William
Hester, CFA is a Senior Financial Analyst with theHussman
Funds, and he
has written an interesting article that attempts to answer the
question: "does the
current economic backdrop yet have the characteristics that usually
coincide with the end of secular bear markets?"
I have
sought answers to a similar question, and this has led to the
development of the "next big thing" indicator, which attempts to
quantify those technical characteristics seen at market bottoms
just prior to secular trend changes. I have written enough in these
pages aboutthe proper
launching padand having
tailwinds not headwinds.
I believe
Hester's real insight is the link between valuations and investors
willingness to pay for those valuations. If investors are certain
about the future (albeit based upon
recentpast
experiences), then they are willing to pay up for equities.
Investors believe the good times will continue, and this is how we
get bubbles. If investors are uncertain about the future, then they
need lower valuations. Investors perceive that the bad times will
continue, and within this period of uncertainty, valuations are
driven lower and markets bottom.
To measure
investors' "comfort level" with the economy, Hester uses the
volatility of inflation. In his own words, Hester states:
It's not
only the level of volatility and uncertainty in the economy that
matters to investors, but also the trend and the persistence in
this uncertainty. Shrinking amounts of volatility in the economy
creates an environment where investors are willing to pay higher
and higher multiples for stocks, while growing uncertainty brings
lower and lower multiples.
One of
themes that appears to be on investors' minds is inflation. Even
though inflation, as measured by year over year CPI, is low,
investors
perceiveinflation
to be a threat as we have rising deficits, a government willing to
"bailout" all those who fail, and a government willing to avoid
today's pain and "kick the can" down the road, and world central
banks willing to devalue their currencies to gain a competitive
advantage.
To assess
inflation, I have developed a composite indicator that looks at the
trends in gold, crude oil, and yields on the 10 year Treasury. When
these trends are strong and rising as they are now, equities tend
to under perform. Previously, I had shown this in the article
entitled,"More
Headwinds To Worry About". Going
back to 1985, when these trends were strong, equities
underperformed - even during the bull market of the 1990's and
particularly from 2004 onward.
But let's
get back to Hester. He states that"it's
important to note that during the current secular bear market, the
volatility of inflation has mostly been well contained."The value
is less than those seen at past bear market bottoms, but the trend
is rising.
"Valuations going forward may show their typical sensitivity to
economic uncertainty, and for this reason, the change in the slope
of the volatility of inflation over the last two years is
troublesome. The level of inflation volatility is still low,
relative to the peaks reached during prior secular bear markets. If
the level of inflation volatility continues to increase, it will
become more difficult to argue that the secular bear market has
come to an end."
To
summarize by answering his own question from above -does the
current economic backdrop yet have the characteristics that usually
coincide with the end of secular bear markets? - Hester
states:
"...secular bear markets of last century shared three
characteristics. They each lasted for more than 15 years, they each
ended at extremely attractive levels of valuation (generally about
7-9 times trailing 10-year earnings), and , and they each endured
many years of growing volatility in output and inflation, which
eventually created the mindset for investors to price stocks at
attractive levels of valuation. The current secular bear market can
claim none of these characteristics yet."
So how can
we use this information? Inflation concerns are legitimate, and the
uncertainty of inflation is a headwind. How much so? Let's meld our
inflation indicator with theFaber
strategy. We will
use our inflation indicator as a filter in that no new positions
will be established or current positions will be exited when the
inflation indicator is in the high inflation zoneas it is
now. See
figure 1 a monthly graph of the S&P500 with our inflation
indicator in the lower panel. One note, in the original articles on
this indicator, I utilized the trends in crude oil, gold, and
yields on the 10 year Treasury bond to construct our indicator. In
this article, I replaced the crude oil data with data from the
Reuters - CRB Index as this data set goes back to 1971; doing this
does not affect the results of this study.
Title: Inflationary Pressures Are A
Posted by ravun on 30th of Jun 2009 at 05:31 pm
William Hester, CFA is a Senior Financial Analyst with the Hussman Funds , and he has written an interesting article that attempts to answer the question: " does the current economic backdrop yet have the characteristics that usually coincide with the end of secular bear markets?"