All contents copyright 2003, John P. Hussman Ph.D.
Excerpts from these updates should include quotation marks, and identify the author as John P. Hussman, Ph.D. A link to the Fund website, www.hussmanfunds.comis appreciated.
Sunday March 30, 2003 : Weekly Market Comment
Copyright 2003, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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The Market Climate for stocks remains characterized by unfavorable valuations and unfavorable trend uniformity, holding us to a defensive position - fully invested in favored stocks, with an offsetting short position of equal size in the S&P 100 and Russell 2000 indices. We've also got a small contingent asset in the form of call options sufficient to remove about 40% of our hedge in the event of a sharp, near-term advance, but given the likely extension in the time horizon of military operations, we raised our strike prices and took a significant amount of the value of those calls off the table last week. At present, we've got a small fraction of 1% of assets in this position, so it will only become relevant in the event of a powerful near term rally. Overall, the calls have not materially added nor reduced the value of the Strategic Growth Fund, but the position has added a bit of volatility - specifically, the Fund's gain two weeks ago and the Fund's pullback last week were both somewhat larger than they would have been in the absence of those calls.
In bonds, the Climate continues to be characterized by unfavorable valuations but tenuously favorable trend uniformity. This holds us to a fairly short maturity profile. Though we do have a modest exposure to the 5-7 year maturities, most of our holdings are decidedly near term in nature. Alternative assets - foreign government bonds, precious metals shares, and utilities currently represent about 30% of assets. These assets are the primary source of our day-to-day volatility, but also the primary source of expected return in an environment of very low yields.
At over three years in duration, the current bear market in stocks is getting fairly long in the tooth, so we have to be aware of the possibility of an advance more sustained than the brief 20% advances that have punctuated the market's decline since 2000. This isn't to say that such an advance would be sustained over the long-term. Despite my view that the S&P 500 is priced to deliver a total return in the 3-6% annual range over the coming decade, this does not rule out extended, powerful but ultimately unsustainable market advances. Our discipline accounts for such periods, and takes a greater exposure to market risk, when they recruit favorable trend uniformity. On a historical basis, favorable trend uniformity has emerged very quickly at the beginning of bull markets, on average.
As Peter Bernstein notes in Kate Welling's excellent institutional letter Welling@Weeden, "rallies of 30% and even more are common in secular bear markets - Japan has had something like 9 rallies greater than 25% since 1990, and 3 that were greater than 40%, while the U.S> experienced 13 bull markets of greater than 30% during its secular bears of 1902-21, 1929-49, and 1966-82... there are lots of periods where you get big rallies, even in major bear markets or in stationalry markets. But for now, equities aren't the best place to be in the long run."
Our own approach distinguishes the long-term investment merit (valuation) of the market, from factors that create speculative merit (trend uniformity). When trend uniformity is favorable, it is essentially a signal that 1) market action is conveying positive information about future economic growth, earnings, and other fundamentals, and 2) investors have a robust preference to take market risk. Even if valuations are excessive, favorable trend uniformity is a sufficient basis for us to take at least a moderate exposure to market risk. At present, we have neither merit working in the market's favor, but we are completely open to the possibility of a favorable shift.
The corollary is that unfavorable trend uniformity - until it shifts - is essentially a signal that there is something negative being conveyed about future fundamentals and risk preferences. While we don't really think in terms of "bull" or "bear" markets (neither which is observable except in hindsight), there is an aphorism that in a bear market, everything that can go wrong will go wrong.. Richard Russell of Dow Theory Letters has frequently noted this in recent years, applying it to explain why many events that would typically be bullish have failed (for example, Federal Reserve interest rate cuts, or the view of a quick military resolution).
To the extent that trend uniformity remains negative, then, there is an inference that a wide range of events may be resolved unfavorably. In contrast, as I've noted before, the most favorable signal of oncoming good news, be it economic growth, earnings surprises, or war resolution, would be conveyed by market action positive enough to recruit a favorable shift in trend uniformity.
A final note about short-term returns. There is a clear tendency for weak trading volume to be associated with weak market returns. Consider the weeks since 1940 when NYSE trading volume has been higher than in the prior week. In this sample of data, the average total return for the S&P 500 has been 28.6% annualized. In contrast, when trading volume has been lower than in the prior week, the average total return has been -0.7% annualized. In effect, the entire gain in the S&P 500 since 1940 can be attributed to weeks when trading volume was rising.
While our own approach doesn't require heavy trading volume in order to generate gains (or even gains relative to the market), I do believe that the ability to profit from favorable valuation is more reliable when investors are willing to commit to long-term investments, and that the ability to profit from favorable market action is more reliable when investors are willing to commit to a theme. Without this commitment, we would still expect these factors to be compensated - it's just that the ability to profit from them over short periods of time is less reliable. That can be frustrating for short-term investors. But for long-term investors, it's not a problem. As long-term investors, we continue to adhere to our discipline, and to consistently take the daily actions that we believe will best achieve our investment objectives.
Sunday March 23, 2003 : Weekly Market Comment
Copyright 2003, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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The Market Climate for stocks remains characterized by unfavorable valuations and still unfavorable trend uniformity. However, there is a clear possibility that trend uniformity will shift to a favorable condition within the next few weeks. In that event, we expect to remove about 40% of our hedges, regardless of valuations.
As I noted weeks ago, this creates a "contingent liability" - the contingency is the potential for a market advance broad enough to recruit favorable trend uniformity, and the liability being the need to close a substantial part of our hedge. Given that this contingency is well-defined by both a specific time horizon and a reasonable likelihood that this shift could occur, our approach has a well-defined response: establish an offsetting contingent asset that matches the character and timing of the contingent liability.
In simple terms, that means that we purchased a substantial call option position a few weeks ago for a fraction of 1% of total assets. While trend uniformity remains negative at present, the call options we purchased several weeks ago are already in-the-money, and will therefore already have the effect of taking us out of a fully defensive position on rallies. Currently, our call position has grown to about 1.5% of total assets. This amount will be lost if the market plunges from current levels, but I view this as an acceptable risk given the substantial possibility of a favorable shift in trend uniformity in the coming weeks. Our investment position does not require us to make a forecast either way.
In bonds, the Market Climate is characterized by unfavorable valuations and tenuously favorable trend uniformity. Much of the short-term behavior in the bond market has been dominated by an unwinding of "safe haven" trades. Both straight and inflation-protected Treasuries have come under pressure. Meanwhile, there has been pressure on commodity hedges such as oil and gold.
While prevailing conditions suggest that long-term bonds are unfavorable at present, the likely source of further pressure on yields is not likely to be real interest rates, but inflation pressure. Much of the reason for falling inflation in recent years has been declining "velocity," reflecting a willingness of individuals to hold larger cash balances as a consequence of falling short-term interest rates, a declining burden of government spending as a fraction of GDP, and a strong dollar which held import prices down. Unfortunately, there is little prospect for a continued decline in velocity, every prospect for growth in the monetary base to finance government spending, and a record current account deficit weighing on the dollar.
Both valuations and relevant market action remain strongly favorable for precious metals shares and many foreign currencies (the Japanese Yen is now the most attractive major currency in our work). Our investment approach leans strongly toward purchasing highly ranked candidates on short-term weakness. In our view, the recent softness in precious metals shares and foreign currencies presents just such an opportunity for action.
With gratitude and prayers for our troops. It is the responsibility of Congress to declare war after careful deliberation, and the role of the President to set its objectives wisely. These can be discussed later, because involvement in this war, and the strategies chosen, are no longer the subject of debate. The role of the military is to achieve those objectives demanded of it, with respect for the conventions of war. In this, our troops have acted bravely and honorably at every step. By all accounts, military action in Iraq has been carried out with great skill, prudence for the lives of U.S. and allied soldiers, and effort to minimize the loss of life among Iraqi soldiers and innocent civilians. To all of us, their conduct is a source of admiration and pride.
Sunday March 16, 2003 : Weekly Market Comment
Copyright 2003, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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Just a note - I've added a new report to the Research and Insight page of the website: The use (and abuse) of short-term performance. I hope that this report is helpful not only in evaluating the Hussman Funds, but also in your other investment decisions.
As of last week, the Market Climate for stocks remained characterized by both unfavorable valuations and unfavorable trend uniformity, holding us to a defensive position - fully invested in favored stocks, with an offsetting hedge intended to remove the impact of broad market fluctuations on that portfolio. We do carry a small call option position sufficient to remove a portion of our hedges in the event of an abrupt shift to a favorable Market Climate within the next few weeks, but the cost of that position is a small fraction of one percent of portfolio value, and we do not intend to maintain it indefinitely if the time frame for U.S. action in Iraq becomes less immediate.
Last week produced the first 90% down day of the year, to use Lowry's definition - 90% of up volume + down volume represented by down volume, and 90% of point changes in NYSE stocks to the downside. This is good, lopsided action that helps to set the stage for a possible shift in trend uniformity, but it is far from sufficient. Typically, one 90% down day is followed by a series of others within weeks. But this is a very news driven market, so typical behavior may not apply very well. While we always adhere to our investment discipline, that discipline includes provisions for just this sort of environment. Our small contingent asset (inexpensive, near-term, out-of-the-money call options) is sufficient to cover the contingent liability (the need to buy in a portion of our hedges) created by current uncertainties.
