October 6, 2008
The Beginning of Wisdom
With the S&P 500 trading below 1100, the U.S. stock market is now in the upper range of what I consider to be reasonable valuations. Stocks are certainly not "cheap" or undervalued overall, but they are no longer priced to deliver unacceptably poor long-term returns. I have no strong belief that stocks have reached a bottom. Although there is an increasing likelihood of a sustained "bear market rally," I believe there is a good chance that valuations will eventually move lower still before a durable cyclical low is established. Still, investors should recognize that normalized valuations are now the best they've been since 1995. That may not be saying much, since the total return on the S&P 500 since 1995 has averaged only about 7% annually, but it is what we might call "the beginning of wisdom."
I'll cut to the chase - beginning late into Monday's plunge, and then on Thursday and late Friday, we finally covered our short call option positions in the Strategic Growth Fund. As of Friday, the Fund's stock holdings were still fully-hedged with in-the-money index put options, which continue to defend against any major downside continuation in the markets. This does not imply that the Fund will be unaffected by market fluctuations - rather, a long position in our stocks, combined with index put option coverage, essentially retains much of the potential for upside participation, while muting but not eliminating downside risk.
Compared with a standard matched hedge (long put options, short call options), buying in those call options risks 2.5% of assets - that amount would be the proceeds from maintaining the short call option position. My view is that the potential for missed returns here would substantially exceed that amount if we were to maintain a short call option position at current levels.
Recall that the 2000-2002 bear market contained three separate advances of 20% from intra-day trough to intra-day peak. Given significantly improved valuations, compressed oversold conditions, an extreme spike in the VIX, and declining interest rate trends, the catalysts for such a rebound are quickly accumulating. As usual, we respond in a proportional way to that changing evidence.
As I've frequently noted, the best time to panic is before everyone else does. That was certainly an appropriate market stance last year, when I was waving my arms about with pieces like Warning - Examine All Risk Exposures and Minding the Hinges on Pandora's Box. But good investors love situations where panic is full blown and conditions appear utterly certain to get worse. As I wrote during the 2000-2002 bear market, at meaningful market lows, "the tenor of news reports has always been something to the effect that 'conditions are bad, expected to get worse, and there is no end in sight.' When the news reports are uncontroversial in reporting that the U.S. is in recession, when they suggest that there is worse news ahead, and when they indicate that nothing seems to be helping, that is when the market is more likely to register its low."
My assertion is not that we are necessarily at such a low yet, but the present sentiment of panic is typically one that presents useful opportunities for gradually scaling into market exposure, as uncomfortable as it might feel over the short term. This is what good investors get paid to do - not always immediately, but over time. If I could encourage one thing of shareholders here, it would be to take day-to-day fluctuations with a slightly larger grain of salt than usual. Basing periods in the stock market tend to be associated with well above average day-to-day and even hour-by-hour market fluctuations. Though the Fund's fluctuations are likely have a fraction of the market's volatility, there is enough disperson across various industry groups like financials, technology, retail, materials, and so forth that we would observe some amount of volatility even if we had zero market exposure at all.
In recent weeks, I've noted my intention to close out some or all of those short call options if the market was to decline substantially below its recent trading range. Last week provided that opportunity. If the market declines further, we may roll the strike prices of our put options down to capture a portion of their intrinsic value, or close out 20-30% of those put option hedges. In any event, I expect that the significant majority of the Fund's stock portfolio will remain hedged until we observe either better valuations or a quick and fairly lopsided improvement in market internals.
None of this is to suggest that the market can't decline further still. But if the idea of accepting any market risk at all seems frightening, think about it this way. Suppose that we were to remove say, 20-30% of our hedges on a further decline, yet the market was to decline by an additional 10% afterward (bringing the market's overall loss to over 40%, and further increasing the likelihood of a violent "clearing rally"). Such an event would result in a loss of about 2-3% to us on the basis of that additional market exposure (20-30% of 10%), much or all of which could be expected to be quickly recovered on even a sub-standard bear market rally. In all, a continued major loss in the market would expose us to a few percent of downside by virtue of having closed out the short calls, and a few percent of downside by virtue of added exposure to market flucuations. At some point, an equity investor has to stand up and accept careful, measured amounts of risk. My hope is that I've established a sufficient record of prudence in that regard.I've updated our projections for 10-year S&P 500 total returns below (standard methodology). The heavy line tracks actual 10-year total returns. The green, orange, yellow, and red lines represent the projected total returns for the S&P 500 assuming terminal valuation multiples of 20, 14 (average), 11 (median) and 7 times normalized earnings. Current valuations place the most likely expectation for 10-year total returns in the 5-8% range for the S&P 500. That's not particularly high on a historical basis, but already exceeds the projection we had at the 2002 bear market lows, and is the "least bad" since 1995.
