Hussman Funds


Market Comment Archive

Investment Research & Insight Archive

April 12, 2004

Hyperactive Sheep

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

One of the most fundamental ideas of finance theory is the notion that the stock market is "efficient," making superior performance virtually impossible.

That result actually rests on a number of fairly special assumptions:

•  it's common knowledge that all investors are rational, and;

•  the only motive for trading is an expected profit.

As long as assumptions are met, the result is an efficient market. Even if you have private information that I don't have, it's impossible to use it to make a profit because as soon as you try to buy, I infer that you must have information that the security is desirable at the current price. I can make that inference because it's common knowledge that you're rational, and your only motive for trading is an expected profit, so we've ruled out the possibility that you're buying, for example, because your preference for risk has changed.

[The word "rational" has a particular meaning in finance: faced with the same information, everybody will reach the same conclusion, and that conclusion will be consistent with empirical evidence.]

The assumptions we've made ensure that your actions reveal your information, even if that information is private. If you place a bid for the stock, I immediately raise my offer. If you still bid, I raise my offer even higher. If I raise my offer so high that you're actually willing to sell to me at that price, I'll quote a lower price again. In the end, the price quote reflects all of your private information, and we both agree on the value of the stock. However - and this is one of the less-advertised results of finance - nobody actually trades at that price. Every theorem that says the market is efficient goes hand-in-hand with something called a "no-trade theorem" that says that trading volume is zero. When the only motive for trade is an expected profit and price quotations move to reveal all information, there is no trade at all, since nobody would trade against an efficient market.

Bend either one of the assumptions, and you get a market where prices and trading volume look a lot like the real world. In reality, we observe disagreement among investors and we observe trading volume. Most of us would also concede that not all investors are rational, or at least, that investors sometimes make rational decisions and sometimes do not, and that investors have changing preferences for risk.

Market efficiency isn't a property of the stock market - it's a result that constantly has to be enforced. The requirement is a group of rational investors who are constantly monitoring the markets for profit opportunities. The pursuit and exploitation of inefficiencies is precisely what results in their absence. Hands down, the fastest way to destroy market efficiency is for investors to assume it exists.

Hyperactive sheep

As I used to say to my students, trying to keep an efficient market is a lot like trying to keep a drunk, hyperactive sheep standing on a nickel.

Suppose that there are a bunch of sheepdogs around. If they get a bone for nudging the sheep back onto the nickel, and if they get a bigger bone the more they have to move the sheep, and if the sheepdogs are very hungry and vigilant, then yes, the sheep will probably stay on that nickel.

But if the sheepdogs ever become convinced that the sheep will stay on the nickel, regardless of their own actions, and the sheepdogs start looking for free bones at Mr. Greenspan's house rather than doing their job, the sheep may not even stay in the neighborhood.

In short, an efficient market cannot exist independent of investors who enforce that efficiency through their actions. It isn't at all clear that investors are doing that now.

A bubble requires the complicity of professionals.

In general, there will always be investors who buy the high of the market, convinced that the uptrend is irreversible, and who sell the low of the market for the opposite reason. As long as those investors are a moderate fringe, rather than the core of investors, they become the source of profits for others, but there is no particular danger to market efficiency. Market swings are always partly driven by this sort of "bandwagon" effect.

When investment professionals begin to jump on the same bandwagon, however, nobody is left holding the brakes. See, one of the ostensible benefits of investment professionals is that investing is their profession.

Consider doctors. We all self-diagnose our colds and minor injuries, and we recognize when we've got a serious problem, but we don't go and give ourselves an appendectomy even if we need one. We leave that to the professionals.

Similarly, it's good for investors to have enough knowledge of finance to self-diagnose problems in their portfolios, but it's really not the profession of most investors to properly evaluate and price all of their security investments. That's what professionals are supposed to do. They're supposed to have enough historical insight to understand what constitutes reasonable valuation. They're supposed to have enough understanding of diversification not to over-concentrate client portfolios. They're supposed to have enough understanding of asset management to roughly match the duration of a client's investment portfolio with the duration of the lifetime liabilities that those assets are supposed to fund.

When the professionals themselves disregard those responsibilities, you get bubbles. You get guys who go on CNBC and talk about the stock market as if it is simply a thermometer of current economic conditions (rather than a discounted stream of very long-term cash flows). You get analysts more interested in justifying higher price targets than in managing risk and preserving the long-term financial security of their clients.

No, any idiot can make bad investments. It takes a team of professionals to really screw things up.

The last time that thought ran through my head was in the late stages of the recent bubble. I've started thinking it again.

Market Climate

The Market Climate for stocks remains characterized by unusually unfavorable valuations and tenuously favorable market action. The adjectives are important. Often, I'll describe market action as "robust" - indicating market action that suggests a very firm willingness of investors to take risk. At present, that preference for risk is beginning to look very fragile.

The Strategic Growth Fund remains fully invested in a widely diversified portfolio of stocks, with about half of that portfolio hedged against the impact of market fluctuations. In addition, we've got enough deterioration in market action already to warrant a small position (less than 2% of the Strategic Growth Fund) in "contingent" put options capable of hedging the other half of the portfolio in the event of a substantial market decline. "Locally", the Fund is likely to appear about 60-70% hedged, but less than that on substantial advances, and more than that on substantial declines. The implied volatility in options is fairly low here, but to the extent that actual market volatility comes in even lower, we would lose some portion of that 2% through time decay that we could not recover through active management of the position.

The Strategic Total Return Fund continues to hold a portfolio duration of about 6 years, meaning that a 1% (100 basis point) change in interest rates would induce a roughly 6% change in the value of the Fund. That duration is roughly in line with the duration of the overall U.S. bond market, and I would consider it neither aggressive nor strongly conservative.

While the recent employment report has made market participants expect a somewhat earlier Fed move, my impression of the FOMC's members is that they will be extremely reluctant to "risk" a still fragile economic expansion on the basis of moderate employment strength. Fed tightenings are not intended to slow economic growth, but to slow demand growth when capacity constraints are too binding to allow growth in supply . We're nowhere near that point here, and this Fed has displayed an enormous tendency toward populism in recent years. Cuts come easy, but tightenings come only when failure to do so would be generally viewed as imprudent.

Our current portfolio duration is driven by the prevailing Market Climate we observe (not by those views about the Fed), but we're comfortable with a fairly typical duration here in bonds.


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 (see for example Investment, Speculation, Valuation, and Tinker Bell, The Likely Range of Market Returns in the Coming Decade and Valuing the S&P 500 Using Forward Operating Earnings ).

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