John P. Hussman, Ph.D.
President, Hussman Investment Trust
New: Hussman Strategic Allocation Fund (HSAFX)
A few weeks ago, based on the prevailing level of stock market valuations and interest rates, our estimate of likely 12-year average annual total returns for a conventional, passive investment portfolio (invested 60% in the S&P 500 Index, 30% in Treasury bonds, and 10% in Treasury bills) fell to 0.46% – the lowest level in U.S. history except for single week of the 1929 market peak.
Given the extraordinarily low prospective returns that we currently estimate for a conventional, passive investment mix, we believe that it is important for investors to have a disciplined alternative, or at least a value-conscious diversification, to a fixed-allocation investment strategy.
Hussman Strategic Allocation Fund
The goal of the Hussman Strategic Allocation Fund is to provide for the ongoing, long-term inflation-adjusted spending needs of investors. Rather than setting a fixed, passive asset allocation regardless of valuations, or based on a specific target date, the Fund varies its investment allocation to stocks, bonds and cash equivalents based on our analysis of prevailing investment conditions; primarily valuations and our measures of market internals.
The Fund’s asset allocation approach combines two components:
1) A value-focused asset allocation component that jointly considers prevailing stock market valuations and interest rates, and;
2) A risk-management component that is intended to adjust the sensitivity of the portfolio to general market fluctuations when prevailing market conditions suggest risk-aversion or speculation among market participants.
We regularly determine the value-focused asset allocation based on our estimates of average annual expected returns for stocks, bonds, and cash equivalents over varying time frames, in light of prevailing stock market valuations and interest rate levels. The value-focused allocation reflects the extent to which we estimate each respective asset class to provide the highest expected returns, adjusted for risk, over these varying time frames.
The risk-management component of the asset allocation approach is further intended to reduce the sensitivity of the Fund’s portfolio to the impact of general market fluctuations when we infer that market participants are inclined toward risk-aversion, and to increase the sensitivity of the portfolio to general market fluctuations when we infer that market participants are inclined toward speculation.
In evaluating this inclination of investors toward risk-aversion or speculation, we examine the joint behavior of thousands of individual stocks, sectors, industries and security types, including debt securities of varying creditworthiness (what we often call “market internals”). We generally view divergence or broad weakness in these measures as an indication of risk-aversion among investors. In contrast, we generally view uniformly broad or indiscriminate advances in these measures as an indication of speculation among investors. Our evaluation of prevailing market conditions also considers economic factors, investor sentiment, interest rates, credit-sensitive indicators, and other factors in an attempt to classify prevailing market conditions with historical instances having similar characteristics.
Strategic Allocation represents a disciplined, value-conscious, historically-informed, risk-managed, full-cycle approach to long-term investment, capable of responding to changes in market conditions in a way that target-date and fixed allocation strategies do not.
In our view, aligning asset allocations with the valuations that drive long-term returns, while adjusting exposure to allow for shorter-term risk-aversion or speculation among market participants, is a systematic way to respond to the ever-changing landscape of investment risk and opportunity.
For more information, please download the Hussman Strategic Allocation Fund Prospectus and read it carefully.
The Fund is available for immediate investment. For an account application, please visit the Open An Account page of the Hussman Funds website.
If you would like to invest in the Strategic Allocation Fund (HSAFX) through a broker or other financial intermediary where Hussman Funds are presently available, please let them know your interest in having the new Fund added to their platform. Indications of investor interest can be very helpful in expediting this process.
Hussman Funds 2019 Annual Report
The 2019 Hussman Funds Annual Report is now online. The report includes information on performance, fees, and portfolio holdings for each of the Funds. The report also includes a detailed letter to shareholders, which is reprinted below:
One of the best indications of the speculative willingness of investors is the ‘uniformity’ of positive market action across a broad range of internals. Probably the most important aspect of last week’s decline was the decisive negative shift in these measures.
− John P. Hussman, Market Internals Go Negative, July 30, 2007
For most of the period since January 2018, we have observed persistently divergent market action, based on the behavior of thousands of stocks, industries, sectors, and security-types, including debt securities of varying creditworthiness. During this time, major stock market indices comprised of large-capitalization stocks, such as the Standard & Poor’s 500 Index, have experienced wide swings but little net progress. Still, occasional market rebounds from correction lows to marginal new highs have created the appearance of resilience, similar to what Barron’s Magazine described in February 1969:
“The failure of the general market to decline during the past year despite its obvious vulnerability, as well as the emergence of new investment characteristics, has caused investors to believe that the U.S. has entered a new investment era to which the old guidelines no longer apply. Many have now come to believe that market risk is no longer a realistic consideration, while the risk of being underinvested or in cash and missing opportunities exceeds any other.”
