January 15, 2007
Last week, the S&P 500 pushed slightly above its mid-December level to register a new high (though still underperforming Treasury bills over the past 8 years). As I noted a couple of weeks ago, "the repeated occurrence of marginal new highs, minor pullbacks, and recoveries to further marginal new highs all provide the appearance of a market that is running away quickly. The truth is that even a minimal pullback would eliminate the advantage over T-bill yields that the S&P 500 has accrued since early May."
Nevertheless, I see it as my responsibility to explain, in what might even be considered a market warning, why I have not significantly shifted the Strategic Growth Fund from a defensive investment stance. Though my concern about market risk may turn out to be unwarranted in this instance, I manage the Fund on the basis of what can be expected on average from various conditions. If my concern turns out, in hindsight, to have been wrong in this instance, at least it can be said that the historical record offered no stronger alternative.
Overvalued, overbought, and overbullish conditions have generally resulted in disappointing market returns, regardless of other features of market action. Yet the past several weeks have quietly added a new ingredient: Treasury bill yields are now higher than they were 6 months ago, and Treasury yields of all maturities have popped higher in recent weeks. While this might seem like a trivial and low-magnitude event, it actually contributes to a syndrome that has invariably been negative for near-term market outcomes (not to mention the negative long-term results that overvalued market conditions have historically produced).
We've got overvalued, overbought, overbullish conditions, coupled with upward pressure on yields. I'll just go ahead and give it a name: "Ovoboby."
To convey some idea of the potential risks, I've assembled a very simple set of conditions that, taken together, have usually been followed by awful near-term returns, not to mention long-term disasters. Importantly, these conditions have been unfavorable even when earnings have been growing, interest rates have been reasonably low, and the prevailing trend of the market has otherwise appeared quite strong. The general results aren't particularly sensitive to alternative criteria. Indeed, stocks tend to produce tepid returns under far broader and more subtle definitions, but my hope is that a simple, specific example will drive the point home:
Here is an exhaustive list of the instances where we've observed this set of conditions on a weekly closing basis (I've used Dow Jones Industrials data for easy reference). Note also that this is an "event" indicator - once observed, it doesn't have to be repeated in subsequent weeks, though one would probably downgrade the significance of a signal if it was not "cleared" by a substantial market decline within about 10-12 weeks without another fresh instance):
April 30, 1965: The Dow advanced less than 2% to its May 14, 1965 peak, 10 trading days later. The Dow then skidded -10.5% lower over the next 30 trading days.
December 18, 1972 and January 5, 1973: The Dow advanced less than 2% from the first instance, and a fraction of a percent from the second instance, to its bull market peak on January 11, 1973. The Dow then toppled -12.3% over the next 50 trading days, and collapsed to half its value over the following 22 months.
August 14, 1987 and August 21, 1987: No remark is really necessary, but for the record, the Dow advanced less than 2% from the first instance, and a fraction of a percent from the second instance, to its bull market peak on August 25, 1987. The Dow then crashed -36.1% over the following 38 trading days.
April 3, 1998: The Dow advanced another 2.5% over the following 6 weeks to a preliminary high on May 13, 1998, and quickly dropped -6.3% over the following 22 trading days. The market then enjoyed a short-lived 8.1% rebound over the next 22 trading days to a fresh high on July 16, 1998, before suddenly plunging -19.1% to its August 31, 1998 low, 32 trading days later (overall, a -16.1% loss from its April 3 level).
April 23, 1999: From a longer-term perspective, the market was already floating on the suds of the late-1990's bubble. Indeed, despite the recent high in the S&P 500, its total return has underperformed Treasury bills in the years since then. Still, from a short-term perspective, this was the most benign instance on the list. The Dow advanced less than 3% to a peak on May 10, 1999, followed by a selloff of -4.9% over the next 13 trading days. The lack of a deep correction, however, left subsequent gains open to repeated selloffs, erasing them even before the bear market began in earnest.
July 2, 1999 and July 16, 1999: The Dow advanced less than 2% from the first instance and about 1% from the second instance, to a peak a few weeks later on August 25, 1999. The Dow then fell -11.5% over the next 36 trading days.
December 23, 1999 and December 31, 1999: The Dow advanced less than 3% from the first instance and less that 2% from the second instance to the final peak of the market bubble a few weeks later, on January 14, 2000. The Dow then plunged -16.4% over the next 35 trading days.
