Entire contents copyright 2003, John P. Hussman Ph.D. All rights reserved and actively enforced.
Brief excerpts from these updates (no more than 1-2 paragraphs) should include quotation marks, and identify the author as John P. Hussman, Ph.D. A link to the Fund website, www.hussmanfunds.com is appreciated.
Sunday September 28, 2003 : Weekly Market Comment
Copyright 2003, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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New information can't be predicted
One of the reasons that I don't make market forecasts is that I rarely have confidence about which Market Climate we will identify even a few weeks into the future. So our approach is to align ourselves with the prevailing Market Climate (the combination of valuations and market action at any particular point in time), and to change our position when there is a change in Market Climate.
Our measures of market action are driven by new information, and new information can't be predicted. New information is the portion of the "news" that could not have been anticipated based on information already in hand. Statistically speaking, there are "decomposition theorems" assuring that if we process the data right, today's data can be written in terms of past surprises, plus the current surprise ("mutually orthogonal innovations"). The "random walk theorem" is a trivial version of this, saying that the entire change between yesterday's price and today's price is one of those surprises. The Buddha put it more generally: The present is made up of the past. The future will be made up of the present. If we look deeply into the present, we can see the past, and we can find the best actions to take care of the future.
Investors are very aware of this concept as it applies to earnings and economic reports. The "new information" in these reports is the portion of that news that was unanticipated. It's the surprise that contains the new information.
Similarly, when we analyze market action, the information is contained in divergences that are "out of context." If Treasury bond prices are rising, and corporate bond prices are also rising, you've got interest rate information. But if Treasuries are rising and corporates are falling, the divergence gives you information about bankruptcy risks.
At present, I have no idea when or whether the Market Climate will shift to an unfavorable condition. Still, we are beginning to see which divergences would move us to a defensive position most rapidly. Right now, the worst market action would not be a further broad decline. Rather, the worst action would be substantial strength in the S&P 500 and other large-cap indices not reflected in the broad market. This outcome would be particularly negative if it occurred on dull volume, weak breadth (advances vs declines) or eroding leadership (new highs vs new lows).
To put it another way, the fastest way that investors could signal a substantial increase in their aversion to risk would be to drive up large blue chip stocks in a relatively narrow advance. With risk premiums very thin here, any indication of increased risk aversion by investors would be a very strong warning signal. Something to watch.
Tag, you're it
Last week, I noted that performance chasing appears to have been an important element during the recent market advance Michael Santoli's latest column in Barron's supports the belief that this performance chasing was also an important element of last week's decline (the S&P 500 lost -3.81%, while the Nasdaq dropped -5.96% and the Russell 2000 fell by -6.71%):
"The tempting conclusion suggested by last week's losses is that portfolio managers' performance anxiety is now manifesting itself in different types of behavior. While the zeal to grab a fair share of the market's upside has for months spurred the pros to chase the highly valued market leaders, last week there were hints that money managers were eager to preserve their gains..."
"If indeed investor psychology is beginning to take on a more defensive cast, then larger, more stable stocks might be expected to grab the lead, at least temporarily, from the long-shot, highly leveraged bets that have been rewarded for some time now... stocks with high-quality earnings and attractive valuations [have] underperformed the market since its March low. In examining past periods back to 1966 when this quality screen has trailed the market this badly, its laggard behavior tends to last five or six months before rebounding strongly. It's been just over six months this time."
The one word that I am concerned about in that quote is the word "larger." If a broad group of attractively valued, stable growth stocks - across a wide range of capitalizations - begins to perform well, great. Greater traction from those stocks would be very welcome. Indeed, recognition of quality and value by investors is generally how our bread is buttered. In contrast, if the market's leadership in the coming weeks becomes isolated solely to large blue-chip safe-haven names, the heightened activity might turn out to be the last gasp.
In the economy, the recent surge in the Japanese Yen was important. I've noted frequently that periods of softer economic growth were likely to have their onset with weakness in the U.S. dollar. We're already seeing initial signs of this. In recent weeks, there has been a marked shift from U.S. economic reports coming in better than expectations and toward reports that are worse than expectations. In its report to institutional investors, Bridgewater occasionally releases its "economic surprises index", which is something of an advance-decline line tallying whether various economic indicators have come in better or worse than expected. After inexorably rising for months, this index has abruptly turned down. Again, something to watch.
The Market Climate for stocks remains characterized by unusually unfavorable valuations and modestly favorable market action. Our fully invested position in individual stocks is just over 50% hedged against the impact of market fluctuations. Again, the most negative development for stocks here would be a sharp advance in the large blue-chip indices, without an equivalent follow-through in the broad market. For now, we remain positioned to gain primarily from market advances. We may forego a portion of short-term returns as a result of our moderate defensiveness here, but as I noted a couple of weeks ago, there's no historical reason to believe that defensiveness at these valuations will compromise long-term returns. Quite to the contrary.
In bonds, the Market Climate remains characterized by modestly favorable valuations and modestly favorable market action. With the recent rally in long-term bonds, valuations are near the cusp of becoming unfavorable once again. A further revaluation of Asian currencies also threatens to reduce buying activity in U.S. Treasuries by foreign governments. At the long end of the yield curve, the outcome is uncertain. Lower foreign buying interest would be unfavorable, but the attendant economic weakness could soften the blow to long-term bond prices. At the short end of the yield curve, I would expect that slower foreign capital inflows would take precedence. For this reason, any shift in the yield curve ahead will most likely be a flattening, with short and near-term yields rising - possibly substantially - while long-term yields rise less or remain stable.
As usual, we don't rely on such forecasts. Given the current, observable status of the Market Climate in bonds and the current status of the yield curve, our holdings in the Total Return Fund include very little in the way of intermediate bonds. Our position is instead split between short and long maturities, with an overall portfolio duration of just over 5 years. That is, a 100 basis point change in (long term, at this point) interest rates would be expected to impact the value of the Fund by just over 5%.
In gold, there's some potential for U.S. dollar weakness to translate to higher gold prices, and possibly even to higher gold stock prices. But investors should not rely on this translation being direct or instantaneous. Until we see an actual shift to economic contraction (watch for an ISM Purchasing Managers' Index below 50) and the feedback of more expensive import prices on the CPI (all of which could take a few months) it's not clear from a historical perspective that we've got enough factors in place to warrant fresh exposure to gold market risk just yet. That's not an argument for long-term investors in precious metals shares, but it's an important comment to investors inclined to "chase" gold stocks. Given their volatility, it is greatly preferable for precious metals investors to build positions on weakness rather than strength. Gold stocks generally aren't a rewarding group to buy on "technical breakouts" and such. At present, we remain on the sidelines here, having liquidated our positions on strength a few weeks ago. We do accept the risk of remaining on the sidelines in the event that gold advances strongly from here. But again, we don't have the evidence to place assets at risk on the basis of that possibility. Suffice it to say that we'll be quick to reestablish positions on weakness in gold stocks, provided it is accompanied by identifiable signs of fresh economic contraction. For now, we don't have enough of this evidence in hand.
Sunday September 21, 2003 : Weekly Market Comment
Copyright 2003, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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The big picture: speculative merit without investment merit
At least brokerage analysts are entertaining. When they are intent on recommending stocks in an overvalued market, they just can't bring themselves to say that stocks are overvalued and that they're willing to take market risk for speculative reasons. Instead, they create new and theoretically unsound definitions of "value" in order to justify their case. The Fed model and its variants are one class of these models. P/E and other valuation multiples based on "operating earnings" (which deduct neither interest owed to bondholders nor taxes owed to the government) are another.
Here, we take a different approach. If stocks are overvalued by sound measures, we say that they are overvalued. Historically, valuations have a great deal to do with the long-term return that an investor can expect. But in themselves, valuations are weak tools for navigating the markets over shorter periods. When we look back over a century of market history, it is clear that there were many periods of overvaluation when stocks continued to advance for months or even years, and other periods of overvaluation when stocks plunged dramatically. In our work, the best way to distinguish these periods is by examining the quality of market action accompanying these valuations. Combinations of overvaluation and favorable market action tend to be accompanied by resilient markets; though valuations are high, investors are so eager to own stocks and take risk that these valuations become largely - though only temporarily - irrelevant. Combinations of overvaluation and unfavorable market action (particularly a pattern of internal divergences and breakdowns across a variety of industries and security types) tend to be accompanied by very poor returns.
In any event, it's clear that the willingness to take market risk need not be based on investment merit (undervaluation), but can be based solely on speculative merit (favorable market action). That's the situation we've had in recent months, and we've been content to take a moderate amount of market risk on that basis, without resorting to intellectually dishonest analysis of valuations ("This stock looks attractive based on projected 2006 operating earnings..."). The attendant responsibility, however, is to carefully monitor the quality of market action.
To put this in the context of risk premiums, we're willing to take market risk even when it is priced to deliver a fairly low long-term return, so long as investors appear willing to take on even greater levels of market risk. We read that willingness out of market action. In contrast, there is little sense in accepting low risk premiums when investors are becoming skittish about risk. That's when plunges occur. At present, we're not in that situation, but it is essential to monitor the character of market action for subtle breakdowns that might signal increasing skittishness among investors.
As of last week, the Strategic Growth Fund continued to hold a nearly fully invested position in favored stocks (as we always do regardless of market conditions). Of course, these stocks are affected by fluctuations in the overall market. To reduce this impact, we held an offsetting short sale in the S&P 100 and Russell 2000, intended to remove over half of our exposure to market fluctuations.
Given that position, it should be clear that market internals displayed some unusual divergences last week. Specifically, we didn't participate as much in advances as one might have estimated from our net market exposure, yet the Fund also tended to gain value on market declines.
Here's what's going on. In recent sessions, market advances have been increasingly dominated by two groups - speculative growth stocks, and financials. Both of these groups receive relatively low weight in our holdings. So that strength doesn't filter through to our own returns. In contrast, market declines have been increasingly accompanied by a flight to safety in value and stable growth stocks. On those days, our returns have been better than one might have predicted by looking at our "net" market exposure.
Historically speaking, these divergences between speculative growth and stable value have not tended to work out well for the market. Periods like this can last for weeks or even months, but they tend to be associated with what are often seen in hindsight as "blowoffs." To the extent that we're also seeing the heaviest ratio of insider selling to buying in 17 years, and a surge in Nasdaq margin debt (see Alan Abelson's latest column in Barron's), it strikes me that there are a whole lot of investors out there who are intent on getting back to even, quick. Performance-chasing has evidently become an important feature of the stock market here. That's a dangerous goal to have in an overvalued market.