In hindsight, the S&P 500 had already entered a bear market weeks earlier. The S&P 500 Index would stand below its 1968 peak even 14 years later, with its total return lagging inflation by -3.4% over that period.
Small- and mid-cap stocks, particularly those with less extreme valuations, have not enjoyed the same resilience as the large-cap indices. For the year ended June 30, 2019, the large-cap S&P 500 Index gained 10.42% and the large-cap Nasdaq 100 Index gained 10.16%, while the small-cap Russell 2000 Index lost -3.31%.
A similar pattern of divergences across various market sectors reflects a loss of what I call “internal uniformity.” Our interpretation is that investor psychology has increasingly shifted from speculation toward risk-aversion. In a steeply overvalued market, the emergence of risk-aversion among investors often opens a trap-door that permits deep market losses. In the interim, however, this dispersion has created a headwind for hedged-equity strategies that purchase individual stocks and hedge those portfolios using offsetting short-sales using futures or option combinations on major indices like the S&P 500 Index.
This difference in performance between value-focused stocks and large-capitalization “glamour” stocks is similar to what we observed at the 2000 market peak, which was followed by an enormous reversal in the opposite direction in subsequent years. There is no assurance that we will observe a similar reversal in the current instance, but the evidence across a century of market cycles suggests that the current overvaluation of the large-capitalization indices is not sustainable, particularly when investors are becoming increasingly risk-averse.
Meanwhile, I continue to believe that it remains reasonable to accept the risk that results from active, value-conscious stock selection. Indeed, the stock selection component of Strategic Growth Fund has generally been compensated by returns in excess of the indices it uses to hedge, despite recent headwinds. In fact, this difference in performance was a major contributor to the 105.57% gain in Strategic Growth Fund from its inception on July 24, 2000 to the March 9, 2009 market low, a nearly 9-year period when the S&P 500 lost -45.99%, including dividends.
In short, although the loss of internal uniformity has been challenging for hedged-equity strategies over the past year, the combination of extreme market valuations and deteriorating internal uniformity also creates a potential trap-door for the equity markets that investors should not ignore.
As I observed in October 2000, near the peak of the technology bubble, “Historically, when trend uniformity has been positive, stocks have generally ignored overvaluation, no matter how extreme. When the market loses that uniformity, valuations often matter suddenly and with a vengeance. This is a lesson best learned before a crash rather than after one.”
Our measures of both valuation and market internals have continued to be effective, particularly in combination, as they were in prior market cycles. The difficulty we experienced during the speculative half-cycle since 2009 was the result of our pre-emptive bearish response to syndromes of “overvalued, overbought, overbullish” conditions that had reliably placed something of a “limit” on continued speculation in other market cycles across history. Extraordinary monetary and corporate tax policies during the recent cycle eventually led us to abandon the idea of “limits” to speculation.
In late-2017, we adapted our approach to refrain from adopting or amplifying a negative market outlook unless our measures of market internals have explicitly deteriorated. As I expressed in our 2018 Semi-Annual Report, my hope and expectation is that over the completion of the current market cycle, and in future ones, our long-term investors will feel very much like an old, familiar friend is back at the wheel.
Passive investing and performance-chasing
Every financial bubble is characterized by self-reinforcing behavior. As investors look backward at past returns, they are often emboldened to chase the securities or strategies that have enjoyed popularity, driving prices higher, further emboldening performance-chasing, and eventually producing a situation where prices become detached from underlying fundamentals.
In prior bubbles, the objects of this speculation have taken the form of “Nifty-Fifty” glamour stocks, industrial conglomerates, dot-com stocks, technology stocks, mortgage obligations, and other securities. In the recent speculative episode, they have primarily taken the form of government debt, low-grade “covenant lite” corporate debt, leveraged loans (loans to already highly-indebted borrowers), glamour technology companies that benefit from “network” effects (e.g. FAANG), and stocks that comprise widely-followed stock market indices such as the S&P 500.
According to Morningstar, the amount invested in “passive” U.S. equity funds is now equal to the amount invested in actively-managed funds. Passive funds typically invest in a specific list of stocks, generally in proportion to their individual market capitalizations, and tied to popular indices like the S&P 500.
