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February 5, 2007

It's All Fun and Games Until Someone Gets Hurt

John P. Hussman, Ph.D.
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One ought to become concerned about risk when investors become convinced that it does not exist. There are certainly times when it appears easy, in hindsight, to make money in the stock market. The difficulty is in keeping it through the full cycle. The fact that over half of most bull market advances are surrendered in the subsequent bear doesn't sink in until after the fact. It's all fun and games until someone gets hurt.

If the parents or the children of Wall Street analysts were to ask for wise investment advice, would the first thought of these analysts really be to encourage stock purchases at a multi-year market high, in a long-uncorrected and strenuously overbought advance, at a multiple of over 18 times earnings on unusually wide profit margins, with wages and unit labor costs rising faster than inflation, while interest rates are rising, bullish sentiment is unusually high, and corporate insiders are selling heavily? Would the potential for further gains in that environment exceed next inevitable correction by an amount that would make the net gains worth the risk? Would they encourage using trend-following systems in an overbought market, even though a decline to simple moving averages already implies substantial losses?

Uncorrected market advances give a voice to the idea that “this time it's different.” They invariably produce alternate valuation measures (like EBITDA multiples in the 90's, or price/forward operating earnings today) to replace the ones that suggest stocks are overvalued. These new-era arguments prevail despite the fact that the most recent evidence; the most recent market cycle; confirms the relationship between rich valuations and unsatisfactory long-term returns.

No. We've been here before, and the consequences – though not always immediate – have invariably been bad. There is not a single instance in historical data since 1871 when the S&P 500 traded above 18 times record earnings and there was not a low a year or more later that erased every bit of advantage over Treasury bills. Not one.

That's why despite the easy profits of the late 1990's, the S&P 500 has lagged risk-free Treasury bill returns since 1998. Despite the easy profits of recent months, the overall total return for the S&P 500 Index from July 24, 2000 through December 31, 2006 was just 7.83% (1.18% annually). The deepest drawdown in the S&P 500 over this period was more than -47%. During the same 2000-2006 period, the Strategic Growth Fund achieved an overall total return of 112.06% (12.38% annually). The deepest drawdown in the Fund during this period was less than -7%.

Simply put, there is no investment merit to the stock market at these valuations. The only reason to accept market risk might be speculative merit – the belief that stocks could be expected to outperform Treasury bills, on average, under prevailing conditions. That expectation would imply that some change in conditions would make a higher, likely, and acceptably profitable exit possible. Unfortunately, the present combination of overvalued, overbought, and overbullish conditions has produced average returns below Treasury yields. The evidence supporting a defensive position – at least temporarily – is already in hand. It's possible that we'll develop enough evidence to establish a more constructive investment position, particularly if a moderate decline can clear this overbought condition without a great deal of deterioration in market internals. Presently, however, we have no reliable basis for accepting market risk here.

Full Cycles

A full market cycle comprises a bull market and the subsequent bear market, or vice versa. Both the returns on the S&P 500 and the returns on the Strategic Growth Fund during the current cycle (respectively, 1.18% and 12.38% annually) have been less than I would expect during a typical market cycle. The present cycle – measured from the 2000 bull market peak to the present bull market level – has featured unusually rich average valuations, and has accordingly produced unusually low average returns.

In a typical market cycle, the profile of valuations allows the S&P 500 to achieve much higher returns. More typical valuations also make it reasonable to accept a greater average exposure to market fluctuations than we have during this cycle. So I would expect the returns for the S&P 500, as well as the returns for the Strategic Growth Fund, to be substantially higher in future market cycles that feature more typical valuations.

While our longer-term objectives have been nicely achieved, I have clearly not done much for you lately. Normally, the Fund has achieved a fairly smooth gain even when it has been fully-hedged, but we've flat-lined during the past several months. That's primarily due to a stock-selection environment that has buoyed low quality stocks (on the basis of earnings stability and balance sheet strength), and in which an unusually low percentage of individual stocks have outperformed the S&P 500.

So rather than enjoying a performance increment (between our stocks and the indices that we use to hedge) that adds to the implied interest on our hedge, our stock-selection performance shortfall of just a few percent has offset our implied interest earnings, leaving us with obstinately flat returns. I have no reason to believe this is anything other than a short-term hurdle.

The Strategic Growth Fund has achieved positive returns every year since its inception, but last year's return was disappointing, particularly if you extrapolate it as “normal” (which I would hasten to contradict). The Fund achieved double-digit annual returns despite market losses in 2000, 2001, and 2002, with another decent return of 21.08% in 2003, but has since produced an overall return of only 15.07%, versus 34.70% for the S&P 500.

