from John Hussman...his sunday comment of the 22nd...at hussman.net
Just a note, we've added a few extra reports in the Research & Insight area of our website www.hussman.net, and I expect to post a new streaming audio interview with George Gamble of GEM Radio by Wednesday.
The Market Climate has shifted to a Crash Warning. That climate is characterized by extremely unfavorable valuations, unfavorable trend uniformity, and rising yield trends. This is the most unfavorable of any Climate we define. Though it has only occurred in 4% of the historical data, nearly every important market crash has emerged from this single set of conditions. Needless to say, we take it seriously. Our current position is strongly defensive.
I realize that it seems desirable to try to trade in-and-out of the market in attempts to capture periodic bear market rallies. The difficulty is that we have no objective way of identifying when they are likely to begin or end. Certainly, they tend to begin when the market is oversold, but in bear markets, oversold conditions can persist and worsen for weeks or months at a time. So an oversold reading is simply not enough evidence to take a counter-trend position in a bear market (just as an overbought reading is not enough evidence to go short in a bull market). Unless we have evidence that allows us to say "market conditions are predictably favorable and risk is reasonable", any attempt to "play" a short-term rally in a defensive Market Climate would be a violation of our discipline. And as soon as that discipline is violated, there is no clear guidance as to when it should be re-established. Once you break discipline, you start investing on hope, "feel", and opinion. We just don't operate like that, and if history is any guide, we don't need to. All that is required is to position ourselves in line with the prevailing Market Climate. Despite the recent "fast and furious" bear market rally, internal market action has been terribly unconvincing.
That said, our models would readily allow us to hold a more constructive position if internal market action was to improve sufficiently. We would also move off of a Crash Warning if the action of interest-sensitive sectors such as bonds and utilities were to improve. We don't rule these possibilities out, but again, we don't try to second-guess whether or when they might occur. For now, the Market Climate is in the most negative possible condition, and we are positioned defensively. For our most aggressive accounts, that means a sufficient put option position to gain strongly in a market plunge. For the Fund, it means that our portfolio of stock holdings is fully hedged by an equal-sized short sale in the Russell 2000 and S&P 100.
Keep in mind that even in a neutral position, we remain relatively light in large-cap technology and financial stocks. So we can lose a bit of ground when those specific groups lead the market higher without similar performance from the broad market (or when they decline less, as was the case on Friday). Again, our allocation to each individual stock is strategic and driven by the characteristics of each specific stock and industry. We set our positions because we have objective evidence that their return/risk tradeoffs are attractive, not simply because a certain sector is moving this week.
Earnings reports are now in full swing, and the raw numbers are terrible. You'll notice that invariably, earnings growth numbers are far below revenue growth numbers, which indicates that profit margins have been hit hard. Investors have a terribly misguided impression that if a company's earnings collapse by 80%, it's still good news as long as the earnings report beats analyst estimates by a penny. This sort of view demonstrates a complete ignorance of how securities are priced.
As I constantly stress, value is determined by the relationship between prices and properly discounted cash flows. In simplest terms, a stock price is always based on two figures: the long-term growth rate of future cash flows, and the long-term rate of return demanded by investors. The faster the growth of cash flows, and the lower the long-term rate of return demanded by investors, the higher the value for the stock. Current stock prices can only be justified by assuming implausibly high future growth rates for earnings and cash flows, and by assuming that investors are willing to hold stocks for a ridiculously low long-term rate of return (for more on this, see my comments about Byron Wein's model, on page 3 of the April issue of Research & Insight).
Current earnings reports are not important for whether they beat estimates by a penny or two. They are important because they are inconsistent with the earnings paths required to justify current stock prices. In other words, investors are focused on whether the quarterly results are above or below expectations, but aren't considering the crucial question, which is whether assumed long-term earnings growth rates can be justified. Those expected growth rates are still completely disconnected from anything seen in history. It's those long-term earnings growth expectations that are crucial, and current reports leave little or no hope of those expectations being satisfied. For that reason, long-term earnings expectations are likely to crater in the next couple of months. That, combined with an increase in the rate of return demanded by investors, is what could combine to produce a market crash here.
We don't require forecasts here. We aren't positioned in a way that requires a market crash, but unlike most investors, we do not rule it out. Our defensive position is consistent with the Market Climate currently in effect. As always, these comments are simply intended to provide background and texture to the cold, hard evidence. We'll change our position as the Market Climate shifts. It's just that right now, the evidence remains very cold and hard. |