The exodus to passive investing has two self-reinforcing elements. First, as funds have purchased the component stocks of the S&P 500 in proportion to their market capitalizations, with zero regard for price or value, the S&P 500 Index has performed better than both the broad market and the unweighted average of the very same stocks. That, in turn, has provoked further performance-chasing. In addition, because the funds are passively managed, they can operate with lower expenses, and the combination of strong backward-looking performance and relatively low fees has further amplified the exodus from active to passive investing.
Nearly 30 years ago, I wrote my dissertation at Stanford University on the efficiency and inefficiency of financial markets where rational investors hold differing sets of private information. One of the interesting features of a so-called “efficient market” is that, because the willingness of an investor to buy or sell reveals that the investor holds private information, other investors can infer that private information without actually seeing it, so the equilibrium market price always comes to reflect all information, whether private or public.
Apart from the largely ignored side-theorem that trading volume will always be precisely zero in that sort of market, a central requirement for an efficient market is that investors must be constantly monitoring and policing the market for inefficiencies. It is the very act of using prices as information, and aggressively policing every possible profit opportunity, that enforces an efficient market. Without that constant vigilance, one can never assume that financial markets are efficiently priced.
To put this in simple terms, one can visualize an efficient market as a sheep standing on a nickel. If there are enough sheepdogs around, constantly ensuring that the sheep doesn’t stray, then yes, the sheep will keep standing on the nickel. But if the sheepdogs simply assume that sheep always stand on nickels (the equivalent of asserting that “low-cost index investing is always efficient”), the sheep may not even stay in the neighborhood. That is the situation that the performance-chasing popularity of index investing has created today.
My own view is that every stock is a claim to some expected stream of future cash flows that will be delivered into the hands of investors over time. We spend a great deal of effort evaluating those factors, as well as market action that helps to convey the information of others. Across multiple market cycles, this sort of analysis has enabled our stock-selection approach to materially outperform the major indices, even after fees and transaction costs.
Indeed, despite the recent underperformance of our value-conscious stock selection discipline, the stock-selection approach of Strategic Growth Fund, excluding the impact of hedging, has had an average annual return of 8.60% from the inception of the Fund on July 24, 2000 through June 30, 2019, compared with an average annual total return of 5.81% for the S&P 500 during the same period. Our goal, of course, is for the hedging component of the Fund’s strategy to augment our stock-selection returns over the complete market cycle.
One consequence of the exodus to passive indexing is that the median price/revenue ratio of S&P 500 components has reached the highest level in history, easily eclipsing both the 2000 and 2007 market extremes. My expectation is that over the completion of the current market cycle, and during the market cycle that follows, the valuation gap between stocks favored by our stock selection discipline and stocks comprising the S&P 500 will be reversed, much as we observed during the 2000-2002 period. Such a reversal would be expected to contribute to future investment returns.
At present, our most reliable measures of market valuation remain near the highest levels in history, rivaling the extremes of 1929 and 2000. Meanwhile, apart from a brief positive whipsaw in early 2019, our measures of market internals have been unfavorable since February 2018. Generally speaking, when a hypervalued market is joined by risk-aversion among investors, the market environment becomes permissive of steep, waterfall losses.
Given weakness in leading measures of economic activity, coupled with unfortunately-timed shocks to global trade, the Hussman Funds are well-prepared for the potential for steep losses in the U.S. stock market. Improvement in our measures of market internals may ease our immediate downside concerns from time-to-time, but only a significant retreat in prices, or at least a decade of near-zero market returns, will ease the profound downside potential that our valuation measures presently imply for the U.S. stock market.
Strategic Growth Fund
During the fiscal year ended June 30, 2019, Strategic Growth Fund lost -8.05%, wholly attributable to a difference in the performance of the stocks held by the Fund, relative to the indices that the Fund uses to hedge. The primary driver of Fund returns during the recent fiscal year was broadening divergence in the internal behavior of the stock market, which has historically been associated with vulnerability of the U.S. stock market to major losses.
Despite losses that I view as a temporary consequence of this divergence, the objective of the Fund’s hedging approach is to mitigate or even benefit from likely market losses, as it has during other major market declines.
The stock selection approach of Strategic Growth Fund has outperformed the S&P 500 Index by an average of 2.79% (279 basis points) annually since the inception of the Fund. During the fiscal year ended June 30, 2019, however, Fund’s stock selections, excluding the impact of hedging, lost -1.39% despite a 10.42% gain in the S&P 500 Index.
