Sunday November 17, 2002 : Hotline Update
The Market Climate for stocks remains on a Warning condition, characterized by unfavorable valuations and unfavorable trend uniformity. In bonds, the Market Climate is moderately constructive, characterized by unfavorable valuations but favorable trend uniformity. As I've noted before, favorable trend uniformity in bonds is not generally as beneficial as it is in stocks. So while Strategic Total Return holds a moderate exposure to medium-term Treasury securities in the 6-7 year maturity range, our remaining assets lean to short-term securities and alternatives such as 2-year foreign government notes, precious metals shares, utilities, and even TIPS (Treasury inflation-protected securities) based on their still-competitive real yield, which we would receive even if the inflation rate goes negative (TIPS principal values aren't adjusted down even if deflation takes place).
Frankly, I believe that deflation remains less likely than low and persistent inflation, unless default rates spike much higher. As I've long noted, inflation has to do with the relative scarcity of goods versus government liabilities. So rapid growth in the supply of goods (i.e. strong economic growth) should be, and is, well-correlated with lower inflation. Indeed, the inflation rate has historically been higher when the Purchasing Managers Index is falling than when it is rising. Inflation is primarily the result of government spending that simultaneously draws on the available supply of goods while increasing the supply of government liabilities such as bonds or currency. It hardly matters which, since an increase in government debt that places upward pressure on interest rates also reduces the desirability of holding currency (which doesn't bear interest). In either case, the "marginal utility" of goods rises, relative to money, and the result is inflation. Given that government spending is rising rapidly, along with both debt and currency, the only thing preventing inflation here and now is a relatively strong appetite for safe assets like cash.
This puts the U.S. economy on a tightrope. If the economy suffers fresh weakness, rising bankruptcies may very well push inflation rates lower (though even then, I don't anticipate steep deflation). This would create something of a "deleveraging" spiral, since the worst thing that can happen to a borrower is to borrow on the assumption of high inflation and have to repay in an environment of low inflation (where the "real" burden is much heavier). At least this risk is widely recognized. What's not recognized very well, in my opinion, is what is likely to happen if the economy strengthens. In that event, the somewhat deflationary effect of greater economic output is likely to be swamped by a sharp reduction in the demand for safe-haven Treasuries and currency. This is particularly true since incipient economic growth will drive up short-term interest rates significantly, raising what is known as the "velocity" of money. The end result would probably be a sudden upward jolt in the inflation rate, seemingly out of nowhere.
Which outcome is more likely? Well, the NBER Business Cycle Dating Committee recently delayed any determination that the recession is even over. In addition, capacity utilization dropped again last month to 74.4%; not much higher than the trough of the recent economic downturn. As I've noted before, with the notable exception of the short and quickly-failed 1980 recovery, past economic rebounds have always generated a very strong jump in capacity utilization and help-wanted advertising. Both remain near their recessionary troughs here, placing the widespread view of an imminent recovery in question. So defaults and deleveraging appear more likely than a quick recovery (not that we base our investment positions on such opinions - in general, the Market Climate drives our opinions, not the other way around).
As for prices, rather than substantial inflation or deflation in the overall economy, we're likely to see a dispersion in inflation rates, with relatively weak pricing in manufactures, and relatively strong pricing in labor and services. Overall, I expect positive and persistent inflation, though not much acceleration. Also, even with the pop in the Producer Price Index last week (largely a result of discontinued 0% auto financing, which is counted as a price increase), labor prices continue to rise faster than output prices, which reduces the likelihood that profit margins will widen much anytime soon.
An environment of weak profit margins and high P/E multiples, with an interest rate climate that is slightly constructive but prone to upside surprises, really isn't a situation that makes substantial risk-taking advisable. This is unfortunate, because we take absolutely no joy in defensive positions. Still, we've earned good returns from the risks that we have chosen as appropriate. As usual, it is important to emphasize that even when we hedge away the market risk of our positions, there are always other risks that we do take. So a defensive position should not be confused for a riskless one. Also, it is important to understand that we will experience substantially more volatility when we do take market risk than when we hedge it away. The 4.6% pullback in Strategic Growth since mid-August is almost entirely due to the fact that we were partially unhedged during the initial part of the market decline since then. As of Friday, the Russell 2000 remains down 5.8% from its August peak, while the S&P 500 remains down 5.5%.
