Comfortable With Uncertainty

Comfortable With Uncertainty
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By John P. Hussman, Ph.D. | 4 May 2009

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Are stocks in a bull market or is this still a bear market? Frankly, I don't put much energy into that question. The S&P 500 has now corrected about one-quarter of its prior losses. Bear market corrections of about one-third are not unusual, but I wouldn't bank on that. Having failed to do anything effective to mitigate the second wave of foreclosures that is set to begin later this year, and seeing very little sponsorship in trading volume (despite good breadth), my impression is that we most likely are in a strong correcting rally in the context of an ongoing bear market. At the same time, cash-equivalents are yielding next to nothing, so it's unclear to what extent investors will decide that stocks are their only real alternative, which might allow a continuation of this advance.

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Our objective is always the same— to outperform the S&P 500 over the complete market cycle, with smaller periodic losses than a passive investment strategy. To that end, we spend much more effort identifying market conditions and their associated return/risk profiles than we spend on predicting them. The difficulty in the bull/bear distinction is that bull and bear markets don't actually exist in observable reality, only in hindsight, and it is futile to base an investment position on things that can't be observed.

What we can observe is that valuations are now in the high-normal range on the basis of normalized earnings. Stocks are no longer undervalued except on measures that assume that profit margins will permanently recover to the highest levels in history (in which case, stocks would still only be moderately undervalued). For instance, the price-to-peak earnings multiple on the S&P 500 is only about 11, but those prior peak earnings from 2007 were based on record profit margins about 50% above historical norms, largely driven by the excessive leverage that has since sent the economy reeling.

On normalized profit margins, valuations are above the historical average, and prospective long-term returns are below the historical average. Overall, I expect the probable total return on the S&P 500 over the coming decade to be about 8% annually, provided we don't observe much additional deleveraging in the economy. At the 1974 and 1982 lows, based on our standard methodology, the S&P 500 was priced to deliver 10-year total returns of about 15% annually. While it has become quite popular to talk about 1974 and 1982, the stock market is presently not even close to those levels of valuation.

Meanwhile, market action in recent weeks has been excellent from the standpoint of breadth (advances versus declines), uneven from the standpoint of leadership (where much of the strength has been focused on speculation in companies with extraordinarily poor balance sheets), and rather uninspiring on the basis of trading volume.

From an economic standpoint, the main argument for an oncoming recovery is simply that the knuckles of investors and consumers are no longer absolutely white. A backing-off from extreme risk aversion is certainly helpful, since it puts banks at less risk of customer flight, but the underlying assets of banks are still deteriorating. For the time being, the recent revision in accounting rules has prevented balance sheets from showing negative capital and revealing insolvency, but the reality is that the mortgages underlying bank assets are still defaulting.

If this was simply a temporary problem of fluctuating asset values that would recover over time, the problem would not be serious. As T. Boone Pickens once said, "I have been broke three or four times, but fortunately for me I'm not an MBA, so I didn't know I was broke." But the assets Pickens owned moved in cycles, and regularly recovered in step with the price of oil. In the case of mortgages, once the loan goes into foreclosure, there's an asset sale, the loss is taken, and the game is over.

Overall, then, the fundamentals of the market and the economy are not nearly as positive as they are being spun by analysts. Stocks are at best only moderately undervalued if one assumes that profit margins will recover to the historical extremes we saw in 2007, and are otherwise mildly overvalued. The financial system is in cosmetic remission, looking better on the surface, but still deteriorating internally.

Still, we can't discard the fact that the extreme risk aversion of recent months has eased. Breadth has been quite strong, but is also overbought (with over 80% of stocks above their 20-day and 50-day averages). The mixed picture offers neither certainty that the bear market will resume, nor that a bull market will emerge.

Still, we are comfortable with uncertainty, and are relying on neither outcome. When we don't have a good basis for accepting market risk, we continue to hold individual stocks, and hedge against market fluctuations with offsetting short positions in the S&P 500, Nasdaq 100, and Russell 2000. Our returns in those conditions are driven by the difference in performance between the stocks we own, and the indices we use to hedge. That difference has been the source of the Fund's returns year-to-date as well.

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Market Climate

As of last week, the Market Climate for stocks was characterized by neutral valuations— modestly overvalued on the basis of normalized earnings, and moderately undervalued on the basis of earnings measures that assume a return to record 2007 profit margins. Market action was also mixed, with breadth being the clearest bright spot, and sponsorship from trading volume being the weakest link.

In bonds, the consensus for an economic recovery has pushed Treasury yields higher on both straight Treasuries and TIPS, while some of the flight-to-safety in precious metals has abated. …we responded to the higher real yields on TIPS late last week by moderately increasing our exposure to that area. I would expect that we will bump our precious metals exposure back above 10% of assets on further price weakness if it emerges, particularly if Treasury yields and real yields begin to decline again, but we are comfortable with our position for now. The Fund also has [a position] in foreign currencies, and …in utility shares.

  M O R E. . .

Normxxx    
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