Friday, February 1, 2008

Broadening Instability

Broadening Instability
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By John P. Hussman, Ph.D. | 28 January 2008
All rights reserved and actively enforced.

As anticipated, the Fed initiated a large “intermeeting cut” on Tuesday morning, which helped the stock market to dodge a bullet. Unfortunately, my impression is that the bear is toting a semi-automatic with a full clip of ammo.

With the disclosure that a single trader incurred billions of losses for Societe Generale, a
fairy tale has emerged that the whole market selloff last week was somehow driven by the unwinding of that position. On that, I have to concur with SocGen's CEO Daniel Boutin that the whole idea is absurd. At bottom, it reflects Wall Street's desire to “explain away” the market's weakness in hopes that it was an anomaly that is now behind us.

The truth is that the recent market weakness is a continuation of deterioration that has been underway since July. While I've viewed the market as being richly valued for some time, I have rarely used the word “warning” as frequently, or have been as vocal about potential risks, as I have in recent months:

A Who's Who Of Awful Times To Invest:

Market Internals Go Negative:

The Problem With Financials:

Warning— Examine All Risk Exposures:

Expecting A Recession:

Critical Point:

Minding The Hinges On Pandora's Box:

It is sheer denial to believe that the market's recent weakness and the Fed's response was just an overreaction to a decline caused by SocGen's unwinding. Moreover, as I noted on December 17:
"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."

From my perspective, that's largely the script we observed last week. Short-term market movements are demonstrating a form of chaotic instability that has generally indicated growing contagion rather than independence among investors. The most important difference between current market conditions and prior crash events is the behavior of interest rates. For example, rates were rising persistently before both 1929 and 1987. The clear downtrend of interest rates may turn out to be a saving grace here, given that the market's most spectacular losses featured hostile rate trends. Still, the best interest rate action has been in Treasuries, while credit spreads have been pushing to new highs, so the favorable trends in Treasury yields are partly a symptom of growing default risks in other areas.

My continued concern is that numerous market plunges have been indifferent to both interest rate trends and even valuations, with the main warning flag being deterioration in the quality of market internals, as we observe at present. Both in the U.S. and internationally, "singular events" tend to occur well after internal market action has turned unfavorable, and prices are well off their highs.

Though I don't want to put too much emphasis on intra-day behavior, if you examine tick data or daily ranges before major declines both in the U.S. and elsewhere, you'll generally see price movements become chaotic at increasingly short intervals even before the event itself. One way to describe it without mathematics is to spin a quarter on the table and watch (and listen to it) closely— you'll observe a similar dynamic at the abrupt point that the coin moves from an even spin to an irregular one, and again just before it stops. If you imagine a pen drawing out its movements, you would see it tracing out faster and faster circles as it moves from stability to instability.

We've been open to a fast clearing rally, which we observed as a 7% surge from intra-day low on Tuesday of last week to intra-day high on Friday of last week, on waning volume. At present, I have no pointed views about short-term market direction. Valuations are better than they were a few months ago (though still generally rich), but none of the risks that have concerned me in recent months have diminished.

As usual, no forecasts are required. If we partition market history into "bins," the current, observable evidence regarding valuation and market action belongs to a bin that has historically been associated— on average— with a negative return/risk profile. Accordingly, the Strategic Growth Fund is fully hedged. The Fund does not carry net short positions, but we did reinforce our hedges on that "clearing rally" late last week, which bolsters our defense against fresh market weakness without exposing the Fund to a net short position in the event that the market recovers further. For now, the Market Climate remains negative and the Fund is fully hedged. Our investment position does not rely on market weakness, but we do allow for it at present.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action. While the market remains generally oversold, the sharp mid-week clearing rally removed the ability to anticipate further strength as a probable outcome. Presently, the Strategic Growth Fund is fully hedged. The objective of our hedges is to mute the impact of market fluctuations, not to eliminate all risk by precisely offsetting our stock holdings. As is always the case when the Fund is hedged, our primary source of risk, as well as our primary source of expected return, is the potential for our stock holdings to behave differently than the indices we use to hedge.

The Fund currently has intentional overweights in sectors including consumer stocks (including consumer discretionary), technology, and healthcare. The Fund has less weight in financials and industrial cyclicals than the indices we use to hedge (primarily the S&P 500, the Russell 2000 and the Nasdaq 100). All of these relative weightings are built from the "bottom-up"— by investing in individual stocks that reflect some combination of favorable valuation and market action. We also constrain these weightings from the "top-down"— by limiting our exposure in any particular sector to a level that produces an acceptable level of overall "basis risk" versus the indices we use to hedge. Importantly, we observe a great deal of dispersion even within individual sectors, so among technology and consumer stocks, for example, many stocks reflect very favorable combinations of valuation and market action, while others appear almost ridiculously overvalued.

I am not an advocate of "investing by caricature"— choosing groups from the top-down that have done well in past economic downturns, without any analysis of how the underlying stocks are valued. Still, given our bottom-up approach, it may be helpful to know that behind the two "knee jerk" defensive sectors— consumer staples and healthcare— the next best performing sectors during recessions since 1973 have been consumer discretionary and information technology. Ned Davis Research notes that on the basis of relative performance during recessions, the "batting average" of consumer staples and healthcare has been 100%, while consumer discretionary has outperformed 80% of the time, and information technology only 40% (but by a substantial margin when it does). In contrast to 2000-2002, which was a terrible period for the hypervalued tech group, and a period where our exposure to that sector was virtually nonexistent, my impression is that technology stocks are currently a very appropriate area to moderately overweight. Our use of the NDX as part of our hedge reflects the belief that our specific holdings are better situated than the average index member even within the tech sector.

It's generally the case that a good number of stocks achieve their bear market lows during the initial phase of a market decline and then scrape along their lows for a while (although with good strength relative to the major indices), while stocks that dominate the indices often hit their downside stride well after the average stock has turned down. As I've noted before, increasing dispersion in the valuations of various stocks and sectors tends to be a favorable development because it tends to improve the potential for good stock selection to perform differently than the major indices. It isn't always comfortable when a particular overweight gets hit harder than the market for a few days, but we expect that from time to time, and it's a short-term risk that we've typically been compensated for over the long-term.

In bonds, the Market Climate last week was characterized by unfavorable yield levels and relatively favorable yield trends. Credit spreads widened yet again, which reinforces the downward pressure on Treasury yields because investors appear to be pricing in heightened default risk. We saw a massive "dropout" in Treasury yields that quickly reversed later in the week. That's a pattern we should expect to continue— a "safe-haven" compression of Treasury yields on increasing economic concerns, abruptly relieved by periodic upward spikes— most likely on inflation data, which I would expect to remain persistent until perceptions of a recession are well established.

Despite the overall downward bias of this sort of trading range, it appears unlikely that long-term Treasury investors will ultimately be willing to sustain a 3.5% yield to maturity over the next decade. So there is undoubtedly an element of "speculation" in the Treasury market, based on the lack of default risk. That prevents us from taking more than a short-duration exposure of about 2 years in this market, still mostly in TIPS. Again, I would expect that the inflation compensation element will become less useful at the point that a recession is clearly established, so straight Treasuries will eventually become appropriate.

  M O R E. . .


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