead Cat, Downward Path, ETFs, European Elections, Futures Market, Hallmarks, Intermediate Term, Investment Group, Market Futures, Moving Average, Nbsp, Next Level, Oversold Stocks, Rebound, Relative Strength, Rubber Band, Selloffs, Standard Deviation, Sunday Evening, Swoons, Threshold, Trough
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Earnings Growth—Is It Enough? (Ezrati)

Monday, May 7th, 2012

by Milton Ezrati, Lord Abbett

After two-plus years of exceeding expectations, earnings this year seem poised, at last, to reflect the plodding nature of this economic recovery. In 2010 and 2011, even as the real economy managed only a paltry 2.4% average annual rate of expansion, the earnings of S&P 500^® Index¹companies soared, rising more than 47% in 2010 and almost 20% in 2011. Such a pattern could not persist. And this year, the slow fundamentals will almost surely assert themselves. Even so, it would be a mistake to read matters too pessimistically. There certainly is nothing ominous in the pattern. It is, after all, well-established historically that earnings should come into line with slower-growing revenues in this, the third year of economic recovery. Besides, this year’s probable 10% earnings growth, though only about half 2011’s pace, is sufficient to sustain the stock market rally.

This unfolding pattern of surge and moderation is hardly surprising or new. It has, in fact, become a cyclical commonplace, a reflection of the increasingly huge operating leverage of American business. Every year, business relies more and more on machinery, facilities, systems, and other forms of technology, often in place of labor. Because the trend builds a larger proportion of fixed costs into the production model, even slight variations in revenues have an exaggerated impact on the bottom line. In the more distant past, when variable labor costs were a bigger part of the overall production equation, layoffs could reduce a significant part of overall costs and so relieve some of the strain on the bottom line in recessions, and then, when rehiring raised labor costs in recovery, the profits recovery was more muted. But operating leverage has introduced a more volatile pattern.

The dramatic effect was clear during the last recession and in this recovery so far. In 2008–09, when the real economy dropped 5.1% peak to trough over 18 months, revenues followed, but because businesses had little ability to cut costs, the full brunt of the downturn fell on earnings, which, for the S&P 500, plunged from almost $22 a share in the second quarter of 2007 to a loss of more than $25 at the end of 2008. But however much strain the operating leverage imposed in the recession, it has worked in business’s favor in this recovery. As this huge array of productive capital has come back on line, the fixed costs allowed virtually all the additional revenue to fall to the bottom line. And because profits are a small difference between revenues and costs, the small percentage revenues gain have created huge percentage changes in profits. But now, in this third year of expansion, when most of this productive capital has at last become more fully utilized, the effect of operating leverage should dissipate, forcing earnings to follow slower revenues growth more faithfully.

Still, even as 2012 fails to enjoy the remarkable earnings surges of 2010 and 2011, the outlook for this year is not entirely as depressing as some media reports imply. Earnings can still outpace the 5–6% expected advance in domestic revenues because there is still some operating leverage left in the system and because S&P companies gather more than half their revenues abroad. Europe’s recession, of course, will weigh against foreign revenue growth, but the emerging economies should more than offset Europe’s depressing influence. Though these economies, too, have slowed, and that fact has attracted a lot of attention, they still outpace the United States and other developed economies by far. China, after slowing, still registers real growth of more than 8% and India more than 6%. In nominal terms (which, of course, is the way revenues are measured), those economies should still contribute double-digit growth of their part of the 2012 S&P revenues equation. Adding to likely 7–8% overall revenues gains, the remains of operating leverage should bring S&P earnings up to about 10% in 2012.

That growth, though half last year’s pace, should nonetheless allow equity markets to hold the gains they have already made and likely rise further. Even after market gains of the last six months, valuation measures are far from stretched. Price-to-earnings multiples, after all, depending on which of the seemingly endless calculations one chooses, show a market that at worst is near its historical valuation benchmark, allowing it room to keep up with earnings at least. Since, in most other respects, valuations are still more attractive, equity price advances should exceed the earnings growth. Stocks, relative to Treasury bonds, offer valuations not seen since the early 1950s or even the Great Depression. Next to corporate bond yields, equity valuations look less dramatic, but still suggest considerable upside potential. It is noteworthy that, even today, dividend yields on many stocks atypically exceed the yields on the firm’s own bonds.

