... interesting ... from John Hussman yesterday ...
Ken Wilson
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Sunday July 14, 2002 : Hotline Update
The Market Climate remains on a Warning condition here and we remain fully hedged. But things are getting interesting. Last week, interest rates moved back into a downtrend. I've noted in recent updates that sustained bear market rallies (for example, March-May and October-December 2001) typically emerge during periods of declining interest rates, and are initiated by a very sharp reversal in momentum, in which overwhelmingly negative market action is immediately followed by a broad reversal.
The problem at hand is that the "overwhelmingly negative" portion could potentially involve a crash. So we certainly would not attempt to trade in advance of a legitimate and decisive reversal. While we never outline proprietary elements of our approach, suffice it to say that if the market can sustain a few brutal down days in the next week or two, and then reverse sharply off of a spike low (which would probably have to be substantially below current levels), the Market Climate will quickly shift to a constructive stance. It is not the extent or duration of such a reversal, but its quality (primarily breadth) that is essential to a decisive signal. As always, uniformity of market action is the hallmark of sustainable advances. If instead, the market rallies weakly from current levels, or declines without a powerful reversal, the Climate will remain on a Warning condition.
In any event, the next couple of weeks could be important.
It is essential to understand that stocks remain overvalued, and that no market action other than an extreme decline would quickly change that. So even a strong momentum reversal would not make stocks a "value." But much of the 1995-2000 advance occurred in a Climate of substantial overvaluation (poor investment merit) and favorable trend uniformity (reasonable speculative merit). Tradeable bear market rallies have also historically had this character. So we are certainly willing to take a constructive stance on the basis of favorable market action alone.
If the market can recruit a high-quality momentum reversal in the weeks ahead, our most constructive position would be about 40% unhedged. In other words, even in the best case, the majority of our stock holdings (60%) will remain hedged. Furthermore, this sort of shift would not be an indication of "bullishness" or "optimism" about the market. These terms imply a market forecast, and the reality is that we could very well find ourselves shifting back to a fully-hedged position even a week after becoming constructive. Also, while constructive Market Climates have a favorable average return/risk tradeoff, every Market Climate that we identify allows both substantial advances and substantial declines. So it's possible that we could take a constructive position and the market might continue to fall. In that case, we could have 40% of our portfolio exposed to a further market decline until a subsequent shift in the Market Climate. That's a risk we would be willing to take on sufficient evidence.
Shifting to a constructive Market Climate would not imply an end to the bear market, or the attainment of a final, durable low. We make absolutely no forecast of how long any given Market Climate will persist, or when it will shift. As usual, our goal is to identify rather than forecast market conditions. We take a measured amount of market risk in Climates that have historically demonstrated a favorable return/risk profile on average. Otherwise we shut market risk down. There are no specific forecasts that go along with this discipline other than the belief that over the long-term, the risks that we choose to take will be rewarded, on average.
In other news, Standard & Poors made some substantial changes to the S&P 500 Index last week. Among them, S&P ousted Royal Dutch, Inco, Alcan, and Barrick Gold. It added EBay, Electronic Arts, Sungard, Prudential and Goldman Sachs. So out were oil and metals (hard assets), and in were techs and financials. Anybody who knows the history of index revisions knows that they are outstanding contrary indicators. Norman Fosback of the Institute for Econometric Research demonstrated decades ago that stocks kicked out of the Dow, for example, dramatically outperformed their replacements over the following years. This rule certainly held true for the inclusion of stocks like Intel and Microsoft a few years ago. So I suspect that S&P has inadvertently given a somewhat long-term buy signal on hard assets and a sell signal on techs and financials (at least of the genre of EBay and Goldman Sachs).
I continue to believe that the U.S. economy faces risk of substantial weakness ahead, But again, if stocks are brutalized sufficiently in the next week or two, the market could take on a positive speculative tone for a while. As for my personal opinion (which we don't trade on and neither should you), I suspect that such a shift - if it emerges - would be on the order of a bear market rally lasting a couple of months, rather than something more durable. In practice, we'll just take our evidence as it comes. There is no assurance that the Market Climate will in fact shift anytime soon, and we would not attempt to "anticipate" or trade ahead of such a shift at present. In any event, our current position is fully hedged, and we have no inclination to take market risk here.
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