Monday, December 13, 2010

Hussman Weekly Market Comment: Warning - An Updated Who's Who of Awful Times to Invest

In recent weeks, the U.S. stock market has been characterized by an overvalued, overbought, overbullish, rising-yields syndrome that has historically been hostile to stocks. Last week, the situation became much more pointed. Past instances have been associated with such uniformly negative outcomes that the current situation has to be accompanied by the word "warning."

It's not pleasant to adhere to our discipline here, but I believe that it is essential to do so, because conditions like these are often where it matters most, despite the discomfort. We've lost several percent in the Growth Fund in an advancing market, reflecting a tendency of investors to abandon stable investments in preference for the "risk trade" in highly cyclical stocks, as well as option time decay in an environment where defense is seen as unnecessary. The market's recent embrace of the "risk trade" can be traced to the apparent endorsement of risk-taking by the Fed. Still, it's wise to remember that while Fed Chairmen have proven to be apt encouragers of bubbles over the short term, the "Greenspan put" certainly didn't avoid the 2000-2002 mauling, nor did the "Bernanke put" avoid the even deeper 2007-2009 plunge. The only put options that investors can rely on here are the contractual kind.


The "stability trade" versus the "risk trade"

From a stock selection perspective, it is striking how extended the stocks of cyclical companies have now become, relative to more stable companies. This is true both on the basis of price and valuation. Cyclical stocks include companies such as Alcoa, Citigroup, Caterpillar, CSX, DuPont, Deere, Ford, FedEx, Goodyear, Hewlett Packard, International Paper, Southwest Airlines, 3M, Sears, United Technologies, and Whirlpool, among others. Staples include companies like Abbott Labs, ADP, Colgate Palmolive, Disney, General Mills, Johnson and Johnson, Kimberly Clark, Coca-Cola, McDonalds, Merck, Pepsico, Pfizer, Safeway, Walgreens, and Wal-Mart, among others.

The following chart (courtesy of Bill Hester) presents the ratio of the cyclicals index (CYC) versus the staples index (CMR). It's notable that the most recent spike in this ratio coincided with Bernanke's initial announcement of QE2. Cyclicals are now nearly as overextended relative to staples as they were at the 2007 peak. As one would infer from the word "cyclical," these companies are unusually prone to volatility.

Just as relevant for investors is the comparative valuation of these groups. The chart below presents the ratio of price/book value for staples relative to cyclicals. Historically, staples have been awarded higher valuations due to their higher and more stable long-term returns on equity. While staples continue to have strong returns on equity, they are strikingly out of favor. On this note, we have to agree with Jeremy Grantham of GMO in observing that high-quality large-caps (and we would emphasize those with stable growth, profit margins and ROE) most likely present the best prospects for total returns in the coming years. These stocks represent a distinct subset of the S&P 500. The constituents of the S&P 500 should not be viewed as a uniform group of "high quality" companies by any means.