Thursday, December 23, 2010

Red, Green, or Yellow? ( I think yellow)

John Hussman, Ph.D. is a well-regarded institutional investment manager. He holds a Ph.D. from Stanford University, and was formerly a professor of economics and international finance at the University of Michigan. He has also published the Hussman Econometrics newsletter since 1988. In his December 13, 2010 newsletter, he cites significant parallels between today's market environment and others during which outcomes were not pleasant.

First, allow me to present some context. From September 1, 2010 to December 16, 2010, the S&P 500 index has soared nearly 18.5%. Yes, that's eighteen and a half percent.

Dr. Hussman identifies five criteria which identify a market characterized as overvalued, overbought, and overly bullish. He further goes on to say that past instances have been associated with such uniformly negative outcomes that the current situation has to be accompanied by the word "warning". These criteria are as follows:

1) S&P 500 more than 8% above its 52 week (exponential) average
2) S&P 500 more than 50% above its 4-year low
3) Shiller Price/Earnings Ratio greater than 18
4) 10-year Treasury yield higher than 6 months earlier
5) Advisory bullishness > 47%, with bearishness < 27% (Investor's Intelligence)

He further provides the historical instances corresponding with these conditions as follows:
December 1972 - January 1973 (followed by a 48% collapse over the next 21 months)
August - September 1987 (followed by a 34% plunge over the following 3 months)

July 1998 (followed abruptly by an 18% loss over the following 3 months)
July 1999 (followed by a 12% market loss over the next 3 months)
January 2000 (followed by a spike 10% loss over the next 6 weeks)

March 2000 (followed by a spike loss of 12% over 3 weeks, and a 49% loss into 2002)
July 2007 (followed by a 57% market plunge over the following 21 months)
January 2010 (followed by a 7% "air pocket" loss over the next 4 weeks)

April 2010 (followed by a 17% market loss over the following 3 months)

December 2010

Whether history repeats itself again remains to be seen. Often a signal that the market may be near or at a "top" is when retail investors take the plunge and buy stocks. Throughout the market rally from the March 2009 lows, notwithstanding impressive gains in stocks, the vast majority of funds invested by retail investors since this time period has been to bonds; not stocks according to the Wall Street Journal and Investors Business Daily. Within the last two to three weeks, the flow of funds invested by non-institutional investors has shifted out of bonds and into stocks. Defense is out, and risk is in. When sentiment changes and soars, and prices rise feeding the sentiment change, it is often a huge warning sign.

This is not to say that I believe we are about to repeat the precipitous decline of 2008. And, I am truly not a pessimist. It is just that mathematical and universal laws dictate a reversion to the mean. For every action, there is an equal and opposite reaction. When things go up or down too quickly, caution must be imposed. When sentiments rise and values soar, it is very scintillating to want to hop aboard for fear of missing out on the "big one". We have some market exposure today, but the exposure has safeguards strategically incorporated. The bottom line is that the issues which created the great world-wide great recession are not all corrected. Debt is a looming problem that will continue to rear its head. Revenue estimates are being revised upwards, which can lead to disappointments. I believe that we are in a sideways market. By this I mean that we will have big upturns followed by dramatic, quick reversals. The Euro is still an experiment. No one knows for sure how it will unfold. I have difficulty understanding how Germany who is meticulous, disciplined, restrained and has been fiscally responsible can share a currency with others on the continent such as the Italians and the Spanish whose cultures are completely different. Is it really fair that all these nationalities have their single currency adjusted uniformly? If the debt has to be unwound and reallocated to different currencies, how will values be determined? In short, we are acting nimbly, making sure we have offense as well as defensive strategies in place. Particularly when retail investors are accepting more risk and are more euphoric, it is essential that we tighten our hedges.

After all, we're in a yellow zone, so we're proceeding with caution.

The opinoions voiced in this material are for general information and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, you should consult a financial advisor prior to investing.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

Past performance is no guarantee of future results.