The importance of measuring growth from peak-to-peak
As I've frequently noted, investors should rarely put much faith in growth rates that are measured from trough-to-peak or from peak-to-trough. This is true regardless of whether one is measuring earnings growth, economic activity, or investment returns. The most robust estimates of true growth are derived by measuring from peak-to-peak or from trough-to-trough across market cycles.
For example, measured from the trough of a recession to the peak of an expansion, earnings growth can often seem breathtakingly high. Investors who extrapolate those growth rates and price them into stocks can find themselves paying profoundly high valuations, with equally profound disappointment as those expectations prove incorrect. Measured from peak-to-peak across economic cycles, S&P 500 earnings have grown no faster than 6% annually over the past 10, 20, 50 or 100 years. Similarly, it is enticing to extrapolate the strong performance of, say, the Nasdaq from the October low to the recent highs. But this calculation implicitly assumes that an investor has extraordinary timing ability; that the investor could purchase at the exact low of the Nasdaq and hold to its high. We don't believe that markets can be timed in this manner.
It is both more realistic and more robust to measure growth and performance from peak-to-peak or trough-to-trough. These peaks or troughs should preferably span several market cycles, but at minimum, the peaks or troughs should be at least a few quarters apart.
To us, a good investment approach is one that performs well from peak-to-peak without intolerably deep drawdowns in the interim. The goal of the Hussman Funds, for example, is to substantially outperform the major indices over the full market cycle - from one bull market peak to the next (or one bear market trough to the next), with smaller periodic losses than a buy and hold approach would have produced. I think that's a reasonable objective, and it's largely equivalent to targeting both high return and high risk-adjusted return.
My students were always happy to be tested on the same material that they learned. Similarly, we're always happy to be evaluated on the same criteria that we target. For us, those criteria are full-cycle return (bull market plus bear market), and return per unit of risk, measured over any reasonably extended period of time. Unless an investor can reliably call market peaks and troughs in real-time, evaluating our approach by asking whether we match the trough-to-peak performance of highly volatile indices is to thoroughly miss the point.
Even looking at shorter periods than a full market cycle, the analysis of peak-to-peak returns can be instructive. For example, consider the total return of the S&P 500 (including dividends). Friday's close (September 19, 2003) on the S&P 500 was the highest level seen over the most recent 12-month period. During the preceding 12-month period, the highest point for the S&P 500 was achieved on March 19, 2002. Between these two peaks, however, the S&P 500 actually lost -9.1%. Over the identical period, the Strategic Growth Fund gained 24.6%. Turning to drawdown losses, the S&P 500 suffered a decline of -14.3% following the March 19, 2002 peak, on the way to its October 2002 low. The total return of the Strategic Growth Fund has not moved below its March 19, 2002 value at all.
Again, we're still fairly constructive, but hand in hand with our willingness to take market risk is the willingness to constantly monitor the quality of market action. Our ability to defend capital is best when we are willing to build defenses on the basis of subtle deterioration, before the need for defense is clear from broad and obvious weakness.
Smoke without fire
On the economy, there's still a strong likelihood that growth in the second half will be faster than we've seen in several years, but there's still very little evidence of sustainable improvement. The "surprisingly good" data on new claims for unemployment that sparked Thursday's rally barely dropped below the 400,000 level, and the 4-week average actually moved up to the highest level since mid-July. Other early indicators of labor market improvement remain anemic, including flat weekly hours worked and only modest improvement in the hiring of temporary workers. On the capital investment side, the latest data on capacity utilization came in flat once again, at a weak 74.6%.
Most likely, we'll see some improvement in capital spending. But as I've frequently noted, all investment must be financed out of savings. Given deep current account and fiscal deficits, and the fact that the majority of earnings "growth" we've seen is actually the result of layoffs (which tend to depress personal savings) and the absence of massive "extraordinary" losses of a year ago, the prospects for a boom in domestically available savings are very weak. As a result, any growth we see in capital spending is likely to be matched by contraction in other forms of investment - primarily housing.
[It may seem that fiscal and monetary policy can change the savings investment identity, but in equilibrium they do not. Monetary policy doesn't increase savings - it simply changes the mix of publicly held government assets from government debt to monetary base and vice versa. To see why the savings-investment identity must hold, think in terms of real output. Consider an economy that produces goods either for consumption or investment. What is savings? Output minus consumption. What is investment? Output minus consumption. S = I by definition. The same holds true even if we introduce more complications into the economy.]
As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and moderately favorable market action. The diversified portfolio of stocks held by the Strategic Growth Fund was slightly more than 50% hedged against the impact of market fluctuations.
The Market Climate for bonds remained characterized by modestly favorable valuations and modestly favorable market action. The Strategic Total Return Fund continued to hold an overall duration of about 6 years (that is, a 100 basis point change in interest rates would be expected to affect the value of the Fund by approximately 6%).
Past performance is not predictive of future returns. For the one year period ended June 30 2003, the Hussman Strategic Growth Fund earned a total return of 11.25%, compared to returns of 0.25% and -1.64% for the S&P 500 Index and the Russell 2000 Index, respectively. From inception on July 24, 2000 through June 30, 2003, the Fund earned a total annualized return of 18.83%, compared to annualized returns of -11.65 and -3.18 for the S&P 500 Index and the Russell 2000 Index, respectively.
Performance calculations do not reflect the deduction of taxes a shareholder would pay on Fund distributions or the redemption of Fund shares. For a Prospectus containing more complete information about the Hussman Funds, including charges and expenses, please call 1-800-HUSSMAN (1-800-487-7626), or visit our website at www.hussmanfunds.com. Please read the Prospectus carefully before you invest or send money. The Distributor of the Hussman Funds is Ultimus Fund Distributors, LLC.
Sunday September 14, 2003 : Weekly Market Comment
Copyright 2003, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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First, do no harm
There's a teaching that when an action intended to help a situation has the result of making it worse, it is because the action was not grounded in right understanding. The lunacy of U.S. policy toward China continued this week, with a punitive CHINA act being proposed in the House by legislators who evidently have no idea how the U.S. economy works. The simplistic notion is that by forcing China to make its currency more expensive, competition from "cheap" imports will be reduced, and U.S. manufacturers will thrive.
Economic activity is not a one-sided phenomenon, but an exquisitely complex equilibrium that allocates resources among countries and individuals. Still, an understanding of a few simple truths can often get to the heart of the matter. One of these is that a substantial portion of what we "import" from China actually represents outsourced production of U.S. firms. This is precisely why the unusual "productivity growth" in recent years has been found not in technology, but instead in seemingly odd industries such as retail and wholesaling. What we observe as productivity growth is the maintenance of reasonably high final output at lower prices and with less labor input. Want to shut down this productivity growth? Shut down trade in manufactures and intermediate goods from China.
Equally important is that nearly half of all publicly held U.S. Treasury securities are owned by foreigners, the largest buyers being Japan and China. At present, the U.S. exports far more securities to foreigners than it imports, which is what we call a "capital account surplus." This surplus on capital account is the mirror image of our whopping "current account deficit." In other words, if the U.S. imports $100 of goods, but only exports $70 of goods in return, we must be exporting $30 of other stuff, and that other stuff is securities. So we run a $30 current account deficit, offset by a $30 capital account surplus. That $30 represents savings imported from foreigners, which we use essentially to finance our economic activity here in the U.S.
Now, it might be tempting to think that we could shut down that current account deficit by forcing foreigners to revalue their currencies (driving import prices higher, and the value of the dollar lower), in an attempt to induce foreigners to buy more goods from the U.S.. Of course, this would be hostile to both consumers and businesses that benefit from inexpensive imports, and would be both inflationary and quite literally counterproductive. At the same time, there is little probability that this move would trigger a substantial increase in foreign buying of U.S. goods, certainly not by Asian trading partners who have a cultural tendency to run extraordinarily high savings rates. Any attempt to abruptly revalue the currencies of our trading partners (taking away their incentive to support the U.S. dollar through their securities purchases) must result in simultaneous shocks to both the current account and the capital account. Specifically, the flow of foreign savings into the U.S. would plunge, shutting down the capital account surplus, accompanied by a plunge in U.S. domestic investment and import consumption which would shut down the current account deficit. In short, the quick way to "fix" a trade deficit and bring it into balance (and the way that it has typically occurred historically) is for the U.S. to suffer a deep recession, with U.S. gross domestic investment being the primary casualty.
There's no chance that the Chinese will allow the yuan (renminbi) to be fully convertible into U.S. dollars, and the U.S. wouldn't want them to, because this would produce immediate capital flight by Chinese savers into dollars, further strengthening the dollar and cheapening the yuan - exactly the opposite of what the U.S. wants. So it's both misleading and moot to talk about "freely floating" the yuan. It won't happen. Rather, the U.S. is attempting to force China to accept an abrupt revaluation, by changing the official rate at which the yuan is pegged to U.S. dollars. This sort of abrupt shift would be a mistake.
Recessions are an unavoidable part of economics, but it takes major policy failures to produce depressions. It's one thing to take an offensive stance toward international trade when you're running nearly balanced trade. It's another matter to do so when your country is more dependent on foreign capital inflows than ever before in history. I've frequently noted that as our record current account deficit adjusts to more sustainable levels, we can expect U.S. investment and consumption growth to be slower in the coming years than is typical. That's a predictable outcome, but is not particularly dire. Unfortunately, ill-conceived economic policy could easily turn this somewhat benign long-term risk into an immediate and damaging liquidity crisis. As we work off the excesses of our nation's consumption and investment binge, our policy makers seem eager to follow the road sign that reads "fastest route possible." They fail to understand that this is a road that goes directly over the edge of a cliff. No shock absorbers are that good. We would do better to take the slower, scenic route.
Meanwhile, stock prices have now fully anticipated a strong recovery in the economy. With the S&P 500 now trading at over 19 times prior peak earnings, stock prices now reflect the same valuations seen in 1929, 1965, 1972 and 1987, exceeded only in the advance to the 2000 extreme. On any other measure than earnings, valuations are higher than any prior peak except 2000. Of course, the argument is that current multiples are justified by low interest rates and inflation, but this argument relies on excluding all data prior to 1965, when interest rates and inflation were regularly lower than they are today. It also relies on the assumption that interest rates, inflation, and valuations will remain at current levels into the indefinite future - not just 2 or 3 years, but forever. A failure of this assumption even a decade from today would result in weak or even dismal total returns in the future. For example, even if S&P 500 earnings quickly recover all of their lost ground and grow along the very peak of their long term earnings growth channel forever, a return toward normal historical valuations even a decade from now would be associated with total returns of just 3-5% annually on the S&P 500.
