November 2, 2003
John P. Hussman, Ph.D.
All rights reserved and actively enforced.
In recent months, I've noted that third quarter GDP was likely to be very strong, with the probability of a fourth quarter follow-through driven by inventory rebuilding. Last week's explosive GDP report stirred the hopes of some investors for more sustained growth. CNBC's Squawk Back poll of the day asked viewers to respond to the 7.2% GDP growth rate for the third quarter; 60% of viewers voted it "a sign of things to come", with just 40% identifying the report as "a one-time pop." Judging from the market's tepid reaction on Thursday and Friday, this enthusiasm may be premature.
The three engines of any economic recovery are invariably autos, housing, and capital spending. True to form, the highlights of the report were real personal spending, which surged 6.6% (paced by explosive 26.9% annual growth in durable goods - largely auto sales); residential investment, which soared by 20.4%; and investment in equipment and software, which increased by 15.4% at an annual rate.
So the typical engines were on fire in the third quarter. Unfortunately, it was the kind of fire that you get when you empty a can of lighter fluid into a barbecue - a huge ball of flame, lots of excitement, and if you're lucky, just enough follow-through to cook a burger.
Debt and Taxes
At the risk of burning off an eyebrow or two, let's take a closer look at that lighter fluid. It's widely recognized that one-time tax credit checks were a factor, but the extent of this impact is not well appreciated. Personal income increased $91.0 billion in the third quarter, which is 4.0% annual growth in nominal terms. But the PCE price index increased by 2.4%. This means that real pre-tax personal income advanced by only about 1.6% at an annual rate. In contrast, real after-tax personal income soared 7.2% at an annual rate. This observation is echoed by analysts at Bridgewater Associates, who report "without the tax cut spending, personal spending would have grown 1.2% (instead of the actual 6.6%) and contributed only 0.9% to real GDP growth (instead of 4.7%)."
Oddly, the other can of lighter fluid hasn't received much attention. As the quarter began, mortgage rates were at new lows on Alan Greenspan's remarks about deflation risk. This plunge in interest rates was predictably accompanied by a remarkable surge in the mortgage refinancing index. Housing and durable goods sales - the two forms of investment that have a measurable sensitivity to interest rates - also surged as a result.
In general, the response of housing lags interest rates by a few months, so the beneficial effects of the mortgage refinancing spike carried through the bulk of the quarter, contributing to that 20.4% explosion in real residential investment. Given that interest rates have surged higher from those lows, accompanied by an equally dramatic plunge in the mortgage refinancing index, forthcoming GDP growth will be at the mercy of other factors.
In short, the GDP report was a ball of fire ignited by a big can of one-time tax credits and another big can of cash-out mortgage refinancing. Consumers received a bunch of lump-sum distributions and spent them on consumption goods, autos, and housing. To expect this spending to continue in the absence of such distributions requires very strained analysis.
This isn't to say that the report was a complete artifact. Spending on equipment and software did increase at a 15.4% annual rate, driven by upgrading of computer equipment, laptop sales, and legitimate investment such as database and web-enabling software. This category only represents 8% of GDP though, and the faster growth largely represented pent-up demand, but it is at least positive that businesses finally acted on that demand. A number of companies we own would benefit from a continuation of this sort of spending, though I would expect any further gains to be at a slower, more sustainable pace.
Finally, the explosive demand during the third quarter led to the lowest inventory-to-sales ratio on record. This will predictably support output growth during the fourth quarter and beyond, as companies rebuild inventories. However, without the massive lump-sum boosts to disposable income we saw in the third quarter, there is little reason why companies cannot build inventories gradually, without the need for significant shifts in employment. So while it's likely that inventory rebuilding will be supportive to GDP in the coming quarters, the case for rapid growth in GDP and employment on that account is exaggerated.
The mutual fund industry has come under scrutiny for allowing (and in some cases engaging in) retrospective trading. This primarily involves two issues:
The first is the practice of knowingly submitting or accepting orders initiated after the 4:00 P.M. close of trading (often based on information reported after the close), yet filled at the NAV as of the 4:00 P.M. close. While batching and processing orders from brokerage companies ensures that a large portion of orders received for mutual funds will be delivered to those fund companies after the close, it is illegal and predatory to initiate those orders after the close.
The second practice generally involves international funds. Unusually large advances in the U.S. markets are typically followed by similar advances in international markets once they open for trading. Purchasing an international fund on the basis of a strong U.S. market close (priced at net asset values that reflect the preceding day's foreign stock prices) is therefore also a form of retrospective trading. This practice is currently legal, but is clearly predatory, because it dilutes the gain that existing shareholders would otherwise enjoy. It is also a breach of fiduciary duty if it is done by fund managers.
Neither of these practices are properly described by the term "market timing" - they are much better described as "retrospective trading": transactions executed at net asset values that do not reflect fair market values as of the time that the order is placed (generally because the market in question is closed at that time).
