Sunday June 8, 2003 : Weekly Market Comment
John P. Hussman, Ph.D.
The Market Climate for stocks remains characterized by unfavorable valuations but favorable trend uniformity, holding us to a constructive position. Last weeks' market action was particularly good in terms of uniformity - the NYSE recorded 1097 new highs and just 2 new lows. The only other instance in which the NYSE has recorded over 1000 new highs was the week of October 15, 1982. While I certainly don't view the market as similar to 1982 in any respect, it's clear historically that a large number of new highs is not a negative unless it is also accompanied by a large number of new lows - the bearish feature in that case being widespread internal divergence - we don't see that here.
Still, stocks remain overvalued, and neither strong market action nor the likelihood of good second-half economic growth will change that condition. Assuming that current, rich valuations will be sustained into the indefinite future (S&P 500 price/peak earnings currently 18.4, dividend yield 1.67%), stocks are priced to deliver long-term total returns of less than 8% annually. If the assumption of sustained overvaluation is removed and valuations move toward historical norms even a decade or two from now, the S&P 500 will deliver total returns in the neighborhood of 2-5% annually overall. Clearly, our willingness to take market risk here is based strictly on evidence of robust speculative merit, not long-term investment merit.
This does not mean that current market conditions are fragile or unreliable. To the contrary, historical market returns in the current Market Climate have been quite good on average, with somewhat below-average levels of volatility, regardless of valuation levels. We always allow for the possibility that the Market Climate will shift, which is why we never make forecasts even a few weeks into the future, but for now, we have no evidence by which to hold a substantially defensive investment position.
Last week, the Dow Industrials finally generated a Dow Theory confirmation by advancing past their November peak. While we don't actually use Dow Theory, we do respect it enough to keep an eye on divergences and confirmations under the theory. Against that favorable news, stocks are clearly overbought, and the percentage of bearish investment advisors has dropped to just 20% - lower than can be explained simply by appealing to the recent market advance. We wouldn't speculate on the possibility of a market pullback here, but we certainly wouldn't rule one out. In the current Market Climate, such pullbacks have historically represented reasonably good buying opportunities. Overall, we're constructively positioned, and inclined to use short-term weakness as an opportunity to purchase desirable investments.
There are two basic factors behind the market's strength here. First and foremost, investors have taken on a measurably greater willingness to accept market risk. Despite the fact that stocks are priced to deliver relatively low long-term returns, investors are willing to drive those prospective returns even lower, which results in higher prices over the near term. Remember, the higher the price investors pay for a given stream of future cash flows, the lower the long-term rate of return they accept on that investment (and vice versa). The second, much less important factor behind this rally is that investors are looking ahead to a certain amount of economic improvement in the second half; reasonably so from our perspective.
I say that this is a less important factor simply because stocks are a claim on a very long-term stream of future cash flows. Fluctuations in one or two years of those cash flows have very little impact on the discounted present value of the entire stream. Economic weakness doesn't hurt stock prices by reducing their long-term value, but by raising investor's short-term aversion to risk.
So the central fact of the recent rally is very simple: investors have become somewhat more willing to accept risk. We measure this willingness largely through market action in prices, yields and trading volume. When we begin to see divergences or breakdowns in market internals, it will be a signal that investors have become more more sensitive to risk, and we will quickly become more defensive. But for now, the willingness of investors to accept risk seems to be fairly robust.
Of course, you can always flip on the TV to hear analysts offering other reasons for this rally. You can usually identify which subject they flunked by the argument they make.
The econ flunkies argue that stocks are advancing because investors are "selling money market funds and buying stocks." The quickest way to cut through this argument is to ask "to whom?" and "from whom?" As I've noted before, if Mickey sells his money market fund to buy stocks, the money market fund has to sell commercial paper to Nicky, whose cash then goes to Mickey, who uses it to buy stocks from Ricky. In the end, the cash that Nicky used to hold is now held by Ricky, the commercial paper that Mickey used to hold (via the money market fund) is now held by Nicky, and the stock shares that Ricky used to hold are now held by Mickey.