Vickers reports that the pace of selling by corporate insiders (relative to buying) has accelerated to the highest level in 17 years. Market action has begun to show subtle signs of distribution, with rallies increasingly occurring on dull trading volume while declines occur on expanding volume. Meanwhile, advisory sentiment remains quite bullish. All of these are background indications that in themselves do not reverse the moderately favorable implications in overall market action, but these early indications are worth watching.
The housing market has also been uncharacteristically strong. The Economist reports that the ratio of home prices to rents - a sort of P/E ratio for housing - is a steep 18% over its 25-year average. These deviations tend to be corrected by changes in housing prices over the following 4 year period. Again, low interest rates seem to be a natural explanation, but as the Economist points out, interest rates are not unusually low in real inflation-adjusted terms, and this is what matters. "Initial interest payments may seem low in relation to income, but inflation will not erode the real burden of debt as swiftly as it used to. So in later years, mortgage payments will absorb a bigger slice of a borrowers income than when inflation was higher."
With valuations fairly rich in both the stock market and the housing market, we turn to the current economic picture. Recall that the NBER has dated the end of the recent recession at November 2001. In other words, the economy has been in an "expansion" for nearly two years. By this point, and certainly as implied by the financial markets, even lagging indicators such as employment should have improved significantly.
It is somewhat uncomfortable to refer to the current economic situation as a recovery at all. Every past economic expansion has begun with a current account surplus. With one exception, every economic expansion has also been accompanied by a quick surge in capacity utilization and help wanted advertising (indications of demand for capital and demand for labor). The exception was the brief 1980 "recovery", which was promptly followed by a second and much deeper recession. In 1980, we saw surges in consumer confidence, the Purchasing Managers Index, and the index of leading indicators (which is largely based on indicators such as interest rates, stock prices, and money growth). Still, weakness in capacity utilization and help wanted suggested a sluggishness in demand for capital and labor that belied favorable sentiment and monetary indicators.
At present, the U.S. current account is the most negative in history. Capacity utilization remains at its lows, and the help wanted index has drifted steadily downward. It is lower today than it was the end of the recession.
In short, sentiment says recovery, but there is an increasing failure of real indicators to confirm these expectations in any meaningful way. While we do expect good economic strength in the current quarter and through year-end, the data should be improving much more than we've seen to date. Information is always in the divergences, and the information we're observing on the economy is not encouraging. There's still potential for improvement, and our measures of market action continue to hold us to a constructive position. Still, given the uninspiring fundamentals for the economy and stocks in general, there's a limit to how far and how long they can swim against the current.
The Market Climate for stocks remains characterized by unusually unfavorable valuations and modestly favorable market action, holding us to a moderately constructive position. As of last week, about 2/3 of our stock holdings in the Strategic Growth Fund were hedged against the impact of market fluctuations, leaving us with a positive but comfortably limited exposure to market movements. As usual, this position does mean that we risk missing out on a portion of short-term rallies that might occur. However, this possibility has not historically created risk to long-term returns. To the contrary, the ability to limit market risk during periods of substantial overvaluation would have historically added to long-term returns, relative to a strategy always exposed to market risk. Not that we'd recommend the following strategy - selling the S&P 500 at 19 times peak earnings, sitting tight in T-bills, and repurchasing stocks only when the market reaches 15 times peak earnings - but doing so from 1945 to the present would have generated a final balance twice what a buy-and-hold approach would have delivered. In pre-1945 data, the results would be even better by waiting until stocks hit 7 times peak earnings. Though we saw stocks decline to similar multiples in 1974 and 1982, it's clearly not optimal to require such deep plunges in post-1945 data. In any event, the point is that avoiding market risk at extreme valuations simply doesn't cost investors long-term returns.
In bonds, the Market Climate remains characterized by modestly favorable valuations and modestly favorable market action, also holding us to a constructive position. As of last week, the Strategic Total Return Fund had an average portfolio duration of about 6.2, meaning that a 100 basis point change in interest rates could be expected to impact the Fund's value by about 6.2%.
Sunday September 7, 2003 : Weekly Market Comment
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The more I reflect on the current economic environment, the more I come back to the concept of interdependence, or more precisely, the interbeing of things. The notion of interbeing rejects the idea that anything has a truly separate self. Rather, "self" is really made of non-self elements; every thing has origins, every action has consequence. This is because that is; this is not because that is not. The idea is inherent in the koans "How many elephants are in this blade of grass?" and "What is the sound of one hand clapping?"
In economics, we have a similar notion called "general equilibrium." It is a much more demanding view of economics than the "partial equilibrium" analysis practiced in most research. In partial equilibrium, the essential qualifier is ceteris paribus - other things being equal. Partial equilibrium allows us to examine the effect of a change in the supply or demand in a given market, on the assumption that other conditions in the economy are held constant.
In general equilibrium, that qualifier is dropped. Everything is analyzed as part of an interdependent system in which changes in one market affect all the other markets. Rather than the simple partial equilibrium condition "supply equals demand," general equilibrium approaches look for a solution to a whole system of interrelated equations derived from preferences, technology, profit maximization, utility maximization, budget constraints, and market clearing in the markets for labor, capital, output and financial assets.
Only partial equilibrium thinking allows statements like "Money is going out of Treasuries and into stocks." General equilibrium looks closer and recognizes that if bonds are being sold by Mickey, they have to be bought by Nicky; if stocks are being bought by Mickey, they have to be sold by Ricky. So in order to understand what is happening, we have to know more than Mickey's actions. We also have to know how eager Nicky and Ricky are to make these trades. It is the general equilibrium between stock, bond, and money markets that determines whether Mickey's trades will result in higher or lower stock prices, higher or lower bond prices, higher or lower short-term interest rates.
In fact, Mickey's selling Treasuries and buying stocks may not be associated with lower bond prices and higher stock prices at all. Suppose that these trades are in response to new bankruptcy risks, making Ricky frantic to sell stock, and Nicky frantic to buy Treasuries, while Mickey thinks that the entire response is overblown. In that case, Mickey's selling bonds and buying stocks would be accompanied by higher bond prices and lower stock prices. In every case, you have to know who are the other agents in the general equilibrium and which one is most eager in order to understand the outcome properly.
General equilibrium leads directly to the law of unintended consequences. It is what creates a health care crisis from a small wrinkle in the tax code. Specifically, by allowing full deductibility for employer-provided insurance from all income and payroll taxes, yet little deductibility of costs borne at the personal level, there is enormous bias toward full, employer-provided insurance, creating an all-you-can-eat health care system where prices fail to provide any effective constraint on demand.
General equilibrium is why there is no such thing as government stimulus, assuring that fiscal and monetary interventions must always take the form of redistributions and reallocations, which are only stimulative if those policies ease some constraint that is binding. General equilibrium is why the currency and government securities produced by these reallocations represent not aggregate wealth, but claims of some members of society on the future production of others. (This is also why Robert Barro, not Eugene Fama nor Kenneth French, ought to receive the Nobel Prize in economics.)
Then again, there's no harm in ignoring insignificant things like the price of tea in China, is there?
Why the single most important risk to the U.S. economy is the price of tea in China
With general equilibrium in mind, I want to go back to a little-recognized risk that could quickly throw the U.S. economy into a deep recession: abrupt revaluation of the Chinese yuan (renminbi). I first discussed this risk in a July article called Freight Trains and Steep Curves, and again in the Annual Report of the Strategic Total Return Fund. Last week, Bill Gross of Pimco echoed these concerns in his September commentary, which is worth reading.
Though I discussed the risk that an abrupt revaluation of Asian currencies would have, I also viewed that risk as somewhat remote - an important element to watch but not any sort of imminent threat. After all, China and Japan seemed to be willing to continue with the status quo, and nobody in the Administration would possibly provoke an event that could so profoundly destabilize the U.S. economy.
Well, in a move that is simply beyond comprehension, Treasury Secretary John Snow last week tried to jawbone China and Japan into revaluing their currencies relative to the U.S. dollar (i.e. to allow their currencies to become more expensive). In the unilateralist, partial equilibrium, no-unintended-consequences world that is the Bush Administration, more expensive Asian currencies are a way of protecting U.S. manufacturers from the competition of cheap imports. In the general equilibrium world that is reality, the potential effect of this policy could be disastrous.
How to quickly eliminate our gaping current account deficit
Recall that every major expansion in the U.S. economy has begun with a current account surplus. This means that the U.S. had not only enough savings to finance its own investment, but was even sending savings overseas by purchasing foreign securities. This allowed the U.S. to finance huge investment booms, first by drawing on those excess savings, and then by quickly moving to a current account deficit and importing savings from foreigners. Needless to say, with the U.S. presently running the deepest current account deficit in history, our ability to finance much sustained growth in domestic investment (factories, housing, equipment, capital spending) is sharply limited. Even our present level of economic activity is dependent on the largest inflows of foreign capital in history, largely from China and Japan.
In effect, the factor that allows the U.S. to continue its consumption binge, finance its investment, extend its housing boom, run irresponsibly large government deficits, swap corporate debt payments into ridiculously low short-term interest rates, and maintain unusually high valuations in the equity markets - the quiet support that keeps this whole house of cards standing - is the willingness of Asian economies to accumulate an endless supply of U.S. dollar assets (largely Treasury and U.S. agency securities). That willingness is driven by one goal - to hold their currencies down in relation to the U.S. dollar.
Incomprehensibly, the Administration is now trying to pressure China and Japan to give up that goal. If this effort succeeds, and particularly if that success is abrupt, surging short-term interest rates, higher corporate defaults, and a collapse in U.S. domestic investment would likely follow. As I used to teach my students, there is a really quick way to "balance" a current account deficit (which is also the main way that it happens in practice): plunge the economy into a deep recession. This isn't our expectation yet. It is, however, an increasing risk born of misguided economic analysis.
The Market Climate for stocks remains characterized by unusually unfavorable valuations and modestly favorable market action. We have, however, taken the opportunity from the recent market advance to increase our hedge to cover about 2/3 of our stock portfolio, meaning that we are now accepting only 1/3 of the impact of market fluctuations inherent in the stock portfolio that we hold.
At present, stock valuations are as high as they were at any prior market extreme except the year 2000 peak, roughly matching valuation highs seen in 1929, 1965, 1972 and 1987. The real question is whether investors actually learned anything from the decline of the past three years. Aside from the recognition that stocks don't go straight up, my inclination is to believe that investors have learned precious little. An unrepentant chorus of investment strategists and Wall Street analysts continues to deliver the proposition that stocks move on the basis of near-term economic direction and earnings momentum. The concept of stocks as a claim to a long-term stream of free cash flows does not seem to enter their analysis, nor does the acceptable rate at which those cash flows should be discounted to the present.