As a side note, we're occasionally asked for a list of historical shifts in the Market Climate. We don't provide this for two reasons. First, the Market Climate approach grew out of research between 1996 and 1999, so the approach didn't exist before that time. Second, while I hope that these updates provide information, insight, background and perspective to shareholders, I have no desire to encourage reverse-engineering of our proprietary methods by competitors. Suffice it to say that we have analyzed this approach using a century of market data, and we are enthusiastic and even rigid about following it.
Broadly speaking, favorable valuation and favorable trend uniformity warrants a leveraged position, unfavorable valuation but favorable trend uniformity warrants a partially hedged position, and the combination of unfavorable valuation and unfavorable trend uniformity warrants a fully hedged position. Our research goes as far back as 1871. But to get the basic flavor of our approach, and the frequency of shifts in the Market Climate, the past decade is sufficient.
On our criteria, stocks were undervalued from late-1990 through late-1993, and have been overvalued ever since. Of course, as I always emphasize, overvaluation implies nothing about short-term returns. It only indicates that long-term returns are likely to be disappointing. And indeed, since late-1993, even Treasury bills have outperformed the S&P 500 overall. However, on the basis of the criteria we actually use, trend uniformity was generally favorable from late-1990 through September 2000, with the only significant exceptions being 1994 (a flat year in the market), mid-1998 (very weak - Asian crisis), and several months in 1999 (strong, particularly in the Nasdaq). The sharpest loss of trend uniformity occurred at the beginning of September 2000. While we've seen a few modestly positive shifts since then, we have not seen strong trend uniformity for over two years.
From this, a few things should be clear. First, the Market Climate does not shift frequently. The historical average is about twice a year, and these include moderate shifts from, say, a fully hedged position to a partially hedged position. Our approach does not involve any attempt to forecast market direction. In fact, we believe that such efforts are counterproductive. We will be defensively positioned during some rallies. We will be exposed to market losses during some declines. This fact will frustrate short-term market timers to no end.
Second, the period from late-1990 through late-1993 is the only portion of the past decade in which stocks actually retained their gains over-and-above Treasury bills. This emphasizes the fact that valuations matter. Valuation certainly does not determine short-term returns, but it has a profound impact on the long-term returns that an investor earns over time.
Finally, markets that enjoy favorable trend uniformity warrant a reasonable exposure to market risk, even when stocks are overvalued. Although an investor with a long enough horizon can capture the bulk of long-term market returns by being invested only during undervalued periods, such an approach is inferior to one that continues to take market risk as long as market action remains sufficiently favorable. Market risk should only be avoided completely when both valuations and trend uniformity are unfavorable. Though this has largely been the case over the past two years, this is not the norm. Indeed, this particular Climate has only occurred in about 20% of market history. So while we're adamant about a fully hedged position while both valuations and trend uniformity are unfavorable, this position should not be considered "standard" for our approach.
Until market conditions shift, however, the Climate for stocks remains fully defensive, while the Climate for bonds remains modestly constructive. Neither of these rely on forecasts. Rather, they are derived from an identification of prevailing conditions. Our evaluation of trend uniformity is not based on the extent or duration of a particular move, but on its quality. In general, durable market advances generate excellent quality very quickly on the measures we use. Some, like the advance in the stock market from its October trough, fail to do so. This is often a signal of potential failure, but again, the Market Climate should not be taken as a forecast. It's quite possible that the internal action of the stock market will improve enough to warrant a constructive investment position. We simply don't have that evidence now. In the meantime, we are very pleased to take those risks that we do find attractive.
At present, we remain fully invested in stocks that we view as favorably valued and having favorable market action, while hedging away the impact of broad market fluctuations on that portfolio. In bonds, we are taking a moderate amount of risk in 6-7 year Treasury securities, with the remainder of our portfolio emphasizing short maturities and alternative assets such as foreign government notes, utilities, precious metals shares and inflation protected securities. "Defensive" certainly does not mean "riskless," but those risks that we take, we expect to be compensated over time for taking.
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