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Investment Research & Insight Archive

September 10, 2006

Magnifying the Trivial

John P. Hussman, Ph.D.
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During my years in academia, there was a line that went "why are the disputes in academia so fierce?" The answer - "because the stakes are so low."

It's not unusual for people to magnify trivial differences when the stakes themselves are trivial. Call it a scarcity mentality. My impression is that this sort of mentality is present in the financial markets here.

Over the past two-and-a-half years, returns to both Treasury bonds and the S&P 500 have been well below-average. Interest rate levels are still muted despite wage pressures and other inflationary indications. With no persistent benefit from capital gains, fixed income investors have been stretching for yield, allowing risky corporate bonds to trade at nearly the same yields as default-free Treasuries. In effect, investors are taking higher risks precisely because the stakes are so low. Of course, the potential negative outcomes could substantially exceed the extra interest margin these investors are receiving, but it's historically been the nature of junk bond investors to stand around in smoky rooms until they actually see the fire.

From its intermediate peak on March 5, 2004, the S&P 500 has earned scarcely more than the 3-month Treasury bill yield (on any given day, the exact figure ranges between 2-3% annualized, depending on whether the market is at a short-term peak or trough). Yet every trivial advance to a temporary peak is hailed by analysts and floor reporters as if the stock market is "breaking out" and soaring without bounds.

To put some perspective on this, consider a typical market cycle. During normal "bull market" periods, the total return for the S&P 500 has historically averaged about 27% annualized (for a period of about 3.75 years), followed by a "bear market" portion with losses averaging about -27% annualized (for a period averaging about 1.25 years). Compound the two, and the S&P 500 has normally achieved overall full-cycle returns of about 10.6% over an average 5-year market cycle.

[Of course, every cycle is different, and the lengths have a good deal of variation. The median tends to be closer to a 4-year cycle, but some cycles have been longer, which produces an average market cycle about 5 years. The current bull market is already beyond the median length for past bull markets, and is among the longest stretches the S&P 500 has ever gone without a 10% correction.]

In any event, it's clear that only the first year of the recent bull market produced anything close to typical bull market returns. The extent of the S&P 500's returns over-and-above Treasury bill yields has been statistically insignificant since early 2004. From a longer-term perspective, the S&P 500 has underperformed Treasury bills for what is now more than 8 years. No wonder every minor move of a few percent is hailed as enormous.

The recent inflation data is another area in which investors are magnifying the trivial. For the most part, the excitement about "moderating inflation" in recent weeks has been based on the thinnest "positive" surprises, generally on the order of rounding error. Last week's upward revision in 2 nd quarter unit labor costs threw a bit of cold water on that excitement, as year-over-year figures exceeded 5%.

Given that initial disappointment in the "inflation is going away" thesis, Friday's CPI data will be interesting. Yield curve inversions, as we have at present, have historically been associated with much higher short-term inflation pressures than normal yield curves. The consensus estimate is for a 0.2% increase in the August CPI. My guess (which we don't invest on and neither should you) is that the actual figure will come in well above that. In any case, despite the fact that monthly CPI data is fairly noisy, a favorable surprise may be harder to come by this time around.

Investors seem willing to take high risks because those risks seem the only alternative to still modest-yielding Treasury bills. They also seem willing to charge ahead on even the smallest relief in inflation data, in hopes that Fed hikes are finally behind us. Yet given current valuations, a move to 19 times record earnings on record high profit margins would take less than a 10% climb. And even if the market does scratch its way to 19 times record earnings on record profit margins, the slope on the other side of that peak will probably be very steep. Even an inevitable 10% correction, which is already long overdue, would wipe out the gain. The likelihood of durable market gains over-and-above T-bill yields is very slim.

In short, the financial markets are caught in a low-stakes but potentially sensitive position. Small, statistically insignificant surprises in inflation have the potential to send the market higher, but on an ultimately profitless round-trip. Meanwhile, disappointments have the potential to be quite damaging. As I noted a few weeks ago, we're flexible enough to lift a limited portion (on the order of 15-25%) of our hedges if market action improves broadly, but there's little chance we'll take a more aggressive position than that. The potential for significant market losses shouldn't be ignored.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action. Stock valuations remain extremely elevated on the basis of nearly every historically reliable fundamental, including normalized earnings (price/peak, price/earnings normalizing profit margins, etc). The only fundamental that suggests stocks are reasonably valued is the price/forward operating earnings ratio. While this, of course, is the only valuation measure that's widely quoted by analysts here, the price/forward operating earnings ratio has a very limited historical record, much less any proven reliability. Even here, the assertion that the current multiple is "reasonable" is based on an apples-to-oranges comparison with the historical average of 15 for price/ trailing net earnings.

Our measures of market action remain unfavorable, despite the recent rally in the S&P 500 and even the NYSE advance-decline line. As Lowry's also notes, "the rally had the earmarks of a normal short-term, low-volume, selective rally attempt in a bear market. Rallies occurring on diminishing volume are always highly suspect." Most of the improvement in the advance-decline line in recent weeks has come from preferred stocks. On the basis of operating companies only, the advance-decline profile of the market has improved very little from the lows set in June.

Without the help of favorable internal market action, broad market risk has neither speculative merit nor investment merit here. Still, that doesn't necessarily imply that stocks "should" or "must" decline. It just means that the probable return/risk profile isn't satisfactory.

Think of it this way. Suppose that there was a high 80% chance that the market will rise 10% over the coming year, and just a small 20% chance that it will decline 15% over the coming year. Sound like good odds? Well, given those odds, the expected return would be [.80(10%) + .20(-15%) = ] 5%, which is the same as you'd get in risk-free T-bills. A risk-averse investor wouldn't take the bet.

At present, my impression is that even those odds would be very optimistic, as the expected return given the present Market Climate remains negative here. And again, the market is already long overdue for a 10% correction, so whatever gains the market enjoys would likely be temporary (in general, once the market achieves a price/peak-earnings ratio over 16 or so, its remaining bull market gains become very difficult to retain over the full cycle). So while we can't rule out a short-term advance, the return/risk profile given the prevailing Market Climate has historically been negative, on average. The Strategic Growth Fund remains fully hedged for now.

In bonds, the Market Climate remained characterized by modestly unfavorable valuations and relatively neutral market action, holding the Fund to a limited duration of less than 2 years, mostly in Treasury inflation protected securities, with just under 20% of assets in precious metals shares.

It's notable that credit spreads for low-quality debt have narrowed modestly in the past two weeks, which suggests that investors are stretching for yield now that longer-term Treasury yields have moved under 5%. That seems like an aggressive bet, in my view. Still, higher quality spreads (e.g. the difference between the yield on the Dow Jones Corporate Bond Index and 10-year Treasuries) are still wider than they were say, 6 months ago. Overall, the behavior of credit spreads is consistent with growing recession risks, but not with imminent risk. Something to watch, along with the upcoming inflation figures.


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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