So we have, really, a bunch of analysts touting stocks based on notions of economic and earnings momentum, rather than a careful analysis of values. It's one thing to say that stocks appear overvalued, but that investors still appear willing to take on more risk (which is essentially our argument). It is another thing to ignore those valuations, or to overlook the very substantial risk to market values if investors begin to adopt a more selective approach to risk-taking.
We remain positioned primarily to benefit from market advances, but our exposure to market risk is only moderate here. This is because of very unfavorable valuations, subtle deterioration in market action, and the actions of the Treasury Secretary, which have inexplicably created near-term risks out of what ought to be only long-term ones.
In bonds, the Market Climate continues to be characterized by modestly favorable valuations and modestly favorable market action. We continue to hold an overall duration of about 6 years in the Strategic Total Return Fund. This position is fairly comfortable even in the face of possible currency risks. An abrupt revaluation of the yuan would most probably have the effect of sharply raising short-term interest rates and flattening the yield curve. There could certainly be some near-term pressure on inflation, but the prospect of economic weakness would most probably offset this impact on long-term yields. We certainly don't base our current investment position on the currency situation, but we remain comfortable with our stance even taking that situation into account.
In gold, however, we took last week's strength as an opportunity to liquidate most of our holdings in precious metals stocks. This is not a forecast regarding the direction of precious metals - indeed, the currency situation may be supportive of them. However, at present, we simply don't have enough evidence to override the less favorable Market Climate for precious metals that has now emerged. The article Going for the Gold includes a relevant, though somewhat simplified, set of considerations behind our current stance.
In short, the potential for turmoil in the currency markets is a bullish argument for gold, but this potential isn't sufficient for us to take gold market risk against other conditions we currently observe, or to sidestep the opportunity to take profits on very strong prices. As usual, we try to replace lower ranked holdings on short-term strength, and to buy higher ranked candidates on on short-term weakness.
Monday September 1, 2003 : Weekly Market Comment
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The Annual Report of the Hussman Strategic Total Return Fund is now available on the internet. The report includes a shareholder letter discussing current bond market conditions, the deflation issue, economic conditions and other factors. I strongly enourage shareholders to read these reports, in addition to the Prospectus for each Fund.
The Market Climate for stocks is characterized by unusual overvaluation and moderately favorable trend uniformity. In the Strategic Growth Fund we continue to target exposure to market fluctuations in the range of 40-70% of portfolio value. So we continue to be positioned to gain primarily from market advances.
This week, I've described the market's overvaluation as unusual. By any reliable measure, the valuation of the market now exceeds all other historical valuations except for 1929, 1965, 1972, 1987, and of course 2000. For a great while, the stock market has traded at price/book, price/dividend, price/revenue and other ratios that have far surpassed any historical precedent. Owing to the economic strength of the late 1990's, the least extreme valuation measures were based on earnings. This is another way of saying that earnings were elevated, compared to other fundamentals, during the late 1990's. We observed this as high profit margins (high earnings/sales), high return on equity (high earnings/book value), and low dividend payout ratios (dividends/high earnings).
I developed the price/peak-earnings ratio because it filters out the uninformative volatility of earnings during recessions, and provides a more useful framework to talk about stock values. To quote valuations on any other measure in recent years would have led many readers to extremely bearish conclusions. Unfortunately, the market is now strenuously valued even on the basis of price/peak-earnings. The current multiple of 18.75 has historically been surpassed only a few times in history, with singularly terrible results. This isn't to say that stocks can't deliver adequate returns between now and some narrow set of future dates, but to expect that stocks purchased at these levels will deliver attractive long-term returns in general requires the assumption that current valuations will remain elevated into the indefinite future.
For example, since the 1987 market peak, the S&P 500 has actually delivered an annualized total return of 9.66%. But this reasonably good outcome results precisely from the fact that the extreme valuations at the 1987 peak are roughly matched by the extreme valuations of today. In other words, if a very long-term investor is willing to rely on the notion that valuations when they sell will match or exceed the unusually high valuations of the present, that investor can reasonably expect stocks purchased at current levels to deliver long-term returns somewhere the range of 8-10%. To us, that's a strenuous assumption, and it ignores the fact that stocks may be priced to deliver much stronger returns at various points in the intervening years. For long-term, buy-and-hold investors, it is highly probable that there will be numerous opportunities to purchase stocks at better long-term returns than they are currently priced to deliver.
In our view, defensive positions taken during periods of extreme valuation may cause investors to miss occasional short-term returns, but they do not compromise long-term returns. Moreover, the bulk of our defensive positions occur during periods where both valuations and market action are hostile. We believe that these positions enhance, rather than compromise, our ability to generate long-term returns. While past returns do not ensure future results, our objective is to substantially outperform a buy-and-hold approach over the full market cycle, with smaller periodic losses, on average. Stated another way, our objective is to achieve a high long-term total return per unit of risk. The comments in recent updates regarding Sharpe ratios may be helpful in evaluating how we have performed at this objective to-date.
Market Climate versus market forecasting
As usual, the investment positions we take from time-to-time should not be confused with forecasts. This may seem counterintuitive, but think of it this way. Even in the most favorable Market Climate we identify, the average weekly gain has historically been about 0.40%. In the most unfavorable Market Climate we identify, the average weekly loss has been about -0.20%. In either case, the standard deviation or typical "range of error" is about +/- 2%. As it turns out, these population differences between Market Climates are highly significant on a statistical basis. But looking from week to week, the small sample differences are completely insignificant. A brief example may make this clearer.
Consider the most favorable Market Climate we identify. In any particular week, we could make a so-called "forecast" that the market might advance by about 0.40%. But this forecast would be so swamped by the +/- 2% range of error as to make that forecast meaningless. One might think that lengthening the forecast interval would quickly increase the reliability of the forecast, but it does not. As you increase the number of weeks in the forecast by a factor of n, you multiply the range of error by roughly the square root of n. So for example, a 4-week forecast in the most favorable Market Climate would be a gain of about 4 x 0.4% = 1.6%, but the range of error would grow to the square root of 4 x 2% = +/- 4%. The problem with going to increasingly longer forecast periods is that these forecasts would rely on the Market Climate remaining unchanged. But since we can't actually predict changes in the Market Climate in advance, that is not a reliable assumption.
So there we have it - strong statistical differences in the average market behavior across Market Climates, but virtually no ability at all to predict where the market is going. The appropriate strategy is simple - we align ourselves with the prevailing Market Climate, rather than trying to forecast specific market outcomes. By taking greater risk in conditions that we associate with a high return/risk ratio on average, and taking less risk otherwise, we believe that we can accrue a high average return/risk ratio over time.
In contrast, I don't believe that we have the ability to "call" market bottoms, market tops, rallies, declines, bull markets or bear markets. Shifts in the Market Climate may overlap with important changes in market direction to some extent. But as a practical matter, I don't really think in terms of bottoms, tops, bull markets or bear markets.
In short, we know that the future will be made up of a series of present moments. By taking good care of the present moment, constantly observing and responding to reality as it is rather than how we wish or hope it to be, we naturally expect to take good care of the future.
In bonds, the Market Climate remains characterized by mildly favorable valuations and mildly favorable trend uniformity. These conditions are sufficient to warrant a moderate exposure to fluctuations in long-term interest rates. Currently, the overall duration in the Strategic Total Return Fund is just over 6 years. Other things being equal, a 100 basis point change in long-term interest rates would be expected to induce a roughly 6% change in the value of the Fund. More commentary regarding the bond markets can be found in the Fund's latest Annual Report.
The number of American lives lost in the occupation of Iraq now exceeds the number of lives lost in military combat. The press hardly reports Iraqi deaths anymore. This outcome is outrageous and needless. The element that creates risk for our troops is the perception that they do not have neutrality. As I've noted before, the greatest act of respect for American troops would be for the Bush Administration to extract the U.S. from the role of occupier and to legitimize its role as peacekeeper; to abandon the objective of unilaterally shaping Iraq, shift enforcement to a wider force of NATO troops, and expand the role of the United Nations in civil matters. The security of our troops does not demand a broader use of force, but a broader coalition.
The greatness of America is rooted in the virtue of our principles; that all men are created equal; that they are endowed by their Creator with inalienable rights; that government must be by the consent of those who are governed; that it is precisely the defense of rights and due process for the utterly indefensible that secures the rights of all others. These principles do not require that we overthrow other governments that do not respect them. Rather, they demand that we respect these truths wherever our nation exerts its influence.
The founders of our nation, such as Thomas Paine, recognized the distinction between principles and men - between the virtues of a nation and the individuals who lead it at any particular time. In contrast to the neoconservative view that the U.S. should seek to attain absolute dominance in military power and political influence, our founders sought equality and mutual respect among men and between nations. They rejected, as Paine wrote, "the savage idea of man considering his species as his enemy, because the accident of birth gave the individuals existence in countries distinguished by different names." They distinguished security and defense from dominance, and viewed aspirations of one people to determine the fate of another as repugnant.
The atrocity of war is always multiplied by the willingness of each side to overlook their common humanity with the other side. Thousands of years ago, the Buddha taught that no individual enjoys a separate existence; that no action exists apart from its reaction. He recognized that attending to the suffering of others is a step that can alleviate one's own suffering. Christ asked simply that we do unto others what we would have them do unto us - "You have heard it said that you should love your friends and hate your enemies, but I say to you, love your enemies; bless them who curse you; for He makes his sun rise on both the evil and on the good, and sends his rain on the just and the unjust."
These teachings are not hopelessly impractical. Rather, the challenge is to find ways, consistent with our defense and security, to make them practical in our world. To love one's enemy always begins with the insight that one's enemy also suffers, whether from ignorance, hatred, poverty, injustice or wrong perception. This does not excuse wrong actions, nor defend them from justice. But there are always opportunities to address broad human suffering, even as we pursue enforcement against specific individuals. Even simple actions can have great impact. If we can deliver tanks by helicopter, it is not impossible to also deliver power generators, water, and medicine. The Buddha taught, "He who understands the roots of great suffering comes to enjoy great peace."
Nothing can be done to advance American principles around the world unless we insist on taking actions that are faithful to those principles. We can do better.
Sunday August 24, 2003 : Weekly Market Comment
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Just a note: the Annual Report of the Hussman Strategic Growth Fund is now available on the web. The printed report will be mailed to shareholders in the coming weeks. The report contains an extensive shareholder letter, as well as the latest information on fees, expenses and brokerage costs. Please also read the Prospectus of the Fund for additional information on the Fund's investment approach. The Annual Report for the Hussman Strategic Total Return Fund will be published shortly.