Commenting in the latest Berkshire Hathaway annual report, Warren Buffett makes a number of observations that place our own views in good company: "When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we donít understand how much risk the institution is running. Charlie and I believe Berkshire should be a fortress of financial strength for the sake of our owners, creditors, policyholders and employees. We try to be alert to any sort of megacatastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside."
He continues, "We continue to do little in equities... Despite three years of falling prices, which have significantly improved the attractiveness of common stocks, we still find very few that even mildly interest us. That dismal fact is testimony to the insanity of valuations reached during The Great Bubble. Unfortunately, the hangover may prove to be proportional to the binge. The aversion to equities that Charlie and I exhibit today is far from congenital. We love owning common stocks if they can be purchased at attractive prices. In my 61 years of investing, 50 or so years have offered that kind of opportunity. There will be years like that again."
This week's issue of Barron's features an article with Pimco's Bill Gross. His outlook is that "stocks are in for more tough sledding after nearly two decades of mostly fat returns, and that bonds won't turn in the kinds of gains they have over the past few years. The economy's growth prospects are sub-par, he warned, as much because of post-bubble overcapacity and poor profit growth as any geopolitical risk."
Many have questioned why a bond guy's views on stocks should be taken seriously. The reason is simple. Like Buffett, Gross understands something that many stock analysts don't, which is that the price of any security is nothing more than the present discounted value of the future cash flows it will deliver to investors over time.
Many stock market analysts argue that given a low level of interest rates and inflation, stock valuations should be high, and then make bullish arguments on that basis. But an analyst who understands present value also understands you can't discount future cash flows at a low rate of return, obtain a high valuation as a result, and then argue that the security will deliver anything other than a low rate of return in the future. The high valuation is precisely what ensures that the security will deliver the low long-term rate of return you used in order to justify it in the first place.
So the stock guy Buffett, and the bond guy Gross both have it right for exactly the same reason. They understand how securities are priced.
Still, I've frequently noted that overvaluation implies only unsatisfactory long-term returns. Even when a security is priced to deliver a low rate of return, investors may be willing to take on greater risk, driving prices higher and prospective long-term returns even lower. So in our approach, the fact that stocks remain overvalued will not prevent us from taking at least a moderate exposure to market risk if trend uniformity shifts to a favorable condition (indicating a robust willingness of investors to take risk, regardless of valuation).
Meanwhile, although stocks are not great values on a buy-and-hold basis, there are many stocks that we are very willing to own once the market risk of these stocks is hedged away. Moreover, overvaluation implies that the advances that do occur are ultimately likely to be surrendered over a longer period of time. As a result, any risk of missed returns during rallies in an overvalued market represents a short-term risk, rather than a threat to long-term returns. In contrast, a long-term investor should never take a fully hedged position in an undervalued market, in our opinion, because missed returns from a rebound are likely to be permanent.
Analysts occasionally argue that an investor missing even a small number of the strongest market periods would have underperformed Treasury bills over time. But as I note in Time variation in market efficiency (PDF), about 77% of the strongest market periods have occurred when valuations were below their historical median. In short, stocks remain priced to deliver unsatisfactory long-term returns. This will not prevent us from taking an exposure to market risk if trend uniformity becomes favorable, but in the current Market Climate, we have very little concern about sacrificing long-term returns as a result of our present defensiveness.
In bonds, the Market Climate continues to be characterized by unfavorable valuations and tenuously favorable trend uniformity. We don't anticipate a sharp increase in interest rates, but at current yield levels, it would not take much of an increase over the next year or two to wipe out the interest earnings that bonds are priced to deliver over that period. So unfortunately, I suspect that most bond funds will perform little better than Treasury bills over the next few years. The potential for higher returns is likely to emerge as a result of modest exposure to alternatives such as foreign government bonds, very selective corporate bond positions, call features, and yield curve strategies. In our own approach, limited positions in precious metals shares and utility stocks may provide additional avenues for return enhancement. Again, however, for the bond market as a whole, the prospects for strong total returns over the next few years are not very compelling.
Sunday March 9, 2003 : Weekly Market Comment
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As of last week, the Market Climate for stocks remained characterized by both unfavorable valuations and unfavorable trend uniformity, holding us to a defensive position - fully invested in a diversified portfolio of favored stocks, with an offsetting short position in the Russell 2000 and S&P 100 indices intended strictly to remove the impact of market fluctuations from the portfolio. This is not, however, a riskless position. We continue to take risks that we expect to be compensated over time (specifically, company-specific risks associated with our favored stocks which are not tightly correlated with overall market fluctuations), while avoiding, hedging, or diversifying away those risks that are not associated with favorable investment or speculative merit here (specifically, overall market risk).
A few notes about the short-term performance of the Strategic Growth Fund. At present, the Fund is nearly 5.5% below its August 2002 peak (the Russell 2000 and S&P 100 indices have each declined by about 13.5% since August). Much of this pullback occurred because the Fund was nearly 40% unhedged during the initial part of the market decline from its August peak. The remaining bit represents the margin by which our favored stocks have underperformed the major indices since then.
In turn, the source of this very slight stock selection underperformance is that the Fund is underweighted in stocks that have extremely high levels of debt and financial leverage. These stocks remain poor and dangerous investments, in my view, but have benefited in the short term by a decline in immediate default risk. To the extent that we have avoided them and the market indices include them, our stock selection has very slightly lagged the market in recent months. This is a short-term outcome that I am unwilling to "correct" by purchasing time-bombs with extreme debt burdens.
Underscoring this point, of the 1769 growth funds tracked by Bloomberg, fewer than 10 have generated a gain over the past year. With the exception of the best performer (!), the winners are generally narrowly diversified funds specializing in companies with unusually high debt burdens such as media, financial services and telecom. These stocks enjoyed a striking "V" reversal last October, as investors chased nearly bankrupt firms with poor balance sheets on the justification that they'd been thoroughly beaten to a pulp. We're not arguing that this is a useless justification, but it is not a reliable or durable one, and it is certainly not one that we are inclined to chase.
In short, the easy way to "correct" our position toward something that has performed better in the recent past would be to buy garbage. My hope is that our shareholders understand my reluctance to do so, and are patient with the somewhat dull short-term performance that has resulted from that discipline. As I've noted in recent weeks, I expect any sort of resolution of recent war worries to be accompanied by higher trading volume and an increase in investor's willingness to discriminate on the basis of value, financial strength, and other factors that are well-correlated with strong long-term investment performance.
The Market Climate for bonds is characterized by strongly unfavorable valuations and tenuously favorable trend uniformity. Given low but persistent inflation, downward pressure on the U.S. dollar, and a substantial safe-haven premium built into Treasury bond prices, there is growing risk of an abrupt and potentially sharp reversal in bond yields. While favorable trend uniformity suggests that yields could move even lower over the near term, even a modest reversal in yields would easily wipe out all of the interest return that bonds are priced to deliver. For this reason, we continue to hold a relatively short maturity profile here.
Sunday March 2, 2003 : Weekly Market Comment
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As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable trend uniformity. This condition holds us to a fully hedged position - fully invested in favored stocks, with an offsetting short sale in the Russell 2000 and S&P 100 sufficient to remove most of the impact of market fluctuations. This is not, however, a bearish position. I have no forecast of short term market direction, except for the expectation that volatility will probably be rather extreme in the weeks ahead.
On the downside, there remains uncertainty as to the prospect of war, and bearishness remains somewhat lower than is typical at durable market lows (we pay closer attention to the Investor's Intelligence figures than the much more volatile American Association of Individual Investors numbers). Moreover, since the easiest way to generate favorable trend uniformity here would involve a hard and lopsided market decline followed by a broad, high-volume reversal (typical action just prior to sustained bear market rallies), even bullish investors should be somewhat open to the possibility of a market plunge.
On the upside, the market is clearly deeply oversold - a condition which is often cleared by a fast, furious rally. More importantly, one of the most favorable developments in recent weeks is the continued improvement in risk spreads (corporate bond yields falling faster than Treasury yields). This action suggests that the market does not see much likelihood of a near term acceleration in corporate defaults. While this is only one positive in an ocean of negatives, it is an important positive. The main factor behind any upcoming rally, even bull market, will not be fundamental investment merit (which remains disturbingly absent), and therefore must be speculative merit. Therefore, a continuing decline in risk premiums on bonds cannot be ignored as a factor that could make it easier for a speculative rally in stocks to emerge.
In recent months, we've heard from many analysts that "nothing is working" - also a frequent comment cited by Bob Pisani when he reviews trader talk each morning on CNBC. The basic complaint is that not only have particular investment styles failed to generate attractive returns (e.g. growth, value, technology, etc), they have also failed to work on a spread basis (e.g. long growth / short value, long value / short growth, long tech / short basic industry, etc). Much of this can be traced to low volume resulting from uncertainty about war, and to a lesser extent, the economy. Essentially, investors are not willing to commit themselves to any sort of "theme" until there is a greater resolution of uncertainty.
In our own stance, we've certainly succeeded in avoiding most, though not all, of the market's losses in recent months (the Russell 2000 and S&P 500 have lost about 5% year-to-date and about 12% since their August highs). Still, we observe the lack of investor commitment as a difficulty in obtaining traction from factors that the market typically rewards over longer periods of time (specifically, combination of favorable valuation on a free cash flow basis and favorable market action as we define it).
