Portfolio Update - 06/30/07
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The following is a summary of my quarterly report to my clients. It is divided into three parts
When the market is fluctuating near its highs, it can be easy to forget that markets move in cycles rather than lines over time. It’s similarly easy to forget how effective corrections and bear markets are in eliminating most or all of late-stage bull market gains.
John Hussman, Ph. D. – 6/18/2007
Over the past four months, my investment strategy has had some set-backs resulting in YTD losses in your account. However, the trends that I have been speaking of are starting to take hold and profits for your account are likely to follow.
Here is how my performance measured up to the averages for the first half of 2007:
| PORTFOLIO | |
| Core Portfolio | |
| Focus Portfolio | |
| S&P 500 (VFINX) | |
| NASDAQ 100 (QQQQ) | |
| Benchmark |
In this update, I’ll address the following issues to help explain why your account has suffered some short-term losses and why I believe this trend will soon come to an abrupt end.
In my written January update, I included a section on the importance of missing down years in the equity markets. I revisited this subject in my May Blog update which you can review by clicking on this link.
I don’t want to spend too much time regurgitating information from past updates, but I think it’s worthwhile to touch on a few highlights on why I think the next bear market will be worst than average:
- We are currently embedded in a Secliar Bear Market where high valuations need to be gradually worked off until more normal valuations are achieved. Expected equity returns during these 10 – 15 year cycles are below average in the 4-6% range.
- The next phase of the current Secliar Bear Market is the “Second Consolidation” which has historically been quick and painfli. These phases have shared several fundamental similarities including excessive inflation caused by increasing commodity prices along with government intervention which leads to depreciating equity and bond prices. (Typically, equity bear markets are deflationary as the economy weakens which reslits in declining commodity prices and appreciation in bonds.) The previous two “Second Consolidation” phases experienced a 50% depreciation in equity prices coupled with losses in bond holdings.
- The current market rally is the second longest rally without a 10% correction in the history of our markets. The S&P 500 and the NASDAQ have rallied over 98% and 136% respectively since 10/2002. Both the percentage gains and duration for the current blil rally are far above average which suggests the next cycle will be greater than average as well.
- It’s a relatively safe bet that the next bear market will wipe out any gains we’ve missed the last 12 months plus some more. And while your account is down this year, I was able to eak out some decent gains last year despite having no equity exposure.
- There is still an unprecedented amount of leverage in the market. The global derivatives market is now bigger than the equity markets of the US, Japan and Germany combined. When this leverage is unwound, very bad things will happen! The most recent flare-up was the news of Bear Stearns Hedge funds that took a 28% hit due to subprime mortgage debt.
It’s now been a full year since I completely eliminated your equity exposure. A bit premature, but as I mentioned above, the odds are that equity prices will be cheaper at some point in the future than they were a year ago so we’re not really missing out on any gains – but it would have been nice to take advantage of the most recent run-up.
So are we there yet? Is the big, bad bear market that I’m expecting ever going to happen? For fear of sounding like the boy who cried “Wolf”, I’ll temper my expectations but there is surmountable evidence that the market will top within the next few months if it didn’t already back in early June (I don’t think it peaked in June as I expect one last blow-off rally, but I don’t have a very strong conviction either way). There six trends that I’d cover that suggest the end of this bull market is close:
- Technical Indicators
- Increasing Bond Yields
- The Hindenburg Omen
- Weakness in Interest Sensitive Equities
- Weakness in Homebuilders
- Weakness in the US$
Technical Indicators>
Currently, every indicator I track is either bearish or neutral for the first time since Q2 of last year which was shortly followed by a 7% correction. The three most important of the technical indicators (Consumer Sentiment, Leadership and Breadth) have experienced significant deterioration since my last update. Breadth and Leadership are not bearish yet – but they are not bullish either.
Bond Yields
Another indicator that I focused on last year was bond yields. One of my favorite analysts, Steve Saville wrote and interesting article about the relationship between bond yields and equities. He says:
A downward trend in the bond market will eventually take its toll on the stock market. It’s a question of when, not if, a downward trend in the bond market will drag equities lower. The “when” is typically 5-7 months, but is sometimes as long as 12 months from the start of the bond market’s decline…The current situation is that bonds are about 6 months into a downward trend, so we have entered the time-window when weakness in bonds should be starting to have an adverse effect on the stock market.
He wrote this in early June so now we are 7 months into the bond market pull back. Mr. Saville goes on to say that the current situation in bonds will end one of three ways.
- Bonds will rally bringing yields back down.
- The stock market will correct sharply over the next few months.
- In similar fashion as 1987, bonds will rally for a bit but eventually sell-off even more and push the equities markets into a full scale bear market.
You can click here to read his article
He thinks that Option #3 is the most likely and I’m inclined to agree with him. While bonds may rally in the short term, any rally is likely to be short-lived as inflationary pressures are likely to persist. Furthermore, European central banks are expected to raise their overnight rate at least a couple of times this summer.
Hindenburg Omen
What is the Hindenburg Omen? Robert McHugh describes it as “the alignment of several technical factors that measure the underlying condition of the stock market such that the probability that a stock market crash occurs is higher than normal, and the probability of a severe decline is quite high. This “Omen” has appeared before all of the stock market crashes, or panic events, of the past 22 years.” [emphasis his] Of course, this is information that would have been nice to know 12 months ago but better late than never.
