The Burning Platform

John Hussman is the master of the understatement. Heed his warning:

“Markets move in cycles. Investors learned  that by the 2002 lows, but only after terrible losses. They learned it again in 2009. They  have already forgotten, so investors will have to learn it yet again.”

The show may go on for a few more weeks, but the stampede for the exits will be epic. Your “friends” on Wall Street have blocked the exits and caged you in.

Not In Kansas Anymore

John P. Hussman, Ph.D.      

Having rested the case for a defensive investment stance in  a series of recent weekly comments (see Closing Arguments for  a summary), what remains is simply to update the status of those  considerations. Importantly, our concerns are driven by the average outcomes that have accompanied  similar evidence. We don’t need to forecast near-term direction, and while we  have very strong views about long-term return prospects, there are likely to be  numerous constructive opportunities along the way to more favorable valuations.  Our approach is to align our investment position with the return/risk profile  that we estimate based on observable evidence at the present moment. The fact that  similar evidence has historically been so one-sidedly hostile is certainly  worth noting, but in fact, no forecasts are required, and we have every  expectation of moving with the evidence. What is most necessary here is simply  the recognition that markets move in cycles, that investment conditions will  change over time, and that returns born of euphoria are not easily retained.

On overvalued, overbought, overbullish conditions

Last week, Investors  Intelligence reported that the percentage of bullish investment advisors  moved to 54.2% (from 52.1% the prior week) with just 19.8% of advisors bearish.  The Shiller P/E (S&P 500 Index divided by the 10-year average of inflation-adjusted  earnings) reached 24.5. The S&P 500 is well-through its upper Bollinger  bands (two standard deviations above its 20 period moving average) on weekly  and monthly resolutions, in a mature bull market advance, with 10-year Treasury  yields higher than they were 6-months prior.

None of these conditions in isolation has enormous impact;  each usually only modifies expected  returns. The problem is that when significantly overvalued, overbought,  overbullish conditions have been observed together – particularly coupled with  rising bond yields – the syndrome indicates a disease that none of the symptoms identify individually.

I’ve noted before that even a Shiller P/E above 18 combined  with a wide spread of bulls versus bears at some point during the prior 4-week  period is generally enough to outweigh trend-following considerations, such as  the S&P 500 being above its 200-day moving average (see Aligning Market Exposure  with the Expected Return/Risk Profile). I’ve also noted that some  conditions can be more simply defined. For example, instances featuring bearish  advisors below 20%, with the S&P 500 at a 4-year high and a Shiller P/E  above 18 are limited to the present advance, May 2007, August 1987, December  1972 (though with an early signal in March-May of that year), and February 1966,  all which were followed by significant bear market losses.

Various definitions of an overvalued, overbought, overbullish  syndrome can capture slightly different instances. Less stringent definitions  capture a larger number of danger zones, but also allow more false signals.  Still, as long as the basic syndrome is captured, the subsequent market outcomes  are almost invariably negative, on average. Presently, what we observe is among  the least frequent and most hostile syndromes we identify.  As I observed in the weekly comment that  turned out, in hindsight, to accompany the 2007 market peak (see Warning – Examine All Risk  Exposures):

“There is one particular syndrome of conditions after which  stocks have reliably suffered major, generally abrupt losses, without any  historical counter-examples. This syndrome features a combination of  overvalued, overbought, overbullish conditions in an environment of upward  pressure on yields or risk spreads. The negative outcomes are robust to  alternative definitions, provided that they capture that general syndrome.”

The chart below highlights each point in history that we’ve  observed the following conditions: Overvalued: Shiller P/E anywhere above 18;  Overbought: S&P 500 at least 7% above its 12-month average, within 3% of  its upper Bollinger bands on weekly and monthly resolutions, and to capture a  mature advance, the S&P 500 well over 50% above its lowest point in the  prior 4 years; Overbullish: a two-week average of advisory bulls more than 52%,  and advisory bears less than 28%. Rising yields: 10-year Treasury yields higher  than 6-months earlier. The instance in 1929 is based on imputed sentiment data,  as bullish and bearish sentiment is correlated with the extent and volatility  of prior market fluctuations.

One of the difficulties with this sort of analysis is that instances  that appear to be very clear peaks on an 85-year chart are actually periods  where there was often a cluster of instances with further market advances for  several more weeks. In 1929, the market advanced another 5% to its final peak  in the two weeks following the first instance of this syndrome. In 1972, the  market advanced a final 3% over 6 weeks. The 1987 and 2000 peaks occurred the same  week that the syndrome emerged. In 2007, the S&P 500 advanced to within 2%  of its final peak 3 weeks after this syndrome emerged, and crawled within 1% of  that peak after 9 weeks. The S&P 500 then dropped nearly 10% over the next  4 weeks, and then staged a final 11% spike over 8 weeks to a marginal new high  which actually marked the 2007 peak. In 2011 the market enjoyed a choppy 6%  advance, dragged out over 16 weeks, before rolling into a 19% correction over  the following 12 weeks. The present signal reiterates the first one that we  observed in late-January, 17 weeks ago. To a long-term investor, this is the  blink of an eye, but in the context of day after day of bullish euphoria, it  seems like an absolute eternity.

In general, the initial decline from these peaks tends to  occur as a sharp 6-10% market drop over a handful of weeks, typically followed  by a partial recovery attempt toward the prior peak. This sort of activity both  before and after major peaks gives the market the impression of near-term  “resilience” that dilutes the resolve even of investors who know the history of  these things.

I should note that present conditions are extreme enough  that neither trend-following nor momentum factors can be used to separate out  favorable outcomes from this small set of decidedly unfavorable ones. As I’ve  previously noted, a great deal of our research during this advance has focused  on this sort of “exclusion analysis.” I recognize that many investors have  simply decided on the strategy of holding stocks until QE ends, or some similar  formulation of “strategy,” but for better or worse, we do insist on approaches  that we can validate in historical and out-of-sample data, and that have been  strongly effective over full market cycles. When we examine the past few years,  as well as long-term history, the most effective “exclusions” aren’t simple  ones like “don’t fight the trend” or “don’t fight the Fed.” Rather, they are  more subtle prescriptions like “stay with the trend in an overvalued market,  but only until overvalued, overbought, overbullish conditions are established.”  These considerations aren’t actually required to do well over complete market cycles, but quantitative  easing has held off the resolution of historically unfavorable market  conditions much longer than usual, and these subtle considerations would have  undoubtedly made recent experience less frustrating.

