Hussman Funds


Market Comment Archive

Investment Research & Insight Archive

May 1, 2006

Nickel Slots

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

I've never taken much thrill in gambling, nor in pure speculation. While there are certainly a few carnival barkers on Wall Street who treat the stock market as a gateway to wild, adrenaline-pumping excitement, there's rarely much emotion in our own office one way or the other. The volume level seldom rises above the sound of crickets chirping, which I expect will remain true even when the Strategic Growth Fund is substantially unhedged.

On the rare occasions when I've been to a casino, you'd have found me somewhere in the back, playing the nickel slots next to somebody's grandmother, using various mathematical strategies to make a buck or two last as long as possible despite the fact that the odds were ultimately against me.

Now, there are lots of activities in life where skill, effort and knowledge have an impact on the outcome. So it often makes sense to try even where others might fail. But if the odds are against even a skillful and knowledgeable person exerting a solid effort, it makes sense to walk away.

At present, it makes sense to walk away from exposure to broad stock market fluctuations, for reasons including valuation, persistent distribution, internal dispersion, hostile interest rate pressures, inflation and other trends. All of these are covered in substantial detail in recent updates, so suffice it to say that none of these conditions have improved here.

It's important to recognize that our presently hedged investment position is based on the average return/risk profile that has typically accompanied conditions like we see at present. Still, to say that market conditions warrant a full hedge is certainly not to rule out the potential for a market advance. Rather, it is to say that on average, the return that an investor can expect from current conditions is not adequate compensation for the risk involved.

Suppose, for example, that there was a certain casino where the slot machines were "loose" enough during the week that they actually produced a positive average payoff. But say that on the weekends, they were tightened enough that patrons would generally walk out with less money than they walked in with. Given that knowledge, it would make sense to play the slots during the week, but to just avoid them on weekends.

If you were to visit on a weekend, however, you'd inevitably see a certain number of people winning, and possibly winning substantial amounts. While that observation might encourage a novice to play, in hopes of hitting a jackpot, the key fact would remain that the victories one observes on the weekends a) can't be predicted, and b) are outweighed, on average, by losses.

A good gambler in this case would be one who played the slots during the week, and ignored them on the weekends, despite the fact that there were occasionally a few winners on the weekends.

The same is true with an unfavorable Market Climate. The fact is that broad market risk is presently not likely to produce an acceptable return/risk profile, on average. But nothing in this prevents the market from enjoying periodic rallies, some even to marginal new highs.

While the market's apparent strength despite rising interest rates, high oil prices, and dollar weakness is being commended as a sign that "the market wants to go higher," it's also equally possible that more substantial market weakness is ahead and that the other shoe just hasn't dropped yet. For our part, we don't rely on market weakness here, but neither do we rule it out as an important possibility.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully hedged investment stance. The Fund continues to take a certain amount of risk in the sense that the stocks held by the Fund have the potential to behave differently from the indices we use to hedge, but that difference in performance is also a primary source of investment returns when the Fund has been hedged, and accounts for much of the Strategic Growth Fund's returns since inception.

There will certainly be periods when it makes sense to carry a small or non-existent hedge, but this is not such a period. As a side note, the market will not have to become deeply undervalued in order for the Strategic Growth Fund to relax or eliminate its hedges. It simply has to be somewhat reasonably valued with at least somewhat favorable market action. Since the Fund's inception in 2000, we have not yet seen any point where valuations were below-average. Even using the most optimistic measure - price/earnings ratios - stocks have been above historical norms for the entire life of the Fund. Yet this didn't prevent the Fund from removing 70% of its hedges and accepting a reasonable amount of market risk in 2003, for example.

The Fund's strategy strongly anticipates the likelihood of more aggressive investment positions when the condition of valuations and market action are favorable (which represents the majority of historical data). Presently, however, good results are not likely to emerge - on average - from a Market Climate featuring rich valuations, upward interest rate pressures, fresh highs in consumer confidence (a contrary indicator), waning leadership, persistent distribution, and speculation in garbage stocks.

In bonds, the Market Climate was characterized last week by relatively neutral valuations and still unfavorable market action. Yield levels are approaching the point where they are at least reasonable, though not yet "attractive" and certainly not "compelling." Still, the interest rate structure is more appropriate now than it has been for at least a couple of years. Though our investment positions are driven far more by prevailing valuations and market action than by any sort of forecast for future yields, I'll note in passing that the shape of the yield curve remains consistent with a further "parallel shift" in yields, possibly toward 6% across various Treasury maturities.

In the Strategic Total Return Fund, I've increased the duration of our bond holdings very slightly, toward 2.5 years (meaning that a 100 basis point move in interest rates would be expected to impact Fund value by about 2.5% on the basis of bond price fluctuations). Meanwhile, I reduced the Fund's exposure in precious metals shares further on last weeks rally, now to about 8% of Fund value, which I view as a modest but still appropriately positive exposure to that sector.


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.

Prospectuses for the Hussman Strategic Growth Fund, the Hussman Strategic Total Return Fund, the Hussman Strategic International Fund, and the Hussman Strategic Dividend Value Fund, as well as Fund reports and other information, are available by clicking "The Funds" menu button from any page of this website.

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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