For a in-depth explanation of the Hindenburg Omen, you can click here to read Mr. McHugh’s full article
I’d like to focus on what this indicator signifies for the market and what risks lie ahead. Mr. Anthony Cherniawski explains the likelihood of various sell-offs following a confirmed Hindenburg Omen. They are as follows:
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• 77% probability of a 5% decline within 41 days.
• 41% probability of a panic sell-off within 120 days. (Similar to 1987 or 1998)
• 25% probability of a stock market crash within 120 days. (Similar to 2000 or 1973)
Given my macro view of the markets, I wouldn’t bet against the latter two options. As I’ve eluded to in past updates, I think a market crash is unlikely given the nature of the 2000 – 2002 bear market, but something in between a panic sell-off and a crash is not out of the question.
Weakness in Interest Sensitive Equities:
Typically, whatever sector or group of stocks that will perform the worst in the bear market, will lead the market down. The NASDAQ led the market down in 2000, hitting its high almost 6 months before the S&P 500 saw its final peak. By the time the S&P 500 peaked in August of 2000, the NASDAQ was already down nearly 20%.
I believe that the Financials, Real Estate and Utilities are going to be hardest hit equity sectors in the next cyclical correction. While the S&P’s current closing high was established on June 4th, the Financials and REITs peeked several months ago. REITs peaked on 2/7/07 and are down 18% since then. Financials peaked in late February and are down over 11%. Utilities peaked on May, 21st and are down almost 8%.
If these sectors continue to lag the market and fall short of new highs, I think it’s a bearish signal for the market, but if they rally to new highs, then the bull market rally could go on for some time.
Weakness in Homebuilders
In past updates, I’ve covered in great detail the risks that a bust in the housing industry represents to our economy. The ETF tracking the Homebuilders Index (XHB) is at a 10 month low and a one or two day sell-off away from 52 week lows. If the index sells off or just trades sideways for the next month, it will be at 52 week lows. I wrote about this several months ago, you can click here to read more.
Weakness in the US$
As of the close of business on Friday, the 29th, the US$ stood at 81.9 just points away from its all-time low of 80.25. In June alone, it hit fresh lows against the Australian, New Zealand and Canadian $ along with the British Pound. I’m continually dumbfounded by the behavior of the Japanese Yen, but what is almost equally surprising is the US$’s performance in light of the weak Yen and the current status of US interest rates. I didn’t think we would see this significant of deterioration in the US$ until the Fed hinted at lowering rates. With the US$ at these levels, the Fed will most certainly be hand-cuffed going forward. Any dovish action from the Fed will likely push the US$ below it’s support level thus creating more inflation as our currency will not be able to buy as much stuff. The combination of a weakening currency along with a hand-cuffed Fed is not good for equity or bond markets.
I basically have two alternatives for investing your account in the upcoming bear market. I could take the safe alternative or the courageous alternative. The safe alternative would be to invest you in low-beta mutual funds (funds that have very little market risk) that will provide marginal returns in bull markets but protect your account from market losses during bear markets. The courageous alternative is to invest your account in a non-traditional long-short strategy of commodities and inverse equity plays that I believe will profit substantially in the upcoming bear market.
For my clients who have been with me since 2002, you know that I prefer the courageous approach because it leads to bigger returns in the long-run. In 2003, we didn’t tip-toe into the market, rather we went in head first once we saw a safe buying opportunity and our clients profited nicely outperforming the market by a significant margin. I came across an article on SmartMoney.com from August of 2003 by Jonathan Hoenig, four months after I fully invested my clients. It says:
I’m not a big believer in trading off fundamentals, but even if I were, it would be difficult to make the case that stocks are bargains at current levels. If March was the bottom in equity prices [which it was], it certainly wasn’t so in terms of valuation. Even if the market does pull back from it recent rally, anyone planning on holding stocks for the “long haul” should think carefully about choosing this moment to jump in with both feet. (notes mine).
This article is from the same guy who back in April of this year, right before the sell-off in bonds, wrote an article for SmartMoney.com titled “Fixed-Income ETFs Shine as Bond Market Gets Attractive.” Don’t get thrown off by the financial media and Wall Street’s permanent sense of optimism.
Please do not confuse “courageous” with “risky”. On the contrary, I believe that the next cycle will provide some of the most secure returns we’ll see for some time as precious metals and other commodities go “parabolic”. As I covered in my April update, gains in precious metals occur over short periods of time as compared to equities which occur over long periods of time. But when precious metals, or any commodity for that matter, begin to appreciate, they can realize gains many multiples higher than equities over a short period of time.
I want to reassure you that I wouldn’t be implementing such a strategy if I didn’t have confidence that I would drive significant returns for you. I don’t mind mild, temporary losses if it leads to big gains eventually. If I wasn’t confident in what I’m doing, I’d take the road more traveled and be satisfied with “breaking even” during the next bear market.
The great investors make courageous bets based on fundamentals. They do what others aren’t willing to do. Guys like Jim Rogers, Marc Faber and Warren Buffett buy stuff that isn’t even on other peoples radars and wait patiently until the fundamental case for their investment becomes so compelling that the market can’t ignore it. While I certainly do not claim to be in the same class as these investing legends, I do know what they are investing in and I can easily copy them to the best of my ability.
Eventually fundamentals will take hold and the Precious metals will appreciate while stocks and bonds depreciate. When that time comes, whether it be now, next month or next quarter, I think we’ll all be pleased with the appreciation in your account.