March 24, 2000: The actual bull market high already behind it, the Dow had enjoyed a bounce off of an early-March low. It advanced less than 2% further, to a short-term peak 12 trading days later. The Dow then dropped -8.8% over the following 32 trading days. Over the following 30 months, the stock market would lose half its value.
November 17, 2006, December 8, 2006 and January 12, 2007: We'll find out shortly...
To visualize these instances in a somewhat longer-term context, they are depicted with shaded vertical lines on the graph below. The chart presents the total return of the S&P 500, including dividends (log scale). Note that in every instance, you can find a later point - often years later - where the market had made no net progress. This underscores the fact that while valuation may not pose much resistance against short-term or intermediate-term market advances (even over a period of a few years), it is the overwhelming determinant of long-term market outcomes. Investors focused on long-term, sustainable, risk-managed returns should have very little concern about having a defensive position here, even if the market continues somewhat higher in the short-term.
Reviewing the foregoing instances carefully, one of the striking features that emerges is the abruptness of the declines. -10.5% in 30 days, -12.3% in 50 days, -36.1% in 38 days, and so forth. The first several days of decline from a market peak has often erased weeks and sometimes months of prior net gains. It's that tendency for abrupt declines from overvalued, overbought, overbullish conditions that has held us to a defensive position despite market action that otherwise looks "good" and has repeatedly produced marginal new highs.
Normally, market internals deteriorate in a way that provides more time to establish a defensive position - market breadth lags, divergences develop across various industries and security types, price/volume action shows signs of distribution and so forth.
The overvalued, overbought, overbullish syndrome may present none of those warnings, particularly when there is even modest upward movement in Treasury yields.
So while I recognize that my insistence on defensiveness may appear to be interminably stubborn and at odds with "obvious" trends, it is precisely the apparent obviousness of those trends that contributes to my uneasiness. At the late 1972 - early 1973 peak market listed above, Barron's annual investment "roundtable" was accompanied by the title "Not a Bear Among Them." It's notable that the latest roundtable just published by Barron's reflects an identical uniformity of optimism.
As of last week, the Market Climate for stocks was characterized by unfavorable valuations, moderately favorable market action, and a combination of overvalued, overbought, overbullish conditions that has historically been associated with short-term returns below Treasury bill yields. As noted above, even the modest upward pressure on Treasury yields in recent weeks has made the present risks far more pointed.
While we can't rule out a further, uncorrected continuation of the recent advance, present conditions simply provide no convincing historical precedent for it, even during the late 1990's bubble. For that reason, even a significant call option exposure is no longer a rational speculation. Again, provided that the market can clear its current overbought, overbullish condition without a significant deterioration in market internals, we would be willing to hold perhaps 2% of assets in call options in order to gain market exposure with limited risk of loss. The market need not become undervalued in order to warrant a constructive investment position, but given the prevailing syndrome of conditions, the only reason to speculate on continued market strength is hope, ignorant of history.
In bonds, the Market Climate continues to feature unfavorable valuations and now relatively neutral market action. The Strategic Total Return Fund continues to carry a short duration of about 2 years, mostly in Treasury Inflation Protected Securities. With the yield curve still inverted, even a Fed cutting cycle would require 6-8 quarter-point reductions to normalize the yield curve, even holding long-term yields constant. Barring a recession coupled with credit pressures (for which the informative signal would probably be an abrupt widening of credit spreads between corporate yields and Treasuries), there does not appear to be much margin of safety in current bond yields.
As usual, that's not a forecast about near-term bond market direction, but a statement about how bonds have generally performed, on average, under similar conditions. We can never rule out speculative runs. But unlike stocks, where speculation can be based on unreasonable hopes of profit margin growth, revenue expansion, and so forth, bonds have a fixed stream of payments. So speculative pressures tend to have a shorter life-span in the bond market.
If we observe a significant widening of credit spreads, particularly at comfortably higher yield levels in Treasuries, I would expect to take a longer duration position in bonds. For now, there is not enough evidence to expect significant capital gains to augment prevailing bond yields. Meanwhile, the Strategic Total Return Fund continues to hold about 20% of assets in precious metals shares, where the Market Climate remains favorable. This position is presently the primary source of day-to-day fluctuation in Fund value.
In Honor of Dr. Martin Luther King, Jr.