If this bull market is to continue, I have little doubt that  considerations like this will provide the opportunity to be constructive on the  basis of well-tested evidence that  actually supports a constructive stance. Here and now, a constructive stance is  an experiment about whether QE can override market conditions that have always  preceded unfortunate outcomes. My views and research should be of no impediment  to investors with a different view, assuming that they have a reliable exit  criterion that will precede the attempts of tens of millions of others to exit.  It would be far easier to conduct that experiment without me than to convince  me that it is a good idea.

As the respected technician Bob Farrell once noted, “exponential rapidly rising or falling markets usually  go further than you think, but they do not correct by going sideways.” This  is really all the 1987 crash was – a mass of investors trying to preserve  profits from the preceding advance by acting on the identical trend-following  exit signal simultaneously.

On valuations

Even in the event that quantitative easing is sufficient to  override hostile market conditions in the near-term, it is worth noting that long-term outcomes are likely to be  unaffected. We presently estimate a prospective 10-year total return on the  S&P 500 Index of just 2.9% annually (nominal). See Investment,  Speculation, Valuation and Tinker Bell for the general methodology here,  which has a correlation of nearly 90% with subsequent 10-year market returns – about  twice the correlation and nearly four times the explanatory power as the “Fed  Model” and naïve estimates of the “equity risk premium” based on forward  operating earnings.

We presently estimate  that the S&P 500 is about 94% above the level that would be required to  achieve historically normal market returns. If you work out present  discounted values, you’ll find that depressed interest rates can explain only a  fraction of this differential, even assuming another decade of QE – and even  then only if historically inconsistent assumptions are made to combine normal  economic growth with deeply depressed rates.

This chart gives a good overview of what has actually  transpired in the stock market through post-war history. Points of deep  undervaluation like 1942, 1950, 1974 and 1982 created foundations on which long secular bull market advances were  built. The rich valuations of the mid-1960’s were enough to ensure that any  return to undervaluation would result  in a long period of poor market returns. The late-1990’s bubble took valuations  far above any historical valuation norm, and ensured that even a return to valuations previously considered “rich” would  produce devastating returns, and we saw that in 2000-2002. The advance to the  2007 peak did not go nearly as far, but still ensured that even a return to normal valuations would produce  devastating returns, and we saw that in 2007-2009.

At present, valuations are less extreme than they were in  2000, approach levels that were reached in 2007, and remain well beyond those  observed at the late-1960’s secular peak. The question is where valuations will  go from here, and while other indicators can be applied to that question,  valuations alone don’t provide the answer. Matching the valuations of the 2007  peak would require another 8% advance in the S&P 500. A return to  historically normal valuations would imply a 48% market decline – the average cyclical bear market in a secular bear market period has typically  represented a decline closer to 38%. A move to secular lows (about 0.5 as a  multiple of fair value) would imply a Depression-like drop of about 75%, but  such lows are typically associated with macroeconomic crises such as world war  or uncontrolled inflation. Still, these are all valuations that we’ve actually  observed in the post-war period. None of these calculations are indicative of  where the market is going, but we should at least be aware of the extremes that  are already in place.

On the economy

Among the better leading indicators of the economy, the  Philadelphia Fed Index of economic activity deteriorated to 1.3 in April, and  dropped to a disappointing -5.2 reading for May. The Chicago Purchasing  Managers Index slipped from 52.4 to a contractionary reading of 49 in April,  though the important “new orders” component held above 50, coming in at 53.2.  The chart below shows data on a variety of national and regional surveys from  the Fed and the Institute of Supply Management. Notably, the chart shows data  only through April. The May reports released thus far are the Philly Fed and  Empire Manufacturing surveys, both which surprised significantly to the  downside.

As I noted last week, holding  hours worked constant, the U.S. economy would have lost the equivalent of  550,000 to 600,000 jobs in April. Meanwhile, excitement about improvement in  the federal deficit is largely driven by several one-off factors and quite rosy  assumptions. These include special distributions, repayments from Fannie Mae  and Freddie Mac, the expiration of accelerated depreciation deductions for  investment, and capital gains realizations taken in advance of the “fiscal  cliff.” Projections of further deficit reductions are predicated on assumptions  that inflation in health costs will be controlled; that corporate tax revenues will  increase by 57% by 2014 (and 88% by  2015); that the U.S. economy will avoid any recession in the coming decade; and  that real GDP growth will increase to 4% (6% nominal) in the coming years,  despite a 9% decline in discretionary outlays by the government next year. The CBO projections also assume that tax revenue as a percentage of GDP will move sustainably  above the long-term average. I do expect that the Federal deficit will gradually come down over time. But barring  a massive, domestically financed increase in gross real investment (which the  data do not suggest is presently in the works), the 2-quarter lagged effect of a  smaller government deficit is likely to be weaker corporate profit margins, for  reasons I’ve articulated previously.

On quantitative easing

Over the past three years,  the U.S. economy has repeatedly approached levels that have historically marked  the border between expansion and recession. There is little question that  massive quantitative easing by the Federal Reserve has successfully nudged the  economy away from this border for a few months at a time. But as I’ve noted  before, the belief that monetary easing solved the 2008-2009 financial crisis  is an artifact of timing. The Fed was easing monetary policy throughout 2008,  and while it is tempting to view the recovery as a delayed effect, the more  proximate factors were a) the change in FASB accounting rules to dispense with  mark-to-market accounting, which relieved banks of insolvency concerns even if  they were technically insolvent, and b) the move to government conservatorship and  Treasury backstop of Fannie Mae and Freddie Mac, which reduced concerns about  default risk among mortgage securities.

The Pavlovian response of  investors to monetary easing – as if it has anything more than a transitory and  indirect effect on the economy – fails to distinguish between liquidity and  solvency; between economic activity and market speculation; and between  investment value and artificially depressed risk premiums. The economy is not  gaining anything durable from these policies, and the conditions for the next  bear market are already established. Meanwhile, the chart below updates the  extreme that monetary policy has already reached (data points since 1929).