With little question, much of the uncertainty weighing on the market is likely to be resolved within weeks, not months. From the standpoint of stock selection, the resulting ability to gain traction from more discriminating investment activity on higher volume would be a good thing. From the standpoint of hedging, it also means that we now have a well-defined contingent liability - the possibility that we will be forced to close out a portion of our hedges on a strong, near-term market rally when this uncertainty is resolved one way or another. Still, with the possibility of a continued and even hard decline first, we certainly do not have evidence that would warrant the removal of any hedges just yet.
The appropriate response is clear, and it is one that we executed near the market's lows last week. We've taken a tiny but important position (a small fraction of one percent of portfolio value) in out-of-the money call options sufficient to take us out of about one-third of our hedges if the market experiences a rally of more than about 4% in the next few weeks. That small position is sufficient to remove the bulk of our contingent risk for now, but since we can adjust our hedges on a daily basis if needed, we'll continue to re-evaluate the appropriate strike prices and expirations that are best suited to match the character of this contingent liability. The key here is that the contingency is near-term in nature and well-defined. If the market clears its oversold status and the prospect of a substantial change in war risks becomes less immediate, we'll close out that call position despite its very low cost. The possibility that the market could rally sharply is not enough to warrant that small call option position, absent characteristics that more narrowly define the contingency.
My personal opinion (which we don't invest on and neither should you) remains far outside the consensus. I don't think there will be a war.
At this point, it is hardly a question of whether the U.N. security council will go along with war, but rather, how much international reproach the Administration would incur by going to war without U.N. sanction. While Iraq has been neither trustworthy nor forthcoming, there is a growing sense that it can be contained without the use of force. It may not be disarmed quickly, and it may not be compelled to a regime change, but there is sufficient consensus that it can be contained, if at the cost of continued frustration and prolonged diplomacy. This view significantly hampers the ability to recruit support for an immediate strike.
Moreover, if history is of any use at all, the probability is that a war would not increase the chances for regional peace, but could instead radicalize neighboring countries, not to mention potential terrorists. When evaluating the current push for war in terms of historical lessons, it is difficult to argue that present-day Iraq is parallel to Germany in 1938. The appropriate pages for reference are not the fall of Czechoslovakia to Germany, but the Gulf of Tonkin, and the emergence of the Khmer Rouge following the 1970 U.S. invasion of Cambodia.
As I noted a few weeks ago, any decline in the likelihood of war is likely to be accompanied by an increasing number of news stories focusing on the human costs - not only the direct casualties from intense air attacks (which would occur first, regardless of whether Iraqi troops prove willing to surrender), but the predictable loss of thousands of children as a result of disruptions in sanitation and food supplies. These stories have begun to appear, but still only occasionally.
Against these arguments, standing down from war is often cited as unacceptable, as it might risk a reduction in U.S. prestige and lowered international perceptions of U.S. resolve. Ultimately, the probability of war rests on whether or not it comes to be seen as an inferior, potentially destabilizing solution and a last resort, despite the political problems that this might create.
As usual, we don't invest on the basis of my opinions, which may ultimately be proven wrong. Still, it certainly appears that very few on Wall Street are allowing for the possibility that there will not be a war. In any investment stance, it is important to evaluate every possible outcome, to identify any that are associated with unacceptable returns, and to take actions that eliminate unacceptable risks. I do believe that we have taken these steps in our own portfolios.
In bonds, the Market Climate as of last week was also characterized by unfavorable valuations, but trend uniformity shifted to a weakly favorable status a week ago. As I've noted frequently, favorable trend uniformity alone is much less of a positive for bonds than it is for stocks. This is because it is much harder to generate bubbles in securities when the stream of payments they will deliver in the future is known with certainty. As a rule, when bonds are priced to deliver a poor long-term rate of return, they also tend to deliver poor short-term rates of return, because favorable speculative merit can be very fleeting when yields are low. As a result, our fixed income positions continue to have a fairly short duration, but given tenuously favorable trend uniformity in bonds, we do have a modest exposure to interest rate fluctuations here.
In short, we remain defensively positioned here, but are very aware of contingencies which may lead to a more constructive stance even in the next few weeks. While we don't believe that a reduction in our overall defensiveness is warranted yet, and do not have evidence on which to base a more aggressive position here, we have already taken actions that allow for the possibility of a significant and possibly abrupt change in market conditions within the coming weeks.
Sunday February 23, 2003 : Weekly Market Comment
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As of last week, the Market Climates for both stocks and bonds remained characterized by unfavorable valuations and unfavorable trend uniformity, holding us to defensive positions. In stocks, we remain fully invested in a widely diversified portfolio of favored stocks, and have hedged away the impact of broad market fluctuations (though not the stock-specific risk that is the basis for our expected returns). In bonds, we continue to hold a relatively short average maturity, with a significant portion of assets in securities which respond to real interest rate fluctuations, but do not rely on low or falling inflation.
Last week's economic reports evidently took many analysts by surprise - inflation figures (especially on the PPI) moved surprisingly higher, while unemployment claims also surged. These pressures are consistent with the possibility of emerging stagflation, which continues to be indicated by the yield behavior of Treasury bonds and inflation protected securities.
In stocks, we simply have not seen the sort of market action that is typical of intermediate market lows, much less final ones. That doesn't mean that stocks can't rally here. Indeed, I will be surprised if trend uniformity does not shift to a favorable condition at some point in the coming months. But at present, we have no evidence on which to expose ourselves to broad market risk.
As I've noted frequently in recent weeks, the easiest way to produce a favorable shift in trend uniformity would be for stocks to endure a hard and lopsided decline, followed by a high-volume reversal. Though we use sentiment information only as background information, to confirm what we observe in market action, the case for taking market risk would be much more compelling if the percentage of advisory bears moves well over 40%. The latest figures from Investors Intelligence show 33.7% bears. This is another slight improvement over the low levels of recent weeks, but certainly not a level from which broad advances typically emerge. As usual, however, we don't base our positions on this sort of evaluation, but on the prevailing Market Climate we identify.
On a practical note, it is important - despite relatively unfavorable valuation and economic fundamentals - to always be open to the possibility of a strong and sustained market advance. While I don't really think in terms of bull and bear markets (which can only be identified in hindsight), it is clear that historical periods of poor fundamentals were not necessarily resolved in a single, compact bear market decline. Though the 1982 low in the Dow was nearly 20% below the 1965 high in the Dow, that terrible long-term performance was punctuated by a whole series of bull and bear markets, the worst being 1973-1974. So it is important not to rule out the possibility of a bull market, given that this bear market is fairly long in the tooth.
As usual, that's not a forecast, but neither bull nor bear markets last forever. The "Go-Go" bubble of 1968-69 was not resolved by the 1970 bear (though tech stocks were certainly brutalized), but by the 1973-74 bear which followed an intervening bull move. Similarly, it would not be impossible to see a 40-50% market advance over a span of a year or two, followed by another possibly more severe bear market in say, 2005. Not a forecast, but we don't rule it out.
Every once in a while - just to remind myself that things change - I run a Fourier analysis on market data, to examine various "cycles" that describe it. This sort of analysis computes a whole series of sine and cosine waves to exactly replicate a historical data series, then you can run those same sine and cosine waves forward to produce forecasts just for fun. Since your forecasts are built on cycles of different length and amplitude, you're fairly assured that the forecasts will include both bull and bear markets. I never believe, much less act on, spectral forecasts, since they're very dependent on the sample of data used, and the "stationarity" of that data. Still, they're great reminders: there are numerous plausible "scenarios" which include bull and bear moves, all consistent with past market cycles, none which should be used as the basis for investment, but all which underscore that seasons change.
So how should we invest? Simple. We don't focus or rely on forecasts or scenarios at all. We focus on the prevailing Market Climate, which is observable in real time. When the Climate shifts, so does our investment stance. For now, we remain defensive.
Monday February 17, 2003 : Weekly Market Comment
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The latest Semi-Annual Report of the Hussman Strategic Growth Fund is now posted to the Fund website. We expect to post the report for the Total Return Fund later this week.
Just a note - the report indicates a 1.47% expense ratio for the period ended December 31st. At present, the Fund's expense accrual is 1.42% annually. It is also important to emphasize that one-year returns are decidedly short-term. This is why we don't advertise these returns, and why we don't believe that one-year performance deserves news coverage or special rankings, particularly without adjustment for risk.
As we move into 2003, a few comments are in order regarding the Strategic Growth Fund, investment strategy, asset size, and appropriate reasons for investing in the Fund.
A decision to purchase or sell the Fund should not be based on short-term returns, but on an understanding of our investment approach, and whether it is appropriate to your financial goals, risk tolerance, and investment horizon. Accordingly, we are very heavy on shareholder communication, very light on marketing, and completely unreceptive to short-term investment perspectives.
Except for proprietary methods, we try to be very clear about our investment positions and the reasons behind them. We have an outstanding shareholder services group to address account matters and questions. But we don't charge a 12-b1 marketing fee, we avoid sales loads, "soft dollars," and trailing fee arrangements, and we actively and deliberately discourage "hot money" and short-term investors by imposing redemption fees on shares held for less than six months (these fees become assets of the Fund for the benefit of our remaining shareholders). These practices also help to reduce fund expenses, and those benefits are passed on to shareholders.