From the inception of Strategic Growth Fund on July 24, 2000 through June 30, 2019, the Fund had an average annual total return of 0.16%, compared with an average annual total return of 5.81% for the S&P 500 Index. An initial $10,000 investment in the Fund at its inception on July 24, 2000 would have grown to $10,311, compared with $29,142 for the same investment in the S&P 500 Index. The deepest loss experienced by the Fund since inception was -56.13%. The deepest loss experienced by the S&P 500 Index since the inception of the Fund was -55.25%.
Strategic Growth Fund and the S&P 500 have each experienced their own periods of difficulty and loss since 2000, though at different times. Notably, the performance of the Fund since its inception remained materially ahead of the S&P 500 from its inception in 2000 until June 2013. As noted below, I believe that the primary difficulty in recent years has been fully addressed.
It is also notable that the steep losses of the S&P 500 in 2000-2002 and again in 2007-2009 were largely consistent with a century of historical experience. In contrast, the difficulty experienced by Strategic Growth Fund during the advancing half-cycle since 2009 resulted from an extraordinary departure from historical experience.
A century of historical experience indicates that extreme market valuations are predictably followed by major market losses over the completion of the market cycle. Indeed, during the 9-year period from March 24, 2000 to March 9, 2009, the Standard & Poor’s 500 Index declined by -55.71%, with a total return, including dividends, of -48.04%. By the 2009 market low, the S&P 500 had lagged Treasury bill returns for the nearly 14-year period since May 3, 1995.
Given current extremes in the valuation measures we find best-correlated with actual subsequent market returns, a loss in the S&P 500 on the order of 60-65% over the completion of this cycle, and negative S&P 500 total returns over the coming 10-12 year horizon, would be fully consistent with historical experience.
In contrast, the loss in Strategic Growth Fund in recent years has reflected wholly unprecedented conditions. Specifically, the novel and experimental pursuit of zero interest rates by the Federal Reserve encouraged persistent speculation by investors, despite extreme “overvalued, overbought, overbullish” syndromes that had historically placed a reliable “limit” on further speculation.
In late-2017, we adapted our investment strategy to abandon our pre-emptive bearish response to these syndromes. We now require explicit deterioration in our measures of market internals before adopting or amplifying a negative market outlook. This adaptation eliminates the key source of the Fund’s difficulty in the recent advancing half-cycle. In contrast, I do not have any belief that a presently hypervalued stock market has somehow adapted away the risk of profound losses over the completion of this cycle.
Strategic Growth Fund retains the flexibility to respond to improved market conditions, which we expect to emerge over the completion of the current market cycle, as well as unfavorable conditions like the 2000-2002 and 2007-2009 collapses, which emerged from the same combination of rich valuations and market internals as we presently observe.
Strategic Total Return Fund
During the fiscal year ended June 30, 2019, Strategic Total Return Fund gained 9.72%, compared with a gain of 7.87% in the Bloomberg Barclay U.S. Aggregate Bond Index. During this period, Strategic Total Return Fund held a moderately constructive position in long-term bonds, with a duration typically ranging between 3-4 years (meaning that a 100 basis point move in interest rates would be expected to affect Fund value by about 3-4% on the basis of bond price fluctuations). The Fund benefited from holdings in shares of companies engaged in the mining of precious metals, largely by varying the size of its investment positions in response to periods of strength and weakness in this sector.
From the inception of Strategic Total Return Fund on September 12, 2002 through June 30, 2019, the Fund had an average annual total return of 4.63%, compared with an average annual total return of 4.22% for the Bloomberg Barclays U.S. Aggregate Bond Index. An initial $10,000 investment in the Fund on September 12, 2002 would have grown to $21,399, compared with $20,015 for the same investment in the Bloomberg Barclays U.S. Aggregate Bond Index. The deepest loss experienced by the Fund since inception was -11.52%, compared with a maximum loss of -5.08% for the Bloomberg Barclays U.S. Aggregate Bond Index during the same period.
Strategic International Fund
During the fiscal year ended June 30, 2019, Strategic International Fund lost -5.79% compared with a total return of 1.60% in the capitalization-weighted MSCI EAFE Index. During the same period, the unweighted version of the EAFE Index lost 1.70%. While the 3.30% spread between the capitalization-weighted and unweighted EAFE Index may appear modest, this level of underperformance in the unweighted index has been observed on only a few occasions in the past 20 years. The two most pronounced instances were in March 2000 and January 2008, both near the beginning of major bear market declines.