The 3-month Treasury yield  now stands at a single basis point. Unwinding this abomination to restore even  2% Treasury bill rates implies a return to less than 10 cents of monetary base  per dollar of nominal GDP. To do this without a balance sheet reduction would require 12 years of 6% nominal growth (which  is fairly incompatible with sub-2% yields), a more extended limbo of stagnant economic  growth like Japan, or significant inflation pressures – most likely in the back  half of this decade. The alternative is to conduct the largest monetary  tightening in the history of the world.

None of this is to suggest  that speculation cannot go further – though present overvalued, overbought,  overbullish extremes weigh against it. Still, valuations and monetary  conditions are far removed from what is sustainable, and there is more evidence  to indicate that the economy is weakening than support of the idea that it is  strengthening.

Knowing where you are doesn’t mean that you’re leaving, but you should still know where you are. We’re  not in Kansas anymore.

The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Only comments in the Fund Notes section relate specifically to the Hussman Funds and the investment positions of the Funds.

Fund Notes

Last week, market conditions reiterated the most hostile  syndrome of overvalued, overbought, overbullish, rising-yield conditions we  identify. Strategic Growth Fund remains fully hedged, with a “staggered strike”  hedge that raises the strike price of the index put option side of the hedge  closer to market levels, but we continue to significantly lag those strikes  below the market in order to minimize time decay. Presently, that staggered  strike position represents less than 1% of assets in additional time premium  looking out to mid-summer. This also means that until the market declines by  more than several percent, most of the day-to-day fluctuation in Fund value is  likely to be driven by differences in performance between the stocks owned by  the Fund and the indices we use to hedge. Strategic International remains fully  hedged. Strategic Dividend Value is hedged at about 50% of the value of the  stocks held by the Fund. Strategic Total Return continues to carry a duration  of about 3 years (meaning that a 100 basis point move in interest rates would  be expected to impact Fund value by about 3% on the basis of bond price  fluctuations), and just over 12% of assets in precious metals shares.

There are countless investment strategies that offer  aggressive investment approaches, long-only exposure, and loads of various  market risks for investors who desire them. We follow a specific, long-term  discipline defined by an effort to accept market risk in proportion to the  expected return/risk profile that we estimate based on prevailing conditions.  We make every attempt to refine that discipline over time, but the Funds are  defined by the specific investment objectives and disciplines that we promise  to our shareholders. We constantly research promising indicators and investment  considerations. Those that place heavy weight on trend-following and  Fed-following are testable strategies,  and their return/risk characteristics can be carefully evaluated. Once  overvalued, overbought, overbullish conditions emerge, they don’t perform  nearly as well over time as investors seem to believe. Quantitative easing is certainly  “new” in the sense that such extreme policies have never been pursued. But data  on interest rates, Fed action and the monetary base go back nearly a century,  and even analyzing more recent experience with quantitative easing by Japan,  England, the European Central Bank and the Federal Reserve leaves us with  little confidence that QE does much more than to temporarily suppress periodic  spikes in risk premiums.

Investors who wish to follow the Fed to the exclusion of  other evidence should feel no compulsion to consider our own research, or our  own performance in the years prior to the recent bull market advance. In my  view, we are now in a very mature, unfinished half of a market cycle  spectacularly distorted by monetary and fiscal imbalances. The prospects that  the financial markets will face over the next few years are quite unlikely to  mirror the lovely ones that they enjoyed while these imbalances were being  established.

Nearly all of my own assets remain invested in the four  Hussman Funds, with the largest allocation to Strategic Growth, because despite  the challenges we’ve experienced in the advancing portion of this cycle, I have  no doubt that the financial markets will experience cycles – not endless parabolas  – over time. We accept a significant of “tracking difference” versus a  buy-and-hold approach because our objective is to achieve full-cycle returns above  the long-term norm for equities, with smaller losses than the general market over  the full-cycle. There is no assurance we’ll achieve that objective, and the  recent cycle has been an extraordinary challenge for reasons that I’ve  frequently detailed. In contrast, I view the performance of Strategic Growth in  the 2000-2008 period to be a reasonable reflection of those objectives in practice, even in an  environment where the general market achieved no net gain.

With regard to the challenges of the most recent market  cycle, my insistence on stress-testing our approach against Depression-era data  in 2009 to early-2010  led to an unfortunate miss in the interim, but I believe  that it will make us more resistant to extreme market conditions in the future.  I also believe that we’ve addressed most (though probably not all) of the challenges  created the monetary-driven speculation of recent years by incorporating what  I’ve described as “exclusion analysis.” This involves refining the pool of  periods where average expected  outcomes are negative in order to “exclude” the largest set of constructive  instances from that pool, and validating the exclusion criteria in out-of-sample data. For example, trend-following considerations can be important  even in periods where our return/risk estimates are negative, but only in the absence of overvalued,  overbought, overbullish syndromes. That refinement could have saved us some  trouble in recent years, but such considerations still do not encourage a  constructive position here. That may be a shame, or it may turn out to be a  blessing. All we know with certainty is that nearly a century of evidence –  even including trend-following and monetary factors – supports a defensive  stance from our investment approach here.

This will change. Markets move in cycles. Investors learned  that by the 2002 lows, but only after terrible losses. They learned it again in 2009. They  have already forgotten, so investors will have to learn it yet again

 This is a very analytical letter from John Hussman. In case you don’t want to read it, here is the key paragraph:

A practical note – as of Friday, our estimate of prospective  10-year S&P 500 total returns (nominal) has dropped to just 3.3%. With the  exception of 1929, this level of estimated returns was never observed in  historical data prior to the late-1990’s market bubble. Rich valuation is not a  rally-stopper in itself, and we’ve certainly narrowed our defensive criteria  enough to entertain a more constructive stance under some conditions without a steep market decline first. But  the end-game here is still most  likely a 30-50% market decline over the next 2-3 years, which would be far more  than enough to wipe out any interim market gains. To dismiss that  likelihood is to ignore predictable experience since 2000, as the bubble-bust cycle  of easy money has repeatedly interacted with rich valuations to produce gleeful  roller-coaster rides with very bad endings.

