John P. Hussman: Cyclical Bull Market Call

» Kirk - Cyclical Bull Market Call

From the Hussman Funds Web Site:

April 20, 2003 : Weekly Market Comment

http://www.hussman.com/hussman/members/u...

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable trend uniformity. That said, it is now very likely that the Market Climate will shift to a favorable condition within the next few weeks. Whether this will occur at higher or lower levels in the major indices is unclear. But barring a substantial and nearly immediate plunge in the market, we expect to move to a 60% unhedged position, and already have call options in place (largely purchased near the market's lows) to do this automatically in the event of a further market advance.

The call position confers great flexibility at what we view as a critical point in the market cycle. Essentially, it takes us to a 60% unhedged position - in the limit - if the market advances sharply here, and preserves a 100% hedged position - in the limit - if the market plunges sharply. The cost of this flexibility is a bit of time decay (a fraction of 1% of asset value) if the market moves sideways in the next few weeks, but again, given that this is exactly the time window in which trend uniformity is most likely to shift, that's an acceptable cost. I noted several weeks ago near the market's lows that we had purchased these call options to cover a well-defined contingency that trend uniformity could shift to a favorable condition within a fairly narrow time frame.

Unlike the "bear market rallies" in the past two years that have produced briefly constructive Market Climates on the basis of what could be called "momentum reversals", there is a good chance that we will have a full-featured shift in trend uniformity in the weeks ahead. If that occurs, it will be the first time that we have seen broadly favorable trend uniformity since it was decisively lost on September 1st, 2000 (a shift which I noted at the time). On this basis, we would expect to remove about 60% of our hedges, rather than the 20-40% stances that we've taken during recent bear market rallies.

It is critical to remember that we do not treat shifts in the Market Climate as forecasts. A favorable shift in the Market Climate should not be interpreted as a "bull market" prediction. Rather, we set our positions on the basis of the prevailing Market Climate. In my opinion, the market remains in what would best be described as a secular bear market - one that takes the market to lower long-term valuations through a series of bear markets, each with intervening bull rallies, but each settling closer and closer to durable undervaluation. The recent bear market, ruthless as it has been, certainly has not achieved durable undervaluation. So the advance that it engenders is unlikely to be a source of sustained long-term returns.

If the Market Climate does become favorable in the weeks ahead, it will not imply that stocks are favorably valued. We continue to view the market as overvalued. But overvaluation implies only unsatisfactory long-term returns, and has very little impact on shorter horizons - even horizons of 2-3 years. At present, the S&P 500 trades at a price/peak-earnings ratio of about 16.8. Historically, the perimeters of valuation have been about 6-8 times peak earnings on the low side, 20 times peak earnings on the high side (the exception being the year 2000 bubble peak at over 30 times peak earnings), a historical average of about 14, and a median of about 11. Needless to say, pinning a market stance on a particular forecast for valuations is absurd. Valuations have a tight correlation only with long-term returns, not with short-term ones.

When trend uniformity has been favorable, even extreme overvaluation has exerted very little impact on short-term market returns. This is not simply an observation about the recent market bubble, but is a robust fact of history. That's not to say that the market always advances when trend uniformity is favorable. But on average, the return/risk characteristics of the market have been quite good during periods of favorable trend uniformity. Valuations do influence the extent to which we hold a constructive position, but when trend uniformity is favorable, our investment approach prohibits a fully hedged stance.

Still, with valuations still above normal, how far could an advance really be expected to go? My opinion is that it would be difficult for a market advance to run much beyond about 20 times prior peak earnings. Except for the most recent bubble, that level has historically put a cap on the market. Still, that's about 19% above current levels. In price terms, a 1/3 retracement of the S&P 500's peak-to-trough bear market loss would take the index to 1027, still 15% above current levels, and a fairly minimal target even within an ongoing bear market. A retracement of half the S&P 500's losses would take the index to 1152, about 29% above current levels. This figure would also be within historical precedent for past bear markets, but it would require the market to reach valuations that would be difficult to sustain. Suffice it to say that neither overvaluation nor poor economic fundamentals prevent the possibility of a substantial market advance. But again, we don't forecast, we identify. If the Market Climate becomes favorable, we remove a portion of our hedges. If it becomes unfavorable a week later, we put the hedges back on. No forecasting required.

A constructive market stance certainly does not require investors to assume that stocks are undervalued. Nor does it require investors to ignore the very real economic and national security risks which currently exist. Certainly, the U.S. economy is far from clearing the burden of excessive leverage and overcapacity that weighs on future growth. But these fundamentals unfold fairly slowly over time. Oncoming economic downturns generally reveal themselves through fairly specific market action (see A Brief Primer on Economics for details). Barring these signals, such as widening credit spreads, it does not follow that poor long-term fundamentals must express themselves in short-term weakness.

Likewise, my views on terrorism risks have not been lost on readers of these updates. To understand that the roots of terrorism against the U.S. lie in resentment of foreign presence and occupation is to understand that recent military action has copiously watered these roots. It seems a poor trade to have destroyed a tyrannical but puny, centralized, and containable third-tier enemy at the cost of radicalizing much more sinister, malignant, and broadly diffused first-tier ones. And there is no question that foreign resentments have been inflamed beyond any precedent.

A doctrine that justifies the preemptive destruction of those considered a threat poses an unstable equilibrium if that same doctrine is adopted by more than one nation, because it can only result in escalation. The first casualty of escalation is peace, because escalation tends to foster extremism on both sides, at the expense of moderates who would be most capable of diplomatic solutions. If history is any guide, escalation among proud people results in peace only when the casualties have become intolerable.

Of course those actually responsible for criminal evil have to be punished, but the best way to reduce future risks is to simultaneously cut these extremists off from any source of broader support - to fill the void of moderates. This is accomplished by taking actions - rooted in an understanding of history, cultural tradition, diplomacy, poverty, perceptions of injustice, and the rule of law - to address the suffering, fear, resentments and hopes of those who might become our enemies. Again, appeasement is the dishonorable grant of concessions to an enemy that is not entitled to them. Understanding, compassion and diplomacy do not constitute appeasement.

That said, from an investment perspective, current geopolitical conditions not necessarily resolve into short-term risks. To avoid all risk-taking on the basis of these conditions is simply unreasonable.

It is important to keep in mind that the Strategic Growth Fund is not a hedge fund, a bear fund, or a market-neutral fund, but is in fact a growth fund that has an inherently bullish bias. It is the job of a growth fund to take financial risks when, clearly evaluating relevant conditions, risk appears to be worth taking. Indeed, the only Market Climate in which the Fund takes a fully hedged position is when both valuations and trend uniformity are unfavorable - a condition that has occurred in less than 25% of market history. Understandably, investors who have not carefully read the Fund's Prospectus may have concluded that our defensive position in recent years is "standard" policy. However, the Fund can and will take unhedged and even aggressive investment positions, depending on the prevailing Market Climate.

In short, our broadest measure of trend uniformity, unfavorable since September 1, 2000, has a good chance of becoming favorable in the immediate future. In that event, we will position ourselves by removing about 60% of our hedges. We already have the option (though not the obligation) to do so.

-- posted by Kirk