[Dr. King's words seem as relevant today as when he originally spoke them. The details have changed, but the principles are enduring - John]
Excerpted from "Beyond Vietnam," April 4, 1967
As I have walked among the desperate, rejected and angry young men I have told them that Molotov cocktails and rifles would not solve their problems. I have tried to offer them my deepest compassion while maintaining my conviction that social change comes most meaningfully through nonviolent action. But they asked -- and rightly so -- what about Vietnam? They asked if our own nation wasn't using massive doses of violence to solve its problems, to bring about the changes it wanted. Their questions hit home, and I knew that I could never again raise my voice against the violence of the oppressed in the ghettos without having first spoken clearly to my own government. For the sake of those boys, for the sake of this government, for the sake of hundreds of thousands trembling under our violence, I cannot be silent.
Now, it should be incandescently clear that no one who has any concern for the integrity and life of America today can ignore the present war.
As if the weight of such a commitment to the life and health of America were not enough, another burden of responsibility was placed upon me in 1964; and I cannot forget that the Nobel Prize for Peace was also a commission -- a commission to work harder than I had ever worked before for "the brotherhood of man." This is a calling that takes me beyond national allegiances, but even if it were not present I would yet have to live with the meaning of my commitment to the ministry of Jesus Christ. To me the relationship of this ministry to the making of peace is so obvious that I sometimes marvel at those who ask me why I am speaking against the war. Could it be that they do not know that the good news was meant for all men -- for Communist and capitalist, for their children and ours, for black and for white, for revolutionary and conservative? Have they forgotten that my ministry is in obedience to the one who loved his enemies so fully that he died for them? What then can I say to the "Vietcong" or to Castro or to Mao as a faithful minister of this one? Can I threaten them with death or must I not share with them my life?
Finally, as I try to delineate for you and for myself the road that leads from Montgomery to this place I would have offered all that was most valid if I simply said that I must be true to my conviction that I share with all men the calling to be a son of the living God. Beyond the calling of race or nation or creed is this vocation of sonship and brotherhood, and because I believe that the Father is deeply concerned especially for his suffering and helpless and outcast children, I come tonight to speak for them.
This I believe to be the privilege and the burden of all of us who deem ourselves bound by allegiances and loyalties which are broader and deeper than nationalism and which go beyond our nation's self-defined goals and positions. We are called to speak for the weak, for the voiceless, for victims of our nation and for those it calls enemy, for no document from human hands can make these humans any less our brothers.
They must see Americans as strange liberators. For nine years following 1945 we denied the people of Vietnam the right of independence. For nine years we vigorously supported the French in their abortive effort to recolonize Vietnam. When Diem was overthrown they may have been happy, but the long line of military dictatorships seemed to offer no real change -- especially in terms of their need for land and peace.
The only change came from America as we increased our troop commitments in support of governments which were singularly corrupt, inept and without popular support. All the while the people read our leaflets and received regular promises of peace and democracy and land reform. Now they languish under our bombs and consider us -- not their fellow Vietnamese -- the real enemy.
Somehow this madness must cease. We must stop now. I speak as a child of God and brother to the suffering poor of Vietnam. I speak for those whose land is being laid waste, whose homes are being destroyed, whose culture is being subverted. I speak for the poor of America who are paying the double price of smashed hopes at home and death and corruption in Vietnam. I speak as a citizen of the world, for the world as it stands aghast at the path we have taken. I speak as an American to the leaders of my own nation. The great initiative in this war is ours. The initiative to stop it must be ours.
This is the message of the great Buddhist leaders of Vietnam. Recently one of them wrote these words:
"Each day the war goes on the hatred increases in the heart of the Vietnamese and in the hearts of those of humanitarian instinct. The Americans are forcing even their friends into becoming their enemies. It is curious that the Americans, who calculate so carefully on the possibilities of military victory, do not realize that in the process they are incurring deep psychological and political defeat. The image of America will never again be the image of revolution, freedom and democracy, but the image of violence and militarism."
The world now demands a maturity of America that we may not be able to achieve. It demands that we admit that we have been wrong from the beginning of our adventure in Vietnam, that we have been detrimental to the life of the Vietnamese people. The situation is one in which we must be ready to turn sharply from our present ways.
A true revolution of values will soon cause us to question the fairness and justice of many of our past and present policies. On the one hand we are called to play the good Samaritan on life's roadside; but that will be only an initial act. True compassion is more than flinging a coin to a beggar; it is not haphazard and superficial. It comes to see that an edifice which produces beggars needs restructuring.