You have to ask yourself whether Ben Bernanke and QEfinity can defy history and common sense. Right now Wall Street and the MSM are joyous and making you feel stupid for not joining the party. They are calling you a fool for missing out on the splendid returns. It’s 2:00 am and the party is rollicking. It may go on for a few more hours, but it will end. There will be vomit and empty bottles everywhere. The hangover will be a doozy.

Aligning Market Exposure With the Expected Return/Risk Profile

John P. Hussman, Ph.D.      

Some risks and market conditions are more rewarding than  others. My objectives for this week’s comment are very specific. First, to  demonstrate – using a very simple model – that investment returns do indeed vary systematically with market  conditions. Second, to demonstrate that overvalued, overbought, overbullish  conditions have historically dominated trend-following measures when they have  emerged. Third, to demonstrate the impact of accepting investment exposure in  proportion to the return/risk profile (technically the “Sharpe ratio”) that is associated  with a given set of market conditions.

My hope is to walk through the general framework of how I  think about market exposure. However, what follows is not a description of the investment models we use in practice,  which involve more numerous considerations and a much broader ensemble of  models and methods. The measures I present here are very simple, and while even  these conditions identify strong distinctions between market conditions, they  are nowhere close to the degree of separation that can be obtained and validated across history with a  broader ensemble of evidence.

The discussion here will not help to understand my “miss” in  2009-early 2010, which was related to the need to stress-test our approach to  ensure that it was robust even to the worst portions of Depression-era data.  It’s incorrect to view that “miss” as a result of our indicators, strategies,  or valuation methods; it resulted from the similarity between Depression-era  events and what the U.S. economy was actually experiencing in real-time, and my  insistence on having the a robust method to navigate that uncertainty (despite  our existing methods doing just fine to that point). Both trend-following methods  and typical valuation thresholds were torn to pieces during the Depression, far  more violently than investors may appreciate. Like me or hate me for that  decision, but I wouldn’t fly a plane that I wasn’t certain could handle extreme  turbulence – and I expect there will be more of that turbulence over the coming decade than  investors seem to envision here.

A practical note – as of Friday, our estimate of prospective  10-year S&P 500 total returns (nominal) has dropped to just 3.3%. With the  exception of 1929, this level of estimated returns was never observed in  historical data prior to the late-1990’s market bubble. Rich valuation is not a  rally-stopper in itself, and we’ve certainly narrowed our defensive criteria  enough to entertain a more constructive stance under some conditions without a steep market decline first. But  the end-game here is still most  likely a 30-50% market decline over the next 2-3 years, which would be far more  than enough to wipe out any interim market gains. To dismiss that  likelihood is to ignore predictable experience since 2000, as the bubble-bust cycle  of easy money has repeatedly interacted with rich valuations to produce gleeful  roller-coaster rides with very bad endings.

Again, my objective here is to detail my general approach to  thinking about market exposure, which is the best way to understand my present  views, and what one can expect going forward. There are certainly portions of  the recent market cycle (particularly that 2009-early 2010 period) where even  this simple model was more effective in  hindsight than the “first-do-no-harm” approach that I insisted on once the  credit crisis forced us to contemplate Depression-era outcomes. The advancing  half of the present, unfinished market cycle began with that stress-testing episode,  and since 2010 has continually demanded research into how long a frog can or  should remain in a heated cauldron without ending up dead in the water. Refinements  based on trend-following and momentum measures, under certain conditions, can  help to more finely navigate the late-stage, overvalued portion of a bull  market and avoid an overly early exit. Strategically, none of that is actually required to do well over the complete market cycle, but I would  obviously have had an easier time with QE in recent years had I allowed the  frog to break into sweat and hallucinations before yanking him out  of the kettle. He’s quite willing to plunge in, or at least dangle his little  legs into the water, as opportunities arise. I expect the effect of all that to  be evident over time.

Staying Sharpe

We’ll start with two useful concepts. One is what is  sometimes called the “excess return” of the market, which is the total return  of the S&P 500 in excess of Treasury bill yields. A negative expected  excess return means that stocks are expected to underperform the risk-free  alternative. A positive expected excess return means that stocks are expected  to outperform the risk-free alternative. Clearly, we should prefer to accept  risk only when we expect to be paid, on average, for doing so.

The second concept extends the idea of “excess return” by  measuring that return per unit of  risk. The “Sharpe ratio” essentially takes the expected excess return and  divides it by the expected risk (measured as volatility or standard deviation).  We should prefer to accept more units of risk when we expect that risk to be compensated  by a strong excess return (this is particularly true if we have a “risk  budget”).

In fact, nearly every “dynamic portfolio allocation” model  in the literature of finance has this central feature: the optimal investment exposure is proportional to the excess return  per unit of risk that can be expected at each point in time. While some  continuous time models – like those of Merton and Samuelson – sometimes include  additional “hedging demand” that relates to how prices vary as expected returns  change over time, the core structure of nearly all optimal portfolio allocation  models is that investment exposure should be relatively proportional to the  excess return that can be expected per unit of risk.

[Geek’s Note: if you solve the dynamic optimization problem,  you actually get an investment demand function where the denominator is a  risk-aversion coefficient multiplied by the variance of returns rather than the  standard deviation. But given that variance is much more stable than expected  return, there’s little impact to subsuming one of those sigmas into the  risk-aversion coefficient and varying exposure in proportion to the expected  Sharpe ratio. An extra “hedging” term is necessary for models that use a  long-term prospective return in computing the Sharpe ratio, as the correlation  between that prospective return and realized returns is significantly negative.  “Hedging” in this context means hedging against changes in the investment  opportunity set. That correlation is negligible for the version that we’re  discussing here, which is based on instantaneous expected returns].

What really differentiates investment approaches (or at  least, what ought to differentiate them) is the approach that is used to  estimate that expected return/risk profile. Though my insistence on getting  this right in the face of potential Depression-type outcomes did us no favors  in the unfinished half of this particular market cycle, a robust approach to estimating return/risk profiles, and the discipline to consistently maintain alignment with them, are the  most  important tools in asset allocation.

