February 7, 2005
With the S&P 500 again trading near 21 times record earnings (20.88 to be exact), hopes are becoming increasingly implausible that the S&P 500 will deliver acceptable returns to buy-and-hold investors in the coming years. Even if earnings continue to expand along the peak of their 6% long-term historical growth channel (earnings really don't grow faster than nominal GDP over time), a still-elevated P/E of 18 five years from now would be enough to restrict total returns to 4.75% annually over that period. My impression is that these assumptions are optimistic.
Though the quality of internal market action has not deteriorated to the point where we would fully hedge against the impact of market fluctuations, the expected return to risk profile of the market finally flat-lined last week. Given our present measures of valuation and market action, the “conditional expected return” on stocks now appears no better than Treasury bills. This is not a forecast of upcoming market direction in this specific instance. Rather, it's a statement about the average profile of market return and risk when conditions have historically been similar on the basis of valuation and market action.
On the basis of our investment discipline, the only reason for accepting market risk here is the potential for a re-emergent market bubble. While I don't view a renewed bubble as a probability (if it were, that probability would feed into expected return), we only adopt a fully hedged investment position when both valuations and the quality of market action are unfavorable. In practice, about 70% of the equity holdings in the Strategic Growth Fund are now hedged against market risk with matched put/call positions (effectively short sales on the S&P 100 and Russell 2000 indices), while about 30% remains hedged with put options only, leaving the Fund well defended against downside risk, but retaining a modest potential for participation in an extension of the market's advance.
[Financial engineering geek's note: when investor's preferences are “myopic” – so that they only optimize their value function over the next period, a zero expected risk premium does generally translate into a zero investment position. In a dynamic optimization where the expected return on stocks is stochastic and investors look over more than one period, optimization results in an extra term in the investor's demand function, which hedges against the potential that the expected return may decline further, with a corresponding increase in price.]
My opinion remains that the market lows registered in early 2003 represented only the first of a series of cyclical bear market lows which will gradually correct the overvaluation of the late 1990's market bubble. Secular bear markets contain a series of such lows, each occurring at gradually more normal levels of valuation. While it is not necessary for secular bear market to produce consecutively lower troughs in terms of price (for example, growth in earnings allows P/E valuations to decline even without the necessity of lower prices), the first price low of a secular bear market is not likely to be durable. Suffice it to say that I wouldn't even think about ruling out a decline in the S&P 500 below its 2003 market trough in the coming few years.
If profit margins had substantial room for expansion, interest rates had substantial room to decline, and capital spending had substantial potential for growth (which is typically highest when the U.S. current account is in balance or surplus), valuations might be capable of remaining elevated for perhaps several years. That wouldn't substantially change the likelihood of below-average long-term returns, but it would make the risk of contracting valuations less pointed.
Presently, however, there are few considerations aside from a pure continuation of investor speculation that would support a further expansion in market valuations here. Though the market rallied on strong breadth Friday based on hopes that a tepid employment report will derail further rate hikes by the Fed, slower economic growth is likely to be associated with a weaker dollar and sustained pressure on inflation through the import sector. There's little reason to expect any change in Fed policy here.
The main factor that could derail the Fed's rate hikes would be a measurable increase in corporate defaults (which would lower the velocity of money and shift pressures toward falling inflation or deflation). Since we haven't observed a substantial widening of risk spreads (the difference between risky corporate bonds and default-free Treasuries), there's no reason to expect the Fed to shift monetary policy on that basis either. And in any case, a trend toward rising corporate defaults would hardly be a favorable one. While Treasury bonds would be helped by that sort of development, it would also be associated with weaker GDP growth, narrowing profit margins, and increased risk premiums on stocks – hardly an environment in which overvalued stocks would be expected to do well, regardless of Fed policy.
As of last week, the Market Climate for stocks was characterized by unusually unfavorable valuations and still modestly favorable market action. Simply put, however, market risk no longer appears worth taking on the basis of expected return. While we will continue to maintain a modest exposure to market fluctuations (primarily by hedging a portion of the Strategic Growth Fund with puts only, rather than matched long put/short call positions), that constructive exposure serves strictly to allow for the possibility of investor speculation and a re-emergent market bubble. I don't view that as likely, but we simply don't adopt a full hedge unless both valuations and market action are unfavorable. For now, we remain well hedged against potential downside risk, but this is not a “bearish” stance or a net short position. We continue to maintain a modest positive exposure to market risk, and will maintain that until we observe sufficient deterioration in the quality of market action to warrant a full hedge.
In bonds, the Market Climate last week was characterized by unfavorable valuations and modestly unfavorable market action overall. The Strategic Total Return Fund continues to hold a portfolio duration of about 2 years, mostly in medium-term Treasury Inflation Protected Securities. Market conditions for precious metals shares continue to be positive on our measures, holding the Fund to about 19% of assets invested in precious metals shares.
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