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February 6, 2012

Notes on Risk Management - Warts and All

John P. Hussman, Ph.D.
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One of the great challenges of investing is the distinction between hindsight and foresight. Hindsight treats each major advance, each market crash, each recession and each expansion as if their turning points were obvious, and extrapolates prevailing trends as if their continuation is equally obvious. Foresight is much messier, because it deals with unknowns and unobservables. It recognizes that major financial and economic events are often hidden from view when they are actually already in motion. Foresight requires the willingness to rely on data that tends to precede important outcomes (recessions, market crashes, durable long-term returns), even when those outcomes can't be observed in recent economic and market behavior that we can see and touch. Most importantly, hindsight creates the illusion that uncertainty is never very great, and risk management is never very challenging. Foresight demands a much greater appreciation for randomness, noise, uncertainty, risk management, and stress-testing.

Presently, there seems to be an unusually wide gap between hindsight and foresight, both in the financial markets and in the economy. In both cases, forward-looking evidence suggests weak outcomes, but recent trends encourage optimism and risk-taking. Rather than sugar-coat these uncertainties and minimize the messy divergences in the data, I think the best approach is to review the evidence, warts and all, including economic risks, market conditions, and the strengths and limitations of our own investment approach.

The economy: weak leading, lukewarm lagging

The most important news in the financial markets last week was undoubtedly the January employment report, which showed a 243,000 increase in non-farm payrolls, outstripping the 150,000 figure expected by a consensus of economists. Two questions immediately arise. What does this news do to change the likelihood of an oncoming economic recession? And what does this do to change the prospects for the returns and risks in the financial markets?

With regard to recession risks, the January employment report increases the divergence between leading evidence on one hand, where the broad set of data remains in a conformation that is almost exclusively associated with oncoming recession, and the more favorable, if lukewarm, signs from coincident indicators (e.g. employment, purchasing managers index, weekly unemployment claims) and lagging indicators (e.g. unemployment rate).

There is always some element of information when divergences and inconsistencies emerge in the data. But you can't extract that information very well by throwing all the data in a high-speed blender and just taking the average. Rather, inferences should be based on which indicators are relevant in which contexts. Specifically, we know that leading indicators lead, lagging indicators lag, and coincident indicators are coincident. Given that coincident indicators have improved in recent months, we can easily conclude that economic activity has also improved in recent months. But to make a forward-looking statement, we can't just extrapolate those improvements, because we know that coincident data doesn't extrapolate reliably at all. So we have to focus primarily on leading indicators instead.

And that's our dilemma here. It's undeniable that coincident measures have improved in recent months, but we have not seen a convincing turn in the leading data. So either the leading data will uncharacteristically lag the recent improvements, or what remains more likely, the coincident data will taper off and deteriorate. I'll reiterate that we aren't table-pounders for recession, and that we certainly don't hope for a recession (though we would welcome higher prospective investment returns that would be brought about by lower market valuations). Overall, an economic downturn remains the most likely prospect, and it's not at all clear that the latest employment report changes that risk. I think the best way to see why, as always, is to show you the same things that I'm looking at.

To begin, it's useful to understand how the Bureau of Labor Statistics calculated the 243,000 increase in employment that it reported for January. Total non-farm employment in the U.S., before seasonal adjustments, fell by 2,689,000 jobs in January. However, because it's typical for the economy to lose a large number of jobs after the holidays, largely in retail trade, construction, and manufacturing, the BLS estimated that the "normal" seasonal decline in employment should have been 2,932,000 jobs in January. The difference between the two numbers, of course, was 243,000 jobs, which was reported as an increase in employment. The fact that the size of the seasonal adjustment was more than 12 times the number of reported jobs, and more than 30 times the "beat" in economists' expectations, should provoke at least some hesitation in taking the number at face value.

