From Hussman:
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Consider advisory sentiment. Last week, the percentage of bearish investment advisors reported by Investor's Intelligence dropped to just 20.9%. We carefully analyze these figures, because they do carry information. But the key is understanding how to extract that information. As I've frequently noted, information is often contained in the divergence between how a particular indicator behaves and how it would be expected to behave given the surrounding context.
It is one thing for advisory bearishness to be low during a period of negative market action. Low bearishness in an environment of weak market returns is a real negative because it is out-of-context. It suggests that investors have been caught by some "hook" that is enticing them to ignore market behavior. In contrast, low bearishness following strong rallies is not unusual or particularly informative - if you look at most bull market periods, you will see very sharp declines in bearishness and spikes in bullishness that are not followed at all by subsequent market reversals. So no data point can be taken at its face value without considering the context in which that data resides.
Reviewing the history of the Investor's Intelligence figures since the 1960's, even bearish percentages of 25% and lower have been associated with subsequent market returns of nearly 15% annualized, on average, during periods of favorable trend uniformity (which we currently observe). Market returns remain quite good even if the data set is further restricted to periods of overvaluation and unfavorable seasonal conditions (May-October). In short, context matters.
Similarly, the preponderance of new highs versus new lows might be seen as an indication of an overextended market. Over the past three weeks, new highs have outpaced new lows by a factor of at least 25-to-1. Yet in fact, this sort of preponderance is typically associated with the relatively early phase of bull markets, not bear markets. That's just an observation - I don't really think in terms of bull and bear markets, and I certainly don't mean that as a forecast. To use our own terminology, a preponderance of new highs is a kind of uniformity across a wide range of stocks. The time to worry is when new lows start increasing despite new highs in the major indices. Such internal breakdowns are informative exactly because they are out-of-context. Reviewing history, the most notable instance in which a lopsided high/low ratio was followed by a sharp decline (about 12%) was in mid-1975; a decline that was quickly recovered and followed by substantially higher prices. That's not any assurance that stocks will rally in the present case, but again, the average performance of the market has been quite good when the market has enjoyed strong leadership from new highs.
Again, these comments should not be interpreted as forecasts. Given the relatively strong rally we've seen in recent months, there is nothing that prevents the market from experiencing a deeper correction than we saw last week. But there is not sufficient evidence on which we can base an expectation of negative returns.
Historically, a buy-on-dips approach has generally been rewarded in the present Market Climate. Given that the average return has also been favorable in this Climate, it has not generally been rewarding to wait for such dips, and certainly not to wait until they carry all the way to oversold conditions. In my view, even last Monday's decline was a reasonable buying opportunity.
There is a world of difference between responding to market movements because of the opportunity they offer, and reacting to market movements because of the emotion they create. One never knows whether a specific purchase or sale will be rewarding, but it is extremely important for investors to make a habit of buying favored securities on short-term weakness and selling lower-ranked holdings on short-term strength. This can also be done on a relative basis. For instance, there is nothing wrong with selling a stock on a 5% decline if the more attractive one being purchased is down 10%. Unfortunately, many investors make a habit of buying stocks (or funds) only after they have been convinced by a relentless series of advances, and of selling during flat periods or outright declines - not for analytical reasons, but simply out of fear and impatience. This sort of habit is suicide.
Investment actions should be driven by the merits of the security, not by the position you already have (unless your position invites the risk of unacceptable losses, in which case you should lighten up regardless of market action). If you own a security that is declining in price, ask yourself what you would be doing if you didn't own it. If you would be inclined to buy it on the decline, you should re-think your impulse to sell. Similarly, if you don't own a security that is soaring in price, ask yourself what you would be doing if you did own it. If you would be inclined to sell it into the rally, you should re-think your impulse to buy. There are a few cases when a particularly attractive security should be bought even on strength, or a particularly unattractive security should be sold even on weakness. But as a general rule, the idea is to buy low and sell high. This should be obvious, but having observed the actions of countless investors over the years, I can assure you that it is not.
In the bond market, the Market Climate is characterized by extremely unfavorable valuations, but tenuously favorable trend uniformity. Since bonds are not as subject to "bubbles" as stocks are, favorable trend uniformity alone is not sufficient to warrant taking substantial bond market risks. Still, to the extent that the bond market can experience bubble-like features, the U.S. bond market is currently doing exactly that.
Like the stock-market bubble three years ago, the same force is behind the current action in bonds: Alan Greenspan. The word "deflation" is to the bond market what the phrase "structural productivity growth" is to stocks. In both cases, Greenspan has been the head cheerleader (no need to linger on that visual).
Over the past year, we've noted that the most probable outcome for prices is not likely to be deflation but a divergence in inflation rates for manufactured goods versus services. Excess global manufacturing capacity, combined with a massive trade deficit, does place downward pressure on the prices of imports and manufactured goods (though less so in the face of a weak dollar). Still, the labor market remains relatively tight compared with past recessions. Since rents generally accrue to the scarce factor, the main beneficiary of the economic growth that does occur will not be capital (or profit margins) but labor. So wage inflation and services prices are likely to experience continued upward pressure. The overall result is likely to be a relatively low but persistently positive level of overall inflation when measured over any reasonably extended period of time.
Further reasons to expect positive inflation (based on the exploding supply of government liabilities combined with a likely ebbing in the demand for safe-havens) can be found in the latest issue of Research and Insight.
The recent surge in the value of the euro versus the U.S. dollar has been a largely predictable move toward fair value (see Valuing Foreign Currencies. As I've frequently noted, movements in currency values are driven primarily by real interest differentials between countries. The plunge in U.S. Treasury yields, combined with still positive inflation pressures, represents clear downward pressure on real U.S. rates, and is one of the key factors behind the weak dollar and recent strength in precious metals. Both markets are vulnerable to corrections, of course, but the pressure on U.S. real interest rates remains in force.
To the extent that movements in the U.S. dollar reflect real interest rate movements, we can consider dollar weakness to be a valuation move, not evidence of disinvestment by foreign investors. We would be concerned if the decline in the dollar was to substantially exceed what is warranted by real interest rates. In that case, dollar weakness could indicate a reduction in the willingness of foreign savers to purchase U.S. securities. This foreign investment finances a substantial portion of U.S. domestic investment, so a pullback in this financing would be a real negative. For now, we don't observe this. In the absence of a flattening yield curve, widening credit spreads, unfavorable trend uniformity and other evidence, recent dollar weakness does not reliably indicate oncoming economic weakness.
As always, context matters. With the exception of data that includes April (which will be predictably weak), we don't have strong evidence to expect an oncoming downturn in the economy. Fundamentals such as debt burdens and overcapacity remain relatively unfavorable, but those fundamentals only exert their influence over the long-term. In the meantime, market action provides the most reliable information about how the economy will evolve over shorter horizons.
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