Importantly, the Funds are long-term investments that take risk, and that can and will experience periods of flat and negative returns. While we prefer these periods to be short, strong long-term returns do not require that they be short, so long as our occasional losses aren't extremely deep.
With regard to our flat performance since August (in the face of substantial losses in the major indices), I'll point out what I've frequently noted over the years, regardless of market direction or performance. Our objective is high long-term capital appreciation, with added emphasis on defending capital during unfavorable market conditions. I strongly believe that this is a realistic objective. But I don't have any confidence at all that the Funds will deliver strong or even positive short-term returns.
Frankly, I wish it were different too, but that would require investors to constantly recognize merit based on valuation, free cash flow, financial condition, management, realistic growth prospects, market action, and so forth. If investors constantly did so, a portfolio that loads these factors might consistently be rewarded. Unfortunately, it just doesn't work that way. It's precisely the fact that investors sometimes misprice these factors that creates the opportunity to profit from a portfolio that loads them.
Every day, we take actions to load the portfolio with favorable valuation and market action, by purchasing highly ranked securities on short-term weakness, replacing lower ranked holdings on short-term strength, and aligning our position with the prevailing Market Climate. Our measure of success is not whether the Fund gained or lost value over some short period of time, but whether we took actions to build value and strength into the portfolio, following a discipline that we believe will produce good results if followed consistently.
These are actions that we can directly control. But whether or not investors recognize specific investment merits over the short-term is not under such tight control. In some periods, investors become quite hostile toward poor investment characteristics (as when they destroyed valueless tech stocks). We tend to do well in such environments. In other periods, investors become inclined toward good investment characteristics (as when they accumulate stocks with strong free cash flow and attractive valuations). We tend to do well in these environments too. But sometimes investors chase trashed-out stocks that have no merit except that they've been beaten to a pulp. We just don't get much benefit from that, and we certainly don't try to jump on the bandwagon. Instead, we rely on the expectation that investors will recognize identifiable merit, we build features into our approach (such as analysis of market action) to speed this process along, and we base our approach on exhaustive research over decades of historical data on the markets, the economy and individual companies. Still, we have no expectation that investors will recognize these merits smoothly and continuously. So we are demanding of our actions, and patient with the consequences.
But are we hot?
Even with its strong absolute and relative performance since inception, I don't consider the performance of the Strategic Growth Fund to be "hot" in any meaningful sense. The Fund has performed as intended in recent years, and in my view, this performance has been neither exceptional nor disappointing from a long-term perspective - roughly in line with our expectations during a hostile Market Climate, and less than we would generally expect in favorable Market Climates when our approach accepts greater risk and exposure to market fluctuations.
Nor is the Fund "hot" on the basis of size. While we expend a great deal of effort in the analysis and selection of investment positions, we continue to find it easy to actually trade investment positions. Not simply "achievable with difficulty," but virtually effortless on our very small asset base ($460 million).
In general, "hot" funds are generally those that achieve their performance by riding a narrow sector of stocks to overextended extremes. Gold funds were hot last year (and may become even hotter for a while longer). Tech and internet funds were hot during the late 1990's. Still, no narrow investment sector stays hot forever. So "hot" funds tend to experience mean-reversion.
In contrast, part of our investment strategy is to replace lower ranked holdings (overvalued or under distribution) on short-term strength with higher ranked candidates (undervalued and under accumulation) on short-term weakness. As a result, we don't often find ourselves holding a large portion of our assets in overextended securities. One of the reasons we aren't at all concerned about asset growth or mean reversion is that our approach includes elements which inherently provide liquidity to the market rather than using it up, and pare overextended securities from the portfolio.
As of last week, the Market Climate for both stocks and bonds remained characterized by unfavorable valuations and unfavorable trend uniformity. Both valuations and market action remain favorable for inflation-protected securities and precious metals shares. The Strategic Growth Fund and the Total Return Fund each currently hold about 10% of assets in precious metals shares.
An important feature of recent market action is the increasing incidence of "air pockets," where individual stocks are taken down 15-30% in a single day on very slight disappointments. This has induced an unusual amount of day-to-day choppiness in market action, and is very difficult to hedge away. We've avoided many of these, though not all, such as Coors and Pacificare. The ones that hit the indices without hitting our portfolio generate gains in the Fund. The ones that hit our portfolio more than the indices generate losses. Overall, this action has not had much net impact on our returns, but it has affected our day-to-day volatility. While we are widely diversified in about 140 individual stocks in many industries, a substantial portion of our fluctuation on any recent day can be often traced to action in one or two issues. This is market action we've seen before, most notably in 2001, and it is clearly unfavorable for the market as a whole. It is a signal of underlying skittishness that could become much more widespread. As always, that's not a forecast as much as an identification of potential risk.
Suffice it to say that the increasing emergence of air pockets is an indication of growing risk aversion, and very few things are worse for the market than thin risk premiums combined with increasingly risk-averse investors. On a sentiment basis, we still see only 31.5% bears according to Investor's Intelligence figures. Better, but still much lower than the level that typically precedes sustained bear market rallies, much less bull markets. So on a number of fronts, the market continues to be susceptible to a substantial increase in anxiety and bearishness. A hard and lopsided decline (overwhelmingly more declining issues and downside volume than advances) would still be the easiest way to set up a potentially favorable shift in trend uniformity.
We certainly identify many areas where risk appears to be worthwhile, including a wide range of individual stocks (once their sensitivity to overall market fluctuations is hedged away), precious metals shares, and inflation protected Treasuries, among others. With regard to overall market fluctuations, however, we remain defensively positioned in both stocks and bonds.
Hussman Strategic Growth Fund Semi-Annual Report
Sunday February 9, 2003 : Weekly Market Comment
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As of last week, the Market Climates for both stocks and bonds remained characterized by unfavorable valuations and unfavorable trend uniformity, holding us to a defensive position. In stocks, our fully invested and widely diversified position in individual stocks remains well-hedged against the impact of market fluctuations. In bonds, we continue to emphasize investments such as Treasury inflation protected securities, near-maturity callable agency notes, precious metals shares, and foreign government notes. This position has a fairly low sensitivity to fluctuations in nominal interest rates, but is favorably affected by declines in real interest rates.
We remain prepared to remove a substantial portion of our hedges and to take a much more constructive stance toward market risk when we observe evidence that trend uniformity has shifted to a favorable condition. While the market frequently recruits this evidence very quickly in new bull markets or durable bear market rallies alike, the Market Climate has been persistently hostile in recent months.
At present, the best chance for a quick shift in trend uniformity would be for the market to experience a hard decline (which despite the action of recent weeks, has not been sufficient by our metrics), followed by a sharp and broad reversal on explosive trading volume. By broad, I mean that we would need to see leadership by a much wider set of industries than tech and financials. Such a reversal does not have to go very far at all to give a good indication that investors have adopted a fresh willingness to take on market risk.
So there is the quick way to generate favorable trend uniformity. That sort of shift wouldn't improve the fairly dire condition of fundamentals, but nothing prevents the market from enjoying periods of speculation anyway, if investors are so inclined. Fundamentals typically develop and exert their effects over an extended period of time, so there is no contradiction in a willigness to take a moderate speculative exposure, based on specific evidence, even when fundamental investment merit is lacking. Still, nothing ensures that trend uniformity has to change in the near future, nor that market action could not generate favorable trend uniformity in a more complex way. But here and now, the fastest route to a favorable Market Climate would be for the market to experience a brutal decline first. As my high school calculus teacher Father Arnold Perham told me at 14, "Kid, the road to easy street runs through the sewer."
Among the factors which may increase the chance of that route, advisory sentiment remains unusually bullish here. While there is a great deal of lip service about the risks of war, the fact is that only 29.2% of investment advisors surveyed by Investor's Intelligence are bearish. We generally view anything less than 30% as particularly important, because bearishness below that level often results in tepid returns when the Market Climate is favorable, and very negative ones when the Market Climate is unfavorable. It is rare to find even a modestly durable intermediate-term low in the market with bearishness below 40%. Not to mention final bear market lows, which generally feature more than 60% bears.
Suffice it to say that the market is capable of generating a much higher level of bearishness and anxiety than is currently evident. We would not rule out the possibility of an advance, of course, since we never rule out anything. But there is very little evidence on which we could confidently base a speculative position. Our rule is simple - unless a particular risk displays evidence of investment merit (favorable valuation) or speculative merit (favorable market action), we simply avoid, hedge, or diversify it away.
In bonds, the important divergence between straight and inflation-protected Treasuries continues. As always, the information is in the divergences. In recent sessions, that divergence has abruptly widened. The yield on inflation protected securities essentially measures the real interest rate, while the yield on straight Treasuries is the real yield, plus the anticipated inflation rate. When both yields decline, but the inflation protected yield declines faster, it means not only that real yields are declining, but that anticipated inflation is increasing (from about 1.5% in December to about 2% currently, to be exact). Since real interest rates are tied closely to future real economic growth (see prior updates on this), bond market action is giving a very specific forecast - weak economic growth combined with positive and persistent inflation. In a word, stagflation.
