A week ago, I was reading “Decidedly Speculative” by John Hussman, who writes as well as anyone about analyzing the stock market as a whole. Here are a few excerpts:
As of last week, the S&P; 500 nearly matched the richest valuations, on normalized earnings, ever observed prior to 1995. While it is quite true that valuations have been higher for the majority of the period since the late 1990’s, it is equally true that the total return of the S&P; 500 over that period has been dismal.
Undeniably, stocks are still “cheap” compared to the record overvaluations of 2000 and 2007. In order buy stocks on that basis, investors must accept the prospect of unsatisfactory long-term returns in any event, but they are free to speculate as long as they are willing to treat 2000 and 2007 as normal, and to rely on the market pressing to even greater overvaluation in order to achieve satisfactory near-term returns.
It is also true, however, that market valuations since 1995 have been distinct outliers from a historical perspective (as are the disappointing overall returns). That does not imply that near-term returns must be negative. While we continue to observe weak sponsorship from a volume perspective, flattening momentum, increasing non-confirmations, and some early pressures in yields and credit spreads, we have not observed sharp internal deteriorations at this point. As a result, it is unclear whether or not investors will continue to speculate for a while. Even so, it is already evident that the longer-term outcome of risk-taking here will almost undoubtedly be unrewarding.
In short, any virtue of stocks here is decidedly speculative. Stocks are overvalued to a level from which uninspiring returns have always followed. That fact is true regardless of whether or not the economy is in a sustainable recovery.
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As part of our ongoing attention to what I’ve called “second wave” credit risks, we’re just beginning to hear concerns about fresh credit problems, foreclosures and loan losses from other corners. A few of these concerns are from particularly credible voices, which makes us feel, well, slightly less alone in our analysis.
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“I think that first quarter of next year we’ll see a new wave of foreclosure activity. Delinquencies have been going up – we have five and a half million homeowners who are late on their mortgage payments right now, and many of those, under normal circumstances, would have already been in foreclosure. But the Treasury is asking lenders to make doubly sure that anybody who qualifies for the HAMP program or other modification program gets in those programs. We think we’ll probably hit the historic peak next year, in 2010, as a lot of the Option-ARM loans reset, as unemployment related foreclosures peak, before numbers finally start to settle down a little bit in 2011. We’re expecting the first quarter to be pretty ugly.”
Striking a similar chord, on Tuesday, Meredith Whitney appeared as the guest host on CNBC’s Squawk Box. Whitney was one of the few Wall Street analysts who foresaw the recent credit crisis, and also anticipated what I’ve called the “March-November 2009 lull” in credit difficulties. Having been generally positive on the financials since the first quarter, she recently became quite negative. At the end of the broadcast, when asked to end on just one short, positive note, she replied, “The Blind Side was an amazing movie.”
Whitney noted, “In the second quarter, you had banks recapitalizing themselves with huge equity volumes, you had a lot of write-ups throughout the year, but the core loan books have been declining dramatically, so what’s left? The toxic assets have all been written up. There’s a very limited cash market for them. You would never know about the degradation in asset quality (of loans backed by Fannie Mae) because the government has been buying the paper. The paper has never traded higher. There’s still time (for toxic assets to become a major problem again). They have to because there are not cash flows to support the payments on those bonds, and the bonds will break covenants. What’s happening is that the banks are going to have to start selling stuff, and so you’ll start seeing a yard sale to raise capital.”
One of the main concerns Whitney expressed was the collapse in credit availability. “In the last cycle in the early 1990’s, the economy slowed and banks stopped lending but the securitization market was really getting started, so consumers actually had more liquidity. Now, consumers and businesses are being stuck by – banks aren’t lending and there’s no securitization. So you haven’t had this amount of credit contraction. There has been a trillion and a half of credit taken away from credit card lines, and that is accelerating with all the regulatory changes. So the numbers just aren’t big enough from a government standpoint to mitigate the decline in credit, which is ultimately going to influence behavior. The component parts do not add up. You cannot get to a robust economic recovery with so many states under duress.”
Looking forward to next year, Whitney warned of a 2010 outlook “which is so disturbing on so many levels to have so many Americans be kicked out of the financial system, and the consequence both political and economic of that is a real issue – you can’t get around. It’s never happened before in this country or in the modern economy. The biggest trend in 2010 will be seeing who gets kicked out of the banking system.”
I agree with what’s being said, however, keep in mind that while this type of analysis is an interesting read, it is not a good timing indicator. While you may have heard similar views, they are merely an opinion has to what may come down the pike at some point in the future.
I have received some reader feedback based on similar articles asking how to best prepare (their investments) for the inevitable changes that may come about. Again, the only thing that’s real as far as investments are concerned is the closing price and the trends you can identity by charting price action—everything else is simply a guess or an opinion. owevhowever
Don’t confuse those two. You can read an opinion, but use the development of trends as an indicator as to where momentum for a particular sector is headed. While that does not guarantee a successful outcome of an invested position (nothing ever does), I believe that it increases your odds of a positive transaction more often than not.
Furthermore, it does not require any interpretation of well written facts on your part, such as stated in the above article, but merely requires you to jump aboard when upward momentum indicates you should.
Following trends, such as I advocate, will simplify your investment life and, when used in conjunction with my recommended exit strategy, will let you sleep better at night because you have a plan in place to control the ever present market uncertainties.