Notably, the January 2011 and 2012 seasonal adjustment factors ( seasonally adjusted payrolls divided by unadjusted payrolls) have been the two largest factors used by the BLS since the 1960's, at 1.0166 and 1.0165, respectively. This compares with a January seasonal factor of 1.0155 a decade ago, and a factor of 1.0152 as recently as 2009. Now, a range of 0.0014 in the seasonal factors for January may not seem like much, until you consider that non-seasonally adjusted payrolls are presently about 130 million jobs, so variation in the seasonal adjustment factor alone amounts to a difference of 182,000 reported jobs. I'm not suggesting there's anything nefarious going on here, it's just that part of what we're seeing here is most likely a statistical artifact of the adjustment process.

Moreover, we've had a remarkably mild winter in the U.S, particularly in January, and it's clear that this has favorably affected both construction and retail activity. Ironically, however, nothing in the seasonal adjustment actually adjusts for this purely seasonal effect. If the mild winter weather reduced the "normal" number of January layoffs by just 3-4%, that would account for the entire amount by which the January employment number "beat" economists' expectations.

Our understanding is that most economic series are seasonally adjusted using the same algorithm from the Census Bureau, and indeed, we've been able to closely replicate the labor department's adjustments to various data series using that software [Geek's note: take the option to log-transform the data]. One concern we are aware of is that some data providers such as the ISM use exceptionally short windows (such as 5 years) to estimate their adjustment factors, which appears to invite a large amount of statistical noise in these factors due to the deep and unusual weakness of the 2008-2009 period.

As a side note, because the ISM incorporated the newly released seasonal factors from the Department of Commerce, we saw some significant downward revisions in the December ISM figures that made the January figures appear stronger. For example, the January figure for new orders was 57.6, the same as the original December figure. But since the December figure was revised down to 54.8, the January report appeared to be an improvement. Compared with the original December figures, both production and employment actually dropped. The original December PMI was 53.9, inching higher to 54.1 in January, primarily due to higher inventories. The upshot is that the composite signal from Purchasing Managers Indices and regional Fed surveys has improved modestly, but the overall picture remains lukewarm.

I certainly don't want to push that argument to the point of suggesting that recent reports are irrelevant, or that they don't reflect actual improvements. There is enough conformity across multiple pieces of economic data to conclude that the positive economic performance of late is not purely statistical noise. The real issue is the extent, durability, and "leadingness" of those improvements, where we continue to be adamant that lagging data (such as the unemployment rate) should not be expected to lead. Indeed, job growth has typically been reasonably positive in the 1, 3, 6 and 12 months prior to a recession. Job growth was positive in the month prior to 8 of the past 10 recessions, and in the 3 months prior to 9 of the past 10 recessions. In other words, we shouldn't expect weak job reports to lead recessions, though the year-over-year growth rate in payrolls invariably drops below 1.5% in the early months of a downturn (a level that we're still below).

In any event, a reasonable interpretation of the January employment report is that fewer jobs were lost in January than the BLS estimated that the economy should have lost on the basis of seasonal patterns. The economy is essentially bouncing around the flatline, and the main question is how much longer we can avoid a negative shock of any kind.

On a related note, we've seen a few suggestions that because the latest Purchasing Managers Index came in above 54 (the January figure was 54.1) and the S&P 500 is now above where it was 6 months ago, any concern about a recession is now invalidated as two of the four components of our basic Recession Warning Composite (see Expecting A Recession ) are no longer active. Put simply, this is not how this particular "Aunt Minnie" works. At least one signal from the Recession Warning Composite has appeared either just before or during each of the past 8 recessions, without false signals (the PMI never hit that 54 level in 2010), but those signals are typically not "step" impulses that stay continuously active. Rather, the appearance of even one composite signal is, in and of itself, cause for some recession concern. But given the simplicity of the Recession Warning Composite, a much broader set of evidence is clearly preferable, much of which has been the subject of numerous recent weekly comments.