Strategic International Fund remained fully hedged against the impact of general market fluctuations during the 2019 fiscal year. As we observe in the U.S. equity market, the performance of international equities has been strongest in passive, capitalization-weighted indices, with weaker performance in the broader market, particularly among value-oriented stocks.
Because international stock markets tend to become highly correlated during steep declines in the U.S. stock market, the downside risk that we observe in the U.S. market exists in international equity markets as well. A material improvement in U.S. conditions, particularly in our measures of market internals, would likely encourage a constructive stance in the international markets as well. Without the elevated level of market risk that we currently observe, the Fund will have substantially greater opportunity to establish a constructive investment stance based on individual country valuations, market action and other local considerations.
From the inception of Strategic International Fund on December 31, 2009 through June 30, 2019, the Fund had an average annual total return of -1.29%, compared with an average annual total return of 5.05% for the MSCI EAFE Index. An initial $10,000 investment in the Fund on December 31, 2009 would be worth $8,840, compared with $15,967 for the same investment in the MSCI EAFE Index. The deepest loss experienced by the Fund since inception was -21.77%, compared with a maximum loss of -26.48% for the MSCI EAFE Index during the same period.
As of June 30, 2019, Strategic Growth Fund had net assets of $293,905,889, and held 138 stocks in a wide variety of industries. The largest sector holdings as a percent of net assets were consumer discretionary (24.4%), communication services (15.5%), health care (15.0%), information technology (13.1%), industrials (11.1%), consumer staples (7.3%) and materials (7.2%). The smallest sector holdings were in financials (3.9%), utilities (3.2%), energy (1.1%) and real estate (1.0%).
Strategic Growth Fund’s holdings of individual stocks as of June 30, 2019 were valued at $302,249,214. Against these stock positions, the Fund also held 725 option combinations (long put option/short call option) on the S&P 500 Index, 400 option combinations on the Russell 2000 Index and 25 option combinations on the Nasdaq 100 Index. Each option combination behaves as a short sale on the underlying index, with a notional value of $100 times the index value. On June 30, 2019, the S&P 500 Index closed at 2,941.76, while the Russell 2000 Index and the Nasdaq 100 Index closed at 1,566.572 and 7,671.074, respectively. The Fund’s total hedge therefore represented a short position of $295,118,168, thereby hedging 97.6% of the dollar value of the Fund’s long investment positions in individual stocks.
Though the performance of Strategic Growth Fund’s diversified portfolio cannot be attributed to any narrow group of stocks, the following equity holdings achieved gains in excess of $1.5 million during the year ended June 30, 2019: Cree and NeoGenomics. Equity holdings with a loss in excess of $1.5 million during this same period were United Natural Foods, Urban Outfitters, Mallinckrodt, Express and Inogen.
As of June 30, 2019, Strategic Total Return Fund had net assets of $221,235,166. Treasury notes, Treasury Inflation-Protected Securities (TIPS) and investments in money market funds represented 74.7% of the Fund’s net assets. Shares of exchange-traded funds, precious metals shares, and energy and utility shares accounted for 4.0%, 14.8% and 6.3% of net assets, respectively.
In Strategic Total Return Fund, during the year ended June 30, 2019, portfolio gains in excess of $1 million were achieved in U.S Treasury Note (2.875%, due 8/15/2028), Barrick Gold, Anglogold Ashanti (ADR), U.S. Treasury Note (2.25%, due 2/15/2027) and U.S. Treasury Note (1.50%, due 8/15/2026). The Fund did not incur any portfolio losses in excess of $1 million during this same period.
As of June 30, 2019, Strategic International Fund had net assets of $21,934,105 and held 74 stocks in a wide variety of industries. The largest sector holdings as a percent of net assets were in industrials (12.3%), consumer discretionary (11.1%), financials (8.7%), information technology (7.4%), communication services (5.7%), consumer staples (4.8%), materials (4.0%) and health care (3.7%). The smallest sector holdings were in utilities (3.0%), energy (1.6%) and real estate (0.8%).
In order to hedge the impact of general market fluctuations, as of June 30, 2019, Strategic International Fund was short 140 futures on the Mini MSCI EAFE Index. The notional value of this hedge was $13,463,100, hedging 97.3% of the dollar value of equity investments held by the Fund. When the Fund is in a hedged investment position, the primary driver of Fund returns is the difference in performance between the stocks owned by the Fund and the indices that are used to hedge.