The Market Climate for stocks remains characterized by unfavorable valuations and moderately favorable trend uniformity. Last week, the Dow Industrials and Transports actually cleared the non-confirmation they've displayed lately, by rising to joint new highs. That is a constructive development, and while we wouldn't increase our exposure to market risk at present levels, a well-behaved decline would create an opportunity to modestly increase our exposure. At present, our exposure to market risk is likely to fluctuate between about 40% on the low side to 70% on the high side, depending on the condition of trend uniformity that we observe at any particular point in time.
That brings up a subtle point - our identification of trend uniformity is very discrete: favorable or unfavorable. But within each status, trend uniformity can range from tenuous and weak to extremely strong. In some cases those details matter, and in other cases they do not. When both valuations and trend uniformity are unfavorable, that's all we need to know to establish a full hedge against market fluctuations. It does not matter how weakly or strongly negative trend uniformity might be. In contrast, when valuations are unfavorable and trend uniformity is favorable, our discipline requires us to accept some amount of market risk, but the extent to which we do so is determined by how strong or weak the status of valuation and trend uniformity is at any point. Again, at present, that extent is likely to fluctuate between about 40%-70%. Currently, we're near the low side of that range, but a well-behaved decline may change that.
Well-behaved essentially means a market decline that does not extend existing divergences or create new ones. For example, a decline in which the major averages retreat, but financials, utilities, retails, or some other sector goes into free fall, is not a well-behaved decline. Nor is a decline in which the number of new lows suddenly explodes on high trading volume. Nor is a decline in which risk spreads between corporate and Treasury yields suddenly widen markedly. Suffice it to say that there are a great many ways in which the market can decline while also behaving badly. Bad behavior conveys negative information. In contrast, well-behaved declines during periods of favorable trend uniformity tend to be good opportunities to increase our exposure to market risk. We'll see.
In bonds, the Market Climate continues to be characterized by modestly favorable valuations and modestly favorable trend uniformity. If trend uniformity was simply a measure of obvious trends in interest rates, one might be prompted to ask what kind of psychedelic mushroom would lead us to grade those trends as favorable. But as I've frequently noted, trend uniformity doesn't measure the extent or duration of any particular market movement, but instead measures its quality. Bond yields have certainly moved higher in recent months. But while the move has been very rapid, it has also been impressively well-behaved on the measures that we use. So we take the surge in yields as a signal of better valuation rather than deteriorating conditions for the bond market, and we've acted accordingly. Our position in the Hussman Strategic Total Return Fund remains fairly restrained, but we established some exposure to long-term Treasuries near the recent lows. The Fund continues to have a portfolio duration of less than 7 years.
Sunday August 17, 2003 : Weekly Market Comment
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Five star fund: Morningstar has given the Hussman Strategic Growth Fund its highest rating of 5 stars for 3-year and overall performance as of 7-31-03.
Top in return per unit of risk: According to Morningstar data as of 7-31-03, the Hussman Strategic Growth Fund achieved the highest Sharpe (return/risk) ratio of any U.S. equity fund (ex-specialty) covered by Morningstar for the preceding 3-year period. The Sharpe ratio is an annualized measure of total return, over and above Treasury bill returns, per unit of risk as measured by the annualized standard deviation of Fund returns. The Sharpe ratio of HSGFX, as reported by Morningstar, was 1.47. The Fund had the only ratio above 1.2 among U.S. equity funds (ex-specialty), and was one of only 5 funds in this group with a 3-year Sharpe ratio above 1.0.
Lower expense ratio: Finally, I am pleased to report that due to the achievement of additional fee breakpoints and other economies, the expense ratio of the Hussman Strategic Growth Fund has been reduced again - this time to 1.40% as of August 11, 2003. According to Morningstar data, the average expense ratio for funds in the same category is 1.45%. The expense ratio of the Fund is affected by a number of factors, including the total amount of net assets of the Fund, and may change over time.
Additional information on the Morningstar Rating (tm) is at the bottom of this update. Standardized performance figures as of the quarter ended June 30, 2003 are provided in the July 27, 2003 update, also on this page.
The Market Climate for stocks continues to be characterized by unfavorable valuations and moderately favorable trend uniformity. However, there have been enough blemishes in recent market action to move the Hussman Strategic Growth Fund to a 60% hedged position on last week's market advance.
It is important not to misinterpret this position. We continue to be aligned primarily to earn returns from market advances. However, potential market risks have steadily increased, based on our reading of market action. So we have taken the opportunity created by the recent advance to modestly reduce the sensitivity of our portfolio to market fluctuations.
As I've noted before, the two most frequent questions that run through my mind in the day-to-day management of the Funds are "What is the opportunity?" and "What is threatened?" In any aspect of life, be it investing, parenting, relationships, electricity grids, or international politics, when one is forced to react, it is often because one has already missed several opportunities to respond. Our obligation is to observe reality clearly, and to respond to opportunities before we are forced to react to crises. To be observant, to deeply understand, to act on principle, and to always look for chances to improve the situation - these are the best ways to mitigate threats to what we value.
Abrupt events such as last week's power outage also allow us to discuss the benefits and limitations of our investment approach. One of the striking aspects of market history is that the market's response to various events seems to be strongly conditioned by the status of valuations and trend uniformity when those events have taken place.
Historically, major market crashes (1929, 1987, as well as numerous, less memorable plunges like 1962) invariably occurred after the market had entered the most unfavorable Climate we identify: unfavorable valuations and unfavorable trend uniformity. Indeed, what investors identify as the 1929 and 1987 crashes each occurred after the major indices had already experienced persistent declines of about 14%.
In my view, there is a clear analytical reason for this. Very few events have historically had a significant impact on the long-term stream of cash flows that could be expected from equities. Clearly, deep recessions can affect near-term cash flows, but for a security whose price is based on a discounted stream of cash flows over a period of many decades, the impact of a recession is actually quite small. The primary factor behind market crashes is not a reduction in future cash flows, but a spike in the risk premium demanded by investors. The impact of these spikes on stock prices is greatest when 1) risk premiums are very thin, and 2) investor preferences to accept risk are very weak. In our discipline, these are synonymous with 1) unfavorable valuation and 2) unfavorable trend uniformity.
Several years ago, a colleague at the University of Michigan produced a piece of research showing that an investor missing even a relatively small number of outstanding market periods would have earned very disappointing long-term returns. This was followed by counter-arguments noting that sidestepping even a relatively small number of weak market periods would have resulted in unusually strong market returns. Which view is correct?
As I note in Time-variation in market efficiency - a mixture of distributions approach, this issue can be quickly resolved by examining combinations of valuation and trend uniformity. For proprietary reasons, the paper uses a simple, even naive, set of criteria to define valuation (S&P 500 dividend yield high or low) and trend uniformity (position of dividend yield, T-bill yield and 10-year bond yield above or below their levels 26 weeks earlier, 2 of 3 defining the status). Yet the results are still very powerful. Looking at the best 30 market weeks since 1940, the clear majority of these strong returns occurred in conditions of favorable valuation. In contrast, the weakest 30 market weeks predominantly occurred in conditions of unfavorable trend uniformity.
Notice what this implies. The Climate with the largest number of strong weeks and fewest poor weeks is characterized by favorable valuations and favorable trend uniformity. The Climate with the smallest number of strong weeks and largest number of poor weeks is characterized by unfavorable valuations and unfavorable trend uniformity. The Climate with the fewest of each, and therefore the least volatile Climate, is unfavorable valuations, favorable trend uniformity. Finally, the Climate with the greatest level of volatility is favorable valuation and unfavorable trend uniformity. Interestingly, these general characteristics, derived simply by looking at outlier returns, also hold in historical data for the remaining periods, on average.
So while I don't believe that the market's return in any specific period can be predicted with any accuracy at all, I do believe that the relative probability of large advances and declines is influenced by the Market Climate in effect.
Of course, none of this can eliminate the basic fact that financial markets have risk. The acceptance of calculated risks is an essential fact of investing. Though we believe that the theoretical and historical evidence for our approach is sound, there is no assurance that market declines - even substantial ones - will not emerge during Market Climates that we define as favorable. Still, the historical tendency is for unusual market declines to occur during periods of unfavorable trend uniformity, particularly when valuations are unfavorable.
Market action reflects the trading of millions of investors, acting on their own risk preferences, information, and personal circumstances. As a result, market action conveys information that cannot possibly be captured in government statistics. In many instances, unfavorable market action contains the signal that "something is wrong" - a signal that often precedes unfavorable events. In other instances, such as the recent power outage, unfavorable events happen without notice. Still, market action provides useful indications about investor's attitudes toward risk, and therefore, indications about how strongly investors are likely to respond to these events.
The world will always have uncertainty and risk. We don't claim to remove those features from investing. Instead, we attempt to manage them effectively. As always, we align our investment positions and our expectations about the economy with the prevailing Market Climate.
In bonds, the Market Climate continues to be characterized by modestly favorable valuations and modestly favorable trend uniformity. We added a few percent to our holdings of long-term Treasuries in the Strategic Total Return Fund on the recent decline in bond prices. Our overall portfolio duration remains below 7 years; that is, a 100 basis point change in interest rates would be expected to impact the value of the Fund by less than 7%.
Morningstar rated the Hussman Strategic Growth Fund among 185 Mid Cap Blend funds for the overall and 3- year periods ending 7-31-2003, respectively. For funds with at least a 3-year history, a Morningstar Rating(tm) is based on a risk-adjusted return measure (including the effects of sales charges, loads, and redemption fees) with emphasis on downward variations and consistent performance. The top 10% of funds in each category receive 5 stars, the next 22.5% 4 stars, the next 35% 3 stars, the next 22.5% 2 stars, and the bottom 10% 1 star. Each share class is counted as a fraction of one fund within this scale and rated separately. The Overall Morningstar Rating(tm) is derived from a weighted average of the performance figures associated with a fund's 3-, 5-, and 10-year (if applicable) Morningstar Rating(tm) metrics. Past performance is not a guarantee of future results. Fee waivers and reimbursement of fund expenses by the Adviser, which capped the Fund's expense ratio at 2%, positively impacted the Fund's total return. As of 7-31-2003, the Fund's expense ratio was 1.45%, and such fee waivers were no longer required.
Thursday August 14, 2003 : Special Update
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Just a note in response to the recent power outages. We've had no disruptions at our management offices in Maryland or our administrative offices in Ohio. Even if the outages were to affect our areas, the Fund has detailed contingency plans and backup power supplies to respond to this sort of event.
