Sunday, March 04, 2007

The Correction is Just Starting

If you believe the hype in most of the financial press, the "correction" last week was just the market needing some breathing room, because it got a little ahead of itself. All week, I've been subject to the same nonsense that "fundamentals are good" and that now is the time to go "bargain-hunting" (hmm, stocks were up 15% last year, but a sudden drop of 3% suddenly makes them bargains?) All week, I intended to pen a piece on why this was garbage, but the latest weekly commentary of John Hussman, fund manager of the Hussman Strategic Growth Fund helped explain a lot of what was on my mind (no accident since I'm a HUGE fan of Hussman - reading his weekly commentary is usually a Monday morning ritual for me!)
Needless to say, last week's decline had virtually nothing to do with China. While the decline in China (reflecting similarly overvalued, overbought and overbullish conditions) may have been a catalyst, blaming China for the U.S. decline is like having an open can of gasoline next to your fireplace and blaming the particular spark that sets it off.

What is the issue? It's valuations, silly! But what about those stories talking about how cheap stocks are relative to 2000. First, why is the year 2000, at the height of a ridiculously inflated stock bubble, a benchmark? Going across history, stocks aren't cheap. But they're even less so when you account for the historically high profit margins.

But isn't that touted as a good thing. The graph is courtesy of William Hester of the Hussman Funds, who showed that historical profit margins are rarely sustainable. Also, he showed that investors consistently overpay for those profit margins - the market has returned 3.45% annual return over 5 years when the margins when in the top 20%, and 15.69% when the margins where in the bottom 20%. Value investing - buying when no one else wants to - works!!

Additionally, Ben Inker of GMO, the investment firm that manages high net-worth individuals including Vice President Dick Cheney, points out that the surge in profitability has been in capital-intensive industries (see figure).

Hussman also takes on the popular talking points such as this nonsense of how the M&A boom means that stocks are a value - something I've ranted about previously:
A related theme is the notion that stocks must be good values because of the private equity buyouts we've been observing. It's important to understand that these buyouts are being done with OPM – other people's money – and that the main factor driving them is not low stock valuations but low risk premiums. Risky debt can currently be issued at interest rates barely above the low yields on default-free Treasuries. This will certainly end badly for investors in low-rated credits (as companies that issue sub-prime mortgages are beginning to realize). It is no indication of attractive stock market valuation. Investors should be skeptical enough not to draw conclusions from transactions that use OPM. It's interesting, for example, that analysts wax rhapsodic about corporations repurchasing their shares, while ignoring the fact that sales of personal stock by corporate insiders have rarely been higher (recently at rates of 8-10 shares sold for every share purchased). What people do with their own money is much more informative than what they do with someone else's.

So what's an investor to do? Ignore the press. Pare down stock allocations to no more than 50%, load up on high-quality debt (using a bond fund for most readers), focus on quality in stocks (harder to do if you use a mutual fund) and bonds (low duration, Treasuries or investment-grade). An investor is simply not being paid enough to take risk, as this chart from GMO shows.

1 comment:

Sowmiya said...

I chanced upon your blog. Jeez! Hard core nerd eh? I am one too. Plus a ardent Foodie and hence my blog. Keep up the serious stock market news! Cheers