Market Indicators - Investor Sentiment: BERNARDO: Please Note!

» Normxxx - BERNARDO: Please Note!

By John P. Hussman, Ph.D. | January 18, 2005
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One of the central notions of the efficient markets hypothesis is that prices reflect all available information about future fundamentals, whether held publicly or privately, so outperforming the market is impossible. I take the EMH seriously, though as you might expect, not literally. Aside from the fact that the EMH makes implausible assumptions about the rationality of market participants (which can be disabused by watching a few interviews with Wall Street analysts), the EMH has several far less recognized implications, including that trading volume is exactly zero and that all traders agree. Even a slight relaxation of assumptions such as perfect rationality and purely speculative trading motives results in a market that looks much more like what we observe – one in which traders disagree, trading volume is non-zero, and where prices fluctuate in a potentially wide but stable neighborhood around fair valuation.

If you accept that broader view of market efficiency as a “stable neighborhood,” it follows that the market doesn't simply trade at “fair value” at all times. Rather, it trades in a neighborhood around it, the width of that neighborhood being determined by the extent to which the basic assumptions of the EMH are violated (which was patently true at the 2000 peak, even to a blind monkey). “Stable” in this context means that there is a tendency, however weak, to converge toward efficiency, even though new events constantly whack the market toward or away from that efficient point. So while there may be very little tendency to “revert to the mean” in the short run (which is why valuation is not a reliable tool for predicting market direction), valuations remain a very good indication of long-term investment returns. In that kind of market, there are still profit opportunities available, but only by making trades that consistently provide the market with scarce, useful services (such as information, liquidity, and risk-bearing). Unfortunately, actually providing those services can be very uncomfortable from time to time.

In general, comfort is an expensive thing to purchase in the financial markets. Still, investors do it all the time. They seek comfort by liquidating stocks – even deeply undervalued ones – after the market has experienced a long period of weakness. They seek comfort by chasing stocks – even wildly overvalued ones – after the market has experienced a long period of strength. It is very uncomfortable to actually provide other investors the comfort they seek, by standing there bidding for stock in frightening, undervalued markets, and by selling into exuberant, overvalued markets. But it's that very willingness – to trade in a way that provides scarce, useful resources to others – that is the foundation of long-term gains.

Market action as information

Price movements have at least two components. One is tied to fundamental values, and the other is tied to investors' willingness to accept market risk at any given time. The problem is that we don't get to directly observe which one is making stock prices move.

For instance, a decline in price may by a signal that future fundamentals are likely to be poor, and the fundamental value of the stock has declined. On the other hand, it might be that the stock price has declined even though the outlook for future fundamentals hasn't changed, in which case the stock is now a better value. How can you tell which is happening?

As always, context matters. Stock prices can never be analyzed properly without additional information to place their movements in context. For instance, if the price of a particular stock is plunging, but the overall market is also plunging, and all the other stocks in that industry are plunging, then we take the decline as a signal about what they share in common: overall economic conditions may be deteriorating, or investors may be broadly concerned about risk (those two possibilities could be further distinguished with additional information about the economy, valuations, credit spreads, and so forth). On the other hand, if the price of a particular stock is plunging, but the overall market and other stocks in the industry are holding up well, we take the decline as a negative signal about that specific company's prospects, or at least investor attitudes toward that specific company, and immediately look for information related to products, management and other factors idiosyncratic to that particular stock.

With the broad market, it is equally important to examine not only valuations but also market action. On the valuation front, knowing that the price/peak earnings multiple of the S&P 500 is 20.5 is already enough to anticipate that long-term returns (over the coming 7-10 years or more) are likely to be unsatisfactory. It is important to recognize that P/E multiples aren't just arbitrary objects, but are instead complex little mathematical beasts that have a long-term rate of return built into them, just as bond prices have a long-term yield to maturity built into them (for more on this, see Natural Consequences). This knowledge of valuations is a major advantage to investors who take the information seriously, because it provides an enormous amount of context in which to interpret shorter-term market action. As Charles Dow wrote a century ago, in one of the single most important observations in stock market history, “To know values is to comprehend the meaning of movements in the market.”

Now, we already know that long-term returns have not historically been penalized by avoiding market risk at high valuations. Still, there's a lot of “tracking risk” to that valuation-only approach, and it turns out that investors would have historically done better by considering the risk preferences of investors as well, which I do by analyzing market action.

Though the recent selloff in the major indices is certainly what one might have expected from an overvalued, overbullish, overbought market, it does not follow that stock prices are inherently poised to fall apart. Again, valuation has everything to do with long-term returns, but precious little to do with short-term ones. As long as investors have a robust willingness to accept risk, there can be very little pressure on the market to decline toward more historically normal valuations. So in addition to valuations, we have to consider the quality of market action. The greatest plunges in market history have always emerged from overvalued markets in which investors have recently become skittish toward risk, as evidenced by market action.

So far, strongly negative evidence from market action hasn't emerged. That's not to say we can rule out a further decline, or an abrupt shift in risk aversion ahead, but for now, our investment discipline prevents us from taking a fully hedged position against market fluctuations.

Frankly, I've been impressed by two things in recent weeks. One is the failure of credit spreads to widen (the difference between risky corporate bond yields and default-free Treasury yields), and the other is the failure of new 52-week lows on individual stocks to expand above the number of new highs. Richard Russell notes that the Dow Transportation Average has already broken its December low, so a like breakdown from the Dow Industrials (below 10,440.58 on a closing basis) would be a negative from the standpoint of Dow Theory. So far, however, even that sort of event is not in place.

Now, I certainly believe that credit spreads are overly narrow, and that this will end badly, and I am equally convinced that recent bullish extremes will ultimately give way to considerable pain for investors. Valuations are already extreme enough to warrant holding a very defensive put option position against our stock holdings. But that doesn't mean that a fully hedged investment position (a full offsetting short sale in the major indices against our stock holdings) is warranted – yet.

The bottom line is simple. So far, the recent market decline tells us that an overvalued, overbought, overbullish market has corrected. This is not enough information content, because the market has failed to produce the sort of wide internal divergences that have historically been the hallmark of extreme market risk. Again, we can't rule out further market weakness, and defending our stock holdings with put option coverage is essential, but we still don't have enough evidence to warrant a fully hedged position.

I expect that we will derive an enormous amount of information as we observe how the market responds to the current, oversold condition of stocks. Given that the bulk of our put option coverage is roughly at-the-money, I would expect the Strategic Growth Fund to participate modestly in any early weakness from here, but that the put coverage will substantially mute the impact of any sustained decline.

It will be very important to see whether new divergences develop on any market advance that might occur. In any event, the behavior of market internals in the weeks ahead will matter far, far more than the behavior of the major indices. For now, we're well defended against any serious market weakness that might emerge, but particularly with the market now reasonably oversold, the continued modestly favorable Market Climate demands at least some benefit of the doubt.

The contents of this letter/report does not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of this message is not to be construed as constituting market or investment advice. It is intended for educational purposes only. Individuals should consult with their own advisors for specific investment advice.

-- posted by Normxxx