Market timing also involves costs to mutual fund shareholders, but primarily in the form of commission costs and market impact. Essentially, market timers believe that they can forecast short-term movements in the market, and make transactions on this belief. I don't believe that this sort of forecasting is possible, and also believe that mutual funds should defend long-term shareholders through the use of redemption fees for short-term holding periods. However, it is incorrect to use the term "market timing" to describe the predatory "retrospective trading" practices that have recently come to light .
Redemption fees work
Regulators are moving quickly to address the scandal. I think the best way to handle the problem really is through a requirement that funds impose redemption fees on very short term holding periods (for Pete's sake, is it too much to expect shareholders to hold a fund for say, 5 days?) While this would impose a cost to short-term traders by reducing their trading flexibility, it compensates long-term shareholders for trading costs and disruption. The exception to these redemption fees would be funds that trade strictly in actively traded futures contracts. The reason here is that the futures markets generally reflect fair market values even if the underlying securities markets are not yet open. There is no doubt that if sufficient interest exists to "time" the foreign markets, futures-based funds would gladly fill that need, without undue retrospective trading risk to existing shareholders.
Don't require investors to fly blind
One ill-considered proposal is to require all fund orders to be delivered to mutual fund companies by the 4:00 P.M. close, which would impose something like a 2:30 P.M. cutoff to place mutual fund orders for a given trading day. The reason I oppose this is that it effectively forces shareholders to "fly blind" for an hour and a half, having committed to a purchase or sale based on market prices that may move dramatically and adversely between the time the order is placed and the time the fund is priced.
In short, this proposal obligates investors to take delivery at a later, unknown price every time they buy a fund. This is like forcing them to write a put option with a life of 1.5 hours, with no compensation. Given that the CBOE volatility index has averaged about 22.4% over the past decade, the approximate market value for such a put option on the S&P 500 index would be about 2.5 points. In other words, the implicit cost to shareholders of "flying blind" would be something in the neighborhood of one-quarter of one percent of their assets every time they trade in a typical growth fund , less for very stable funds, and significantly more for volatile investments like technology funds. There are better solutions.
(Geek's note: The specifications of the option are unusual because the strike price is stochastic, but the underlying mathematics are the same - you take a one-sided value-weighted integral of the price distribution, which is just Black Scholes).
Again, a good solution is simply to require redemption fees for very short holding periods. Meanwhile, plenty can be done by enforcing existing laws against brokers and fund companies when there is a clear pattern of retrospective trading like those that have recently come to light. This enforcement will work, without new and heavy-handed regulations.
Outside of international funds, where retrospective trading really does pose a risk, I think soft dollars and inappropriate 12-b1 charges are more detrimental to the average shareholder. I have little doubt that these will be under hot lights in the future.
The Hussman Funds are designed for long-term investors
Since the securities traded in the Hussman Funds are generally actively traded and have timely bid, ask and last sale information as of the 4:00 P.M. market close, the likelihood of retrospective trading would be negligible even without redemption fees. Still, because I believe that attempts to "time" the Funds would be disruptive and ill-considered, and also to discourage short-term investors for whom our approach is unsuitable, I've always insisted on a 1.5% redemption fee in the Hussman Funds for holding periods of 6 months or less. This redemption fee applies both to the Strategic Growth Fund and the Strategic Total Return Fund, as well as transfers between the funds, but again, only for holding periods of 6 months or less. The redemption fees we collect are added to the net assets of the Funds for the benefit of our remaining shareholders.
The Hussman Funds are designed for long-term investors following a disciplined saving and investing program. As I note in The Two Essential Elements of Wealth Accumulation, I strongly believe that investments - even small ones - should be the first checks you write, as if you were paying a bill. With the exception of a tiny percentage in money market funds, all of my own liquid assets are invested in the Hussman Funds. I make no attempt to "time" these investments (they are made automatically at the beginning of each month) or to trade in-and-out of the Funds.
As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and still modestly favorable market action. There are enough early divergences to warrant hedging about half of our stock holdings against the impact of market fluctuations, but for now, we continue to be positioned primarily to gain from market advances.
The distinction between production for final demand and production for inventory rebuilding is an important one. For that reason, it's worth keeping a close eye on transportation stocks in addition to overall market breadth. Financial stocks are also important to monitor here. That action will be informative about the prospect for corporate lending as well as any risk of abrupt shifts in the yield curve. Short-term interest rates remain quite low, but as I've frequently noted, the U.S. economy is much more sensitive to the risk of rising short-term interest rates than investors seem to recognize.
In bonds, the Market Climate remains characterized by modestly favorable valuation and modestly favorable market action. The Strategic Total Return Fund continues to carry an overall portfolio duration of about 7.5 years, meaning that a 1% (100 basis point) move in interest rates would be expected to impact the Fund by roughly 7.5%.
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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