That's actually a very small disparity from a full-cycle perspective. With the market extremely overdue for a material correction, it would take little market difficulty to put the Fund even with the S&P 500 for the period since 2003. Indeed, a one-year Fund return of 5% (basically Treasury bill returns) during a one-year market loss of 10% would be sufficient. The calculation here is 1.1507 x 1.05 vs. 1.3470 x .90. Given the Fund's fully-hedged position and the implied interest on our hedges, that outcome would only require our individual stocks to roughly match the performance of the index in a decline.

Of course, if the Fund was to significantly participate in a market decline (which I would not expect given our current hedge) a deeper market decline would be required to put the Fund ahead for the most recent few years. If our stocks were to resume a more characteristic performance profile relative to the market, an even shallower pullback would put the Fund ahead of the S&P, even for the portion of the current cycle since 2003.

In any event, a 10% decline in the S&P 500 would not even take the index to 1300. Are investors really willing to rule out that possibility?

With the S&P 500 having lagged Treasury bill returns for more than 8 years, investors are clearly starved for long-term returns. I can't emphasize strongly enough that I do not view further market gains in this environment as being retainable. Unfortunately, the repeated cycle of pullbacks and then fresh advances to marginal new highs also makes investors magnify differences in returns that are, in fact, trivial from the standpoint of the complete market cycle. It bears repeating that the market has had difficulty sustaining even a 3% gain over its late-October high for more than a few days.

As usual, it's important to remember that the profile of returns for the S&P 500 and the Strategic Growth Fund will often be different, depending on market conditions. The Fund is a long-term, risk-managed investment that is intended to outperform the market over the full cycle, with smaller periodic losses than a passive investment approach. It is not appropriate for investors with a strong desire to closely track market fluctuations of shorter duration.

Market Climate

As of last week, the Market Climate for stocks was characterized by unusually unfavorable valuations, relatively favorable market action on the basis of market internals, but also overbought, overbullish conditions that have historically combined with rich valuations to produce market returns below Treasury bill yields, on average. The Strategic Growth Fund remains fully hedged. This is not a market-timing position in anticipation of a short-term decline, but rather a risk-management position that recognizes the poor average return/risk characteristics that similar market conditions have historically produced.

We can't rule out the possibility that the market could extend its recent advance further. Such gains, if they occur, should be viewed from a full-cycle perspective. Even the 1500 level on the S&P 500, for example, is only about 3.5% above present levels. If we are to rule in the possibility of a 10%, 20% or even 30% market decline (all which I believe should be ruled in), we should also allow for further, though probably marginal, new highs.

Currently, the main factors that would support a speculative exposure to market risk here are measures based on market action. The issue here is that at “overvalued, overbought, overbullish” extremes, these measures have not always reliably deteriorated in advance of market losses. Though they do tend to deteriorate before major losses occur, some initial decline is often required in order to provide sufficient evidence of internal deterioration. Overbought markets usually require deeper initial declines, and therefore leave little room for error.

Once the market reaches one of those strenuously overextended conditions, the question is no longer “how much further might the market rise from this point to its ultimate peak?” but rather, “how much further might the market rise from this point to the point where the technical evidence would turn negative?” It's that second question that prevents us from taking a speculative exposure to market risk here.

The historical evidence does support using broad measures of market action to complement measures of valuation. But once the market has become strenuously overbought and overbullish, (particularly with interest rates also rising), stocks have achieved returns below Treasury bill yields, on average, until those conditions have cleared.

In bonds, the Market Climate last week was characterized by relatively neutral valuations and relatively neutral market action. I would expect to gradually increase the duration of the Strategic Total Return Fund if Treasury yields advance much beyond 5%, particularly if we begin to observe a widening of credit spreads. On balance, the economic data continue to appear relatively soft – the “positive” surprises of late have simply represented less softness than analysts had expected. Inflation figures have been constrained, but again, a widening of credit spreads would provide better evidence toward price stability. Essentially, wider credit spreads reflect concern about default risk, and in that environment, monetary velocity tends to decline, inflation pressures relent, and investors seek Treasury securities as a safe haven. Presently, the Strategic Total Return Fund maintains a duration of about 2 years, mostly in TIPS, and continues to hold about 20% of assets in precious metals shares, where the Market Climate remains favorable on our measures.

For disclosure purposes, as of December 31, 2006, the Strategic Growth Fund achieved annual total returns of 3.51%, 4.79%, and 9.80% for the most recent 1, 3 and 5 year periods, respectively. The average annual total return of the Strategic Growth Fund since its inception on July 24, 2000 was 12.38%. Returns as of January 31, 2007 were 2.01%, 4.23%, 8.81%, and 12.14%, respectively. Past performance does not ensure future returns, and the value of the Fund will fluctuate so that an investor's shares, when redeemed, may be higher or lower than their original cost.

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