Since earnings, though slowing, are still showing substantive growth, the most conservative interpretation of valuations would suggest that equities should hold this year’s gains so far. Anything other than the most conservative interpretation suggests greater gains.

¹The S&P 500^® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.

Tags: American Business, Bottom Line, Commonplace, Dramatic Effect, Earnings Growth, Economic Recovery, Forms Of Technology, Layoffs, Lord Abbett, Market Rally, Milton Ezrati, Moderation, Operating Leverage, Production Model, Proportion, Recession, Recessions, Reflection, Stock Market, Trough
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“Release the Kraken” (Hussman)

Monday, April 30th, 2012

by John P. Hussman, Ph.D., Hussman Funds

Over the past 13 years, and including the recent market advance, the S&P 500 has underperformed even the minuscule return on risk-free Treasury bills, while experiencing two market plunges in excess of 50%. I am concerned that we are about to continue this journey. At present, we estimate that the S&P 500 will likely underperform Treasury bills (essentially achieving zero total returns) over the coming 5 year period, with a probable intervening loss in the range of 30-40% peak-to-trough.

Why? First, with respect to 5-year prospective returns, it’s important to recognize that returns at that horizon are primarily driven by valuations – not the “Fed Model” kind, but the normalized earnings and discounted cash flow kind. Stocks remain strenuously overvalued here, and only appear “fairly priced” relative to recent and near-term earnings estimates because corporate profit margins are more than 50% above their long-term norm. Meanwhile, corporate profits as a share of GDP are about 70% above the long-term average. As I detailed in Too Little To Lock In, these abnormally high margins are tightly related (via accounting identity) to massive fiscal deficits and depressed household savings rates, neither which are sustainable.

Our projection for 10-year S&P 500 total returns – nominal – is about 4.4% annually, which is far better than the 2000 peak, far inferior to the 2009 trough, and save for the period before the 1929 crash, worse than any prospective return observed prior to the late-1990′s bubble – even in periods having similarly depressed interest rates.

Of course, rich valuations can persist for some time – predictably resulting in poor long-term returns, but often doing little to prevent short-run speculation and temporary gains. The issue is then to identify the point at which overvalued conditions are joined by sufficiently overextended conditions, and a sufficient loss of speculative drivers, to make rich valuations “bite” even in the shorter-term. This is where additional criteria come in, such as overbought technical conditions and extreme optimism in the form of low bearish sentiment, depressed mutual fund cash levels, and heavy insider selling. Presently, it doesn’t help that T-bill yields and long-term bond yields remain higher than 6 months ago, and we have signs of oncoming recession. This is particularly evidenced by collapsing economic measures in Europe, softening economic performance in developing economies including China and India, and jointly weak year-over-year growth in key U.S. economic measures such as real personal income, real personal consumption, real final sales, and reliable leading indicators from the OECD and ECRI, as well as our own measures.

The combination of rich valuations, overbought conditions, overbullish sentiment, and deteriorating leading economic evidence can still unfortunately persist for months before being resolved. But once the hostile syndromes we’ve seen recently have emerged in the data, attempts at continued speculation have amounted to playing with fire. Similar conditions have repeatedly resulted in disastrous outcomes for investors. It would be nice to be able to “time” these outcomes better. We haven’t found a reliable way to do so, and would still be concerned about robustness – sensitivity to small errors – even if we did. Yet even when unfortunate outcomes are not immediate, the fact that the S&P 500 has underperformed T-bills for 13 years is not very sympathetic to arguments that stock market risk has been worth taking overall, except in confined doses.