There seems little risk of banking disruptions here, but given that I've written more generally about the banking system and we've received questions about how bank problems could affect the Funds, it's an issue worth mentioning. With regard to the banking system, keep in mind that while Fund assets are custodied at U.S. Bank (one of the nation's largest banks and mutual fund custodians), these assets are held in segregated accounts, generally in physical form, fully paid, not subject to any securities lending arrangements, and the sole property of the Funds - neither assets nor liabilities of any bank. Bank difficulties affect holders of CDs, checking deposits, and the like because these are actually liabilities of the bank. In contrast, even in the event of a banking crisis, the Fund's ownership of its securities would be unaffected. There is always risk of price fluctuations in these securities, of course, but that risk is intentionally accepted in expectation of investment returns.
The current position in the Strategic Growth Fund remains nearly 50% hedged against the risk of market fluctuations, with a sufficient additional put option position to extend hedge coverage to about 60% of the value of the Fund's stock holdings in the event of a substantial market decline.
In the Strategic Total Return Fund, we added a few percent to our holdings of long-term Treasury bonds on Thursday morning's decline. At present, the Fund's overall duration remains under 7 years (that is, a 100 basis point change in interest rates would be expected to induce less than a 7% change in Fund value, other things being equal).
Sunday August 10, 2003 : Weekly Market Comment
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The Market Climate for stocks remains characterized by unfavorable valuations and still favorable trend uniformity. There are enough initial divergences in market action to advise against a full or aggressive exposure to market risk. Overall, however, we continue to accept the majority of the market risk inherent in the stocks we own, with less than half of net assets in the Strategic Growth Fund hedged against market fluctuations.
The initial divergences we've seen in market action have been fairly persistent. Our preference is always to see these divergences clear quickly. One difficulty has been interest rate behavior. Given that stocks are priced to deliver quite unsatisfactory long-term returns, anything that creates competitive pressure is a distinct negative. Despite improvement in the Market Climate for bonds about a week ago, the current action of bond yields creates some risk of rising stock yields and falling stock prices.
Though we don't use Dow Theory explicitly, it frequently offers convenient (if simple) examples of trend divergence, without the need to resort to complex statistical arguments or proprietary work. From that perspective, it is notable that the Dow Industrials and Dow Transports reached their June peaks at 9323.02 and 2556.40, respectively. These indices registered subsequent lows in late June at 8985.44 and 2356.13, respectively. From there, the Transports rallied to new highs (on the strength of trucking and package delivery stocks), but the Industrials failed to confirm. Meanwhile, volume has become dull on advances, and market reaction toward favorable economic news has been very tentative. This dulling of market action mirrors what we observe in much broader and exacting statistical analysis. Though these risks are sufficient to take modest defensive action, market action has not broken down to the extent that would warrant a significantly defensive position. So we remain constructive, but not aggressive.
From a Dow Theory perspective, the first real sign of trouble would be a break in the Industrials below their June low of 8985.44. A subsequent break below 2356.13 on the Transports (Dow Theory looks at daily closing prices only) would be a negative confirmation. While our own evaluation of trend uniformity often does not match inferences drawn from Dow Theory analysis (in which case we rely strictly on trend uniformity), the parallel action in these approaches in recent months is instructive, and worth watching.
In bonds, the Market Climate remains characterized by modestly favorable valuations and modestly favorable trend uniformity. The shift in Market Climate about a week ago moved us to moderately increase our holdings of long-term Treasury bonds. While we still estimate our average overall portfolio duration at less than 7 years, this is still a clear improvement in conditions over what we saw even two months ago.
Our moderately longer maturity profile doesn't imply a forecast that interest rates will retreat to new lows, or even that they will decline substantially, for that matter. As always, shifts in our investment position indicate only a change in the average return/risk profile of the market. This does not require a directional forecast (every Market Climate includes both advances and declines, and we are not under any illusion that we can forecast what the next draw from the hat will be). Rather, our investment stance simply implies that the average return/risk profile in the bond market has improved.
We require no forecast of what the bond market will do in this particular instance, but base our actions instead on the average characteristics of the bond market in this Climate.
In short, we carry an umbrella in April, but we make no attempt to predict which day it might rain (and we sure don't try to squeeze in a picnic after the clouds roll in). At present, however, the Climate in bonds has improved, and we are aligned accordingly.
Sunday August 3, 2003 : Weekly Market Comment
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The Market Climate for stocks remains characterized by unfavorable valuations and moderately favorable trend uniformity. This places us in a constructive position, with a range of 30-50% of our stock holdings hedged against the impact of market fluctuations. Still, we remain positioned to benefit from market advances here.
We continue to observe a range of breakdowns in market action, the most obvious being on the interest rate front, and extending to a wider set of market internals. Recent advances, for example, have tended to display dull or diminishing volume, while new lows have persistently expanded on market declines. The response to good economic news has also been curiously muted. So while the overall pattern of market action continues to indicate a preference of investors to accept risk, we're also seeing a tendency for investors to become more selective. In an overvalued market, this warrants some level of reserve. Our current position has enough market exposure to participate in any continued advance, while also responding to moderately heightened risks.
Meanwhile in the precious metals markets, conditions remain favorable overall as well, but strength in several of our holdings in combination with a moderate weakening of underlying conditions prompted us to reduce our gold and precious metals holdings in both Strategic Growth and Strategic Total Return last week.
In bonds, the Market Climate has shifted to decidedly improved condition; moderately favorable valuation, and moderately favorable trend uniformity. This shift in Market Climate warrants a shift toward long maturity bonds. We shifted approximately 20% of the Strategic Total Return Fund to long Treasury bonds on Friday. This isn't an aggressive position, but it is measurably more constructive than we've been carrying.
It is important to interpret this shift properly. It would be incorrect to infer that we have become "bullish" on bonds, that we believe the bond market has turned, or that we are forecasting a bond market rally. We don't require such specific forecasts. Very simply, we believe that the average return/risk characteristics of the bond market have changed. Our goal is to allocate risk in proportion to the return/risk characteristics of each Climate we identify. Changes in Market Climate, which prompt changes in our investment exposure, may have the appearance of "calls" on market direction, but such an appearance is unintentional. We make absolutely no attempt to "call" rallies, declines, bottoms or tops.
Think about it this way. The Market Climates we identify are based on observable conditions. Based on these conditions, we can identify the Market Climate that existed at any particular point in history. If we gather up all the periods that fall into a given Climate, we get set of "bell curves" or "probability distributions." Every Climate includes advances, declines, and neutral periods. But the average return/risk characteristics vary significantly. It's those average characteristics that drive our positions. Once we identify a particular Climate, however, we have absolutely no ability to forecast whether the next draw from the distribution will be positive or negative. Also, since there is no stable "transition probability" to help forecast when one Market Climate might shift to another, it is useless to attempt forecasts over any extended period of time. Our willingness to act on the basis of these average characteristics relies on repeatedly aligning our positions with them week after week, year after year. But we have literally no faith at all that a given Market Climate will resolve into specific short-term market performance.
So the change in our investment positions is based on evidence that the market is now living in a different probability distribution. This change is not associated with a forecast, beyond a small, unreliable and statistically insignificant expectation about what the market might do over the coming week, on average.
On the questions that needlessly fill investors minds, such as "Is this a bull market or a bear market," "Where is the market headed," "Where will the market be six months from now," "How long will this rally last," and "How close is the market to a top?": I honestly have no idea. I have no illusion that we can predict bull markets or bear markets. These things don't even exist in observable reality, only in hindsight, so what is the sense of using these concepts as the basis for investment decisions?
What I believe we can do fairly well is to identify observable conditions that are associated with differing average return/risk ratios for the market as a whole. These Climates may have some amount of overlap with what turn out in hindsight to be bull and bear markets, but we don't actually go out and try to identify bull or bear markets. Instead, we focus on reality as we find it.
We also don't evaluate the performance of our approach by whether we "call" specific tops, bottoms, rallies or declines. We evaluate our approach on the basis of return per unit of risk over an extended period of time. Specifically, our goal is to generate stronger long-term returns with smaller drawdown losses than experienced by the major indices over the full market cycle (bull market plus bear market). We hope that these criteria are also the ones that matter to our shareholders.
By the way, Value Line has a neat set of return/risk rankings for fund managers reported in the latest issue of Barron's (though the table has some typographical errors, and our ranking was computed without the benefit of our 3-year return figure - it's always something...). In any event, return per unit of risk is the correct measure by which to evaluate our approach, and we're pleased to be ranked on that basis.
Sunday July 27, 2003 : Weekly Market Comment
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Quick notes: I've posted a new article regarding the U.S. financial system's profound dependence on short-term interest rates: Freight Trains and Steep Curves. We've also updated our due diligence report which addresses frequent questions from investors and portfolio managers about the Hussman Funds.
Also, for those who have asked, the Hussman Strategic Total Return Fund is now available through Charles Schwab. As we manage the Hussman Funds as true no-load funds (with no 12-b1 fee, and no trailing fee, soft-dollar or other marketing arrangements), purchases of the Funds through Schwab are subject to standard commission charges. While this may not be desirable for short-term traders (and reduces the extent to which some firms will even offer the Funds), we believe that operating as a true no-load family is decidedly in the best interests of long-term investors in the Hussman Funds. We are glad to have the Hussman Funds carried by Schwab, and are grateful for the service they provide to their customers and our shareholders by doing so.
The Market Climate for stocks remains characterized by unfavorable valuations and favorable trend uniformity, holding us to a constructive position. Our net exposure to market risk varies between about 50-70%, depending on market movements. This variation is due to the fact that we still have enough call options to provide "convexity" (see recent updates for details). In the event of a substantial market advance, we would expect to experience about a 70% exposure to market fluctuations. In the event of a substantial plunge, we would expect about a 50% exposure. From the opposite perspective, between 30-50% of our diversified stock holdings are hedged against the impact of general market fluctuations. Of course, we also experience fluctuation due to the behavior of the specific stocks we hold, independent of what the market does. While this is a source of risk, this "active" or "stock selection" aspect of our discipline has historically been one of our most important sources of return.
The Market Climate we currently identify has historically been associated with a favorable return/risk tradeoff on average. Still, risk management considerations prevent a full or aggressive exposure to market risk here. Valuations remain quite rich, which is another way of saying that stocks are priced to deliver fairly unsatisfactory returns over the long term. The risk to stocks here is anything that would cause investors to demand higher long-term returns (the only way to drive long-term returns higher is to drive current prices lower).