For expositional approaches (only), we’ll use a relatively  simple model to demonstrate these concepts. Let’s start with one of the most  common trend-following approaches, which is to track the market’s position  relative to a moving-average on the order of about 10 months, 200 days, or 39  weeks. Below, we’ll use a 39-week smoothing. Since 1940, when the S&P 500 was  above its 39-week smoothing, the total return on the index, in excess of  Treasury bills, has averaged about 9.6% annually. In contrast, when the S&P  500 was below its 39-week smoothing, the excess return averaged just 0.3%  annually. It’s interesting that since early 2010, a switching strategy based on  this fact would only be up about 8.3%, and transaction costs and slippage would  have eaten up much of that. Still, there’s no question that trend-following  components are extremely useful in any full-cycle investment approach (particularly  for loss reduction).

Interestingly, even when trend-following measures are  favorable, the market has historically not performed well when overvalued,  overbullish conditions have also been in place. Let’s define these very simply  here – say a Shiller P/E greater than 18 (the ratio of the S&P 500 to the  10-year average of inflation-adjusted earnings), and advisory sentiment  featuring more than 47% bulls and less than 27% bears at any point over the most  recent 4-week period (based on Investors  Intelligence figures and imputed prior to the 1960’s). Historically, this  combination of conditions has been associated with an average excess return of  -3.3% at an annual rate.

Meanwhile, valuations have also been extremely useful in  distinguishing strong Sharpe ratios from poor ones. Again, for simplicity,  let’s use a Shiller P/E of 18 as a threshold. Since 1940, periods with the  S&P 500 above its 39-week  smoothing and the Shiller P/E below 18 have been associated with total returns in excess of T-bills averaging 15.1%  at an annual rate. Periods featuring neither have been associated with total  excess returns averaging -1.9%. Periods with the S&P 500 below its 39-week  smoothing and the Shiller P/E below 18 are typically quite volatile, and  average a 1.2% average excess return.

The fourth possibility is the interesting one at present.  While periods with the S&P 500 above its 39-week smoothing and a Shiller  P/E above 18 (it’s presently approaching 23.7) have averaged an excess return  of about 4.3% at an annual rate, all of that return actually loads onto periods where overbullish conditions were  absent. If we look at the combination with favorable trends and overvaluation  but an absence of overbullish  conditions, the excess return has averaged 11.7%. In contrast, when overbullish  conditions have been in place, the overvalued, overbullish conditions have  dominated, producing a negative excess return averaging -3.3%.

The following is a summary of some of these simple  investment environments and their historical frequencies in data since 1940 (not all of them are mutually exclusive). SPX  = S&P 500, MA = MA39, OVOB = overvalued, overbullish, PE = Shiller P/E  ratio.

I should note that in practice, it’s essential that estimates of expected  excess returns and Sharpe ratios should be validated in multiple split samples  across history, as well as holdout data that was not “seen” at all by the  estimation approach. For the conditions I’ve noted above, all of these  separations do hold up in split samples, but again, my intent here is to  demonstrate a very basic model. This model is far simpler and less effective  than the ensemble approach that actually informs my views, it doesn’t reflect  transaction costs or slippage, and it does not reflect the strong  validation considerations required of a real-world approach.

The chart below shows a switching strategy (holding T-bills  when out of the S&P 500) where exposures are taken in proportion to the  Sharpe ratio, allowing a slight amount of leverage where the Sharpe ratio  exceeds 1.0 on an annual measure, and slight short positions where the Sharpe  ratio is negative. Notice that most of the market’s historical gains are  captured in periods where the S&P 500 has been above its 39-week smoothing  (MA39). Switching does a reasonable job of risk reduction, but it is still  subject to significant drawdowns periodically (particularly in Depression-era  data). Not surprisingly, excluding overvalued, overbought periods (OVOB) has  performed better. The strongest approach over complete market cycles and over  history, again not surprisingly, has been to align investment exposure with the  prospective return/risk profile based on conditions at each point in time. The  version below uses the combination of MA39 and Shiller P/E, except when MA39 is  positive and the Shiller P/E is over 18, in which case, OVOB is used to further  partition market conditions.

A few observations – again, these figures are hypothetical  and don’t reflect transaction costs, slippage or other factors, but do provide  some insightful context. Measured from the 1990 market peak to the 2000 market  peak, the S&P 500 gained about 432% overall, including dividends. MA39  gained 262%, MA39 without OVOB gained 362%, and the Sharpe Ratio approach  gained 394%. It was very difficult for any strategy to outperform a straight  buy-and-hold during the bubble. But notably, measuring the full cycle from the  1990 market trough to the 2002 market  trough, the S&P 500 gained just 245% overall, MA39 gained 262%, MA39  without OVOB gained 373%, and the Sharpe Ratio approach gained 444%. The  deepest drawdown losses were 46% for the S&P 500, 23% for MA39, and less  than 15% for MA39 without OVOB and the Sharpe Ratio approach.

In the 2000-2007 peak-to-peak cycle, the S&P 500 gained  16% including dividends, with a 46% interim loss (weekly data), MA39 gained 41%  with a 23% interim loss, MA39 without OVOB gained 22% with an 8% interim loss,  and the Sharpe Ratio approach gained 18% with a 9% interim loss. Measured from  the 2002 trough to the 2009 trough, the S&P 500 lost 3% overall after a 55%  drawdown, while each of the other strategies gained more than 10%, with the  worst drawdown for MA39 at 21%, and smaller losses for the others. Notably, the  deepest loss for the Sharpe ratio strategy in weekly data since 1940 was just over  18%.

Measured from the 2007 peak to the present, all of the  strategies have roughly matched the S&P 500, with the deepest interim  drawdown for MA39. What’s striking though is that all of the strategies have badly  lagged the S&P 500 since April 2010, with returns of less than 10% each. This is true even for a pure trend-following strategy using the 39-week  smoothing. Part of the reason for this is the degree to which market returns in  recent years have come in the form of vertical spikes in response to sudden  monetary policy announcements, just after trend-following approaches were  whipsawed into a defensive position by the preceding market decline.