As it happens, I received identical criticism of my recession concerns in May 2008, when the S&P 500 briefly rose above its level of 6 months earlier, and credit spreads briefly retreated from their levels of 6 months earlier, leading to suggestions that even our own recession evidence had "turned." At the time, the Fed was easing, Congress had passed an economic "stimulus" in the form of tax rebates, economic reports were coming in tepid but ahead of expectations, and any concern about recession was viewed with disdain. The S&P 500 had advanced about 12% over a period of about 10 weeks, and was only about 8% below its 2007 peak, having recovered much of what was (in hindsight) the initial bear market selloff. This was the most recent example of the "exhaustion syndrome" that emerged again last week (see Warning: Goat Rodeo ).

At the highs of that May 2008 advance, I observed "The reality is that as recessions develop (and I continue to believe the U.S. faces a much more significant downturn than we've observed to date), the data can take months to accumulate to a compelling verdict, and in the meantime, speculative pressures can remain alive" (see Poor Fundamentals with Borderline Market Action ). A few weeks later, the surreal calm in the face of seemingly obvious risks prompted the title of my June 2, 2008 weekly comment - Wall Street Decides to Close its Ears and Hum , where I noted "investors appear to be viewing the recent period of weak but not terrible economic news as a signal that the worst is behind us and that clear conditions are ahead." Memorably, that was not the case.

Though I don't expect a 2008-type collapse here, I would view a 25% market decline as only run-of-the-mill. I don't view the probability of recession as 100%, but the leading evidence continues to indicate recession as the most likely probability. While we track a very broad set of data, a crude but useful rule of thumb is that the combination of a) an upturn in the OECD leading indicators (U.S. and total world), coupled with b) a turn to positive growth in the ECRI weekly leading index, has generally been a good sign that recession risk is receding. Those shifts can occur fairly quickly, but we don't observe them at present.

[Geek's Note: We use standardized values of the growth rates for all of these measures: WLI mean 2.2, std 7.6, OECD_US mean 2.8, std 5.1, OECD_W mean 2.8, std 4.3. Standardized values below -0.5 on all three of these are nearly always associated with recessions (and always when the average of the three is less than -1). A subsequent move above a standardized value of about -0.2 in at least two of these three has quickly marked new expansions in the past. The corresponding level to monitor on each of the unstandardized indices, of course, is mean - 0.2*std, which translates to levels of about 0.7 on the WLI, 1.8 on the OECD US leading indicator, and 1.9 on the OECD total world index. Again, this is a rule of thumb, but it has a good record for a three-indicator model. The index symbols for Bloomberg users are: ECRWGROW, OLE3US, and OLE3TOTA, which can be examined alongside USRINDEX, which is a binary recession flag].

We aren't oblivious to the comfortable reports from indicators that typically lag the economy, but we also see disturbing recession risks in indicators that typically lead the economy. The problem is that even though investors know that lagging data lags, it deals with actual recent outcomes that can be "seen and touched." In contrast, even though investors know that leading data leads, it deals with unobserved future prospects that have not yet been realized. It's natural to focus attention of what can be seen and touched, even if it's not indicative of the future.

An angry army of Aunt Minnies

From a stock market perspective, even if we zero-out the recession warnings we've been seeing from a broad range of leading indicators, we are still left with rich valuations (we estimate that the S&P 500 is likely to achieve a nominal total return averaging about 4.4% annually over the coming decade), and an increasing set of very hostile "Aunt Minnies." These are indicator sets that regularly invite very skewed negative outcomes for the stock market (for examples, see Extreme Conditions and Typical Outcomes near the 2011 peak, Don't Mess with Aunt Minnie before the 2010 market break, Expecting a Recession in late 2007, A Who's Who of Awful Times to Invest at the 2007 market peak, and our shift from a modestly constructive investment position to a Crash Warning in October of 2000).