Money never goes into or out of the market - merely through it. Every security issued must be held. Regardless of the trading that takes place, in aggregate, investors hold exactly the same amount of cash, commercial paper, and stock as they held before those trades. It's only the terms of trade that may change. To the extent that Mickey is eager to sell money market instruments and Nicky is not eager to buy them, Mickey has to give Nicky more money market instruments for a given amount of cash - that is, the price of money market instruments will decline, increasing short-term interest rates. To the extent that Mickey is eager to buy stocks and Ricky is not as eager to sell them, Ricky will sell fewer shares of stock for a given amount of cash - that is, the price of stocks will increase. Similar trades, but different price changes, would result if Ricky was the eager trader instead of Mickey (work through this as an exercise - it's worth the trouble). Still, in the end, any change in stock values comes down to changes in the eagerness to hold stocks, not to any aggregate change in the amount of stocks or cash held by investors.
Meanwhile, the math flunkies argue that the rally is due to the recent cut in dividend taxes. Look, the long-term total return on stocks breaks into two elements - income and capital gains. Long-term capital gains are already favorably taxed, so the only incremental change is the reduced tax rate on dividends (relative to what was already priced into stocks before the change), applied to the stream of dividends over the period to which the tax rate change applies.
Given a current dividend yield of 1.67% on the S&P 500 index, the 10-year dividend tax relief passed by Congress raises the long-term after-tax rate of return on stocks by just 4 basis points. In order to fully reflect this dividend tax change, stock prices would have to rise by only 2.5% (dropping the dividend yield by that same 4 basis points). Applying this change to the total market value of U.S. stocks, the entire impact on the capitalization of the U.S. stock market would be roughly $350 billion. This is an interesting figure, because it is none other than the present value of the dividend tax reductions just passed by Congress.
So we have an elegant and intuitive result: the justified increase in stock market value as a result of dividend tax reductions is equal to the present value of the tax reductions themselves. There's no such thing as free money.
If instead, the dividend tax relief is extended for 30 years, the long-term after-tax return on stocks would rise by about 9 basis points, justifying a stock market advance of about 6%. This larger increase in the capitalization of the U.S. stock market would mirror the larger cost, in present value, of extending this tax relief.
Arguably, whatever tax rate on dividends anticipated by the market beyond 30 years from today was probably already priced into stocks before the recent tax cuts anyway. Tax policy is simply too fluid and unstable to price long-term assets on static assumptions beyond that horizon. But only by unexpectedly and permanently reducing taxes on dividends would stock values be significantly affected. In the infinite-horizon case (assuming that no tax reduction was priced into the market prior to the change, and the entire tax reduction was suddenly priced into the market for the infinite future), the present value of the market would need to rise by about 20% in order to maintain a constant after-tax rate of return. Even this assumes that rich current valuations are actually sustainable over the long-term.
In short, recent tax changes may be part of investor's willingness to take greater stock market risk, but they have a negligible effect in raising the fundamental value of stocks. The entire exercise is worth less than 250 points on the Dow. Still, this negligible effect in terms of total market value still has a fairly heavy price tag in terms of tax revenues. There is a right way and a right time to adjust tax policy. This cut just sets the tax system up for a Clintonesque backlash. We certainly wouldn't price it into stocks for more than a decade or two, and doubt that the markets will either.
In bonds, the Market Climate continues to be characterized by extremely unfavorable valuations and favorable trend uniformity. Valuations, however, carry more weight in determining near-term fixed income returns than they do in stocks, so we are fairly defensive here. Alan Greenspan made some interesting comments last week, indicating the likelihood of markedly stronger economic growth in the second half - remarks strangely at odds with recent deflation talk. The whole deflation issue is increasingly looking like a pretense for further lowering of the federal funds rate rather than any deeply held conviction by members of the FOMC.
As I've noted before, a continued reduction in the demand of investors for "safe havens" is likely to result in a fairly abrupt increase in inflation rates. My opinion is that further easing in the federal funds rate is likely to be accompanied by increases in market-determined interest rates, and that the Fed could be forced to quickly follow suit. If this were to occur, we could see a much flatter yield curve a year from now, with much of the shift accomplished by higher short-term rates. I've already noted the difficulties a flattening yield curve could have on the banking and credit system. Suffice it to say that the greatest risk to the financial system here is not deflation, but rather a substantial flattening of the yield curve.
That said, we'll get plenty of evidence to confirm or refute these risks as the coming quarters develop, and beyond taking a relatively short-maturity stance based on the prevailing Market Climate for bonds, there's no need to take any investment positions on this basis just yet. For now, we're aligned with the prevailing Market Climates in stocks and bonds. We'll take our next steps as new information arrives.
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