While the investment portfolio of Strategic International Fund is widely diversified and its performance is affected by numerous investment positions, the hedging strategy of the Fund was primarily responsible for the reduced sensitivity of the Fund to market fluctuations from the Fund’s inception through June 30, 2019. Air Canada was the only individual equity holding having a portfolio gain in excess of $125,000 during the year ended June 30, 2019. Equity holdings recognizing a portfolio loss in excess of $125,000 during this period were Norwegian Air Shuttle and U-Blox.
Supplementary information including quarterly returns and equity-only performance of the Funds is available on the Hussman Funds website: www.hussmanfunds.com.
There are three principal phases of a bull market: the first is represented by reviving confidence in the future of business; the second is the response of stock prices to the known improvement in corporate earnings, and the third is the period when speculation is rampant – a period when stocks are advanced on hopes and expectations. There are three principal phases of a bear market: the first represents the abandonment of the hopes upon which stocks were purchased at inflated prices; the second reflects selling due to decreased business and earnings, and the third is caused by distress selling of sound securities, regardless of their value, by those who must find a cash market for at least a portion of their assets.
– Robert Rhea, The Dow Theory, 1932
Amid the increasing perception that market and economic cycles are artifacts of the past, it is important to recognize where the financial markets and the economy actually stand in their respective cycles.
The recent bull market has already clocked in as the longest in history. As of the recent July peak in the S&P 500, the market advance since the March 2009 low has outlived the 1990-2000 bull market by nearly a year. Likewise, as of July, the current economic expansion is now longer than the record 10-year expansion that ended in early 2001. The U.S. unemployment rate is down to just 3.7% from a peak of 10% during the global financial crisis. The entire post-crisis “output gap” between actual real GDP and the Congressional Budget Office estimate of potential real GDP has been eliminated.
Meanwhile, based on the valuation measures we find best-correlated with actual subsequent market returns across history, the current market extreme already matches or exceeds those of the 1929 and 2000 peaks. There is little question that the market is long into what Rhea described as the final phase of the bull market; “the period when speculation is rampant – a period when stocks are advanced on hopes and expectations.”
Monetary policy has not repealed market or economic cycles
Market valuations have been extreme for a long time. While valuations have enormously important implications for long-term market returns and full-cycle market risks, valuations are not a timing tool. Indeed, it is impossible for valuations to reach hypervalued peaks like 1929, 2000, and today without persistently advancing through lesser extremes.
As I have regularly emphasized, extreme valuations can become even more overextended, provided that investors remain inclined toward speculation (which we infer from the condition of market internals). In previous market cycles across history, sufficiently extreme “overvalued, overbought, overbullish” syndromes typically acted as a limit to further speculation, and helped to warn of oncoming market plunges even before market internals deteriorated. That regularity failed in recent years. One had to wait for market internals to deteriorate explicitly before adopting a bearish market outlook.
The elevated risk of the stock market here is not merely the result of extreme valuations. It is the result of the full combination of extreme valuations, plus unfavorable market internals (indicating a shift among investors from speculation toward risk-aversion), plus extreme overextension, plus persistent weakness in leading economic measures.
The economic expansion since the 2009 economic low has been a rather standard mean-reverting recovery, with a trajectory no different than one could have been projected at the time of that low. Nearly every economic expansion in the U.S. has followed a rather simple trajectory, where the amount of economic slack at the economic trough (measured by the GDP “output gap”) has gradually narrowed at a rate of about 8% per quarter. Extraordinary monetary policies did nothing to materially change that basic mean-reverting trajectory.
Much of the growth in real U.S. GDP since the global financial crisis has been driven by a cyclical decline in the rate of unemployment. Meanwhile, the long-term “structural” drivers of the economy – labor force growth and productivity growth – have continued their persistent slowdown from historical norms. Holding the U.S. unemployment rate constant, U.S. real GDP growth would currently be running at only about 1.6% annually. This is the norm that investors should expect in the years ahead, and it amplifies the vulnerability to recession, because even a 0.8% increase in the unemployment rate from its recent lows would likely be associated with negative GDP growth.
Understand what low structural growth implies for the U.S. stock market. First, while Wall Street mechanically recites the aphorism that “lower interest rates justify higher valuation multiples,” this proposition actually holds only if the trajectory of future cash flows is held constant. Even then, this proposition is identical to saying that lower interest rates justify lower future stock market returns.