Tags: Corporate Profit, Corporate Profits, Discounted Cash Flow, Earnings Estimates, Fed Model, Fiscal Deficits, GDP, Household Savings, Hussman Funds, Kraken, Market Advance, Market Plunges, Model Kind, Profit Margins, Speculation, Term Earnings, Treasury Bills, Trough, Valuations
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The Importance of Being Earnest (Columbia)

Thursday, April 12th, 2012

Tags: Bias, Bonds, Bulls, Columbia Management, Corporate Pension Funds, Dividends, Great Depression, Inclination, Market Gyrations, Maxim, Meltdown, Nasdaq, Oil Crisis, Portfolio Managers, Portfolios, Rich Rosen, Spite, stagflation, Trough
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A False Sense of Security (Hussman)

Sunday, March 25th, 2012

“The world economy has stepped back from the brink and we have causes to be a little bit more optimistic. But optimism should not give us a sense of comfort and certainly should not lull us into a false sense of security.”

IMF Managing Director Christine Lagarde, March 17, 2012

As we examine the present evidence relating to both the financial markets and the global economy, the aspect that strikes us most is the extent to which Wall Street continues to emphasize superficially positive data in preference for deeper analysis, to extrapolate short-term distortions as if they were long-term trends, and to misconstrue freshly printed wallpaper and thin supporting ice as if they were solid walls and floors.

Two propositions we heard last week were characteristic of this false sense of security. One was a remark by an analyst that stocks were in a “secular bull market” here. The other was a Wall Street “factoid” being passed around, suggesting that the “equity risk premium” on stocks has never been higher.

Let’s address these in turn. When people talk about bull and bear markets, they often use the terms “cyclical” and “secular.” One cyclical bull and one cyclical bear market comprise the normal garden-variety market cycle of about 5 years in duration (though with quite a bit of variation around that norm, see “notes on secular and cyclical markets” in Hanging Around, Hoping to Get Lucky ). Taking very broad averages, a cyclical bull market lasts about 3.75 years, averaging a trough-to-peak gain of about 150%, and a cyclical bear market lasts about 1.25 years, averaging a decline of just over 30% from peak-to-trough. If you do the compounding, you’ll observe that the typical bear market wipes out more than half of the preceding bull market gain.

However, those averages mask an additional source of variation, which depends on “secular” conditions. If you examine market history as far back as the late-1800′s, you’ll find that market valuations have moved in broad advancing and declining phases, with each phase lasting about 17-18 years in duration (that still should be treated only as a tendency, and there’s no reason I know for treating it as a magic number). As an example, stocks moved from extremely low valuations in 1947 to quite rich valuations by 1965, producing a long “secular” bull market where each successive cyclical bull market topped out at higher and higher valuation multiples. In contrast, from 1965 to 1982, valuation multiples went through a long contraction, where each successive cyclical bear market bottomed out at lower and lower valuation multiples.

The effect of these longer valuation “waves” is this: during long secular bull phases, the cyclical bull markets tend to be longer and more rewarding, and the cyclical bear markets tend to be shorter and less damaging. In secular bulls, the market is running with the wind at its back. The secular bull market period from 1982 through 2000 was a good example of this tendency.

In contrast, during long secular bear phases, the cyclical bull markets tend to be shorter and less rewarding, while the cyclical bear markets tend to be longer and more violent. In secular bears, the market is swimming against the tide. The secular bear period that began in 2000 has been a good example of this tendency.

As Nautilus Capital observes, the average cyclical bull market in a secular bear market period has produced an average gain of only about 85%, lasting less than 3 years on average. In contrast, the average cyclical bear in a secular bear has been unusually violent, averaging a 39% loss over a span of about a year and a half. Compound the two, and that’s enough damage to drag the cumulative full-cycle return down to just 13%, on average.

Needless to say, the assertion that stocks are in a “secular” bull market is really an assertion that investors can let down their guard, in the sense that downturns are likely to be muted and advances will be extended. But from our standpoint, if you’re going to pick a secular team, it would be best to have reliable data to back up the choice.

