October 5, 2009
Defensive, With a Measure of Equanimity
The surprisingly weak September employment report, coupled with a fresh drop in factory orders, was met with a confidently muted response by investors on Friday. We did observe some eagerness to sell in the morning, but that was quickly matched by offsetting demand, most likely from investors looking for an entry point into what has thus far been an almost relentless uptrend from the March lows. Every seller needs a buyer, and at least on Friday, not much price weakness was required to induce them to meet.
Four weeks ago, I noted that if indeed the economy is in recovery, we have already entered the “show me” phase. The jobs report was dismal on that front, with even overtime hours and temporary workers declining. Those are the first measures that should advance, well before we can expect any turn in headline employment. The unemployment rate met expectations at 9.8%, but only because 571,000 workers left the labor force, dropping out of the calculation entirely.
My view continues to be that the intrinsic condition of the U.S. economy has not improved, and that the green shoots we've observed are a transient artifact of green dollars poured out by the government. There is little reason to expect this spending to propagate into “organic” growth. Of the range of possible catalysts for fresh risk aversion, my guess is that all hell is likely to break loose at the point where the first bank CFO resigns out of refusal to sharpen his pencil any further. That, however, could be months from now. Think about it – we've got continued employment weakness, coupled with continued record delinquencies and foreclosures, compounded by a mountain of Alt-A and Option-ARM resets that only started a few weeks ago and will continue heavily into 2010 and even 2011. By what magic has a replay of the recent credit crisis been averted?
Still, we consider all the risk factors, but in the end, base our investment positions on the prevailing weight of the evidence as it stands at present – not on any specific scenario about the future. Valuations are not attractive here, price-volume behavior is notably tepid, advisory bullishness is nearly as high as it was at the 2007 peak, and earnings estimates for coming quarters already require a return to record high profit margins (see Bill Hester's research piece this week – additional link below). Still, market internals have not broken down notably, and a reasonable portion of the overbought condition of recent weeks has been cleared. Our assessment of current conditions is defensive, but we also have to have some equanimity about possible market direction until we observe further deterioration in market internals.
Accordingly, we are still well-hedged, but we did re-establish a modest “anti-hedge” in index call options on last week's selloff. If the market plunges from here, we're well defended, though our returns may be roughly a percent less than they otherwise would have been. If the market advances, we'll appear reasonably hedged initially, but gradually more constructive on an extended move higher.
I should note that we also saw some volatility last week due to earnings pre-announcements in various stocks, which induced some day-to-day basis fluctuation into the Strategic Growth Fund. Much of this was quickly reverting “noise,” but it does reflect an underlying skittishness among investors that has implications for the broad market as well.
Market internals, as well as the uniformity of action across major indices, should be monitored closely here. The probable economic concerns become quite pointed about 6 months out (when current delinquencies will be transformed into foreclosures and reportable balance sheet losses). That's about the horizon over which the market often begins to pay attention to oncoming trouble, so while we've known about the risk of a second wave of credit problems for a while, we may be at the point where investors begin to act on those prospects.
Probably my clearest drawback as an investment manager is that I have too often assumed that investors should recognize what seemed to me to be patently obvious dangers (the predictable collapse of the dot-com bubble, the tech bubble, the housing bubble, the oil and commodities bubble, etc) with a longer lead-time. Unfortunately, we inevitably experience a period of frustration – at least temporarily – for assuming such foresight. Still, none of those has caused trouble for us like they did for the rest of the world. Sustainable long-term returns require the avoidance of major losses, and the best way to avoid major losses is to avoid a) securities where the probable long-term cash flows do not justify the price, and b) markets where the probable returns from accepting risk are unlikely to be durable. There are a lot of investments that can be bought for short-term speculation that fail this test, but advance anyway - until they don't. The most important lesson I keep having to re-learn is how utterly myopic investors can be when there's an uptrend to be played.
Since I have no plans to risk the financial security of our shareholders on securities that are not worth their price, or premises that I believe are dangerously false or irrational, I can't say that learning this lesson will make us strikingly more responsive to speculative runs in the future. But there may be some middle ground that we can exploit. Our objective remains constant: to significantly outperform our benchmarks over the complete bull/bear market cycle, with smaller periodic losses than experienced by a passive buy-and-hold strategy.
For now, we remain defensive, but with a measure of equanimity about market direction, at least over the near term.
As of last week, the Market Climate for stocks remained characterized by moderately unfavorable valuations, generally positive trends in major indices, tepid price-volume behavior, but also a partial clearing of the overbought condition of recent weeks. As noted above, the Strategic Growth Fund remains defensively positioned, but we did re-establish a modest “anti-hedge” in index call options on market weakness late last week.
In bonds, the Market Climate was characterized last week by relatively neutral yield trends and modestly favorable yield pressures. The Strategic Total Return Fund remains primarily invested in TIPS and straight Treasuries, with an average duration of about 3 years. The Fund holds only about 1% of assets in precious metals shares at present, with about 4% in foreign currencies and about 4% in utility shares.
New from Bill Hester: Forward Earnings Imply a Return to Near-Record Profit Margins
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