Last week, Treasury bill yields and 10-year Treasury yields both advanced, compounding the existing exhaustion syndrome with an overvalued, overbought, overbullish, rising yields syndrome, and not far from generating another rigidly hostile set of conditions outlined in the July 2007 comment A Who's Who of Awful Times to Invest . The fact that numerous Aunt Minnies are converging here is indicative that market risks are unusually high even if we ignore concurrent economic risks.

Market conditions are emphatically not comparable to the 2009 low, nor to the less extreme intermediate lows we observed in the summer of 2010 and again in 2011. What we observe today are market conditions very similar to what we observed near the 2011 peak, the 2010 peak, the 2007 peak, and to a lesser magnitude, the 2000 peak. Whatever questions one may have about our decision to maintain hedges in 2009 and early 2010 (more on that below, because it's an important discussion with shareholders), now is not then - not in terms of valuations, sentiment, overbought conditions, implied volatility, or measures or exhaustion. We know that the current "risk syndromes" can be associated with weeks and in some cases months of further progress and marginal new highs, but anyone who is has followed these conditions over the past decade with us has repeatedly seen those weeks or months of marginal gains erased in a handful of trading sessions. That is just how they work - they are not a forecast about market direction of the next few weeks. They are an indication of disproportionate downside risk on a larger and more extended scale.

Again, specific features, and in some cases failures, of our own hedging approach deserve a separate discussion (below). But we are presently observing market conditions that have regularly ended badly, and this can even be demonstrated over the past two years. However one wishes to deal with the extraordinary central bank can-kicking interventions that seem to regularly appear at the lows of those declines, it does not change the clearly negative outcomes that have regularly followed the overbought advances similar to what we observe today.

"Are the models working?"

We recently received an interesting and honest question from one of our shareholders in Strategic Growth Fund. Referring to the ensemble models that we introduced in 2010, the question was "Are the models working?"

The simple answer is that over portions of the past two years, our hedging approach has both "worked" and "missed," depending on the specific segment of market action under evaluation. We've hedged downside risks well, but have not taken advantage of the intermittent periods of speculation that followed massive central bank interventions at the 2010 and 2011 lows. Moreover, our avoidance of financials and "tight" choice of defensive put option strikes has sometimes produced moderate losses during periods of aggressive "risk on" speculation. The result has been something of a "chump to champ, champ to chump" rotation between underperformance and outperformance since we altered our hedging methodology in 2010. For newer shareholders, and to provide a more complete performance review, the challenging period from 2009 to early-2010 is discussed separately below.

The majority of my personal assets are, and remain, invested in Strategic Growth Fund. This is because I expect it to have the highest long-term return of the funds we manage, despite more recent years where the Fund has essentially treaded water (albeit with a fraction of the volatility of the S&P 500, which has been a screaming and volatile roller-coaster to nowhere over the same period). Our hedging approach is intended to be applied over a complete market cycle - generally several years, but in any event comprising a complete bull and bear market. While that approach may lag during the overvalued, overextended portions of a given cycle, I strongly believe - for reasons below - that it is well-suited to perform well over future market cycles.

I'm sometimes characterized as a "perma-bear." This is because the period since 2000 has been generally characterized by unusually rich valuations, which is duly reflected in the abysmal 0.80% average annual return, including dividends, that the S&P 500 has achieved from the 2000 peak through last week's close. That is not an accident, but instead matches the total return that we projected more than a decade ago, based on our standard valuation methodology. Given that, it should be clear that my generally defensive stance during this period is not some fixed aspect of my personality or temperament, but instead owes far more to the repeatedly and predictably disastrous overvaluation of the stock market since the late 1990's.

Such a richly overvalued period is unique in U.S. stock market history, and as a direct result, 12-year periods of virtually zero returns are also rare. Only two periods come close. The stock market suffered negative returns in the 12 years after the 1929 peak, which started at a Shiller P/E of about 22. Stocks also achieved an annual total return of just 3.7% in the 12 years between 1963 and 1975, owing to the unfortunate combination of a high starting valuation, with a Shiller P/E of about 21, and a low ending valuation, with a Shiller P/E below 9. As of last week, the Shiller P/E was again over 22. Regardless of economic prospects, this is a strong headwind.