The questions here are these. Given that a buy-and-hold  approach has outperformed these other strategies in recent years, should we  assume that aligning investment exposure with prospective return/risk is no  longer a useful approach? Should we assume that the market has achieved a  permanently high plateau, or better – a permanently upward diagonal – and that downside  risk has been eliminated? Should we assume that the failure of risk-managed  strategies to match the performance of a speculative ramp in prices (as they  did leading up to the 2000 market peak) will continue indefinitely, and that  risk-managed approaches should be abandoned out of faith in a central bank that  has repeatedly demonstrated its capacity to produce bubbles that ultimately  collapse?

In my view, the introduction of quantitative easing and the  expansion of fiscal deficits does not repeal market cycles or make risk  considerations irrelevant. They certainly should not encourage investors to  depart from the principle of aligning their exposure to market risk with  objective estimates of how such exposure is likely to be rewarded or punished. Long-term  investment returns typically emerge as the delayed payment for adhering to a sound  discipline even when it is uncomfortable to do so. Immediate investment returns are  often easier to find, but they tend to be advances on a loan that will eventually  be repaid with interest.

There is no question that new features of the market  environment, when observed, should be examined for their interaction with existing  features. But it has never been the  case that these new features have served as a veto against all other  considerations. It wasn’t true of the dot-com and tech bubble. It wasn’t true  of the housing bubble. It is not true of the QE bubble that the Fed has created  today (and which is overlooked primarily because corporate profit margins are  70% above historical norms as a result of mirror-image deficits in the combined  government and household sectors – not just domestically but globally).

Investment exposure should be aligned with the estimated  return that can be expected in return for the risk one accepts. It is clear  that market returns do indeed vary depending on observable conditions, and although  returns can certainly depart from expectations during various portions of the  market cycle, there is a century of evidence to support the proposition that  this kind of disciplined investment allocation has been effective over complete  market cycles, and has significantly reduced the depth of periodic losses.

Economic Notes

It’s worth observing that despite the modest but legitimate surprise  in April employment, year-over-year growth in non-farm payrolls has now dropped  below 1.6% for the second month; something that is typically observed only during  or prior to recessions (shaded in the graph below). Real GDP and real final  sales also both slowed to their typical pre-recession thresholds (1.8%) in  first quarter data. This instance may be different, and repeated bouts of  monetary easing have certainly kicked the can repeatedly with some success.  Still, in light of the nearly unanimous deterioration in regional purchasing  managers surveys, with no material strength in Philly Fed or the new orders  component of the Chicago Purchasing Managers survey (two of the better leading  measures), it’s difficult to share the enthusiasm that a modest beat on a  lagging economic indicator signals a new economic Renaissance.

The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Only comments in the Fund Notes section relate specifically to the Hussman Funds and the investment positions of the Funds.

Fund Notes

As of last week, market conditions continued to be  characterized by overvalued, overbought, overbullish features that have historically  been hostile to stocks. Over the past few years, we have worked to narrow the  set of market conditions that warrant a defensive position – essentially to  identify observable factors that help to refine the pool of outcomes to the  most negative instances, and to thereby free the other instances from a  defensive position. This sort of “exclusion analysis” can be very useful.  Suppose for example that we write the number -10 on five pieces of paper, and +2  on ten others. The average value on those fifteen pieces of paper will be -2. But  if we can exclude five pieces with +2 on them, we can  concentrate our attention on the smaller set of more pointed outcomes (now ten with an average value of -4), and free up the  remaining ones.

As a practical example, even when our ensemble approach has  indicated a negative expected return/risk tradeoff on the basis of a broad  range of market conditions, it turns out that the worst outcomes are heavily  concentrated in periods where either our best trend-following measures are  negative, or when overvalued, overbought, overbullish conditions have emerged.  As I noted in early 2012, points where the trend-following measures are positive and overvalued,  overbought, overbullish conditions are absent could be “freed” from strongly  defensive positions despite a negative return/risk estimate. That would certainly have made certain points in 2010 and  2011 more comfortable.

Presently, we have allowed the market to advance without  adjusting our “staggered strike” position upward in Strategic Growth Fund. A  staggered-strike hedge raises the strike prices of the index put option side of  our hedge, and has historically been indicated about 5% of the time in data  since 1940, based on a significantly negative expected return/risk profile at  those points. This is because a similar exclusion analysis suggests that it is  optimal to wait until some flattening of momentum is observed. Notice that this  sort of subtlety is not at all required over the course of the complete market  cycle, but it can help to reduce the risk of short-term discomfort while  adhering to our long-term discipline.

That investment discipline remains focused on accepting  market risk in proportion to the return that we expect to be associated with  that risk, on average. In effect, we are looking to accept risk in proportion  to the expected Sharpe ratio (defined as the expected market return in excess  of Treasury bills, divided by the volatility of those returns). In a very simple  sense, even investors who follow disciplined trend-following approaches are  doing the same thing. For example, since 1940, when the S&P 500 has been  above its 39-week moving average, the total return of the index has averaged  about 9.6% above Treasury bill returns (a Sharpe ratio of 0.78). The index has  averaged just 0.3% when it has been below (a Sharpe ratio of 0.01). An investor  who buys the S&P 500 above the moving average and exits the market below  that moving average is essentially taking a position in proportion to the  Sharpe ratio, where the factor of proportionality is 1.28 (that is, 1.28 x 0.78  = 100%). That’s not an endorsement of this strategy, and I believe that overvalued, overbought, overbullish considerations dominate trend-following ones here, but  hopefully this example explains  the concept, which I view as central to disciplined investing.

As a side note, I suspect that it is not well-known that in  data since 1940, the return/risk estimates from our present ensemble approach would  have supported the use of leverage (a fully invested and unhedged position, with a few  percent of assets in call options) in about 51% of historical periods, and zero  or minimal hedging in another 10% of historical periods. These periods are  associated with an average Sharpe ratio of 1.64.  By contrast, a significantly or fully hedged  position would have been supported about 34% of the time (conditions associated with a  Sharpe ratio of about -0.43), while a hard-defensive position such as a  staggered-strike hedge was indicated in only about 5% of the data (conditions  associated with a Sharpe ratio of -1.93). Despite that strongly negative Sharpe ratio, a staggered-strike hedge using higher strike put options is our most defensive stance in practice.