Unfortunately, that appears to be the best case.
One of the disturbing features of the current economic and political climate is the willingness of our Administration to plunge the U.S. into international isolationism. Beyond the predictable political consequences (radicalizing first-tier enemies, amplifying anti-American sentiment, and proliferating exactly those weapons we seek to contain), there is one particularly acute economic risk to this, which is the ease with which U.S. isolationism could trip the economy into a depression.
The U.S. current account remains at the deepest deficit in history, the debt burden on corporations and individuals is also the greatest in history (rivaled only by the late-1920's), and rates of bankruptcy and default are already problematic. The existing current account deficit means, in practice, that present levels of U.S. economic activity and real investment are dependent on foreign capital inflows well in excess of $1 billion each day. Needless to say, the flexibility to tap this source of financing for economic activity is greatest when we are not already reliant on it. So not surprisingly, every prior economic expansion began with the U.S. current account in surplus. In stark contrast, the fastest way to "improve" a large deficit in the current account is to suffer a deep recession through profound weakness in real investment and capital spending. We need not resort to wild speculation to conclude how the deepest current account deficit in history might be resolved, if the Administration insists on forcing the issue.
And this is the risk. By pursuing a stance that isolates the U.S. internationally, however great, however powerful, we pursue a stance that threatens the continued inflow of foreign capital at a time when it is central to our economic stability. The potential effect of a chill on foreign capital inflows could mirror the consequences of our retreat into protectionism during the Depression.
As mathematician Rene Thom noted decades ago, catastrophe is the movement from one stable equilibrium to another, along an unstable path that can be abrupt even if the system itself is only changing gently. The apparent stability of the U.S. economy in the face of massive and continuing foreign capital inflows is a much different equilibrium than would be achieved without those inflows. One might point to Friday's unemployment report for comfort about economic strength, but it is clear that the jobs gain was a seasonal reversal of December's downward revision, and that the decline in the rate of unemployment was not due to job growth but attrition of workers from the job market altogether. It is important to distinguish the waves from the tide, and the tide in this case, is becoming increasingly precarious.
In any event, neither fundamentals nor market action provide us a basis on which to expose our portfolios to the risk of wide fluctuations in the broad stock and bond markets. There are many risks that are appropriate and attractive, once these market fluctuations are hedged away. For now, selectivity and defensiveness remain central to our investment stance.
Sunday February 2, 2003 : Weekly Market Comment
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The Market Climates for both stocks and bonds remain hostile, characterized by both unfavorable valuations and unfavorable trend uniformity. In stocks, we are fully invested in individual stocks displaying favorable valuation and market action on our measures, but we have largely removed the impact of market fluctuations on the portfolio through offsetting short positions in the Russell 2000 and S&P 100 indices. In our total return approach, we continue to hold a relatively short portfolio duration through callable agency notes and short duration Treasuries. We also hold Treasury inflation protected securities over a range of maturities. These securities are sensitive to real interest rate movements, are generally less volatile than straight bonds of similar maturity, but have recently enjoyed equivalent gains. This is because recent declines in interest rates have been driven wholly by declines in real interest rates, while inflation expectations have been constant or rising. Finally, we hold moderate positions in precious metals shares, utilities and foreign government notes. In all, we are positioned in a way that takes advantage of existing pockets of favorable valuation and market action, but without much dependence or sensitivity on overall market movements.
Last week was a powerful negative from the standpoint of trend uniformity. About mid-week, there was a chance that we might actually set the stage for the classic momentum shift that often marks good, tradeable "bear market rallies." Unfortunately, the market stabilized later in the week, and as it happens, moderate deterioration is nowhere near as favorable as a washout. Meanwhile, the percentage of bullish investment advisors remains at 50%. This level of bullishness is uncharacteristic of important market lows, and adds to the risk that the market could break further. As usual, that's not a forecast, but there seem to be few reasons to accept such risks at present.
The best chance for a near term shift in trend uniformity would actually be a washout, consisting of a hard market decline with strongly negative breadth, a preponderance of downside trading volume, and a significant increase in advisory bearishness. That's certainly a possibility given near term uncertainties, so we can't rule out the prospect of a more constructive position ahead. Still, we would never position ourselves in anticipation of that kind of shift, particularly because of the brutal short-term decline that would be required as a prelude. In any event, we're still defensive for now, and we'll take our evidence as it comes.
Clearly, the coming weeks will be critical ones. By unanimous opinion, war with Iraq is now considered a certainty. Well, nearly unanimous opinion. At the risk of being excused as utterly naive, implausibly contrarian, or incorrigibly pacifist, I am increasingly of the opinion that there will be no war, at least no early war, with Iraq.
Following a surge in crude oil futures on the eve of the initial U.N. inspectors' report, crude prices have displayed an inability to better those highs. Certainly a move to $40 or more would suggest an increased likelihood of military action, but at present, the behavior of crude prices is out of context, if war is indeed imminent.
Politically, the reasons to doubt an early war are also increasing. It is probable that Colin Powell's presentation to the U.N. on Wednesday will not present obvious evidence of "material breach" but rather what the Administration considers a pattern of evasion by Iraq during recent inspections. It is also probable that this presentation will not alter the determination of Germany and France to allow more time for inspections in the interest of avoiding war. Statements from political leaders in these countries make it clear that the notion of "material breach", which the Administration equates with justification for war, has no such implication in their view. Rather, the consequence of material breach would be a referral back to the security council for "appropriate enforcement actions" which need not be military in nature. As a result, the German and French governments insist that a second resolution, apart from 1441, would be required in order to constitute U.N. sanction of war.
There is no question that it is in the interest of the U.S. to claim and preserve the right to unilaterally declare war in its own defense. However, in this instance, the imperative for war is far from clear, and nearly 70% of Americans favor war in Iraq only if it is sanctioned by the U.N. - an indication of uncertainty among Americans as to whether military action is actually justified. So unless France (which holds veto power) and Germany (which does not) abruptly lose the resolve that is so popular among their own people, the Administration may be hard pressed to recruit widespread public opinion in support of war even within the U.S. itself.
Needless to say, the press has not been particularly careful in distinguishing the will of the American people with the will of the current Administration. To anybody who believes that America's virtue lies in its principles, its liberty, its democracy, and its people, the eagerness to equate the two in this instance is troubling. But this distinction is a critical factor in assessing the probability of war.
The willingness to choose long and frustrating diplomacy instead of war does not constitute "appeasement" - a word that has been recklessly contorted in recent months. Appeasement involves the grant of concessions - generally dishonorable ones - to an enemy, in return for assurances of nonaggression (as when Hitler was offered part of Czechoslovakia in the Munich Agreement, over the objections of Czechoslovakia, which was barred from attending). Appeasement is not inherent in the pursuit of diplomacy, nor in the demand for grave justifications as a precondition for war.
The argument against war is also not an argument against U.S. security or the defense of its interests, but rather a recognition of the elements that are necessary to achieve those aims. It is exactly in pursuit of American security and interests that the Administration should emphasize containment, deterrence and diplomacy - even years of it if necessary - instead of a war on a government that, while tyrannical, is of questionable threat. A war would predictably increase international resentments, further destabilize very tangible risks in North Korea, and ultimately radicalize countless potential terrorists, with no central authority from which surrender could be obtained. As the International Herald Tribune puts it, the Administration has proved itself "good at fighting terrorists, but not at fighting terrorism."
As John Jay wrote in The Federalist in 1787, "the safety of the People of America against dangers from foreign force, depends not only on their forbearing to give just causes of war to other nations, but also on their placing and continuing themselves in such a situation as not to invite hostility or insult; for it need not be observed, that there are pretended as well as just causes of war... and that whenever such inducements may find fit time and opportunity for operation, pretences to colour and justify them will not be wanting. Wisely therefore do they consider Union and a good national Government as necessary to put and keep them in such a situation as instead of inviting war, will tend to repress and discourage it."
In the weeks ahead, a number of factors are likely to gauge the probability of war, quite apart from the obvious news. One is crude oil prices. Again, a surge above $40 a barrel would suggest a deterioration in the likelihood of peaceful resolution. News coverage will also be important. Any shift in public opinion against military action in Iraq is likely to be accompanied by a substantial increase in news stories focusing on the human costs of war.
We certainly would not take investment positions on the expectation or forecast of a peaceful resolution, but this is mainly because we never take positions on the basis of forecasts or scenarios. For now, the Market Climate holds us to a defensive stance.
Sunday January 26, 2003 : Weekly Market Comment
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The Market Climate for stocks and bonds are both characterized by unfavorable valuations and unfavorable trend uniformity, placing us in a defensive position for both markets. In stocks, we're fully invested in a widely diversified portfolio of individual stocks that display favorable valuation and trend uniformity on the measures we use, but we've offset their market risk with short positions in the Russell 2000 index and S&P 100. The dollar value of our shorts never materially exceeds our long holdings, so our stance should not be interpreted as a "bearish" position, or one that is intended to profit from a market decline. We don't rule out a substantial rally here, nor do we rule out a substantial plunge. We simply don't rely on short-term forecasts at all. The intent of our hedge is strictly to remove the impact of market fluctuations from the portfolio, because market risk has historically not been compensated during this Climate, on average.