Unfortunately, it is both dangerous to speculate, and utterly frustrating to remain defensive, in richly overvalued markets coupled with significant economic risks or strenuously overbought conditions. This is the environment we are presented with, and it is in no way typical of "standard" market conditions, despite its repetition in recent years.

I noted back in 2007, during a similar period of frustration, that less than half of the typical bull market gain is retained by the end of the subsequent bear market - "Once stocks become richly valued, the remaining gains achieved by the market are almost always purely speculative they are generally erased over the remaining course of the market cycle. There are reasonably good tools, based on the quality of market action, that have historically allowed the capture of a substantial portion of those 'speculative' gains. But once the market becomes not only richly valued, but sentiment becomes broadly bullish and stocks become overbought on a shorter-term basis, the return/risk profile of the market becomes unfavorable even for speculation" (see Baron Rothschild ).

While our standard valuation methodology doesn't use Shiller P/Es, it is related, in that it accounts for the very predictable tendency of profit margins to normalize in a competitive economy. That method has been quite accurate both historically and as recently as the 10-year period ended last week. Indeed, just 5-years ago, in May 2007, I noted "investors would be well advised to base their expectations for market returns in the next several years averaging somewhere in a 3-4% band around zero" (see An Optimistic Route to a Poor Market Outlook ). It should be clear that our valuation models are not broken, and that they continue to be accurate and reliable gauges of subsequent market prospects.

What should a valuation model do? It should indicate the appropriate price an investor should pay in order to achieve a particular expected long-term return. Or equivalently, it should indicate the likely long-term return an investor can expect to achieve given the price they are paying. An investment in the S&P 500 Index at present levels is likely to achieve a nominal total return of about 4.4% annually over the coming decade, and investors will have to tolerate a great deal of volatility in pursuit of that return. Market history leaves little doubt that any further advance from present levels will be surrendered over the completion of the current market cycle.

As a side note, the most frequent "valuation" approach that we hear from Wall Street analysts amounts to what we call "forward operating earnings times arbitrary multiple" and is embodied in statements like "we expect forward operating earnings next year to be so-and-so, and we're also expecting a very modest increase in the multiple of about 2 points, which gives us a price target of such-and-such." While this sounds reassuringly analytical and conservative, that particular model has almost always implied a one-year price gain of about 15-18%, regardless of the circumstances (you'll find many analysts who projected just that even at the 2007 market peak). Valuation "targets" of this kind should not be taken as useful information, but instead as red flags.

On our response to the credit crisis - warts and all

Despite the weak 4.4% total return that our valuation models project for the S&P 500 over the coming decade, it is also clear that our projected returns advanced above 10% at the 2009 lows. Our relatively flat performance since early 2010 would not be nearly as uncomfortable had we removed a significant portion of our hedges in 2009. Indeed, from the inception of Strategic Growth to the point of that 2009 low, the Strategic Growth Fund had nearly doubled, while the S&P 500 had nearly dropped in half. At that time, the Fund was ahead of the S&P 500 for every performance horizon since inception.

Our shareholders generally have a clear understanding that we will tend to lag in overvalued markets that are overbought and overbullish, or where economic risks are high. So despite that "champ to chump, chump to champ" cycle we've experienced since 2010, my sense is that most shareholders understand our reasons for not speculating here, and have enough examples from our similar experience approaching the 2000 and 2007 peaks to recognize that we know what we're doing.

The real issue, which I suspect bleeds into a general insecurity about our hedging approach for at least some of our shareholders, is that we didn't remove our hedges in 2009. In general, our conversations with shareholders indicate that they understand this period, but since we continue to get that question periodically, it's important to walk through that set of events again.

