... from John Hussman, tonight ... Sunday July 21, 2002 -Hotline Update
The Market Climate remains on a Warning condition here. That said, the market has now satisfied much of the set-up to a potential bear market rally. In general, the "phases" of a bear market tend to be punctuated by bear market rallies that are often sizeable and sustained for several weeks and even months. They are not occasions for substantial risk taking, and they do not imply that stocks have investment merit, but there is enough speculative to take a modest exposure to market risk when certain conditions are present. Last week, market action provided exactly what we needed on the downside. At this point, a solid advance in market breadth within the next couple of weeks would be sufficient to shift the Market Climate to a constructive position.
Now, from the standpoint of our investment approach, it is irrelevant whether I think an advance is a bear market rally or a new bull market. I frequently refer to bull and bear markets when I talk about my opinion, but these concepts are actually irrelevant to our approach. Bull and bear markets simply don't exist in observable experience - at any given moment, the existence of one or the other is always a matter of opinion. Our exposure to market risk at any point in time depends on the prevailing, identifiable status of valuations and trend uniformity. At present, a favorable shift in the Market Climate would prompt us to remove about 40% of our hedges, leaving our fully invested portfolio of stocks about 60% hedged against the impact of market fluctuations, but having at least a modest sensitivity to market direction.
As for my opinion (which we don't trade on and neither should you), I've noted in recent updates, I don't anticipate a clean, quick end to this bear market. Many analysts are hoping for a final capitulation to clear the air and finally give way to a sustained bull market. I doubt it.
In my opinion, valuations remain too high for a durable bottom anywhere near current levels. On the basis of the S&P price/peak earnings ratio, the S&P is now at just over 16 times prior peak earnings. This may not seem so bad, given that the historical average has been about 14. The difficulty is that those prior peak earnings are increasingly suspect. Even at the bull market high, P/E ratios were by far the most generous of all valuation fundamentals. While P/E ratios were about double their historical average, ratios such as price/dividend, price/revenue, price/book, price/replacement cost ("q"), and price/GDP were easily three or more times their historical averages. In other words, while stock prices were high relative to earnings, earnings were also very high in relation to dividends, revenues and book values (this was observed as low dividend payout ratios, high profit margins and high return on equity, respectively). As recent earnings restatements are making painfully clear, those high profitability levels were not simply unsustainable, they were phony. For this reason, we continue to stress that price/earnings ratios are not a reliable basis for valuation here. And even if they were, historical bear market lows have typically occurred at less than 9 times prior peak earnings (these include not only post-1965 market cycles, but pre-1965 cycles when trend GDP growth was higher, and interest rates and inflation were lower than current levels).
In the July 22 issue of Barron's magazine, there is an excellent interview with Jeremy Grantham (who I've long viewed as one of the outstanding value investors in the country). Grantham notes "There could indeed be important rallies, but before the smoke really clears, it's very likely we will overrun to a level below 700 on the S&P and below 1100 on Nasdaq. It's very scary. The overrun is something of a terra incognita. There is no methodology to calculate how much it will overrun. I can calculate how much it will correct to fair value because we have a pretty good read on fair value. We know that has always happened. But the degree of overrun in the market is always different. The only thing you can say with some statistical backing is that there is a strong tendency for the degree of overrun on the downside to be related to the degree of overrun on the upside." This is one of the few articles I've seen that gets it right. Be careful as you read it though. Grantham's point is not that stocks are likely to decline relentlessly. Rather, the point is that the ultimate trough of this bear market may be much lower than widely believed. Nothing in his argument rules out the possibility of strong, intermittent bear market rallies along the way.
There is another reason why I suspect the market is not in the process of setting a durable bear market low: The bad news is not yet out. I continue to expect substantial debt problems and economic disappointments. I've noted for several months now that analysts have failed to allow for the possibility that the economy - and particularly consumer spending growth - may deteriorate rather than improve in coming quarters. These risks are underscored by factors such as the record current account deficit, increasing credit card charge-off rates, a marked slowdown in bank lending (despite Fed easings), and a plunging dollar (see recent issues of Hussman Investment Research & Insight for more detail behind these concerns). A durable bear market low is likely to occur only after these problems are widely recognized, and widely expected to worsen. At good bear market lows, investors lose their ability to imagine that economic conditions will improve, just as investors lost their ability at the 1999-2000 peak to imagine that conditions could deteriorate.
So in my opinion (I can't stress that word enough), this bear market probably has much further to go, and it will probably require a period of months (perhaps even a couple of years), not days or weeks, for the aftermath of the speculative, capital investment, and credit bubble of recent years to be fully expressed. In the meantime, the market is likely to generate a substantial number of false starts and bear market rallies. Some of these will generate sufficiently favorable market action to warrant a modest exposure to market risk. This sort of opportunity may arise in the next week or two, but we do not yet have such evidence at present.
As for next week, I have no short-term forecast, as usual. Nor do we need one. But for the sake of pure idle curiousity, here are some of my thoughts. I've often noted that market crashes are typically preceded by fairly relentless distribution and a very bad late-week decline, which we've certainly seen. So Monday could certainly involve a serious plunge. NYSE Chairman Richard Grasso also notes "Mondays following Friday declines have always been difficult and I suspect tomorrow will be no different." The Reuters Business Report warns "expect no reprieve."
While the bad Friday, bad Monday combination is typical, my "intuition" actually runs contrary to these expectations here. That intuition goes something like this. Too many investors seem to be primed for a "capitulation" (or a set of Lowry's 90% days - see some of my June updates on this) in order to signal an "all clear." I also suspect that the shorts are waiting for one more ugly plunge before they cover their shorts ("Why leave money on the table?") That, in my mind, creates a potential order imbalance rushing to the buy side if the market fails to quickly follow through on Friday's decline. After all, unless investors are acutely aware of lingering valuation and debt issues (and I'm convinced that they are not) it's still possible to look at this market and ask "Are things really that bad?" And the last thing either the bulls or the shorts want is to miss the opportunity to get in at the "bottom."
Meanwhile, I used to have good results anticipating Fed moves by asking the question "What would a thoughtful economist do?" But as Greenspan was abducted by aliens and replaced with a pod-person in 1998, I've since had good results by asking the question "What would a panic-stricken, reactionary, populist, New Era devotee do if he had no concern for anything but the immediate gratification of crisis-avoidance, regardless of long-term economic consequences?" On that basis, there's an outside chance that the Fed will announce a surprise rate cut on Monday morning. The best point for such a rate cut would be very close to the market opening. Again, that's not an expectation, but it is a possibility.
In short, both a crash and an immediate rally are possible here. My intuition (which doesn't even rise to the status of opinion) is that a hard rally is more likely, but in any event, we don't trade on such speculation. We are fully hedged here. If the market can generate action sufficient to shift the Market Climate to a favorable status, we'll lift about 40% of our hedges, leaving our portfolio mostly but not fully hedged. We've done a few interesting things to allow for the possibility of lifting our hedges, but I'm going to pass on describing them since we never comment on individual positions as we're putting them in place.
In any event, the Market Climate remains on a Warning condition for now. We're prepared for the possibility of a favorable shift in the Market Climate in the next week or two, but that remains a possibility at present. We don't need any forecasts here. We'll shift our position when and if the Market Climate shifts.
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