Valuations, Hedging, and Expected Long-Term Returns
As long-term shareholders know, with the exception of 2003, I have considered stocks to be strenuously overvalued for many years. The unfortunate fact is that over the past decade, the S&P 500 has achieved a total return, including dividends, of just 2.45% annually. Since the 2000 market peak, the S&P 500 has performed even worse, achieving a loss of -2.23% annually, again including dividends. The reckless valuation of stocks has held us to a fully hedged investment stance for a much longer period than I would have imagined, but we place risk management and long-term returns ahead of "tracking the market" for short-term participation. Since the inception of the Strategic Growth Fund in 2000, we've generally refused to accept much market exposure, again with the notable exception of 2003, which was (pleasantly) the only year since 2000 that the S&P 500 achieved a total return in excess of 20%.
From the inception of the Fund on July 24, 2000 through September 30, 2008, the Strategic Growth Fund has achieved average annual total returns of 10.76% (with 5-year, 3-year and 1-year total returns, respectively of 6.12%, 3.63%, and 4.18% annually). Meanwhile, the Fund has never experienced a peak-to-trough pullback of even 7%. I'm pleased to note that the Fund's total returns exceed those of the S&P 500 for all of these periods. The Fund's most recent performance chart is updated through September 30, 2008.
That said, my impression is that since the inception of the Fund, both the returns of the Fund and its pullbacks have been smaller than I would expect in an environment of improved valuations. In a more reasonably valued market (and hopefully undervalued at some point), it becomes appropriate and even desirable to reduce or eliminate the extent of our hedging for some amount of time. As always, we accept market risk in proportion to the investment returns that we expect from taking such risk. So a reduction in our hedges would be driven by expectations for both higher returns, but also somewhat larger pullbacks from time-to-time. Controlling volatility and risk is always a priority, but the Strategic Growth Fund is a long-term, risk-managed, equity growth fund, and given a better environment of valuations, I will continue to manage it accordingly.
The essence of good investing is to strike a balance. Over the past several years, balancing risk against potential return has held us to a fully hedged investment stance with few exceptions. I am excited about the possibility of having a bit more flexibility in our market exposure during the next market cycle than we've had in the recent one.
As a side note, I should reiterate that the Strategic Growth Fund is not a "market neutral" fund, as we can, have, and will accept exposure to general market fluctuations in conditions where the return/risk tradeoff has been favorable on average. The Fund is also not a "bear" fund, since the dollar value of our shorts never materially exceeds our long holdings. Other restrictions are that the Fund must operate as a diversified investment fund (no concentrated positions in a handful of securities), that the Fund cannot borrow money to establish leverage (the most we can do is place a few percent of assets into call options), and that the Fund cannot sell short shares of individual companies (we only use index options and futures traded on listed exchanges). I wrote all of those restrictions into the Prospectus by choice, because my intent is for the Fund to be robust to a wide range of outcomes without being overly dependent on a particular investment stance.
Congress Passes the Rescue Plan
On Friday, Congress approved and the President signed the $700 billion plan authorizing the Treasury to purchase distressed assets. Though the second version had some pork in it, it was clearly a better bill than the first. The final legislation also achieved a worthy landmark, which was to place mental health on "parity" with physical illnesses and injuries for the purposes of insurance coverage. Indeed, the financial rescue legislation passed by the House on Friday was actually passed as an amendment to the mental health parity bill authored by Patrick Kennedy and Jim Ramstad.
During the actual vote, one of the financial networks created some confusion by saying that the vote was on the amendments, and there would be another vote on the actual financial rescue bill. That misunderstanding was still not completely settled when the measure passed, which set a confused, anti-climactic tone for the market. At that point, I suspect that investors - unaware that the financial bailout provisions themselves were the "amendments" - began to make inferences from the tepid market action that maybe something was wrong, or that the Fed would need to immediately cut rates as well. Meanwhile, my guess is that traders who had established long positions in hope for a quick market advance on the bill's passage suddenly became frantic to get rid of those positions. By the end of the day, the market had lost more ground, setting a new bear market low.
The late selloff provided us with the opportunity to cover our remaining short call option positions. We can't rule out further weakness, but I would view such weakness at this point as an opportunity to gradually close out a modest portion of our put option coverage - again, perhaps 20-30%. In any event, it is important to stress that the significant majority of the Fund's positions will remain hedged with put options until we observe even better valuations or a distinct improvement in market internals.
In regard to the legislation actually passed by Congress, one of the interesting improvements is that it includes various mandates (loss recovery, executive compensation limits) that are likely to discourage companies from actually using it, while still creating something of a "lender of the last resort" that will help to thaw the capital markets. As I've repeatedly noted, nearly all of these financials - even the distressed ones - have enough bondholder liabilities on the books that customers will be unharmed even if the companies go belly up. The issue has always been one of capital. As long as the capital cushion from shareholder equity is thin, investors have a tendency to pull money out, which forces institutions to sell assets at distressed prices. With the Treasury now a "last resort" buyer of those assets, my hope is that private investors will be more willing to provide capital. Almost certainly, there will be more dilution ahead for financial companies, so we may not observe a particularly extended rebound in that sector. But in any event, the general easing of concerns about another Great Depression should help the markets.