A true revolution of values will lay hands on the world order and say of war: "This way of settling differences is not just." This business of burning human beings with napalm, of filling our nation's homes with orphans and widows, of injecting poisonous drugs of hate into veins of people normally humane, of sending men home from dark and bloody battlefields physically handicapped and psychologically deranged, cannot be reconciled with wisdom, justice and love. A nation that continues year after year to spend more money on military defense than on programs of social uplift is approaching spiritual death.
America, the richest and most powerful nation in the world, can well lead the way in this revolution of values. There is nothing, except a tragic death wish, to prevent us from reordering our priorities, so that the pursuit of peace will take precedence over the pursuit of war. There is nothing to keep us from molding a recalcitrant status quo with bruised hands until we have fashioned it into a brotherhood.
This kind of positive revolution of values is our best defense against communism. War is not the answer. Communism will never be defeated by the use of atomic bombs or nuclear weapons. Let us not join those who shout war and through their misguided passions urge the United States to relinquish its participation in the United Nations. These are days which demand wise restraint and calm reasonableness. We must not call everyone a Communist or an appeaser who advocates the seating of Red China in the United Nations and who recognizes that hate and hysteria are not the final answers to the problem of these turbulent days. We must not engage in a negative anti-communism, but rather in a positive thrust for democracy, realizing that our greatest defense against communism is to take offensive action in behalf of justice. We must with positive action seek to remove those conditions of poverty, insecurity and injustice which are the fertile soil in which the seed of communism grows and develops.
A genuine revolution of values means in the final analysis that our loyalties must become ecumenical rather than sectional. Every nation must now develop an overriding loyalty to mankind as a whole in order to preserve the best in their individual societies.
This call for a world-wide fellowship that lifts neighborly concern beyond one's tribe, race, class and nation is in reality a call for an all-embracing and unconditional love for all men. This oft misunderstood and misinterpreted concept -- so readily dismissed by the Nietzsches of the world as a weak and cowardly force -- has now become an absolute necessity for the survival of man.
When I speak of love I am not speaking of some sentimental and weak response. I am speaking of that force which all of the great religions have seen as the supreme unifying principle of life. Love is somehow the key that unlocks the door which leads to ultimate reality. This Hindu-Moslem-Christian-Jewish-Buddhist belief about ultimate reality is beautifully summed up in the first epistle of Saint John :
Let us love one another; for love is God and everyone that loveth is born of God and knoweth God. He that loveth not knoweth not God; for God is love. If we love one another God dwelleth in us, and his love is perfected in us.
Let us hope that this spirit will become the order of the day. We can no longer afford to worship the god of hate or bow before the altar of retaliation. The oceans of history are made turbulent by the ever-rising tides of hate. History is cluttered with the wreckage of nations and individuals that pursued this self-defeating path of hate. As Arnold Toynbee says : "Love is the ultimate force that makes for the saving choice of life and good against the damning choice of death and evil. Therefore the first hope in our inventory must be the hope that love is going to have the last word."
We are now faced with the fact that tomorrow is today. We are confronted with the fierce urgency of now. In this unfolding conundrum of life and history there is such a thing as being too late. Procrastination is still the thief of time. Life often leaves us standing bare, naked and dejected with a lost opportunity. The "tide in the affairs of men" does not remain at the flood; it ebbs. We may cry out desperately for time to pause in her passage, but time is deaf to every plea and rushes on. Over the bleached bones and jumbled residue of numerous civilizations are written the pathetic words: "Too late." There is an invisible book of life that faithfully records our vigilance or our neglect. "The moving finger writes, and having writ moves on..." We still have a choice today; nonviolent coexistence or violent co-annihilation.
We must move past indecision to action. We must find new ways to speak for peace in Vietnam and justice throughout the developing world -- a world that borders on our doors. If we do not act we shall surely be dragged down the long dark and shameful corridors of time reserved for those who possess power without compassion, might without morality, and strength without sight.
Now let us begin. Now let us rededicate ourselves to the long and bitter -- but beautiful -- struggle for a new world. This is the calling of the sons of God, and our brothers wait eagerly for our response. Shall we say the odds are too great? Shall we tell them the struggle is too hard? Will our message be that the forces of American life militate against their arrival as full men, and we send our deepest regrets? Or will there be another message, of longing, of hope, of solidarity with their yearnings, of commitment to their cause, whatever the cost? The choice is ours, and though we might prefer it otherwise, we must choose in this crucial moment of human history.
As that noble bard of yesterday, James Russell Lowell, eloquently stated:
Once to every man and nation
Though the cause of evil prosper,
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