In the fixed income markets, we continue to emphasize instruments that are driven by fluctuations in real interest rates, including Treasury inflation protected securities, and moderate positions in precious metals shares and foreign government bonds. We also hold a significant position in money market instruments and alternatives such as Treasury bills and near term callable agency notes.
Both in stocks and bonds, the frequency of such fully defensive positions represents less than 25% of the historical data. But I view the willingness to defend capital in these environments as critical to attaining a high long-term rate of return. Nothing is more hostile to the long-term compound annual rate of return earned by an investor than a large loss taken over an extended period of time. Small losses are recoverable, moderate losses over short periods are generally also recoverable. Missed short-term rallies are recoverable. But large losses endured over extended time periods are devastating.
Our approach is intended for investors following a disciplined, long-term saving and investing plan. Our willingness to avoid market risk in certain environments is not only a strategy toward reducing risk, but toward increasing long-term return. If market risk was always efficient in generating return, then avoidance of risk would also be accompanied by a reduction in expected return. The key is that we don't believe that exposure to market risk is always an efficient means of generating attractive investment returns. More on these views in the latest Manager Insight with Lori Pizzani.
Last week, the condition of trend uniformity deteriorated further across a wide range of measures. We still would not rule out the possibility of a favorable shift at any point in time, so weakness in the current condition of trend uniformity should never be taken as a forecast of future conditions. As always, our approach is based on aligning ourselves with the prevailing Climate, and changing our position when that Climate changes. Still, given the fresh breakdowns, we remain defensive. Notable in these breakdowns was the U.S. dollar, a further decline in real U.S. interest rates (which was completely behind the rally in Treasury bonds last week - meaning that TIPS performed as well or better as straight Treasuries). Interestingly, utility stocks also plunged, something that is incongruent with expectations that dividend taxes will be eliminated, and suggestive that this plan may not pass after all (at least in anything resembling its present form).
Along with this fresh weakness, the U.S. has experienced a particularly severe cold snap in recent weeks. Given the weak action in the markets, the plunge in the U.S. dollar, and the relentless decline in real interest rates, I expect that the U.S. economy will slip into a double dip this quarter.
On the inflation front, however, I do not expect that this economic weakness will translate to substantially lower inflation. As I've argued frequently over the years, inflation is not, in fact, a monetary phenomenon, but a fiscal one. To the extent that government spending is once again rising faster than GDP, we can expect that either the ability of the public to hold government liabilities will be diminished (through taxation), or the quantity of those liabilities will increase (through bond issuance or money creation). Regardless of the financing method, this implies a deterioration in the value of government liabilities. Unless we also see a major increase in the willingness of individuals to hold these liabilities (the main cause usually being high profile corporate bankruptcies), we can expect the inflation rate to be positive and persistent, even if it is not particularly high. Again, the main warning of oncoming deflation risks would be a fresh widening in the risk spread between corporate bond yields and Treasury yields. At present, we don't see this.
The main feature of prices is not likely to be deflation, but dispersion. Prices for manufactured goods, as well as profit margins, will remain under downward pressure due to competitive factors and a relative surplus of capital. Meanwhile, prices for services and wages will continue to experience upward pressure due to a relative scarcity of labor. Last week, the Wall Street Journal caught onto this truth, noting "The government's most widely followed measure of inflation, the consumer price index, shows an important split is growing between two dominant sectors of the economy: services and goods. Prices for services rose 3.2% in December from a year earlier, pushed up primarily by rising medical-care costs, but also by increases in tuition, homeowner's insurance, and rising charges for routine services such as trash collection and auto repair. But prices for manufactured goods, excluding volatile food and energy sectors, were down 1.5% in December from a year earlier. Next to a 1.6% year-to-year drop in November, it was the largest decline of such prices on record going back to 1958."
In short, we expect renewed weakness in the U.S. economy and a double-dip in output this quarter. We remain fully invested in favored stocks, but have largely removed the impact of market fluctuations, leaving us with a portfolio that we believe exhibits favorable valuation and market action without any particular reliance on overall market direction. We don't anticipate deflation, but rather a low, positive and persistent rate of inflation, featuring upward pressure on prices for labor and services, and weakness in manufactured goods prices and profit margins. Weak prospects for economic growth continue to be reflected in declining real interest rates, which supports inflation-protected securities, precious metals, and foreign currencies. While these investment classes could experience some short-term pressure to consolidate their recent gains, the fundamental conditions driving weakness in the U.S. dollar - depressed U.S. savings, excessive debt burdens, and an unsustainably large current account deficit - suggest that further adjustment will be required.
In sum, we remain defensive toward overall stock market and bond market risk, but there is no shortage of attractive investment opportunities so long as we can remove overall market risk from our portfolios through hedging.
Very short-term, I have as usual no forecast at all. The market has declined to a moderately oversold condition, which may admit a fast, furious rally to clear that condition even if the broader direction was to remain downward. And though recent action makes it very unlikely that the market will recruit favorable trend uniformity within the next few weeks, the preference of investors to take risk can be very fluid, particularly now that there is so much emphasis on the possibility of war.
On the subject of war, it is distressing that the primary arguments for military action in Iraq rest on false dichotomies. These include formulations like "If you're not with us, you're against us" when dealing with the objections of other nations; "Who would you rather believe, America or Saddam Hussein?" when dealing with the questions of evidence indicating a pressing need for military action; "We have to end this now, or it will never end" when arguing against a continuation of diplomacy. In everything, particularly in working toward peace, there is a middle way.
Nothing prevents us from trying to understand and seriously consider the doubts of our friends, without responding with hostility. Nothing prevents the Administration from articulating a detailed and specific basis for immediate military action. Nothing prevents the U.S. from pressing for constant and regular inspections even for years, if need be, if doing so will help us achieve our goal of security without violating the rule of law. There is a gaping difference between military action taken in response to an act of war, and military action taken to subordinate and overthrow an enemy as an entirely preemptive measure.
Contrary to the views of some analysts, it is not clear that a war in Iraq will be a favorable development for stocks, nor for the economy, nor for the oil market, nor for the cause of peace. The oil supply from South America is already disrupted. The U.S. already faces depressing effects of overcapacity, low savings, and a massive current account deficit. The economy is already on the cusp of a double dip, with bankruptcies and foreclosures relentlessly increasing. In this context, the addition of war will not create the road to recovery. In this economy, it just might create the perfect storm.
Monday January 20, 2003 : Weekly Market Comment
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As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable trend uniformity, holding us to a defensive position. It is astonishing how abruptly the developing indications of favorable trend uniformity have vanished in the past couple of weeks. The next few weeks will remain important, however, and as usual, we are always open to the possibility of a reversal in the preference of investors to take market risk. Regardless of current valuations and economic conditions, we cannot rule out the possibility of a favorable shift in trend uniformity at some point in the coming weeks or months. For now, however, we observe neither investment merit (favorable valuation) nor speculative merit (favorable trend uniformity) that would warrant a significant exposure to market risk.
Last week's action was decidedly negative. I noted a few months ago that following the October lows, we had tested a number of measures that would have shifted to a favorable condition following the October low. Unfortunately, none of these measures, when applied to historical data, provided an improvement over our existing measures of trend uniformity. Indeed, the best performing candidate reversed to a negative stance last week anyway, at nearly the same level it would have turned favorable. So the measures which might have captured part of the rally following the October low have given up their gains, and have now become negative near the same point as they would have become favorable. To have used them in spite of their uncompelling historical performance would have contributed pure volatility with little overall reward.
A few notable events last week - the U.S. dollar broke to a fresh low (a deterioration which we expect to be mirrored in the U.S economy as a whole). On a technical basis, the McClellan Oscillator (a measure of breadth momentum) broke down, following a series of three declining peaks - nearly the same pattern it exhibited before substantial market losses a year ago.
On the interest rate front, yields declined late in the week, but more striking is that fact that the "real" yield on TIPS (Treasury inflation protected securities) fell faster. In other words, interest rates did not decline because of downward pressure on expected inflation, but because of downward pressure on real interest rates.
This is crucial, because market action is saying something different from the common "deflation ahead" scenario. Real interest rates measure the tradeoff not between dollars today and dollars tomorrow, but between real goods today and real goods tomorrow. International evidence is very clear that higher real interest rates are associated with higher rates of economic growth, because they signify that real goods are scarce today, relative to the future (i.e. goods will be more plentiful thanks to anticipated economic growth, therefore borrowers must promise many goods tomorrow in order to borrow real purchasing power today). In contrast, when real interest rates are declining, as they are now, it is a signal that real goods are relatively plentiful today, in comparison to the future. That is, economic growth is likely to stagnate.
(Geeky theoretical note: One might think that lower real rates would lead to higher investment, but this is a demand-side-only analysis, not an equilibrium one. If the supply of loanable savings is not shifting out, the observation of falling real rates in equilibrium is an indication that the entire demand schedule for real investment is shifting back. This observation is independent of the fact that the demand schedule is itself negatively sloped. The positive relationship between real interest rates and economic growth is fully consistent with standard equilibrium growth theory. In an intertemporal equilibrium, the growth rate of consumption is an increasing function of the real interest rate. Therefore, a lower real interest rate implies slower growth in consumption, other things being equal, largely due to an emphasis on current consumption over real savings and investment. This is precisely what we observe in the U.S. economy).