So what distinguishes a secular bull from a secular bear? Valuations. Not just any valuation measure however – it’s important to demonstrate that the valuation measure you choose actually has a strong and demonstrable long-term relationship with subsequent market returns (which is where Wall Street’s disingenuous use of toy models like simple price-to-forward earnings multiples and the “Fed Model” makes us nearly apoplectic).

Below, I’ve annotated our usual valuation chart to provide a better sense of what drives the long “secular” movements in the stock market. The chart uses our standard valuation methodology to estimate prospective market returns.

It should be quickly evident that secular bull markets don’t simply come out of the blue. They emerge precisely because stocks become priced to achieve extraordinarily high long-term returns. Both the 1947-1965 secular bull and the 1982-2000 secular bull began at points where stocks were priced to achieve 10-year returns of close to 20% annually. In contrast, the 1965-1982 secular bear began with prospective 10-year returns of just 5.9% (though slightly higher than the 4.4% yield on Treasury bonds at the time), and of course, the secular bear that began in 2000 emerged from bubble valuations, where we projected negative 10-year total returns at the time.

It seems to be an article of faith among some analysts that the 2009 low represented the start of a new secular bull market, but two features are noteworthy. The first is that the valuation achieved in 2009 was nowhere near the valuation that typically ushers in a new secular bull market. The second is that the brief undervaluation we observed in 2009 was quickly eliminated. At present, we project total returns for the S&P 500 of just over 4% annually over the coming decade. This is even worse than the valuation where the 1965-1982 secular bear started (though certainly less extreme than the 2000 peak). Though interest rates are lower today than in the 1965-1982 period, satisfactory returns from present levels will require investors to sustain rich valuations indefinitely.

Again, it’s worth emphasizing that our standard valuation methods are (and have remained) well-correlated with subsequent market returns – a very basic criterion that is painfully lacking among many popular valuation measures such as the Fed Model. It strikes me as absolutely bizarre that so many Wall Street “professionals” offer up the Fed Model and the “forward operating earnings times arbitrary multiple” approach so freely, when it takes nothing but some data and a few hours of effort to demonstrate that those approaches are nearly worthless (see for example the August 20, 2007 comment Long Term Evidence on the Fed Model and Forward Operating P/E Ratios – not that many analysts agreed with our valuation concerns at that point either).

A related assertion we’ve heard a lot lately is that “the equity risk premium on stocks has never been higher.” In the finance literature, the “equity risk premium” is essentially the return that stocks are priced to achieve, in excess of the risk-free interest rate. Of course, these estimates vary wildly depending on the method you use (many common ones which, again, have virtually no correlation with actual subsequent returns). A few popular methods include 1) the Fed Model (forward operating earnings yield minus the 10-year Treasury yield); 2) dividend yield plus projected earnings growth, minus the 10-year Treasury yield; 3) historical stock returns minus the 10-year Treasury yield, which is a particularly misleading measure of the returns stocks are priced to achieve in the future, or; 4) any of the above using the prevailing T-bill yield instead of 10-year yields.

Among the problems with these typical approaches is that stocks are not 3-month or 10-year instruments, but have a duration that is essentially the inverse of the dividend yield (so at present, the duration of stocks is roughly 50 years, compared with a 10-year Treasury, which has a duration closer to 7 years). So the appropriate “risk free” return in these estimates should really be either a Treasury yield of equivalent maturity – none which are available, or at least an estimate of the average expected short-term risk free rate expected over the same horizon. Needless to say, estimates of the equity risk premium get a false benefit if you use today’s unusually suppressed, short-duration risk-free rates.

The larger difficulty is the estimate of the prospective return on stocks. If you want to use a 10-year Treasury yield as a benchmark, you would also want to use a 10-year projected return for the S&P 500. On that note, and using reliable valuation methods (see above), the difference between the expected 10-year total return on stocks and the 10-year Treasury yield is presently less than 2% (nominal).

How does this compare historically? It’s notable that the estimated equity risk premium was severely negative during the late-1990′s market bubble. Not surprisingly, stocks have performed terribly versus risk-free Treasuries as a result. Excluding bubble-era data, we estimate that the normal historical equity risk premium (on a 10-year horizon) has been just over 6%, reaching 17% in the late-1940′s as a secular bull market was beginning, and holding in the 5-9% range even during the high-inflation 1970′s. Including the late-1990′s bubble period in the calculation brings the average down to just over 4.5%.

When has the equity risk premium been as low as it is today? Prior to the late-1990′s bubble period, the estimated equity risk premium has been below 2% only during the two-year period leading up to the 1929 peak, between 1968-1972 (when the equity risk premium finally normalized as a result of the 1973-1974 market plunge), and briefly in 1987, before the market crash of that year. We know how each of these periods ended. The only real variation is in how long the preceding overvaluation was sustained.

Profit margins and a false sense of security

One of the aspects of the market that is most likely to confuse investors here is the wide range of opinions about valuation, with some analysts arguing that stocks are cheap or fairly valued, and others – including Jeremy Grantham, Albert Edwards, and of course us – arguing that valuations are very rich.

The following chart may help to bridge that gulf. Essentially, analysts who view stocks as “cheap” here are invariably basing that conclusion on current and year-ahead forecasts for earnings. In contrast, analysts who view stocks as richly valued are typically those who view stocks as a claim not on this years’ or next years’ earnings, but instead are a claim on a long-term stream of deliverable cash flows. Simply put, there is presently a massive difference between short-horizon earnings measures and longer-term, normalized earnings measures.

What’s going on here is that profit margins have never been wider in history. But profit margins are also highly cyclical over time. The wide margins at present are partly the result of deficit spending amounting to more than 8% of GDP – where government transfer payments are still holding up nearly 20% of total consumer spending, and partly the result of foreign labor outsourcing (directly, and also indirectly through imported intermediate goods) which has held down wage and salary payouts. Indeed, the ratio of corporate profits to GDP is now close to 70% above its long-term norm.

Now, if you look at the red line (right scale, inverted), you’ll notice that unusually high profit shares are invariably correlated with unusually low growth in corporate profits over the following 5-year period. Thanks to continuing deficits and extraordinary monetary interventions, this effect has been largely postponed in recent years, allowing profits to expand to present extremes. We are not arguing that profit margins necessarily have to decline over the near-term, and our concerns don’t rest on the assumption that they will. It is sufficient to recognize that the bulk of the value of any stock is not in the early years of earnings, but in the long tail of future cash flows – especially if payouts are low. Stocks are essentially 50-year instruments here in terms of the cash flows that are relevant to their valuation. There are a lot of factors and quiet math that affect the P/E multiple that can be appropriately applied to earnings. Slapping an arbitrary multiple onto elevated earnings reflecting extraordinarily inflated profit margins ignores all of it.

The upshot is that if investors are willing to believe (without the use of off-label hallucinogens) that current profit margins are the new normal, and will be sustained indefinitely, then Wall Street’s valuations based on current and forward earnings estimates can be taken at face value. This assumption of a permanently high plateau in profit margins is quietly embedded into every discussion of “forward earnings” here.

As a side note, analysts continue bemoan the “inexplicable” gap between the economic malaise of “Main Street” and the optimism of Wall Street. Compare the previous graph to the one below, which shows how the “Muppets” are doing (and people wonder why I’m cynical about corporate culture). An economy that is this far out of balance is one that is unlikely to avoid toppling over to some extent. Capitalism and free markets work, and America remains the most creative and innovative nation on the planet, but until policy makers and regulators wake up, it will be impossible to escape the long-term consequences of distorted markets, reckless bubble-seeking Fed Chairmen, repressively low interest rates that penalize saving and lower the bar for productive investment, a self-serving financial system, and bailouts that remove all consequences for misallocating capital that could otherwise create jobs and raise living standards.

The iron law of equilibrium

A final observation. We continue to hear endless variations of this comment – “The Fed is creating huge amounts of money, and all of that money has to go somewhere.”

Actually no, it does not. The iron law of equilibrium is that once a security is issued – whether that piece of paper is a share of stock, a bond certificate, or a dollar bill – that security has to be held by someone in exactly that form, and in no other form, until it is retired. If IBM issues one share of stock, that share of stock can change hands between any number of people, but someone has to hold that share until it is retired. If the Fed creates a dollar of base money, that base money can change hands between any number of people, but someone has to hold that dollar until it is retired. There is no “getting out” of cash and into stocks in aggregate. There is only an exchange of ownership between existing pieces of paper that will each continue to exist until each is retired.

So the proper question isn’t where all of these pieces of paper will go – they still have to be held by someone exactly as they are. They may change hands, but in equilibrium, they don’t go anywhere. They can’t go anywhere in aggregate. The only real question is this: how low do you have to drive the returns on all other competing assets until the “someone” holding that dollar bill has no incentive to try to trade it for some other piece of paper? This, precisely this, and only this, is what the Fed is manipulating with its massive interventions. By creating enormous amounts of paper, and hoarding higher duration securities like Treasury securities, the Fed is trying to force investors into risky assets until the prospective returns on all competing assets are driven so low that investors and banks holding cash are willing to just sit on it. In short, the Fed has focused its efforts on creating a bubble in risky assets, on the misguided, semi-psychotic, and empirically disprovable notion that this will make people feel wealthier and get them to spend and borrow – despite the fact that their incomes can’t support it without massive government transfer payments.

Aside from periodic jolts of enthusiasm that release some amount of pent-up demand for a few months at a time, what this policy has actually produced is near-zero prospective returns on nearly every class of assets. These assets will now go on to actually achieve tepid returns for an extended period of time, provided that things work out well, and a collapse in the prices of risky assets if investors ever get the inclination to demand a normal return as compensation for the risk they are taking.

Market Climate

The Market Climate for stocks remains characterized by an unusually hostile set of indicator syndromes, most notably, an “overvalued, overbought, overbullish, rising-yields” syndrome that has historically been unfavorable for stocks regardless of prevailing Fed policy or trend-following indicators. Even in recent years, the effect of Fed policy and other interventions has been evident after significant market weakness (essentially limiting the follow through and helping to re-establish rich valuations), but those interventions have not prevented the weakness itself – not in 2007-2009, not in 2010, and not in 2011. Our primary risk estimates are now in the worst 0.5% of what we observe in historical data. We have increasingly used the word “warning” in our weekly comments for that reason. Strategic Growth and Strategic International remain fully hedged. Strategic Dividend Value is hedged at 50% of the value of stocks held by the Fund, which is its most tightly hedged stance. Strategic Total Return maintains a generally conservative stance as well, with a duration of just under 3 years in Treasuries, and about 5% of assets allocated between precious metals shares, utility shares, and foreign currencies. I strongly expect that we will have significantly better opportunities to accept financial risk in expectation of return than the near-zero prospects the Federal Reserve has forced upon investors at present.

Meanwhile, our economic concerns persist, as detailed last week and in prior comments. Despite a low-level rebound in various coincident measures, we continue to observe general weakness in the most informative leading measures (as we saw again in data from Europe and China last week as well). Based on the typical lead-time of these measures, we are now in a window where we would expect deteriorating coincident data over the coming 2-3 months. As I’ve noted in prior comments, to the extent that we observe economic data coming in better than expected during this window, the inferred state of the economy is likely to improve, and we would then be able to suspend our recession concerns. Regardless, it’s important to recognize that our defensiveness about the stock market here is distinct from those economic concerns, and our risk estimates would remain quite high (based on factors including the prevailing overvalued, overbought, overbullish, rising-yields syndrome), even if we were to zero out our recession concerns.