Prior to 2008 our hedging approach was based on the historical return/risk characteristics of nearly 70 years of post-war U.S. data. When I developed our Market Climate approach well over a decade ago (which evaluates the return/risk profile of the market by grouping present market conditions with the most similar historical instances), I had excluded Depression-era data, not only because of incomplete availability, but also because it seemed highly improbable that the U.S. would face similar conditions again.

Pursuing our hedging approach, based on post-war data, we correctly identified the steep market risks in 2000 and 2007, while also removing about 70% of our hedges in early 2003 as the intervening bull market was beginning. As is common during the higher-risk overvalued, overbought portions of the market cycle, our hedging missed some potential returns during the approach to both bull market highs, but the 2000-2002 and 2008-2009 plunges easily wiped out the gains that the market temporarily enjoyed during those periods.

The economy entered a recession and the stock market plunged in late-2008. Our initial response, based again on post-war U.S. data, was to soften our hedges as valuations improved. Though valuations weren't anywhere close to normal pre-bubble bear market levels, we had also been willing to reduce our hedges in 2003, when valuations also weren't terribly compelling. In the 2008, however, the market continued to plunge in a way that was out-of-context from a post-war standpoint, leaving us with a loss of about 9% for the year, though a fraction of the losses suffered by the major indices.

As the crisis deepened, we were forced to contemplate the possibility of Depression-era outcomes, at which point the question was this: how would our existing hedging methods have fared during that period? The answer was both comforting and disturbing. Applying our approach to Depression-era data (using proxied or estimated data where important series were unavailable) significantly reduced downside risk and was acceptable in terms of returns, there were still several intervening drawdowns that I viewed as intolerable, approaching a temporary 45% loss of capital in at least one instance. In fact, once the market had declined to the point where 10% returns were expected over the following decade, the stock market went on to lose two-thirds of its value before reaching its Depression-era low.

Admittedly, I should have done that evaluation a decade earlier, but I hadn't contemplated the possibility of Depression-era conditions again. It was small consolation that many Wall Street analysts didn't seem to have stress-tested their approaches in any historical data at all. Given the present rhetoric on Wall Street, it is clear that a large proportion of analysts still have not done so.

In any event, I suspended our risk-taking based on the conflict between the two data sets, because as I noted then, there was no way to "average in" Depression-era information without producing negative return/risk estimates, and I wasn't willing to expose shareholders to such potentially deep losses. As I wrote at the time, my main concern was to ensure that our hedging methods would perform well both in post-war and Depression-era data, with tolerable volatility. More exactingly, I insisted that our approach should work in "holdout" data that it did not previously "see" (anyone can back-fit a model, but those models often fail miserably in out-of-sample data). I called this our "two data sets" problem, which I wrote about repeatedly during 2009 and early 2010.

The result of that research was a set of "ensemble" models that I've discussed at greater length in other commentaries. With those models in hand, we find that the main points where the ensembles would have led us to do things differently than we did in practice were in late-2008, when the approach would have been even more defensive than we were in practice (based on the failure of the market to generate enough confirmation of the periodic "reversals" we saw at the time), and more constructive during much of 2009 and early 2010 (largely based on a retreat in credit spreads, and various subsets of indicators that validated improved conditions). Even so, with a few moderate exceptions, the ensembles have instructed us to remain largely hedged since April 2010. Of course, part of our discipline is the constant attempt to improve that discipline, so we've certainly learned a few subtle things that we could have done differently during 2010 and 2011, but the core differences are in that 2009 and early-2010 period.

The key point is this. The performance of our hedging approach in Strategic Growth from inception through the end of 2008, and from late-2010 to the present, can be taken - gains, losses, sunshine, warts, and all - as an accurate reflection of our existing investment strategy at the time. In contrast, it should be clear - especially to shareholders who regularly read these weekly comments - that our performance during 2009 through early 2010, when we very openly worked to modify our hedging methods, is not an accurate reflection of what we can expected to do in future cycles, even under identical circumstances.