Notice that a decline in economic growth need not be associated with deflation. Indeed, the data are clear that there is an inverse relationship between economic growth and inflation. The lowest inflation rates are typically associated with periods of fastest economic growth.
(Geeky theoretical note #2: This is evident from the monetary identity PQ = MV, which implies %P = %M + %V - %Q, where P is the price level, M is the money supply, V is velocity, and Q is real output. Barring a plunge in monetary velocity that outweighs the growth rate in money itself, lower economic growth is associated with higher inflation rates. The main deflation trigger is not slow growth, but the potential for an increase in credit problems and loan defaults. That could very well cause a decline in velocity, as people increase their preference for holding safe cash, but this risk would probably be foreshadowed by a renewed widening in risk spreads between corporate bond yields and default-free Treasuries. We don't see this yet).
As I've noted before, the most likely course for the price level is not deflation per se, but dispersion in inflation rates - downward pressure on manufactured goods prices and upward pressure in the prices of labor and services, leading to an overall inflation rate that is relatively low, but positive and persistent.
Cutting through the economic theory, the simple point is that market action suggests further economic weakness.
Again, we're not willing to rule out the possibility of a favorable shift in trend uniformity ahead, but at present, we don't have the evidence to hold anything other than a defensive position in stocks. In the bond market, we continue to lean toward an investment position that benefits more from real interest rate movements than from movements in nominal yields. Given the low inflation expectations already built into interest rates, further declines in interest rates will most probably be driven by falling real yields. Meanwhile, any inflation surprises would probably drive nominal yields up much more than real yields.
In short, barring prospects for a strong and robust increase in real economic growth, market conditions continue to favor a relatively defensive stance. Greater risk taking is a useful strategy to earn higher returns only if the risks you take are actually associated with substantial expected returns. At present, we can say neither about overall stock market risk or bond market risk, so our approach continues to emphasize attractive risks in individual stocks and investment sectors that are not particularly dependent on "bull market" conditions in either stocks or bonds. We don't rule out the possibility of a bull market (though we don't really think in those terms). It's just that we don't need one, we don't have evidence of one, and we certainly don't want to depend on one.
Finally, a quick review of the past year's performance in the Strategic Growth Fund (in accordance with regulations, we'll begin reviewing performance for Strategic Total Return once it has a full year of history).
The Hussman Strategic Growth Fund completed 2002 with a gain of 14.02%, compared with a loss of 20.48% in the Russell 2000 and a loss of 22.10% in the S&P 500.
During the second half of the year, the Strategic Growth Fund gained 2.06%. Meanwhile, the Russell 2000 lost 16.56% and the S&P 500 lost 10.30%. All figures include reinvested dividends. Given that the Fund was largely hedged last year, the primary reason for our modest returns in the second half (in absolute terms, anyway) is that our favored stocks simply did not outpace the major indices by much during this period. There is nothing unusual about this. In historical tests of our approach, our favored stocks would have lagged the market in nearly one-third of quarterly data, with no particular pattern across bull or bear markets.
We continue to have little difficulty trading as much as we like of our favored stocks, so the second-half returns were not at all constrained by the size of the Strategic Growth Fund, which at about $450 million is still relatively tiny. Moreover, since we tend to buy stocks on dips and sell on rallies, our trades frequently provide liquidity to the market, rather than absorbing it. So our approach is very amenable to a much larger asset base. Simply put, our somewhat modest recent returns can be completely traced to the fact that our favored stocks outpaced the major indices during the second half, but not by the margin that we've typically seen over more extended periods of time. Still, nothing particularly unusual for a short-term return.
A high compound annual rate of return does not require the absence of flat periods, or even moderate losses. What it does require is the absence of deep losses. Deep losses are extremely hard to recover, due to compounding. For example, three years of 25% returns generate a 25% annualized average. But follow that string with one 30% down year, and the average annualized return drops to just 8%. Once an annualized return becomes deeply negative, very high returns are required in order to pull the annualized average back into a satisfactory positive range.
Our approach is not biased toward defensive positions in general (we only take a fully hedged position when both valuations and trend uniformity are negative, which has only occurred in about one-quarter of historical data). However, it is quite biased against taking market risk during periods of unfavorable valuations and trend uniformity. Deep market losses have historically been much more frequent during these periods - indeed, every past market crash of note has originated from this single climate. Last year reflected that hostile climate, and our strategy performed exactly as intended.
Importantly, the Fund has earned significantly positive returns both in months when the market has advanced, and in months when the market has declined. Since the Fund's inception in July 2000, the Russell 2000 has experienced 13 advancing months and 17 declining months. During those advancing months, the Fund earned an average annualized return of 11.07%. During the declining months, it earned an average annualized return of 25.13%. The dispersion between advancing and declining months can be traced to the fact that declining months have generally been paced on the downside by groups such as technology and financials that we held fairly lightly. Currently, our weighting in technology is somewhat closer to that of the major averages, though we remain light on financials. Note also that these are averages. The Fund does take risk, and it can and does experience periods of negative returns.
As I always emphasize, I have absolutely no confidence at all that our approach will generate gains over any very short-term period, be it a particular week, month or quarter. Since stocks have a great deal of short-term randomness, the returns that we experience over any short period of time often have no clear relationship to the particular actions that we took during that period. Positive or negative short-term returns may be pure "noise," they may be driven by some unpredictable event affecting a small number of positions, or they may be traceable to actions taken much, much earlier. My confidence as an investment manager arises only from the belief that certain actions, taken consistently over a long period of time, have generally been associated with attractive returns and acceptable risks. We have tight control over our actions, but our control over their short-term consequences is much less direct. For us, those actions include focusing on individual stocks displaying some combination of favorable valuation and market action on the measures we use, buying highly ranked candidates on short-term weakness, selling lower ranked holdings on short-term strength, and aligning our market position with the prevailing Market Climate that we identify at any particular point in time. To the investors whom our approach is intended to serve, even a year should be considered fairly short-term. Suffice it to say that I am pleased with the short-term performance of our approach last year.
Slightly longer term, from the inception of the Fund on July 24, 2000 through December 31, 2002, the Strategic Growth Fund gained 52.20% (18.80% annualized). In contrast, the Russell 2000 lost 22.84% (-10.09% annualized) and the S&P 500 lost 37.79% (-17.69% annualized).
Past performance is no guarantee of future results. The return and principal value of an investment in the Hussman Strategic Growth Fund will fluctuate so that shares, when redeemed, may be worth more or less than their original cost. For additional information about the Funds, including fees and expenses, please obtain our Prospectus, and read it carefully before you invest or send money. The Distributor of the Fund is Ultimus Fund Distributors, LLC.
Sunday January 12, 2003 : Weekly Market Comment
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As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable trend uniformity, holding us to a defensive position - fully invested in favored stocks, with an offsetting hedge strictly to remove the impact of market fluctuations on the portfolio. Importantly, our position should not be interpreted as "bearish." I have no forecast regarding short-term market direction. We should not rule out a fresh market decline, nor should we rule out an improvement in market internals that might place us in a more constructive position. For now, we're defensive. That said, I'll be surprised if the market does not recruit favorable trend uniformity within the next few months. I have no clue as to whether such a shift will occur at higher or lower prices, nor does our discipline require short-term forecasts of that sort. We'll immediately increase our exposure to market fluctuations when we have sufficient evidence of favorable trend uniformity. That sort of a shift will not mean that stocks are any less undervalued, but rather that stocks will have enough speculative merit to warrant a less defensive stance.
There is no question that fundamentals remain strongly against a robust recovery in economic growth, capital spending, profits, and credit quality. But the issue of speculative merit is independent of these, and speculative runs can take prices substantially higher even when fundamentals are unimpressive. The simple fact is that fundamentals develop slowly, and investors sometimes become quite eager to look forward. To the extent that investors develop a measurable preference to take on market risk, stock prices can advance for several weeks, months, or quarters in hope, speculation and anticipation of improving fundamentals, even if those improvements never arrive. So we've got to be open to at least a moderate participation in speculative market movements, even when investment merit for fundamental reasons is lacking.
Friday's unemployment report was consistent with the recent decline in the U.S. dollar. As I noted several weeks ago, fresh weakness in the U.S. dollar was likely to be mirrored by fresh weakness in the U.S. economy as a whole. Also, it is notable that despite substantial job losses, wage inflation remained positive. Wage inflation continues to advance faster than producer prices and consumer prices alike, consistent with the relative scarcity of labor versus capital discussed in the recent issue of Research & Insight. These conditions indicate that wage inflation, not strong profit growth, will be the primary result of any expansion in the U.S. economy.
Still, the muted negative response by investors to Friday's weak unemployment report provided at least some indication that investors' risk aversion is receding. As I noted last week, recent improvement in risk spreads (the difference between corporate bond yields and default free Treasuries) also suggests declining risk aversion among investors. It will be important to see how this picture develops in the coming weeks. Though valuations remain too high to take an aggressive or unhedged approach to market risk, we are certainly willing to lift a good portion of our hedges if favorable trend uniformity asserts itself.
I realize that just as there are die-hard bulls among investors, there are many die-hard bears, who are irreversibly convinced that the worst is not over. I do lean toward the assessment that there are more shoes to drop, and probably further economic weakness. But again, we've got to take into account the extended period of time over which fundamentals can deteriorate before major events (such as high profile bankruptcies) bring that deterioration to the forefront of investor consciousness.
