Market internals deteriorated sharply last week, following an extended period of overvalued, overbought, overbullish conditions where interest-sensitive sectors have been under considerable pressure. At present, the line of least resistance appears downward. That will change. It may change quickly, and while we haven’t seen a material retreat in valuations, a firming of market internals even here might support a somewhat more constructive outlook. Still, investors should also recognize that the sequence of conditions we’ve observed – strenuous overvalued, overbought, overbullish conditions, followed by distinct weakness of interest-sensitive sectors (Treasury bonds, corporates, utilities), broadening internal dispersion and reversals in leadership (new highs/lows) and breadth (advances/declines) on both longer-term and high-frequency measures (e.g. anotherHindenburgon Wednesday) – these are conditions that have historically preceded panics and crashes. They are indicative of a shift from risk-seeking to risk-aversion.
Make no mistake, last week’s decline was not because of a hawkish Federal Reserve, but in spite of a dovish one. On Wednesday, Ben Bernanke essentially promised that the Fed would continue to expand the size of a balance sheet that is already leveraged nearly 60-to-1 against its capital, regardless of market distortions. Though the Fed might possibly reduce the rate at which it expands that position, Bernanke indicated that the Fed will not stop adding to it until at least 2014 (stopping only on the basis of economic improvement that we view as implausible). Anyone who understands the relationship between short-term interest rates and the amount of monetary base per dollar of nominal GDP also understands that Bernanke has promised that short-term interest rates will be repressed as far as the eye can see. There was no talk of risks. Not a whisper about diminishing benefits. No – Bernanke came in full-metal dove. Perhaps shaken by the market reaction on Wednesday afternoon and Thursday, Bernanke evidently dispatched the Wall Street Journal’s Jon Hilsenrath tosuggestthat the markets were ignoring all those dovish signals from the Fed.
In short, the only thing that happened with Fed policy last week was that Bernanke reiterated a dovish stance. While QEternity will become QEventualTaper, the Bernanke Fed does not actually contemplate stopping until the unemployment rate comes down, even though that objective is almost entirely detached from Fed policy itself. Investors who believe that “QE makes stocks go up” – with no other condition required – just got a handwritten, perfumed note from Bernanke to keep buying.
The fact that we are instead seeing broad internal deterioration here is of some concern, because it smacks of something more afoot. It might be the increasing credit strains in China. It may be growing expectations for disappointing earnings preannouncements. It may be economic weakness that finally catches up to the general (though not uniform) deterioration that we’ve seen across leading measures of economic activity. My own litany of concerns is well-known (seeClosing Arguments – Nothing Further, Your Honor). But whatever the reason, investors appear to be shifting from risk-seeking to risk-aversion.
Then again, it might be that investors simply overreacted to the Fed, and everything else is just fine. If that is the case, I would expect even our own views to become somewhat more constructive on an early firming of market internals. We don’t have a very wide window between here and the point where we would likely observe overbought and overbullish conditions, and valuations certainly haven’t eased much, so my inclination is that the best way for investors to take market risk in that event would be to use limited-risk instruments such as call options. We’ll take the evidence as it comes.
What concerns me most is that the present market environment is very reminiscent of other cycles in which deterioration of interest-sensitive securities, following overvalued, overbought, overbullish conditions, was then joined by broad deterioration in market internals. The chart below shows the points where the overvalued, overbought, overbullish syndrome I noted a few weeks ago inNot In Kansas Anymorewas followed by a deterioration in utilities, corporate bonds, breadth, and leadership, relative to the prior quarter. There are five instances: 1929, 1987, 2000 and 2007 and today. The prior ones are associated with some of the worst market losses in history. Longer-term readers may recall my concern about this same sequence in 2007 (see the July 30, 2007 weekly commentMarket Internals Go Negative). 1973 does not appear in this set because the 1973-74 plunge was not preceded by a deep deterioration in interest-sensitive securities, though they did lose value later in that bear market. 1937 does not appear only because we’re using a particularly tight definition of overvalued, overbought, overbullish conditions. Suffice it to say that the historical record is not encouraging toward speculation here.
