... from John Hussman this morning ...
Tuesday Morning August 6, 2002 : Special Hotline Update
Copyright 2002, John P. Hussman, Ph.D.
The Market Climate is characterized by unfavorable valuations and favorable trend uniformity. This represents the first shift in the Market Climate since December, and takes the stock market off of a Warning condition. In response, we removed just over 1/3 of our hedges on Monday's market decline. The majority of our holdings remain hedged against market fluctuations.
How could you get a positive signal in a down market?
As I've written frequently, our measures of trend uniformity are not based on the extent or duration of a rally, but on the quality of internal market action across a wide variety of measures. Simply put, recent market action has been lousy in terms of the major indices, but high quality in terms of factors that we use to define "uniformity."
Should this be interpreted as a major buy signal?
No. The core of our market approach is to position ourselves in line with the prevailing, identifiable Market Climate at every point in time. Until Monday, we held a fully hedged position. We now hold a mostly-hedged position. So while the current Climate instructs us to take a modest amount of market risk, there is no forecast attached to this shift. It should not be considered a "buy" signal, nor should we be counted as "bullish." The proper interpretation is that the current Market Climate, defined by valuations and trend uniformity, is one in which market risk has historically been rewarded on average. This Climate may persist for a week, a month, or a year. I have no idea when it will shift. And for that reason, I have no forecast of market direction ahead, except for a very general expectation of positive market returns on average while this Climate remains in effect.
What do you mean by "on average"?
Every Market Climate we identify has its own average return/risk profile, but that average includes both advances and declines, often substantial ones. Even the most negative Climate we identify can and does include occasional periods of strongly advancing prices. Once we align ourselves with a given Climate, we make no attempt to forecast short-term direction within that Climate. So while the current Climate can be considered "modestly favorable," I have no particular expectation that the market will or must rally in the short term. It could just as well decline profoundly. But on average, the current Climate has historically produced reasonably attractive returns when it has been in effect. Given high valuations and a risky economic environment, however, there is a risk that this Climate could be short-lived. The proper response is to accept a modest amount of market risk here.
What would the market have to do to reverse this signal?
Preferably, we'll see a reversal due to internal breakdowns in market action following an advance to higher levels. But nothing rules out a further market decline. I suspect that a decline of about 6% from current levels (on a weekly closing basis) would produce enough internal breakdowns to place the market back on a Warning condition. At our current level of market exposure, we expect to experience about one-third of the market's fluctuations, both up and down. We take that risk, of course, because we expect to be rewarded for doing so.
Have you changed your views about the economy or long-term market prospects?
Currently, stocks are priced to deliver something less than 8% annually even if above-average market valuations are sustained indefinitely. If they are not sustained indefinitely, stocks could very well underperform T-bills over the next decade. So stocks are not a value here, and I doubt that they have established a durable bear market low. My opinion (which we don't trade on and neither should you) is that the economy remains in a recession that is likely to worsen, and that stocks remain in a bear market that is likely to worsen. But evidence of a weak economy takes months if not quarters to be fully recognized, and even the worst bear markets have frequently enjoyed rallies of 20% or more (even the current bear has had two such rallies in March-May 2001 and Sep-Dec 2001). That said, it is lunacy to invest based on whether one believes stocks are in a bull market or a bear market, because they don't exist in observable experience; their existence can only be confirmed in hindsight. Our discipline is simple - we position ourselves in line with the current, identifiable Market Climate. The more favorable the return/risk profile of that Climate, the more market risk we are willing to take. At present, we're willing to take a modest amount of market risk.
So are you a bull or a bear? What's your forecast?
What kind of trees did Christopher Columbus think were planted at the edge of the earth: maples, or pines?
What happened to those call options you held to hedge against the possibility of a signal happening on a rally?
Early last week, the market rallied strongly enough to put most of those calls in-the-money. But we didn't have a favorable signal yet. Since it was not our intent to remove our hedges pre-emptively, and the value of those calls was at considerable risk if the market was to decline, we raised their strike prices, taking in a credit in excess of what we paid for them originally. As in Chess, the two questions we always ask are: "What is the opportunity?," and "What is threatened?" The goal is to take those opportunities that have acceptable risk and sufficient supporting evidence, and to defend what is threatened by unacceptable risk or weak supporting evidence.
So the favorable shift in the Market Climate suggests that a modest, but not aggressive amount of market risk is now acceptable, while this Climate is in effect, but you have no particular forecast regarding short-term direction, and you still believe stocks and the economy face further long-term risks, and your opinion is that this may just indicate a bear market rally of a few weeks or months, but rather than speculate on that opinion, you'll follow the discipline of aligning your investment position with the prevailing Market Climate, and change that position when and if the Climate shifts again?
Yes. It's almost as if I wrote that.
http://hsgfx:reciprocal@www.hussman.com/hussman/members/updates/latest.htm |