The problem is that if interest rates are low because growth is also low, lower interest rates don’t justify any increase in valuation multiples at all. Normal valuation multiples would already be enough to produce lower future equity returns, via the slower growth of future fundamentals. If investors instead bid valuation multiples up anyway, subsequent returns are penalized twice, and can be driven to negative levels for years to come. That is what investors have done here. We are left with the combination of a hypervalued market, historically low structural economic growth, and profoundly weak prospects for long-term market returns.
Put simply, the primary effect of extraordinary monetary policy in recent years was not to drive real economic gains, but instead to amplify speculation. None of this yield-seeking speculation and overvaluation has done anything to create aggregate “wealth” – it has simply taken future returns and embedded them into current prices. Long-term “wealth” is unchanged, because the actual wealth is in the future cash flows that will be delivered to investors over time.
Remember that once a security is issued, somebody has to hold that security at every point in time until it is retired. So the only thing that elevated investment valuations do is to provide an opportunity for current holders to receive a transfer of wealth by selling to some other unfortunate investor who pays an excessive price for the privilege of holding the bag of low future returns over time.
At current valuation extremes, it is only the illusion of “paper wealth” that temporarily anesthetizes investors and pension funds to the fact that their actual basis of wealth – the likely future stream of cash flows that will be delivered into their hands over time – is the smallest amount, relative to those “paper prices,” since the 1929 and 2000 extremes. This is exactly what hypervaluation means.
Easy money does not always support the market
In recent months, even as leading measures of economic activity have deteriorated, investors have become enthusiastic about a shift by the Federal Reserve toward fresh interest rate cuts, after a period of modest normalization that brought Treasury bill yields as high as 2.4%. It is useful to recognize that except for 1967 and 1996, every shift by the Federal Reserve from hiking rates (amounting to a cumulative increase in the Discount Rate in excess of 0.5%) to cutting rates (amounting to a cumulative cut of at least 0.5%), was associated with an oncoming or ongoing recession.
While aggressive monetary policy strongly amplified financial speculation in recent years, the 2000-2002 and 2007-2009 collapses were also accompanied by persistent and aggressive monetary easing by the Federal Reserve, with no benefit to the stock market other than short-lived rebounds that were quickly followed by collapsing prices. It is essential to understand what accounts for this distinction.
The way Fed easing “works” to support stock prices is straightforward. Provided that investors are inclined toward speculation and risk-seeking, Fed easing tends to be very favorable for the market, because safe, low-interest liquidity is a hot-potato to risk-seeking speculators. Each successive holder wants to get rid of it, yet somebody has to hold it at each point in time. The resulting effort to exchange it for something else has the effect of driving up stocks, bonds, and anything else that offers a “pickup” to low short-term rates.
In contrast, when investors are inclined toward risk-aversion, safe low-interest liquidity is a preferred asset rather than an inferior one. So creating more of the stuff does nothing to encourage more speculation. When one recalls that the Federal Reserve eased persistently and aggressively throughout the 2000-2002 and 2007-2009 collapses, it should be clear that a recessionary collapse in stocks would not be interrupted by a sudden shift toward rate cuts, aside for very short-lived knee-jerk reactions.
So while it is possible that Fed easing could help to shift investor psychology back toward speculation, the likely effect of Fed policy on the stock market will be best gauged by monitoring market internals directly. If market internals remain ragged and divergent, as they are as of mid-August, then even persistent and aggressive easing should not be expected to support stocks.
Conversely, during periods when market internals shift to a uniformly favorable condition, Fed easing will tend to amplify the speculative tendencies of investors, and it will be appropriate to adopt a constructive outlook in response. In any event, investors should be very careful not to assume that “easy money” means “rising market.”
Inflation risk should not be dismissed
Following a rumor that he had died, Mark Twain famously said “Reports of my death are greatly exaggerated.” Despite a long period of stability, the same thing can likely be said about inflation.
During the global financial crisis, the U.S. Federal deficit briefly exploded to over $1.5 trillion, peaking at just over 9% of GDP. Yet the size of this deficit was fairly consistent with the substantial level of economic slack at the time.
Presently, even with the unemployment rate down from 10% to a recent low of 3.6%, and even having completely eliminated the output gap between actual GDP and Congressional Budget Office estimates of potential GDP, the U.S. Federal deficit has exploded to nearly $1 trillion. Over the next few years, we expect the Federal deficit to reach record levels. Indeed, even a mild recession is likely to drive the deficit, as a share of GDP, to levels that match or exceed the extremes seen in the global financial crisis.