To believe that the present instance is a good time to accept significant market risk, one has to rely on the premise that this time is different. If one seeks a peg on which to hang the “this time it’s different” hat, corporate profits are not one of them, as profit margins were invariably extended at those other peaks as well. Indeed, even if one computes the Shiller P/E (S&P 500 divided by the 10-year average of inflation-adjusted earnings) using the highest earnings to-date at all points in time, none of the overvalued, overbought, overbullish syndromes I’ve described in recent months would be suppressed. The recent peak of 20 on this alternate measure is still in the top quintile of historical valuations, and still higher than at the 1937, 1972 and 1987 peaks – near or above every historic bull market peak except 1929, 2000 and 2007. If one wants to hang the Mad Hat, the single “different” peg is the absence of outright tightening by the Federal Reserve – only the murmur of tapering.
Again, if one believes that “QE makes stocks go up” and that no other consideration is required, our view is that there is every reason to expect QE to continue, though at a somewhat slower pace, but with no move at all toward higher Fed policy rates for years. It's worth noting that the average 10-year bond yield since October 2010 when the Fed launched QE2 is only 2.26%, so the Fed is increasingly in a loss position on its Treasury purchases. Still, short-term interest rates remain low, and are likely to remain in the grips of Japan-style financial repression for quite some time - unfortunately. The Fed is unlikely to raise its policy rates (Fed Funds, Discount Rate) for years, but it seems unlikely that this will be sufficient to forestall the course of normal bull-bear market cycles. Ask Japan.
A further problem is that investors who caved into the Fed’s encouragement to seek a little more yield in utilities and bonds just had years of incremental yield slapped out of their hands in the form of capital losses. I doubt that suppressed short-term interest rates are enough to indefinitely keep risk premiums from spiking in securities that normally carry meaningful risk premiums.
In my view, the weakness in interest-sensitive securities is not a reflection of growth expectations, but of increasing risk-aversion in a financial market where investors are weakly-attached because they felt forced to take risk in the first place. I do believe that the more risk-free, default-free and bond-like securities are, the more they will benefit from the lack of competition from short-term money.
So despite modest absolute yields, Treasury bonds seem an increasingly reasonable place to invest, particularly if yields rise further. Utilities have some bond-like characteristics, but greater risk, and so are susceptible to greater spikes in risk-premiums. Corporate bonds are next in line, but with risk-premiums that are likely depend on both earnings results and economic events. Gold and commodities in general are suffering from the upward pressure of real interest rates, and while precious metals shares are quite depressed on reliable valuation measures, the headwinds should not be fought aggressively until real interest rates stabilize somewhat. The upward pressure on real yields may eventually make inflation-protected debt desirable, but any deflation concerns will torpedo these securities, and it’s best to seek opportunities in TIPS during such environments. Stocks in general are most vulnerable here, with the effective duration of the S&P 500 index similar to that of a 50-year zero-coupon bond at present, coupled with the lack of risk-free characteristics. With a 2.22% dividend yield on the S&P 500, the yield only has to increase by 5 basis points for capital losses to wipe out that entire dividend yield.
Our primary attention here is on market internals. If they improve, I expect that we’ll adopt at least a moderately constructive view. Presently, however, my impression is that investors have shifted from risk-seeking to risk-aversion. This shift is not because of a hawkish Fed, but in spite of a dovish one - something more appears to be going on. It’s tempting to wait until a stronger and more specific “catalyst” emerges, but the financial markets have demonstrated repeatedly over time that market losses come first, and the catalyst becomes evident afterward. This process seldom happens in reverse.
In some cases (such as 1987), it is difficult to identify a catalyst at all. What mattered then, and the only thing that gave investors a hope of avoiding that crash, was attention to the sequence of events: strenuously overvalued, overbought, overbullish conditions, followed by a deterioration of interest-sensitive sectors, followed by deterioration in market internals (breadth, leadership). The 1987 crash, by all appearances, emerged as numerous investors attempted to execute trend-following exits simultaneously. To a large extent, that’s what concerns me here. In the presence of a broad set of conditions that have preceded the worst market declines in history, the lack of anexplicit increase in short-term Fed policy rates here seems a thin peg on which to hang a hat that holds all of one’s eggs. We’ll take our evidence, constructive or defensive, as it arrives, but the hallmark of present market conditions is a shift from risk-seeking to risk-aversion. Until it clears, it should not be ignored.
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