Frankly, I thought the drama and fear-mongering about another Great Depression was ridiculous in the first place. The same financial news anchors and Wall Street analysts that constantly gurgled about the market's resilience and strong fundamentals at the top, and all the way down, suddenly shifted to warning about Depression, economic meltdown, and bread lines - bread lines! - when they saw a big bucket of money that would only become available if the public was scared out of its gourd. Now you'll hear the same chatter until the Fed cuts rates again (which it almost has to do simply to maintain credibility, because the effective Fed Funds rate - which is hovering below 1% - is already so much lower than the 2% target). Call me cynical. This Depression talk is just outrageous - especially from people who didn't have the slightest sense that any of this was coming.
The legislation is certainly an inefficient way to approach the problem, much like setting the kitchen on fire to heat the living room. But in any event, I've repeatedly noted that the "eye of the storm" so to speak, would be exactly where we are now. You could have predicted that based on lagging the reset schedule for adjustable rate mortgages by about 6 months. Though we'll continue to see some fragility, and continued writedowns into 2010, I expect that the center of the storm is now passing in the sense that the foreclosure rate is probably peaking in the current quarter.
My hope is that the Treasury will refrain from offering too high a price for distressed mortgage securities, because this will discourage private markets from competing. Better to offer prices high enough to assure the markets that there is in fact a bid out there for distressed assets, but low enough to encourage private buyers to compete. Just as Wells Fargo's bid for Wachovia (in excess of the arranged Citigroup purchase) immediately helped bank stocks to stabilize, observing the Treasury being out-bid for these distressed assets will do more for the confidence of the financial system than any amount of actual buying will.
In any event, my impression is that the current panic regarding the financial system will, in fact, stabilize as a result of this legislation, despite its inefficient approach.
As of last week, the Market Climate for stocks was characterized by slightly elevated but reasonable valuations, and unfavorable but compressed market action (with features such as an elevated VIX, a breadth capitulation, and falling interest rates which are often followed by sustained bear market advances, even if not new bull markets). In the Strategic Growth Fund, we have covered our short positions in index call options, leaving put option positions that are generally a few percent in-the-money. That gives the Fund a "local" sensitivity to market fluctuations amounting to about 30% of small movements in either direction. That sensitivity will tend to become smaller on any significant market decline (since the put options increasingly offset market declines point-for-point as they move further in-the-money), and will also give us a gradually increasing exposure in the event that the market advances.
That said, the very high level of option volatility as measured by the CBOE volatility index (VIX), combined with the unusually oversold condition of the market, makes such "curvature" fairly expensive. Closing down a portion of our put option coverage will be increasingly reasonable in the event that the market declines further. Again, my expectation is that closing 20-30% of those positions would strike a reasonable balance between expected return and the potential for further downside pressure. In any event, the majority of the Fund's exposure will be hedged at least with put options until we observe significantly better valuations or a broad improvement in the quality of market internals.
In bonds, the Market Climate last week was characterized by unfavorable yield levels and modestly favorable yield pressures. The Strategic Total Return Fund continues to carry a relatively short duration of only 2.5 years in Treasury securities. However, the total return prospects for utilities, foreign currencies, and precious metals have significantly improved, so the Fund has about 30% of its assets diversified across these sectors. For precious metals shares in particular, the Gold/XAU ratio shot to 7.44 by the end of last week - about double its historical norm. Another way to think about this is that the price of gold itself could drop by half and still leave most precious metals shares reasonably valued at current prices.
As with the Strategic Growth Fund, we appropriately reined in our risk exposures in recent quarters and enjoyed positive returns with low volatility as the result. But at some point it is appropriate for investors to accept careful, measured risk as valuations and other pressures shift. Currently, I believe that expected return prospects are higher for alternatives such as utilities and precious metals shares than for Treasury securities, particularly at longer maturities.
As a final note, the frantic attempt to acquire dollars during this panic has had an interesting impact on the U.S. dollar. In recent weeks, U.S. Libor (the interest rate paid on deposits of U.S. dollars at foreign banks) has soared above the Treasury bill rate, pushing the spread between T-bills and Eurodollars (the "TED spread") to unusually wide levels. My impression is that as that bid to acquire dollars at any price subsides, we're likely to see some very abrupt weakness in the value of the U.S. dollar. So part of the evidence of stabilization in the banking system will be an associated plunge in the U.S. dollar and fairly sudden strength in oil and commodity prices. That strength might only persist for a period of several weeks, until further evidence of ongoing recession develops. But over the short-term, greater financial stability will likely have the apparently strange side effect of dollar weakness.
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