There’s certainly no assurance that the same conditions will  be associated with equally disparate market outcomes in the future, but these  figures should give some indication of the frequency of investment  positions I would expect under reasonably normal circumstances. These figures  should also give some indication how strikingly extreme and out of character  recent market conditions have been from a historical perspective.

Frankly, it might be more scathing to be called a “permabear”  if the period in question did not represent a 13-year span in which the S&P  500 has achieved a total return of just 2.3% annually, with two separate 50%  market plunges, both of which I anticipated in vivid detail, and most likely with  another market loss on that order that I expect will complete the present cycle. Still,  we do not require anything close to such a market loss to support a more  constructive position. We do require a positive expected Sharpe ratio, but the  conditions associated with that are historically more varied and plentiful than  one finds at the highs of an unfinished half-cycle. To everything, there is a  season.

Strategic Growth Fund remains fully hedged, with a  staggered-strike hedge representing less than half of a percent in additional  time premium. Those strike prices may be raised further in the event we observe  a flattening of upward momentum. For now, the majority of day-to-day  fluctuation in the Fund can be expected to reflect differences in performance  between the stocks held by the Fund and the indices we use to hedge. Strategic  International remains fully hedged. Strategic Dividend Value is hedged at about  50% of the value of its stock holdings. Strategic Total Return continues to  carry a duration of about 3 years (meaning that a 100 basis point move in  interest rates would be expected to impact the Fund by about 3% on the basis of  bond price fluctuations). Based on a variety of factors, our return/risk estimates in precious metals shares backed off modestly last week, and we clipped our exposure to a smaller but still constructive 14% of assets.

If you think Hussman is a pessimist, check out Albert Edwards’ forecast of the S&P 500 dropping to 450 from its current lofty perch of 1,582. That’s only a 72% drop.

When Rich Valuations Meet Poor Economic Data

John P. Hussman, Ph.D.

The advance estimate for first quarter GDP came in decidedly below expectations at a 2.5% annual rate, but even that rate belies the fact that real final sales slowed to just 1.5% growth, from 1.8% last quarter. The remaining 1% of the first-quarter growth figure – 40% of the total – represented the accumulation of unsold inventory. My view remains that the U.S. is unlikely to avoid joining the rest of the developed world in a global recession that is already underway, and may well be already underway in the U.S. once data revisions are reflected. The year-over-year growth rates of real GDP and real final sales have declined to just 1.80% and 1.87% respectively, which is the first time in this economic cycle that both have simultaneously declined from above 2.0% to below 1.9% – an occurrence that has been a hallmark of every post-war recession, with remarkably few false signals for such a simple measure. The Fed’s ability to kick-the-can in increments of a few months at a time may allow this time to be different, but investors should recognize that they are relying on that proposition.

It is certainly not the case that economic recessions precisely overlap with bear markets. Rather, bear markets are frequently underway before recessions are evident, and typically end several months before the recessions do. For that reason, market returns aren’t reliably abysmal when measured from the very start of a recession to its very end. Even so, note the shaded recessions in the chart below. Bear markets in equities occurred in 1956, 1961, 1970, 1973-74, 1981-82, 1990, 2000-02, and 2007-09. Of course, there are many less severe but still damaging market declines that occurred in the absence of recession.

Meanwhile, early evidence shows a very uniform deterioration in regional surveys of economic activity, with the Philadelphia Fed, Richmond Fed, and Empire Manufacturing surveys experiencing unanimous declines in overall activity, new orders and order backlogs in the April reports. The coming week will bring data from the Dallas Fed, Chicago and national surveys from the Institute of Supply Management, a Fed statement on Wednesday, and an employment report on Friday. Even deep-seated fundamentals have not always resolved into immediate outcomes in recent years, so I have no particular confidence about the direction of these reports. It’s just that nothing in the data is suggestive of a durable shift toward stronger economic activity.

A great deal of investor confidence resides with the Federal Reserve and other central banks here, and while it’s clear that monetary interventions can do a great deal to suppress spikes in risk premiums after they’ve occurred, the evidence for a durable transmission to the real economy remains wanting. As a side note, while the Federal Reserve Act doesn’t allow it, there are certainly some smaller central banks that have the ability to buy equities (essentially an indirect method of nationalization). This idea got a lot of attention last week. It’s certainly possible that an acceleration in that activity might support various international markets in the short-term, but would also create unbacked currency in an amount proportional to any losses in those equities. The hopeful arguments encouraging this sort of activity rely on the poorly constructed measures of risk-premiums that I reviewed in Investment, Speculation, Valuation, and Tinker Bell. These arguments are unlikely to survive a recession, much less a bear market. It seems a bit late in a mature bull market to rely on these hopes to sustain continued speculation, but we’ll take our evidence as it comes.

Given the full set of market conditions that we observe, including the persistent overvalued, overbought, overbullish syndrome that has developed in recent months, our concerns about stocks are not dependent on the direction of the economy over the coming quarters. An economic downturn would simply add immediacy to those concerns. Still, it’s important to recognize that our market posture is not driven by our concerns about recession risk, and that near-term economic bounces don’t retract our concerns.

That said, we can’t completely partition economic outcomes from market outcomes. On that subject, Bill Hester sent some interesting observations over the weekend that should not be overlooked here:

Bill notes “Investors are virtually ignoring how economic data are coming in relative to expectations. Although we maintain an economic data surprise line internally – comparing how economic data is coming in relative to economist forecasts – here I’ve use the Citigroup US Economic Surprise Index. The chart below shows the 26-week rolling correlation of the Economic Surprise Index and changes in the S&P 500. A declining line represents periods where economic data and the S&P are becoming less correlated, or even moving inversely to each other. The most recent correlation below -0.7 indicates that stocks and negative economic data are moving in almost perfectly opposite directions.”  