Finance theorists generally break long-term returns into two pieces - essentially the risk free interest rate plus a risk premium. Contrary to popular misconception, the appropriate risk free rate is not the 10-year Treasury bond yield but the risk-free rate that would be earned by continuously rolling T-bills for a period similar to the effective duration of stocks (roughly 50 years). So rather than the 10-year Treasury yield, the appropriate risk-free rate to monitor is the Treasury yield that occurs at the very asymptote of the yield curve; the point that the yield curve would approach if you drew it out almost indefinitely. This "asymptotic yield" just doesn't fluctuate all that much. Even here, we estimate it at over 6%. Kick in a 3% risk premium, which would be fairly thin historically, and it would not be historically inconsistent for investors to demand that stocks be priced to deliver 9% long-term annual returns. Currently, they're priced to deliver something in the area of 7.7% (on the strenuous assumption that stocks remain at current valuations forever). To get that baby up to 9% would require a market decline of about 40%. That's not a forecast, but it does emphasize how important it is to be aware of factors that could push the required rate of return on stocks higher.
Again, there are two main factors: interest rates (which we can observe directly), and risk premiums (where we can measure pressure by observing the quality of market action). Both are showing enough potential trouble to force us away from a full or aggressive exposure to market risk. Bond yields have now advanced far enough that stocks and bonds are likely to recouple. In recent years, declines in bond prices (rising interest rates) have been accompanied by rising stock prices, and vice versa. This was unusual activity born of profound economic concerns. At this point, however, we're likely to see the markets exhibiting a new pattern: further declines in bond prices are likely to place downward pressure on stocks as well. Yet since stock yields remain unusually low, increases in bond prices (falling interest rates) will probably have a positive but weaker impact on stocks. This is a typical asymmetry that has historically occurred in overvalued markets, and it's one that we should be careful to monitor.
With respect to risk premiums, we have to monitor any evidence that investors are becoming increasingly discriminating about risk. We find this evidence by looking at a broad range of market internals - a wide variety of industries, market breadth, Treasuries, corporate bonds, market leadership (highs and lows), volume behavior, and other factors. When the market begins to display subtle breakdowns in market internals, it is an important signal that investors have become more alert to risk. Upward pressure on risk premiums often follows. Again, there are enough early divergences here to prevent us from holding a full or aggressive exposure to market risk, but not nearly enough to drive us back to a fully hedged position.
In short, this remains a favorable Market Climate overall, warranting a generally constructive position. The essential responsibility here is to monitor pressures on the required rate of return to stocks: interest rates, and risk premiums. For now, there are enough early divergences to warrant a modest hedge. Still, we remain generally constructive for now.
In bonds, the Market Climate remains characterized by unfavorable valuations and tenuously favorable trend uniformity. This is already enough to hold us to a defensive position, with most of our risk confined to alternatives to straight bonds, including Treasury inflation protected securities (TIPS), near-term callable agency securities, and more modest exposures to precious metals shares, utilities, and foreign government bonds.
Last week, the Hussman Strategic Growth Fund (HSGFX) reached its three-year anniversary. From the Fund's inception on July 24, 2000 through July 24, 2003, the Fund earned an overall return of 70.83% (19.54% annualized), compared with losses of -29.74% (-11.09% annualized) for the S&P 500 Index, and -5.57% (-1.89% annualized) for the Russell 2000 Index. All figures include dividends. The deepest pullback from peak-to-trough in the Fund since inception has been less than -7%, compared with peak-to-trough plunges of more than -46% and -37% for the S&P 500 and Russell 2000 indices, respectively.
In short, we've been faithful to the objective that the Fund is designed to pursue: long-term capital appreciation, with added emphasis on defending capital during unfavorable market conditions. This is an objective that we believe is well suited to both advancing and declining markets. Though the objective of defending capital in unfavorable conditions means, by necessity, that we will occasionally forego advances that occasionally emerge during those periods, I do believe that the effort to avoid capital losses in these conditions has the capacity to add rather than detract from long-term returns.
In my view, the returns from the Fund have been neither extraordinary, nor disappointing. I do believe that our margin of outperformance versus the major indices (20-30% annualized) has been wider than we would expect over the long term, and that our volatility has been lower than we'll experience in more favorable Climates when we take a more aggressive stance. Still, our objective is to measurably outperform the major indices over the full market cycle, with smaller overall losses. I believe that our approach remains well suited to that objective.
As a sidenote, keep in mind that the Fund was fully hedged during the second half of 2002. Since that period displayed extreme market volatility (with no overall gain), investors who select funds based on the one-year rank of HSGFX should expect to see the Fund's rank fluctuate depending on the specific starting date of that one-year period. Without taking this into consideration, such investors may find themselves whipsawed into and out of the Fund by performance-based selection criteria, regardless of current performance. For our views on evaluating Fund performance effectively, see The use (and abuse) of short-term performance.
A few additional figures as of the most recent quarter-end. For the one year period ended June 30 2003, the Hussman Strategic Growth Fund earned a total return of 11.25%, compared to returns of 0.25% and -1.64% for the S&P 500 Index and the Russell 2000 Index, respectively. From inception on July 24, 2000 through June 30, 2003, the Fund earned a total annualized return of 18.83%, compared to annualized returns of -11.65 and -3.18 for the S&P 500 Index and the Russell 2000 Index, respectively.
Past performance is not predictive of future returns. Performance calculations do not reflect the deduction of taxes a shareholder would pay on Fund distributions or the redemption of Fund shares. For a Prospectus containing more complete information about the Hussman Funds, including charges and expenses, please call 1-800-HUSSMAN (1-800-487-7626), or visit our website at www.hussmanfunds.com . Please read the Prospectus carefully before you invest or send money. The Distributor of the Hussman Funds is Ultimus Fund Distributors, LLC.
Sunday July 20, 2003 : Weekly Market Comment
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As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and favorable trend uniformity, holding us to a constructive investment position. Still, there remain an unusual number of cross-currents, as well as modest breakdowns in market action, all of which moves us to partially hedge our exposure to market risk. The precise extent of this hedge varies with market movements since we continue to have a certain amount of curvature (see recent updates). Broadly speaking, between about 30-50% of the Strategic Growth Fund is hedged against the impact of broad market fluctuations.
As always, the returns of the Fund are primarily determined by the peformance of our broadly diversified portfolio of individual stocks. Particularly in the present environment, which is displaying increasing internal divergences in market action (rather than tight uniformity), the day-to-day returns of the Fund are unlikely to directly follow the returns of any particular index. Probably the best way to characterize our stance at present is that in the event of a large market decline, our returns would be exposed to about 50% of the fluctuations in the overall market; in the event of a large market advance, our returns would be exposed to as much as 90% of the fluctuations in the overall market, and in the event of modest market movements, our day-to-day returns would be dominated by the performance of the specific stocks we own. In short, we're still positioned primarily to benefit from market advances, but there are enough cross-currents to invite hedging and curvature strategies as well.
In bonds, the Market Climate remains characterized by unfavorable valuations and tenuously favorable trend uniformity, but since valuations have a much more important impact in bonds than they have in stocks, a defensive position is already warranted. I noted several weeks ago (at the peak in bonds, as it happened), that a screaming buy signal from the "Fed Model" in an environment of low stock yields is not a buy signal on stocks, but rather a fairly reliable sell signal on bonds. That pattern has certainly held in this instance.
While the initial sell-off in bonds has hit both straight Treasuries and inflation-protected issues (TIPS), the relative attractiveness of TIPS is quite strong here, and these issues dominate our Treasury holdings in the Strategic Total Return Fund. In addition, our roughly 20% position in precious metals and utilities shares accounts for much of the day-to-day fluctuation in Fund value. We're always inclined to purchase favorably ranked securities on short-term weakness. Given recent short-term weakness in TIPS, utilities and precious metals shares, I believe that our current position nicely matches prevailing opportunities.
Sunday July 13, 2003 : Weekly Market Comment
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As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and favorable trend uniformity, holding us to a constructive investment position. That said, the investment and economic picture includes an unusual range of cross-currents that individually have the potential to derail this favorable Climate, and in combination were sufficient to move us to a 50% hedged position on Friday.
I've frequently noted that our willingness to take market risk here is not based on investment merit. Stocks remain quite overvalued here. While valuation alone has very little influence over short-term returns, it is the primary determinant of long-term ones. From current levels, a buy-and-hold approach on the S&P 500 is likely to deliver total returns somewhere in the range of just 2-5% annually over the coming decade - though almost certainly in an exciting way, through a series of bull and bear movements.
The underlying force in the recent rally is therefore speculative merit, which we read out of favorable trend uniformity. Put simply, investors have been willing to take greater levels of market risk, which shows up in falling risk premiums and uniformly rising prices across a wide range of assets. While speculative merit is not unusually fragile, it is very dependent on the robust willingness of investors to take on increasing amounts of risk, and it is here that we're starting to see difficulties, ranging from concerns about Iraq, rising energy prices, persistent weakness in employment (last week's new claims figures were very disappointing in my view), and excessive debt levels.
Iraq remains the most probable issue that could rekindle risk aversion by investors. One needs only a cursory knowledge of past occupations - the U.S. in the Philippines, Italy in Libya, France in Algeria, Britain in India, and so on - to understand their terrible cycle of frustration and difficulty even for the best troops, including ambushes by insurgents who easily melt away into the population. As Harry Truman once said, "There is nothing new in the world except the history that you do not know."
The task now is to extricate the U.S. from the role of occupier. The military task has been completed, but our troops remain at risk because they are being called upon not merely as peacekeepers but as enforcers of foreign governance. The greatest act of respect for our troops would be for the Administration to abandon its aspirations of unilaterally shaping Iraq, to shift enforcement actions to a broader coalition of NATO forces, and to increase the role of the U.N. in the civil and humanitiarian tasks of rebuilding. On the eve of the war, our troops remarked hopefully that the quickest way home would be through Baghdad. It's time to fulfill those hopes. Our nation, our principles, and our troops deserve no less.
From the standpoint of market behavior, we still observe favorable trend uniformity, but after a brief period of "clean" action, we've got another set of fresh divergences. Drawing on Dow Theory for an example, it's notable that we've got something of a "dual nonconfirmation" going - a signal of increasing ambivalence among investors. After a new high in the Dow Industrials that the Transports failed to confirm in early June, the Transports have now rallied to a new high which is unconfirmed by the Industrials. While selling pressure is not particularly evident here, recent rallies have been on weaker volume. Our own, more statistical models are also showing fresh divergences. These may be cleared by subsequent action, but there's enough evidence to tread more conservatively.
