Bull by the tail

Guambat likes to look in a mirror. He sees a Guambat. Guambat likes Guambats.

And so, Guambat tends to enjoy, if not actually seek out, other Guambats on the net. He has been radio tagged by Google and countless others and is known to visit sites that look like him, talk like him, walk like him. It makes him a very contented Guambat.

Being a Guambat that enjoys the company of other Guambats, this Guambat came to believe, along with many others, that "the markets" were becoming a bit overbought in late summer (Nothern hemi), but that they would likely push on a tad more into the dreaded late Sep-early Oct period and then tank. Guambat happily found many other like-minded Guambats on the net.

Mr Market likes it when all the Guambats think alike. Mr Market appreciates the fine taste of fat Guambats. He has them for breakfast and again for lunch and dinner. They're much easier to catch when they're all hanging around together.

But Guambat has noticed a lot of other Guambats leaving the picnic. Guambat has heard many of the other Guambats getting on the bandwagon with distainful "no tanks to you". The bandwagon is being pulled by some very big bulls, and this is why Guambat thinks of them as bullish Guambats.

Guambat reckons that the bullish Guambats just couldn't bear the pain of holding to their convictions that the market is overbought, and have decided to go along with the bull ride. Guambat reckons he hasn't had enough pain yet, so he is becoming overly bearish with his pain.

Guambat, being a Guambat, has taken comfort in the company of other pain bearish Guambats, though the ranks are thinning. Guambat kinda secretly held the notion that there were too many Guambats at this picnic anyway, and that Mr Market would relish them, and mustard them, and saurkraut them and eat them....

... As appetizers for the main feast of the bulls who are pulling the cart.

Because Guambat fully suspects that Mr Market likes to eat bulls as much as Guambats.

And so, Guambat is somehow not at all disturbed to see all those other Guambats who used to haunt the same paths Guambat trundled along jump on the bull cart. He wishes them a fun, and short, voyage travelling behind the bull's tail.

All of which is just a set-up for this article from one of the Guambats this Guambat runs acrosst from time to time.

Chasing the Bull's Tail by John P. Hussman, Ph.D.

With stocks still near their recent highs, I think it's useful to remember the tendency of bull markets to surrender large portions of their gains over the full market cycle. Without that understanding, investors are vulnerable to the temptation to “chase” returns in what is already a richly valued, aged bull market advance, where recession risks continue to gradually increase.

[N]otice that bull markets don't start or end at set multiples. Loosely speaking, rallies often started at price/earnings ratios of 11 or less (often in the single digits), and usually ended by the time price/peak earnings ratios approached 17-19 (though the average is closer to 15). Even so, the bull gains have a 90% correlation with the extent to which P/E multiples increased, which was clearly easier when valuations began at low levels. By comparison, the most recent bull market advance from the October 2002 low began at 15.3 times peak earnings, already the highest multiple on record for the start of a bull market advance. The multiple is now in the upper range where prior bull advances have ended.

[O]nly three of the bull market periods retained more gains than what the S&P 500 has already achieved in this advance, and all three involved a more than doubling of the market's P/E ratio from a low starting level. It seems unrealistic optimism to expect the market to make further upside progress from here, and actually keep it over the completion of this market cycle, or without at least a 10% correction. Indeed, all of the prior rallies that ended at a P/E above 18 were followed by declines of at least 25%.

Moreover, the current multiple of 18.4 is actually much more extreme than it appears, because that elevated multiple is being applied to an earnings figure based on record profit margins. Historically, investors have not been rewarded for paying rich multiples on rich profit margins. We're already observing “surprising” wage inflation which is likely to place downward pressure on these margins.

At points like this, our investment approach takes the potential risk of market losses very seriously.

Properly done, a good hedging strategy will typically increase market exposure approaching and slightly after a major low, and it will hedge too early, because the costs of getting out even a little bit too late can be extreme. This means that good risk managers regularly appear to be idiots at market tops, geniuses at market lows, and hopefully, serve their clients very well over the course of a complete market cycle.

After performing well during the 2000-2002 bear market, we properly lifted most of our hedges in early 2003. Once the market got back to extreme valuations in early 2004, we again hedged our stock holdings due to the tendency of the market to underperform T-bills over time from such valuations. Since then, the S&P 500 has maintained its rich valuations somewhat longer than usual, outperforming T-bills by about 5% annually, measured to the recent market high.

So recent hindsight does not look kindly on our defensive position, particularly since stocks have enjoyed a strong “blowoff” rally since mid-July, and we haven't participated much in that. Of course, we don't hold ourselves out as “market timers” and don't place much weight on tracking short-term market movements. Our objective is, and remains, to achieve strong returns over the complete market cycle.

As of last week, the Market Climate in stocks remained characterized by unfavorable valuations and moderately favorable market action. That favorable market action remains a sign that investors have a “speculative” preference toward risk-taking. Until market internals deteriorate, that sort of preference will be enough to warrant at least a modest speculative exposure to market risk, which we prefer to accept by taking a 1-2% exposure to index call options. That's a clearly “asymmetrical” position in the sense that we've got a modest exposure to market advances, but any abrupt market decline shouldn't cost us much. The cost of that asymmetry is that our call options will experience modest time-decay if the market remains relatively unchanged, but that decay is currently very small, due to the low level of implied option volatilities.

It's relevant to note here that the yield curve between 3-month and 10-year Treasury securities remains inverted. Historically, inversions of the yield curve, coupled with above-average stock valuations, have been regularly associated with negative subsequent market returns, on average. While that doesn't remove every speculative reason to accept market risk, it does add to the evidence suggesting that now is far from an ideal time to be placing capital at risk by holding unhedged investment positions.

The issue here is one of patience and discipline – if you believe that conditions favoring strong market returns at contained risks systematically emerge over the market cycle, and that we will visit those conditions repeatedly over time (and in the foreseeable future), then it's relatively comfortable to remain defensive in conditions that have been historically risky. On the other hand, if you mourn every percent that the market gains while hedged as “money forever lost,” then every missed advance will create pressure to get in, whatever the risk, whatever the price. You can easily guess which perspective I endorse.

Despite the seemingly universal acceptance of the “Goldilocks” theme, the potential for further inflation pressures shouldn't be ruled out. For example, if we examine months where the yield curve was inverted, the ISM Purchasing Manager's Index dropped, and the 3-month T-bill yield rose (a combination which we saw last month, and have historically observed a small but not negligible 6% of the time), the CPI has typically shot nearly 1% higher in those same months, on average. Indeed, that small set of conditions (which are motivated by the monetary exchange equation) captures more than half the historical instances when inflation exploded higher in a given month. Not a forecast, just an observation.