There are only a handful of instances – 1967, 1972 and 1979 – where the real GDP output gap pushed to positive levels (i.e. real GDP temporarily moved above CBO estimates of potential GDP) yet the Federal budget was already in a deficit position. These points are notable from the standpoint of economic history because they were exactly the points at which inflation expectations became most unstable, as the public abandoned its faith that fiscal policy was on a stable course.
It is also notable that the rampant inflation of the 1970’s was not ended by actually moving the Federal budget to a surplus. It was enough to restore public expectations that movements in the deficit would not continue along an unsustainable trajectory – particularly, relative to the GDP output gap. These expectations have remained intact for three decades, until recently. The Federal government certainly ran a deficit following the 1981-82 recession, but that deficit was much smaller than would have been expected based on the GDP output gap at the time. This is not likely to be the case during the next recession.
Accelerating inflation is not assured in the years ahead, because inflation has a significant psychological component, and it has no simple linear relationship with any of the factors that are usually used to explain it. From a historical perspective, however, the present “cyclically excessive deficit” creates a substantially increased risk of destabilized public expectations about fiscal discipline and monetary soundness in the coming years. For that reason, it will remain important to attend to various inflation measures, including interest rate spreads, commodity prices, and inflation-sensitive securities.
Based on the behavior of leading economic measures, and the tendency of employment data to lag other indicators of economic activity, I expect a substantial decline in the rate of job creation over the coming months. As a result, it is quite possible that Treasury bond yields may fall below their already depressed levels. This is particularly true given that European and Japanese central banks have already engineered negative interest rates (by creating bank reserves that must be held by someone until those reserves are retired, and then actually charging banks interest for holding them).
Still, the price of gold has begun to advance, apparently in revulsion to these monetary hot potatoes. Moreover, it is worth remembering that a 10-year Treasury bond yielding 1.7% will, in fact, only provide a total return of 1.7% annually over the coming 10 year period. The expectation of obtaining a higher total return in the short run, as the result of a further decline in this yield, is essentially a speculative operation.
Given these conditions, Strategic Total Return Fund presently maintains a modestly constructive exposure to Treasury bonds, with a recent portfolio duration of about 3 years (meaning that a 100 basis point move in interest rates would be expected to impact the Fund by about 3% on the basis of bond price fluctuations), coupled with a moderate exposure to shares in companies in the gold and precious metals industry, recently ranging between 10-15% of Fund assets.
Presently, market conditions feature a combination of rich valuations, vulnerable profit margins, record corporate debt relative to revenues, rising default risk, deteriorating market internals, and accumulating risk of oncoming recession. These conditions largely mirror those we observed in 2000 and 2007. While the deterioration of the broad market, relative to large capitalization-weighted indices has been a headwind for our hedged-equity approach during the past year, I view this market behavior as temporary. The more durable consideration is that we adapted our investment strategy in late-2017 to eliminate the key source of our difficulty during the recent half-cycle.
The Hussman Funds continue to adhere to a historically‐informed, value‐conscious investment discipline focused on the complete market cycle. I expect our investment outlook to become considerably more constructive in response to improvements in valuations and market internals over the completion of the market cycle. Presently, however, the combination of extreme valuations, coupled with ragged market internals, should not be dismissed.
I remain grateful, as always, for your trust.
John P. Hussman, Ph.D.
Past performance is not predictive of future performance. Investment results and principal value will fluctuate so that shares of the Funds, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than the performance data quoted.
Weekly updates regarding market conditions and investment strategy, as well as special reports, analysis, and performance data current to the most recent month end, are available at the Hussman Funds website www.hussmanfunds.com.
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Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based on the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 Index reflect valuation methods focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle.
This Letter to Shareholders seeks to describe some of the adviser’s current opinions and views of the financial markets. Although the adviser believes it has a reasonable basis for any opinions or views expressed, actual results may differ, sometimes significantly so, from those expected or expressed. The securities held by the Funds that are discussed in this Letter to Shareholders were held during the period covered by this Report. They do not comprise the entire investment portfolios of the Funds, may be sold at any time and may no longer be held by the Funds. The opinions of the Funds’ adviser with respect to those securities may change at any time.
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.
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Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 reflect our standard valuation methodology, focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle.