To put some numbers on this, since 1967, when the growth rate of the ECRI Weekly Leading Index has been negative and falling (i.e. no more than 10 points from its 6-month low), the 4-week average of new claims for unemployment has been above its 5-year average, and the S&P 500 has been - based on our standard estimation methodology - priced to deliver a 10-year average annual total return of anything less than 9% (our current projection is closer to 6%), the S&P 500 has lost value at a -17.3% annual rate. Interestingly, the prevailing trend of the market has not mattered in this environment. For example, the average loss has been nearly the same regardless of whether the S&P 500 was above or below its 50-day moving average, though returns have actually been somewhat worse if the S&P 500 was above its 200-day moving average at the time. Suffice it to say that the present combination of valuations and economic indications is not constructive.
Market Climate
As of last week, the Market Climate for stocks was characterized by rich valuations, unfavorable economic pressures, and elevated though not extreme bullish sentiment (the Investors Intelligence figures are 41.7% bulls vs. 27.5% bears). We also observed an abrupt and somewhat surprising amount of technical damage last week. That damage is not quite to the level that would create urgent downside concerns, but as I noted last week, the deterioration could be very abrupt if the economic data continue to come in weaker than expected. We are fully hedged in the Strategic Growth Fund. Given the repeated tendency for investors to "buy the dips" on the false perception that stocks are cheap (primarily on the "forward operating earnings" argument that we've analyzed in recent weeks), we may see a "fast, furious, prone-to-failure" advance to clear the short-term oversold conditions we developed last week. Still, caution is important here, since we're in a set of conditions where one or two hard down days can wipe out weeks of choppy upside progress.
In bonds, the Market Climate remained characterized last week by unfavorable yield levels and favorable yield pressures. Over the near term, perceptions of economic risk are clearly dominant, and given the tendency for the Treasury yield curve to flatten during periods of economic weakness, we may see long-term Treasury yields pressed even lower for a while. At the same time, however, increased risk perceptions could hit corporate bonds very hard even in a softening economic environment. While corporate cash levels may very well reduce liquidity risk for companies that would otherwise need to raise funds in a tight credit market, investors should not ignore that the overall debt burden of U.S. corporations is higher than it has ever been.
For companies with low earnings cyclicality, cash provides a clearly better margin of safety than for companies that are prone to earnings losses during periods of economic weakness. Just as dividends have to be evaluated in relation to the earnings available to cover those dividends, and the stability of those earnings, investors wishing to hold corporate bonds for additional "pickup" in yield should pay close attention to earnings stability, cash reserves, and overall debt burdens. We would emphatically avoid the debt of financials and cyclicals that are prone to massive "extraordinary" losses that can quickly wipe out available liquidity.
Copyright (c) Hussman Funds
