September 7, 2004
Just a note - the 2004 Annual Report for the Hussman Funds is now online. The print version is in press and will be mailed shortly. As always, shareholders are encouraged to read the report, as well as Fund prospectuses and past reports, which are available on The Funds page of this website.
One of the great sources of frustration during the first half of this year was the failure of the stock market to confirm widespread optimism about the economy. As the year has progressed, investors have had the additional frustration of gradually disappointing economic news. One interesting measure of this is Bridgewater Associates' index of economic surprises, which is a sort of advance-decline line calculated by taking the cumulative sum of positive and negative economic surprises (based on actual reports versus consensus forecasts). That index has turned persistently lower in recent months. Of course, the stock market is forward looking, so given that it lost momentum even before the economy did, maybe stock market got it right after all.
Since the third quarter of last year, I've continually argued that the key factor in the economy's bounce has been "helicopter money" - one time windfalls of fiscal policy that provided massive third quarter tax rebates and monetary policy that drove the refinancing boom to a peak at precisely the same time (consumers generally take cash out of their homeowners equity when they refinance). That's not to say this money has been free - we can observe the cost in the form of larger government and consumer debt loads, as well as a heavier reliance on foreign capital. In any event, as expected, that shower of disposable cash has taken a few quarters to work through the system. As a result, we've seen the explosive GDP growth of the third quarter of 2003 gradually diminish to the mild GDP growth in the most recent report.
At present, there remains one additional remnant of the government's Helicopter Money Drop (a well-trained economist has to wince at elevating these policies to the status of an "economic plan"). That remnant is a provision that allows the partial expensing (rather than depreciation) of capital expenditures made before the end of 2004. While new spending has been slow to materialize, there's still some potential for increased capital investment in the months ahead. This will probably be largely offset by a decline in housing investment, so it isn't likely to drive much net growth in GDP. On the positive side, we needn't draw the required savings from foreign investors through a further deterioration in the U.S. current account, and capital spending - if it materializes - might help tech stocks to stabilize after a harsh several months.
Of course, stocks are not a claim on a single quarter of earnings, but on a very long-term stream of cash flows that will be delivered to investors over time. Stocks simply do not reliably track short-term outcomes in the economy. That's particularly true since the short-term kick from helicopter money is not likely to translate into much sustained growth.
In order to get sustainable economic growth, you need more than a short-term boost in disposable income. You need savings, investment, and innovation. Recessions are basically periods in which a mismatch develops between the set of goods and services demanded in the economy, and the set of goods and services supplied by the economy. The whole economy doesn't decline uniformly. Rather, certain industries and companies see their output go out of favor (e.g. telecom services) relative to the capacity that those industries have available. As a result, jobs are lost and plants are closed - not economywide, but concentrated in those industries that have lost demand.
Sustainable expansions, on the other hand, involve new ideas, concepts and industries. The initial bounce tends to come from housing and autos, but again, sustainable growth requires savings, investment, and innovation. At present, the U.S. propensity to save could hardly be weaker, and we don't observe much in the way of emerging industries. The key to long-term economic growth is innovation - new products and services that satisfy unmet needs. To reiterate the point of last week's comment, those products are initially very profitable because they are both scarce and useful. They subsequently become more plentiful as competition increases, which drives forward the growth of whole industries in order to take advantage of the profit opportunities (consider computers, networking equipment, biotechnology, medical devices, and other examples). As Schumpeter wrote, the emergence of profits and their destruction by the competitive mechanism is more than a frictional (short-term) phenomenon, but is precisely the engine that drives long-term growth in the economy and the standard of living.
Consider two scenarios. In the first, economic output expands because some discrete new industry has emerged. In that case, the initial addition to economic output is likely to be followed by a whole series of further additions. In this case, the fundamental character of the economy has changed. In economics, output "shocks" that remain permanently are said to have a "unit root" - they don't decay as time goes on.
On the other hand, consider an increase in output due to a very large tax refund. Initially, you get a jump in demand and a rundown in inventories. The next few quarters, you get a rebuilding of inventories and a bit more economic activity as the stimulus works its way through the system. The pattern is like 1, 0.5, 0.25, 0.125, etcetera. GDP has followed this sort of process in the past several quarters.
In short, helicopter money doesn't "jump start" sustained economic growth - it simply gives a kick that decays fairly quickly. The short-term effects don't fundamentally affect long-term cash flows. Investors may speculate enough to drive prices briefly higher anyway, but those higher short-term returns are simply offset by lower long-term returns. Absent saving and innovation, short-term growth doesn't propagate in a way that benefits the economy much in the long-term. That sort of "growth" shouldn't (and doesn't) benefit stock values much either.
As of last week, the Market Climate for stocks was characterized by unusually unfavorable valuations and tenuously favorable market action. We continue to hold a sufficient call option position to produce a roughly 35% exposure to market fluctuations in the event of a sustained market advance, at a cost of a fraction of 1% of assets in the event that the market declines or moves sideways. I am most interested in how the market behaves in the next several weeks. Though it is difficult to imagine a sustained advance at these valuations, the speculative mood of investors is a psychological factor that is not based on valuations nor subject to specific limits.
Presently, the Strategic Growth Fund remains fully invested in a broadly diversified portfolio of stocks, with an offsetting short-sale of equal value in the S&P 100 and Russell 2000 indices, and again, enough call options to give the Fund a roughly 35% exposure to market fluctuations in the event of a more sustained advance. Given current valuations, economic conditions, and other factors, that position is properly constructive and appropriately risk-controlled. This simply isn't a set of conditions in which investors have generally been highly rewarded for taking market risk, but as always, I am open to the possibility for investors to adopt more speculative preferences. Our current investment position reflects all of these considerations.
In bonds, the Market Climate remains characterized by modestly unfavorable valuations and modestly unfavorable market action. In all, not a particularly compelling environment to take much duration exposure either, so the Strategic Total Return Fund continues to carry a duration of about 2.3 years in Treasury Inflation Protected Securities, and a roughly 14% allocation to precious metals shares.
It would be nice to say that this is a market environment in which broad stock or bond market risk is likely to be highly rewarding. Unfortunately, this is not one of those Climates. Instead, I expect our returns to be driven primarily by the "active risks" that we take - positions that deviate from a passive buy-and-hold on the overall stock or bond markets. At present, our active risks in stocks emphasize what I view as strong value in the stocks we hold, relative to the market, stability of revenue growth and profit margins, again relative to the market, and various sector allocations driven by those considerations (e.g. higher weights in consumer staples, pharmaceuticals and energy, with our smallest weight relative to the market being in financial stocks).
In bonds, our investment position continues to recognize the potential dollar pressure from a record current account deficit, and other pressures on real interest rates. In general, precious metals shares have historically generated their strongest returns in environments of benign interest rates, generally rising inflation, modest valuation (we use a variety of approaches, but even the crude ratio of gold to the XAU index has a good record), and economic softness. Current conditions aren't perfect by these considerations, but they are increasingly aligned, and I continue to view our moderate holdings in precious metals shares as appropriate.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
Prospectuses for the Hussman Strategic Growth Fund, the Hussman Strategic Total Return Fund, the Hussman Strategic International Fund, and the Hussman Strategic Dividend Value Fund, as well as Fund reports and other information, are available by clicking "The Funds" menu button from any page of this website.
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