Undoubtedly, the strong inverse relationship between stocks and economic data lately reflects the belief that “bad news is good news” – that worse economic data bring the next fix of monetary easing closer. This hope has certainly been nurtured by the Federal Reserve. The problem with this idea is that, as we’ve demonstrated previously, the primary effect of quantitative easing on the financial markets is to reduce risk premiums after they have spiked. Put another way, the main effect of QE, both in the U.S. and internationally, has been to help stocks recover the loss that they experienced over the prior 6-month period, with little durable effect on economic growth aside from releasing a few months of can-kicking pent-up demand (see the analysis in Capitulation Everywhere).

Bill goes further to observe that “the troughs in correlation, in hindsight, turn out to be important.” We can formalize this by identifying each point where the correlation registered a new low below zero, and was also followed by an upturn within two weeks. Those correlation troughs are indicated by the blue lines in the S&P 500 chart below.

In most of these cases (as in the present instance), the Economic Surprise Index was at least a few percent below its 13-week high, and the S&P was at least a few percent above its 13-week low (the exception is the September 2008 instance when the market was already at a 13-week low even before it collapsed). A more complete indicator would impose additional requirements to rule out periods of undervaluation, or points where the correlation might be negative because stocks were down and surprises were up.  In any event, this is not a chart that inspires optimism, as the correlation troughs correspond to the beginning of nearly every significant market correction we’ve observed in the recent market cycle.

The dates and S&P 500 values corresponding to the blue lines are: May 02, 2008 (S&P 1414), Sep 26, 2008 (S&P 1213), Apr 23, 2010 (S&P 1217), Mar 25, 2011 (S&P 1314), Oct 21, 2011 (S&P 1238), Apr 27, 2012 (S&P 1403), Feb 08, 2013 (S&P 1518), and Apr 19, 2013 (S&P 1555).

What we know for certain is that during the most recent market cycle, the repeated hope that stocks could detach from the economic data proved to be unfounded in nearly every instance, with the exception (thus far) of the extreme and extended negative correlation observed in recent months. As is already true of other financial and economic conditions today, investors are left to rely on the hope that this time is different.

On the Very Long View

Albert Edwards at SocGen is not optimistic. Last week, he reiterated his concern that the S&P 500 would ultimately establish a low at 450. There is not a missing “1” in front of that figure. At first glance, 450 on the S&P seems absolutely preposterous, as Wall Street will be quick to point out that operating earnings are estimated to be over $110 this year, and a level of 450 would imply a P/E ratio of less than 4.5. But interestingly, if one corrects for the fact that profit margins are more than 70% above their historical norms, and that any recession in the coming years would be likely to draw “forward earnings” estimates to the $70-80 range, Albert’s estimate works out to a forward P/E of about 6 – which again seems low, until you impute forward earnings historically, and realize that the pre-bubble norm for the forward P/E has typically been less than 11, while secular lows have occurred at what would have indeed been forward P/E ratios right about 6 (see the August 2007 comment – Long Term Evidence on the Fed Model and Forward Operating P/E Ratios).

When we take Albert’s target to our own valuation approach, a move to 450 on the S&P 500 would drive our own estimates of 10-year prospective S&P 500 returns to about 18% annually, which is certainly higher than we observed in 2009, but is disturbingly right in line with the valuations that have typically been established with durable secular lows.

For our part, nothing in our own approach requires more than a moderate retreat in valuations to warrant a constructive investment position (provided that our measures of market action are favorable and overvalued, overbought, overbullish syndromes are absent). Over the complete market cycle, I believe that the best investment approach is to accept market risk in proportion to the estimated return/risk profile that is associated with any prevailing set of market conditions – and those conditions include not only valuations, but market action, trend-following measures, sentiment, yes – monetary conditions, and other factors.

For us, the key is the average return/risk profile that emerges from the full weight of these conditions, based on a broad ensemble of models that consider them across numerous subsets of historical data (and that have been validated in out-of-sample data). The challenge is that this strategy requires a full-cycle investment horizon, and it can be very frustrating in late-stage, overvalued bull markets when prices are still advancing despite negative average return/risk outcomes historically. Much of our research in recent years has focused on narrowing the set of conditions in which we take defensive positions, so that the corresponding periods capture the worst average outcomes and leave us free to take a constructive stance in the others. I expect the result of all that to be very clear as we move through the coming cycle, though it doesn’t alter our defensiveness in the present moment.

In short, I expect numerous opportunities to emerge in the form of both intermediate-term advances and possibly one or more complete cyclical bull markets before valuations normalize to any extent approaching the secular lows of 1950 or 1982. We certainly don’t require an implosion of the stock market or a collapse in valuations in order to shift to a much more constructive stance.

Keep in mind that valuations were still no picnic in 2003 when our views shifted to being quite constructive. The need to stress-test against Depression-era data prevented a similar turn in 2009 even though our methods indicated good valuations at the time. In the Depression-era, similarly “good” valuations were followed by a further market loss of two-thirds, which is easy to forget with the benefit of hindsight. With that stress-testing challenge addressed, I continue to believe that the main risk here is not the risk of missing further upside, but the risk of forgetting that financial markets experience inexorable cycles over time – today being about the point that an unfinished half-cycle is in place. I have no doubt that there will be numerous opportunities where the data fully support a constructive investment stance. Such opportunities are not at all dependent on terrible market losses or deep undervaluation.

Previous secular lows have been associated with great economic dislocations, such as world war, rapid inflation and so forth. There are certainly potential economic dislocations inherent in a highly leveraged global banking system that does not value its assets at realizable market value, nor holds capital that is appropriately risk-weighted. That’s particularly true of the European banking system. I do view European bank weakness and U.S. recession as being the two most destabilizing potential risks in the present cycle, but it’s not obvious that either would be sufficient to provoke a secular low in this particular go-around.

All of this argues for a focus on aligning our investment stance with prevailing realities – being mindful of potential long-term outcomes, but not letting them overly impact our positions. Here and now, market conditions are clearly sufficient to encourage a defensive stance, but that is likely to change far sooner than any of our deep-seated long-term concerns come to roost (such as accelerating inflation in the back-half of this decade). I would expect at least one more cyclical bull market between now and then. As I’ve noted before, the most appropriate point to establish a positive investment stance is when a retreat in valuations is joined with an early improvement in market action.

That said, an unsettling reality remains – the next secular bull market period appears unlikely to emerge until Albert is reasonably correct.