Still, it is important to remember that this remains a constructive market environment. We've increased our level of hedging because of risk considerations, more than return considerations. We remain positioned to benefit primarily from market advances, and at present, there remains enough prospect of such advances to maintain some exposure to market risk. From current levels, an advance of even 3-4% would be sufficient to take stocks into historically dangerous levels of overvaluation, which would would make us much more defensive in response to any additional divergences. For now, however, a moderately constructive investment stance is consistent with the prevailing return/risk opportunities in stocks.
Sunday July 6, 2003 : Weekly Market Comment
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As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and favorable trend uniformity, holding us to a constructive position. The combination of a favorable Market Climate, short-term conditions that are still fairly oversold, and low implied volatility in the options market leads us to carry a small options straddle (long both put and call options) representing about 2% of total assets. Aside from this position, which provides us a fair amount of convexity, we remain fully invested in favored stocks.
Essentially, convexity means that the profile of returns does not correspond one-for-one with what the market does, but bends depending on market direction. For example, if the market rises substantially, the call options that we own will move "in the money," which we would expect to result in overall portfolio gains at a faster rate than the general market. In contrast, if the market declines substantially, the put options that we own will become in the money, which we would expect to result in overall portfolio losses at a slower rate than the general market. That favorable profile in the event of large moves comes at the cost of time decay in the value of the options if market movements are in fact less volatile than the options premiums assume ("implied volatility"). Again, we are willing to accept this risk at present due to the combination of low implied volatility, along with a favorable Market Climate and a short-term oversold condition. As always, our investment position at any particular point in time is based on the average market return/risk profile that is associated with the Market Climate at hand. For now, we remain willing to accept market risk, and will evaluate new evidence as it arrives.
Last week's economic news did not strike me nearly as disappointing as many analysts seemed to take it. The ISM Purchasing Managers Index came in below 50 entirely because of weakness in the inventory and employment components. Both components are somewhat lagging, and to the extent that other indications suggest fairly strong demand growth in the second-half, I suspect that these lagging figures will be pulled higher in fairly short order. Similarly, the unemployment figures are the most lagging form of economic data, so Thursday's figures came with their own grain of salt.
That said, we've just entered the second half, so it is now that we should (and had better) see improvements in the labor market. On that note, The Challenger figures on mass layoffs are already at the lowest level in three years; large-scale layoffs are in a sharp retreat - a good sign. What we need to see now is a drop in aggregate layoffs, and for that we'll be paying close attention to the weekly jobless claims figures - not just one week, but a series of readings. These ought to drop quickly under the 400,000 level in the weeks immediately ahead. If not, it will be at that point that we'll observe an informative divergence between actual and expected data. But again, last week's data were not particularly surprising nor disappointing.
Keep in mind that the primary force behind stocks here is not investment merit but robust speculative merit. Historically, this set of conditions has not been particularly fragile, so our approach will not avoid market risk here on the basis of valuations alone. Still, valuations are not favorable, and this strongly implies that long-term market returns from a buy-and-hold approach are likely to be very disappointing - probably in the range of 2-5% annual total returns over the coming decade for the S&P 500. Accordingly, it will be essential to avoid market risk during periods of unfavorable trend uniformity in the years ahead, and I suspect that we'll see plenty of that. For now, our job is to make hay while the sun shines. On our measures, we're still willing to stay in the fields - but we're constantly checking the weather instruments.
In the bond market, probably the most important consideration here is the probability that short-term market interest rates will detach from Fed-controlled rates. In general, the federal funds rate does not determine market interest rates, but instead lags them. The relatively odd shape of the Treasury yield curve already suggests a fairly steep runup in short term rates over the next couple of years, but our own indications suggest an even sharper and front-loaded runup. While bond yields have shot up fast enough in recent weeks to warrant some consolidation, the current Market Climate continues to indicate a poor average return/risk tradeoff in bonds.
Sunday June 29, 2003 : Weekly Market Comment
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The Market Climate for stocks remains characterized by unfavorable valuations and favorable trend uniformity, holding us to a constructive position.
As I've frequently noted over the years, there are few occasions when I have any expectation at all regarding short-term market action, with two exceptions. One is when the market becomes overbought in an unfavorable Climate. Such points are frequently followed by near-vertical drops. We saw exactly that sort of action several times during the past three years. The second is when the market becomes oversold in a favorable Climate. Such points are frequently followed by leaping advances as short sellers suffer a tight squeeze. These advances are not certainties, but there is no set of conditions that produces a higher short-term rate of return on average than an oversold status in a favorable Market Climate. That's exactly what we have today. We'll see.
Last week, I noted that we had taken a few more defenses on the basis of some initial divergences, and that I expected to lessen those defenses if the market produced "clean" action on a decline. A number of things fell into that description last week. First, new lows did not significantly expand on the decline, and trading volume was restrained. The CBOE Volatility Index (VIX) did not increase sharply (contrary to popular misconception, a low VIX is not a danger signal in itself - the main concern is when it breaks into an uptrend from a low level, which has not occurred). Transport stocks, one of the blemishes from the standpoint of Dow Theory, were among the most resilient areas of the market last week, and I wouldn't take the weak non-confirmation of the early June high as sufficient evidence to ignore the more important favorable confirmations that Dow Theory has already provided since the March lows. Lowry's analysis of trading volume also suggests that the pullback was largely driven by a relaxation in buying interest rather than an acceleration of selling pressure. Bonds fell apart, but that was expected in our work, and is unlikely to dampen the stock market outlook until long-term bond yields rise a half percent or more from here.
In short, market action was very "clean" last week on a number of dimensions, and given that the market has cleared its overbought status all the way to an oversold one, we took a moderate position in call options. That places our overall position in Strategic Growth as follows: we remain fully invested in favored stocks, with a modest "straddle" - a total of roughly 2% of portfolio value - in both call and put options. A straddle is effective here because the implied volatility of the options is quite low, and because our main interest is in large market movements - hedging part of our market exposure if stocks were to unexpectedly plunge, but adding to our market exposure in the more likely case (at present) that the market advances. Aside from the portion of our market exposure that we choose to leave unhedged, the main risk of this position is time decay in the value of our options. This risk would arise mainly if the market moves sideways without volatility in the coming months.
As a technical note, even if the overall change in the market is zero over the life of the options, it is possible to "gamma scalp" enough value to cover the cost of the options so long as the actual volatility of the market matches or exceeds the volatility that is implied in the time premium (this involves changing strike prices, hedge ratios, or expirations as the market fluctuates). For that reason, an option only incurs a "hedging cost" in a sideways market when the holder is passive, or when implied volatility priced into the option exceeds actual volatility over the life of the option.
It's not clear at this point how long we'll hold a straddle position, but the combination of low implied volatility (VIX) and an oversold condition in a favorable Market Climate creates an unusual opportunity to take an investment position with curvature. In the event of a sharp market advance, I would expect our position to participate strongly. In the event of a sharp market decline, I would expect our position to have a smaller sensitivity to market risk than a fully invested position would. Again, the main risk is an extended sideways market on low volatility, in which case we would lose the limited amount of time premium on these options. As usual, this position is fully aligned with the prevailing Market Climate, in a way that I believe closely reflects both the opportunities and risks at present.
One might ask why we should hold put options at all at this point, given that the Market Climate is favorable. The answer is risk management. Investment positions should reflect a reasonable balance between expected return and potential risk. The fact that the expected return is favorable does not mean that downside risk does not exist, particularly given current valuations. We never want to take an investment position that relies on a particular market outcome, and results in unacceptable risk if that outcome does not occur. The essential consideration is balance.
That said, I certainly would not over-emphasize the possibility of an abrupt decline. Though our position allows for the possibility to some degree, I would be somewhat surprised if it occurred from present conditions. Such action is simply not typical of favorable Market Climates. Indeed, every historical crash of note has occurred in a climate of both unfavorable valuations and trend uniformity, and most extreme declines are actually accelerations of declines that have been going for quite some time, not abrupt plunges from fresh highs.
Probably the two most frequent questions that run through my mind in the day-to-day management of the Hussman Funds are: "What is the opportunity?" and "What is threatened?" The idea is not to make pointed forecasts about the market, nor to react to what the market is doing. The idea is to constantly review our existing holdings as well as the potential investments available to us, and to respond to what we observe following a very specific discipline. For example, we try to buy higher-ranked candidates on short-term weakness. We try to sell lower-ranked holdings on short-term strength. This is responding, and it stands in stark contrast to reacting. At present, I believe that our positions nicely respond to both the opportunities and the risks present in the markets.
| Past performance does not ensure future results, and there is no assurance that the Hussman Funds will achieve their investment objectives. An investor's shares, when redeemed, may be worth more or less than their original cost. Investors should consider the investment objectives, risks, and charges and expenses of the Funds carefully before investing. For this and other information, please obtain a Prospectus and read it carefully. The Hussman Funds have the ability to vary their exposure to market fluctuations depending on overall market conditions, and they may not track movements in the overall stock and bond markets, particularly over the short-term. While the intent of this strategy is long-term capital appreciation, total return, and protection of capital, the investment return and principal value of each Fund may fluctuate or deviate from overall market returns to a greater degree than other funds that do not employ these strategies. For example, if a Fund has taken a defensive posture and the market advances, the return to investors will be lower than if the portfolio had not been defensive. Alternatively, if a Fund has taken an aggressive posture, a market decline will magnify the Fund's investment losses. The Distributor of the Hussman Funds is Ultimus Fund Distributors, LLC., 225 Pictoria Drive, Suite 450, Cincinnati, OH, 45246.
The Hussman Strategic Growth Fund has the ability to hedge market risk by selling short major market indices in an amount up to, but not exceeding, the value of its stock holdings. The Fund also has the ability to leverage the amount of stock it controls to as much as 1 1/2 times the value of net assets, by investing a limited percentage of assets in call options.
The Hussman Strategic Total Return Fund has the ability to hedge the interest rate risk of its portfolio in an amount up to, but not exceeding, the value of its fixed income holdings. The Fund also has the ability to increase the interest rate exposure of its portfolio through limited purchases of Treasury zero-coupon securities and STRIPS. The Fund may also invest up to 30% of assets in alternatives to the U.S. fixed income market, including foreign government bonds, utility stocks, and precious metals shares.
The Market Climate is not a formula but a method of analysis. The term "Market Climate" and the graphics used to represent it are service marks of the Hussman Funds. The investment manager has sole discretion in the measurement and interpretation of market conditions. Except for articles hosted from the web domains hussman.net or hussmanfunds.com, linked articles do not necessarily reflect the investment position of the Funds.