Friday Morning November 22, 2002 : Special Hotline Update
The Market Climate in stocks remains on a Warning Condition. While some of the most spectacular historical market declines have begun from an overbought condition in a hostile Market Climate (as is the case today), our currently hedged position is decidedly not based on an expectation or forecast of a market decline. Rather, it is based strictly on the fact that we do not have sufficient evidence that market risk is worth taking.
With regard to current market action, the major indices are very overextended. This kind of action often makes investors very insecure about anything but an aggressively invested position. But the impulse to buy into an overbought rally, in an overvalued market, in an unfavorable Market Climate, is generally not useful.
It is important to understand that our approach has an inherent "bullish" bias - the only market condition that warrants a fully hedged position is when both valuations and market action are unfavorable. Historically, this has occurred in less than 25% of the long-term market record. The fact that this condition has generally been in effect since the inception of the Strategic Growth Fund should not be taken as evidence that this condition, or a fully hedged stance, is typical. It is true, however, that the last time that leverage was warranted from the perspective of our approach was between October 1990 through October 1993. This is also the last time I was characterized as a "raging bull" in the media. Still, on the measures we currently use to define the Market Climate, the market exhibited favorable trend uniformity for most of the period between 1990 and 2000.
Since our approach is objective, we can examine exactly how often our measures have been favorable or unfavorable on a historical basis. And while bull markets and bear markets cannot be identified with certainty in real-time, they can always be identified in hindsight. (In the following discussion, we count "bear market rallies" in excess of 20% as "bullish periods").
Looking at bullish periods since 1940, 79.2% of these periods were characterized by favorable trend uniformity, while 20.8% displayed unfavorable trend uniformity. Of course, a constructive stance is also warranted when valuations are favorable. Fully 91.4% of past bullish periods were characterized by either favorable valuations, favorable trend uniformity, or both.
Looking at past bearish periods, 74.9% of these periods were characterized by unfavorable trend uniformity. This does not, however, mean that a fully hedged stance would have been appropriate during all of these periods. A fully hedged stance is indicated only when both valuations and trend uniformity are unfavorable. These periods account for just 38.7% of all historical bear market periods. Fortunately, these periods capture every historical market crash of note. This remains true when we examine vintage data that includes 1929.
Of course, there is also a certain number of periods in which the Market Climate was completely opposed to the major trend (as identified in hindsight). These account for about 10% of historical periods. During 8.6% of bullish periods, both valuations and trend uniformity were unfavorable, indicating a defensive position. During 14.6% of bear market periods, both valuations and trend uniformity were favorable, indicating an aggressive position. How does an investment approach defend against these unfortunate events? Simple: investment restrictions. By avoiding net short positions, even a defensive stance in a bull market period does not result in substantial capital losses. By avoiding the use of margin (and taking leverage only using limited-risk call options), even an aggressive stance in a bear market does not result in unacceptable losses. This is why we've written exactly these restrictions into our Prospectus. In short, we have no fantasy that our investment position will always be profitable over the short term. So we never take an investment position that relies on a particular stance being right, at the risk of unacceptable losses otherwise.
There is, of course, no assurance that future Market Climates will be aligned as closely with bull and bear market periods as in historical data. But in terms of theoretically sound, objective models, the Market Climate approach sets a very high bar. This is why, with rare exceptions (the last being a small innovation in May 2001), nearly all of our attempts to further refine our approach are unproductive. And that's a good thing.
The stock market is still emerging from the largest valuation bubble in U.S. history. Neither the excesses of that bubble, the overhang of low-quality corporate and consumer debt, nor the massive U.S. current account deficit have been resolved. Yet we would still be inclined to expose ourselves to market risk if trend uniformity was favorable. We've now had four substantial rallies since the year 2000 market peak. Three of them produced evidence of favorable trend uniformity on the measures we currently use. The rally from the October low did not. As I noted last week, we've tested a broad range of criteria which would have captured the rally off the October low. But if we apply those same criteria to historical data, they deteriorate the performance or deeply increase loss exposure of our approach in every case. We've emphasized for years that we do not attempt to "correct" short-term pullbacks in our approach if doing so would require us to violate our investment discipline.
So while we are always researching potentially useful extensions to our approach, we never allow opinion or adverse short-term movements to undermine our discipline. The reason the Fund has performed as it has since inception is precisely because we refuse to do so. Most fund managers are petrified at the prospect of missing any rally. With the market still sporting deep losses for the year, these managers are looking for any reason to buy stocks, which largely explains their eagerness to take highly volatile data like weekly unemployment claims as a sign that the economy is turning. We're not among them, and it is precisely the willingness to take short-term "tracking risk" that creates the possibility of outperforming the market by wide margins over the long-term.
The bottom line is simple. The Market Climate remains characterized by conditions that have occurred in less than one-quarter of all historical periods, and less than one-tenth of historical bull market periods. Over 90% of historically "bullish" periods have generated evidence supporting exposure to market risk. Market returns during the other 10% of bullish periods have been less than half the average for bull markets. Suffice it to say that we steadfastly avoid market risk when we lack sufficient evidence of its merit. At present, we remain fully hedged.
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