Tags: Bear Market, Bear Markets, Bull And Bear, Christine Lagarde, Distortions, Equity Risk Premium, False Sense Of Security, Financial Markets, Garden Variety, Global Economy, Hussman, Imf, Market History, Market Valuations, Secular Bull Market, Sense Of Security, Source Of Variation, Term Trends, Trough, World Economy
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Guest Post: Forget Gold—What Matters Is Copper

Saturday, September 24th, 2011

Forget Gold—What Matters Is Copper

Guest contribution by Gonzalo Lira

People are freaking out that gold has fallen to $1,650, from its lofty highs above $1,800—they are freaking out something awful. “Gold has fallen 10%! The world is coming to an end!!!” I myself took a shellacking in gold—

—but copper is what has me worried.

Copper fell from $4.20 to $3.25—close to 25%—in about three weeks. Most of that tumble has happened in the last ten days, and what’s worrisome is that, as I write these words over the weekend, there is every indication that copper will continue its free fall come Monday.

From the numbers that I’m seeing—and from the historical fact that copper tends to fall roughly 40% from peak to trough during an American recession—there is every indication that copper could reach $2.67 in short order. And even bottom out below that—say at $2.20—before stabilizing around the $2.67 level.

But we’ll see. The price of copper is not the point of this discussion. The point of this discussion is what the price of copper means.

What it means for monetary policy.

We all know the old saying: “Copper is the only commodity with a Ph.D. in economics”, or words to the effect.

The ongoing price collapse of copper signals that the markets have collectively decided that there is going to be no resurgence of the global economies—at least not for the next 9 to 18 months. Up until now, the economic data that has been coming out over the last couple of weeks seemed to indicate that there’s going to be a double-dip—but in my mind, this fall in the price of copper confirms this notion that the general economy is going down.

And remember: Market sentiment can not only be a predictor of future economic performance, but its determinant. If today the markets feel that the economy is going to suck tomorrow, often that very sentiment is what makes the economy suck canal water.

So if copper is falling like a mo-fo—which both signals and convinces the market that the economy is gonna suck—what does this mean for monetary policy?

Prima facie, the fall in the price of copper is deflationary: Less demand means that the prices fall—meaning the dollar acquires purchasing power.

What does it mean for monetary policy that copper has fallen so low?

It means that Bernanke will carry out more “non-traditional” Federal Reserve stimulus.

Ben Bernanke is famous for being terrified of deflation—and to his particular mindset, this is a reasonable fear. More to the point, Bernanke’s deflation-phobia actually matters—because after all, he is the Chairman of the Federal Reserve. He controls U.S. monetary policy.

Deflation is supposed to be bad because it shrinks an economy. (Personally, I am more afraid of inflation than deflation: The latter is self-correcting, while the former spirals out of control and into social chaos. But that’s for some other post.)

According to the deflationary world view, falling prices oblige producers to cut back on production—which means firing workers. These fired workers—husbanding their resources during their unemployment—spend less, further contracting demand, thus putting more downward pressure on prices, forcing more producers to cut back and fire even more workers, who thus spend less—

—you get the picture: A “deflationary death spiral”, in the Deflationistas’ parlance.

This is Bernanke’s fear—and he will do anything to alleviate it. Notice: It’s not that Bernanke will do anything to alleviate deflation—he will do anything to alleviate his fear of deflation.

As copper prices continue to tumble, signaling further economic contraction, there is no question in my mind that Ben Bernanke and his Fools of the Fed will view this as evidence of looming dollar deflation.

They will do everything to stop this looming deflation. But since the “traditional” Federal Reserve tools have been used up—that is, the Fed has its rate at zero, and for all intents and purposes all of its liquidity windows open—Bernanke will have no choice but to announce some new “non-traditional” liquidity injection scheme shortly.

Thus I expect some Banana Republic money-printing scheme to be announced by the Bernankster before the end of the year—perhaps as early as this coming October. The fall in the price of copper—more than anything else—is what Benny and his Fools will be looking at, to justify this new scheme.

