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By John P. Hussman, Ph.D. | 20 May 2008
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Investors may end up learning that lesson the hard way too. In recent weeks, investors have chased stock prices higher (though on relatively dull volume and narrow, cyclical leadership) like kids riding their bikes up a board they've laid over a pile of bricks to take a sweet jump. Once in the air, the question is "What now?"
The S&P 500 currently trades at 22.9 times trailing net earnings, but these earnings are somewhat depressed and not representative of normal long-term earnings power. What is more important is that the S&P 500 presently trades at over 20 times normalized earnings (sustainable earnings at normal profit margins). More friendly price/earnings multiples on the basis of "forward operating earnings" or even price-to-peak-earnings are had only on the assumption of a remarkable earnings rebound in the second-half, or a permanent return to the record-high profit margins of recent years.
This is a lot like a kid imagining, once airborne on the bike, that a foam pit will suddenly appear to break the impending fall.
As of last week, valuations remained unfavorable for stocks. Meanwhile, however, market action continued to hover near the point where speculation could begin to feed on itself. The behavior of trading volume and leadership remains relatively uninspiring, but some popular moving averages have been crossed (such as the 200-day moving average of the S&P 500), which has fed some amount of technical buying. Stocks are clearly overbought on a short-term basis, and given that, it's likely we'll observe some sideways movement for a bit even if the speculative interest of investors ends up continuing in the weeks ahead. Meanwhile, that same overbought condition, given a still-unfavorable Market Climate overall, leaves us braced for a possibly sudden hard retreat.
In short, the fundamentals continue to appear very poor, but market action is at something of a crossroads. The reality is that as recessions develop (and I continue to believe the U.S. faces a much more significant downturn than we've observed to date), the data can take months to accumulate to a compelling verdict, and in the meantime, speculative pressures can remain alive. If the consolidation to clear the current overbought condition is fairly shallow, it will suggest that speculation might begin to feed on itself for a while. A sharp selloff from current levels, particularly on lopsided negative breadth, would suggest that the second round of negative financial and economic news is somewhat nearer.
On the economic front, we learned last week that April capacity utilization dropped below 80%. As I had noted in my March 10 comment, "Indeed, among indicators that have generally turned negative early into recessions, about the only one that has not is manufacturing capacity utilization, which generally drops below 80% as the economy turns down." So much for small comforts. It is important to recognize that the kinds of indicators that investors are looking to for verification of a recession (spiking unemployment, negative GDP reports, bankruptcies, margin-related cost cutting, etc) are generally seen further into a recession than we probably are.
As Martin Feldstein of the NBER (the group that officially dates U.S. recessions) noted a week ago, January appeared to be the recent peak in economic activity, and "there's no question that the economy is down by just about every measure" since then. That suggests that an economic recession would currently be only a few months old, so the recent low in the stock market would have occurred with the U.S. economy only about a month into that recession. This is very implausible from a historical perspective.
So there appear to be two possibilities at hand. Either the March low marked the final trough of the recent decline, and the economy will avert a recession despite the fact that virtually every measure that has historically signaled recession risk has now turned negative, or further trouble is ahead for both the stock market and the economy. Some near-term speculative potential aside (which we would respond to using a modest amount of call option exposure only, leaving our defensive put options in place), the evidence continues to suggest continued caution.
Market Climate
As noted above, the Market Climate for stocks last week was characterized by unfavorable valuations and borderline market action— overbought, but also near the point where speculation could be fed by technical "trend followers." The character of any consolidation here will affect the staying power of that speculation, so we'll be paying close attention to breadth, leadership, and price/volume features of any pullback we observe in the next week or two. In any event, we will continue to hold a defense against fresh or abrupt losses, but we may establish a 1-2% of exposure in call options if market internals hold or strengthen here.
In bonds, the Market Climate last week was characterized by relatively neutral yield levels and moderately unfavorable yield pressures. CPI inflation is now about even with 10-year Treasury yields, suggesting that we are near the point where commodity price weakness could emerge. The Strategic Total Return Fund continues to carry a very short duration of less than 1 year, primarily in Treasury bills, with about 15% of assets in foreign currencies. Last week's strong rally in precious metals shares gave us an opportunity to clip our exposure in precious metals down to less than 2% of assets. We are about at the point where economic slack may begin to restrain demand for many commodities, and it is typical for commodities to retreat from their peaks with very little in the way of upward corrections.
M O R E. . .
Normxxx
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