Needless to say, all of our actions and performance are relevant to shareholders, including that 2009-2010 period. It's just that part of that performance reflects an open, deliberate and singular change in our methodology, and should not be extrapolated to future cycles.

Accordingly, if you are a short-horizon investor and are uncomfortable with our tendency to miss rallies that occur in periods that we identify as overvalued and vulnerable to recession risk, you should not own the Strategic Growth Fund, because that sort of performance, under those circumstances, is not unusual for our strategy. Likewise, if you don't intend to hold the Strategic Growth Fund over the course of a complete bull-bear market cycle, you should not invest in the Fund, because we have no firm expectation that the Fund will outperform the market over smaller segments of the market cycle.

In contrast, if you are a long-term investor in the Fund, but having seen us suspend risk-taking in 2009 and early-2010, are now concerned that it is our strategy to remain fully hedged regardless of market conditions, I believe that this concern is unnecessary. Our stock selections have outperformed the major indices by a significant margin since inception, and I believe that our hedging approach is well-suited to reduce our risks while contributing to our returns over the complete market cycle, if not always over shorter segments of that cycle.

As always, my goal is not to have more shareholders (or fewer), but to ensure that our shareholders fully understand our approach, and that they understand risks that are relevant, as well as those that are not. I have little doubt that some of these comments will be taken out of context and used to toast me in the blogosphere, but that's life. My main concern is that our shareholders understand our approach. Very simply, I'm confident that we've addressed the challenges that we faced during the recent credit crisis, and that our hedging models are well-suited to navigate the market cycles ahead. For investors in Strategic Growth Fund, probably the best evidence of that confidence is that the Fund represents the largest holding among my own investments, with nearly all of the rest invested in Strategic Total Return and Strategic International.

Market Climate

As of last week, the Market Climate for stocks remained characterized by rich valuations (associated with a 10-year total return projection of 4.4% annually for the S&P 500), an exhaustion syndrome that has typically been followed by market declines averaging about 25% within the following 6 months (see Warning: Goat Rodeo ), and on the heels of last week's upward move in shorter-dated Treasury yields, the reappearance of the familiar overvalued, overbought, overbullish, rising-yields syndrome. We know from a great deal of market history that this "Aunt Minnie" is associated with what we call "unpleasant skew" - a few weeks of further marginal new highs, where each initial selloff is met with a fresh advance to very slightly better levels that give the impression of endless resilience, often followed abruptly by an "air pocket" that can wipe out weeks or months of prior upside progress in a handful of sessions. This pattern should be familiar to those who read these comments regularly.

Given the convergence of a number of nasty Aunt Minnies here, it's difficult to keep from crossing the line between our usual "on average" language to outright "warning" language - simply because the typical outcomes are ultimately so disproportionately bad. Still, it's important to remember that even these syndromes don't necessarily resolve into immediate risks, and those slight new highs are often so highly celebrated that it's tempting to join the party if the process drags out for any length of time. Even here, it's not entirely certain that market conditions won't shift in a way that allows for some modest amount of market exposure, but at present, we would characterize conditions as very unfavorable for long-term investors, and speculative even for speculators. Both Strategic Growth and Strategic International are well hedged, though we're not raising our put option strikes here, in order to limit any significant erosion in option premium in case that "unpleasant skew" drags on for a several weeks.

In Strategic Total Return, we clipped back our holdings in precious metals shares on strength early last week, to about 7% of assets. The Fund continues to have a duration of about 4.5 years in Treasury securities, so our overall stance remains generally conservative but not outright defensive. A continued increase in Treasury yields would likely provoke a further reduction in our precious metals holdings, as gold stocks in particular do not typically behave well when long-term rates are advancing. That said, my impression is that the enthusiasm about the economy is most likely misplaced, so we may modestly increase the duration of the Fund if yields rise further. Given the overwhelming influence of seasonal adjustment on the January employment figure, which transformed an actual loss of 2.7 million jobs into a reported gain of 243,000, the enthusiasm over that number is almost certainly excessive.

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