And my bet is, this scheme they announce will be as big—and as controversial—as QE-II.

I am giving my people at The Strategic Planning Group a detailed analysis of what has happened over the past week, and what we can expect to happen in the markets over the coming weeks. You’ll have to pay to play for that.

But insofar as my overall view of the situation is concerned, this is what I think:

Bernanke will drive a schoolbus over small children, in order to prevent his notion of deflation from coming true. This fall in the price of copper is much more relevant to his course of action as Fed Chairman than the fall in the price of gold (which was just a combination of options expiration coming up, and gold positions being sold to cover losses in other asset classes).

This dramatic fall in the price of copper signals that the markets do not believe reactivation is anywhere near eminent—not for at least 9 to 18 months.

To the traditional twin Federal Reserve mandates of price stability and full employment, Bernanke has added a third mission: That of “growing the economy”—whatever it takes, however unorthodox or reckless the measures.

Therefore, it is my estimation that very soon now—end of this year at the latest—we will have QE-infinity—and beyond!

If you’re interested in SPG, check out a preview here.

Tags: Canal Water, Collapse, Commodity, Determinant, Double Dip, Economic Data, Economic Performance, Global Economies, Gold, Lira, Market Sentiment, Mo Fo, Monetary Policy, Notion, Price Copper, Price Of Copper, Recession, Resurgence, Shellacking, Signals, Trough
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Russ K.’s Market Calls – Equities, Mega Caps, Germany & More

Thursday, August 18th, 2011

by Russ Koesterich, Chief Investment Strategist, iShares

Call #1: Maintain Overweight Equities, Mega Caps, Germany, the Netherlands & Brazil

Given last week’s extraordinary volatility, my call this week focuses on the overall market today and my take on it. Essentially, I still believe the odds favor slow but positive growth; equities look inexpensive; and volatility appears too high.

As I’ve been discussing for some time, this was always going to be a slow recovery. That said, while I would continue to expect subpar growth, leading indicators aren’t suggesting that we’re heading back into a recession.

For instance, in the year leading up to the 2008 recession, leading economic indicators fell or were flat in 11 out of 12 months. In contrast, during the past year, leading indicators have risen in 11 out of 12 months, including the most recent month.

In short, while an unexpected event (such as a European banking crisis) could easily knock the world back into a recession, growth looks set to continue on a slow-but-positive path in the absence of such an event.

With that in mind, how do stocks look? At their lows last week, global equity markets were trading at around 1.4x book value, close to their 2009 trough valuations. While there are no shortages of headwinds for markets, recent valuations look extreme to me unless one believes that the global economy is going back into another severe recession, another global banking crisis or both. As I don’t see either situation as likely, I advocate being a buyer of equities.

In particular, I continue to like large, quality mega caps, which can be accessed through potential iShares solutions such as IOO, OEF, HDV and DVY. Second, I see good value in much of northern Europe, including in Germany (potential iShares solution: EWG) and in the Netherlands (potential iShares solution: EWN).

Finally, as I highlighted last week, I am also advocating an overweight view for select emerging markets, particularly Brazil (potential iShares solution: EWZ).

Call #2: More on recent market volatility

Now, a bit more on the level of recent market volatility. In May, I noted that market volatility seemed to low. Since then volatility has risen by more than 100%.

Given this big spike, I noted last week that market volatility was too high. As a result, I would now advocate being a seller of volatility and lightening up on fixed-income exposure in order to fund an increased allocation to stocks.

Disclosure: Author is long DVY, EWG and EWZ

Source: Bloomberg

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country and narrowly focused investments may be subject to higher volatility. Bonds and bond funds will decrease in value as interest rates rise.

Tags: Banking Crisis, Brazil, Chief Investment Strategist, European Banking, Ewg, Global Banking, Global Economy, Global Equity Markets, Hdv, Headwinds, Leading Economic Indicators, Leading Indicators, Lows, Northern Europe, Positive Path, Recession, S Market, Trough, Unexpected Event, Valuations, Volatility
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