It is just as dangerous for a physician to give up all hope, saying that the patient is terminal and nothing positive can be done, as for one to give false hope, saying that there is no illness. Both extreme optimism and extreme pessimism are a disservice. We're indifferent to the notions of "bull markets" and "bear markets," neither which can be observed in objective reality and so exist only in hindsight. What is observable is the Market Climate - valuation and trend uniformity - and as it stands, so stands our investment position.
Again, given very early indications that the risk aversion of investors may be receding, the next several weeks could be particularly important. For now, we remain defensive in stocks, but we are continually open to favorable shifts.
In the bond market, conditions are characterized by both unfavorable valuations and unfavorable trend uniformity. We've substantially reduced the duration (average maturity) of the Strategic Total Return Fund, with very little exposure to long-term interest rate fluctuations here. We do continue to hold moderate positions in inflation-protected securities, near-term callable agency notes, foreign government notes, precious metals shares, and select utility stocks. The main factor that would benefit this stance is not falling interest rates per se, but falling real interest rates (the difference between nominal interest rates and inflation). While the low level of Treasury yields and the high default risk of corporates make both classes of bonds relatively uninspiring, valuation and trend conditions continue to be favorable toward instruments that trade off of real interest rates.
Sunday January 5, 2003 : Weekly Market Comment
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Just a note - the latest issue of Hussman Investment Research & Insight is now available online. The print version will be mailed to direct shareholders next week. The performance chart for the Strategic Growth Fund has also been updated. Both documents are in PDF format.
As of last week, the Market Climate for stocks was characterized by unfavorable valuations and unfavorable trend uniformity, holding us to a defensive position. We are fully invested in favored stocks, with an offsetting hedge to remove the impact of market fluctuations from the portfolio. As usual, this stance should not be interpreted as a forecast or expectation of a market decline. We are not bearishly positioned (the dollar value of our shorts never materially exceeds our long holdings), and our positions are not based on forecasts. The proper way to interpret our position is that we presently do not observe sufficient investment merit (favorable valuations) or speculative merit (favorable trend uniformity) to expose ourselves to market fluctuations.
As I've noted many times, I'll be surprised if the market does not recruit favorable trend uniformity at some point in the coming months. Trend uniformity tends to shift about twice a year, and as one might expect, trend uniformity has a higher tendency to be favorable during the seasonally favorable November-April period than otherwise. (Since seasonal factors never reverse the implications of trend uniformity, an unfavorable Market Climate should be approached defensively even if seasonality is favorable). That said, I have no forecast as to whether trend uniformity will ultimately improve at higher levels or lower levels in the market, and our investment discipline does not require such forecasts. We simply align ourselves with the prevailing, objective evidence, and at present we do not have sufficient evidence to take market risk.
Except for very long horizons, for which forecasts of market returns are fairly straightforward (as a direct implication of valuations), market forecasts are not particularly useful. Our view is that market action conveys information about what millions of other investors know, not only about the economy and various industries, but also about their own personal situations, income, job prospects, preferences for risk, and so forth. But the nature of information is that it changes. Information is the part of the news that one cannot forecast based on what one already knows. In the financial markets, this information can shift very quickly (particularly investor attitudes toward risk). The moment that investor attitudes toward risk change, every forecast based on prior conditions goes straight out the window. The fact that investor attitudes can change quickly and unpredictably means that while it is possible to align one's position with prevailing conditions, it is useless to base positions on forecasts of future ones.
Currently, we're fully defensive based on both unfavorable valuations and unfavorable trend uniformity. We have no idea when trend uniformity will shift, but when it does, it will be an indication that investors have adopted a preference to take on additional market risk. Regardless of unfavorable fundamentals, stocks have typically performed well when trend uniformity has been favorable.
But wait. If trend uniformity turns favorable, isn't that a forecast of higher prices? No. The moment trend uniformity turns favorable, we then have the potential that it will shift to an unfavorable position at some unpredictable future point in time. While favorable trend uniformity might persist months, or even years, it could also shift to a negative position the following week (and there are a handful of instances in which that has occurred). So we have literally no forecast of market action that extends beyond the following week, and since any one-week forecast is overwhelmed by short-term noise, we effectively have no forecast of market direction at all.
In short, we concern ourselves entirely with the Market Climate that we identify in the present moment. Of course, we have plans and goals and objectives, but our focus is on daily actions that can be taken on the basis of current reality, rather than on taking positions based on some forecast, and then hoping and worrying that the forecast will come true. As Zen teaches, the future will be made up of the present, so to take good care of the present is to take good care of the future.
One of the most favorable developments in recent weeks has been the improvement in risk spreads (the difference between corporate bond yields and default-free Treasury yields). This is a positive for stocks but a negative for bonds. Offsetting this to some degree is the breakdown in the U.S. dollar, which suggests that the economy may endure some fresh weakness. If that occurs, it could potentially trigger new defaults and a sudden widening of risk spreads. But we'll take that evidence as it comes. For now, the relaxation of risk spreads is among the few legitimate positives in this market, and we'll take what we can get. By itself, it is far from sufficient to justify an exposure to market risk, but it's something.
As I noted last week, seasonal factors were likely to add some favorable support for the market, and we saw exactly that. The fact that stocks actually did enjoy a rally was positive, since a failure to do so would have conveyed unfavorable information. The rally also cleared an oversold condition that had emerged during the prior week. It is typical for such conditions to be cleared by rallies that are fast, furious, and prone to failure. The fact that there was no special update following Thursday's rally is an indication that the action was not particularly unusual or important in the context of the current Market Climate.
A key feature of a more robust market would be an improvement in price/volume behavior. Since late October, rallies have been on fairly dull volume, while declines have frequently picked up higher volume - a standard feature of distribution. Sentiment and smart-money indicators also remain unfavorable, with advisory bearishness still quite low, and insider selling picking up steam. Ideally, a favorable shift in the Market Climate would follow a hard decline, accompanied by higher levels of bearishness, but relatively low trading volume, and followed by a few days of powerful upside breadth on heavy volume. That's not a forecast, of course, and we'll take whatever shift we get, when we get it.
In all, the picture for stocks remains unfavorable, and the few bright spots are still insufficient to shift that profile here. That said, we have absolutely no preference for a negative Market Climate over a positive one, and we'll immediately increase our exposure to market risk if the market recruits favorable trend uniformity.
In bonds, the Market Climate has shifted to a negative condition, with both valuations and trend uniformity unfavorable. As noted in the prior two weekly updates, we actually divested much of our interest rate risk near the highs of the recent advance in bond prices. In hindsight, it looks like we made a good "call" on bonds, but that appearance is purely incidental. We had no forecast that bond prices would plunge last week - we simply aligned ourselves with prevailing conditions which indicated that bond valuations were overextended and trend uniformity in the bond market was deteriorating. An effective investment approach should generally give the appearance of buying low and selling high, on average, but the attempt to actually pick tops and bottoms is not useful.
In short, the Market Climate is now unfavorable for both stocks and bonds. While shifts in either are possible and may occur at any point, we are defensive at present. No forecasts required.
| Past performance does not ensure future results, and there is no assurance that the Hussman Funds will achieve their investment objectives. An investor's shares, when redeemed, may be worth more or less than their original cost. Investors should consider the investment objectives, risks, and charges and expenses of the Funds carefully before investing. For this and other information, please obtain a Prospectus and read it carefully. The Hussman Funds have the ability to vary their exposure to market fluctuations depending on overall market conditions, and they may not track movements in the overall stock and bond markets, particularly over the short-term. While the intent of this strategy is long-term capital appreciation, total return, and protection of capital, the investment return and principal value of each Fund may fluctuate or deviate from overall market returns to a greater degree than other funds that do not employ these strategies. For example, if a Fund has taken a defensive posture and the market advances, the return to investors will be lower than if the portfolio had not been defensive. Alternatively, if a Fund has taken an aggressive posture, a market decline will magnify the Fund's investment losses. The Distributor of the Hussman Funds is Ultimus Fund Distributors, LLC., 225 Pictoria Drive, Suite 450, Cincinnati, OH, 45246.
The Hussman Strategic Growth Fund has the ability to hedge market risk by selling short major market indices in an amount up to, but not exceeding, the value of its stock holdings. The Fund also has the ability to leverage the amount of stock it controls to as much as 1 1/2 times the value of net assets, by investing a limited percentage of assets in call options.
The Hussman Strategic Total Return Fund has the ability to hedge the interest rate risk of its portfolio in an amount up to, but not exceeding, the value of its fixed income holdings. The Fund also has the ability to increase the interest rate exposure of its portfolio through limited purchases of Treasury zero-coupon securities and STRIPS. The Fund may also invest up to 30% of assets in alternatives to the U.S. fixed income market, including foreign government bonds, utility stocks, and precious metals shares.
The Market Climate is not a formula but a method of analysis. The term "Market Climate" and the graphics used to represent it are service marks of the Hussman Funds. The investment manager has sole discretion in the measurement and interpretation of market conditions. Except for articles hosted from the web domains hussman.net or hussmanfunds.com, linked articles do not necessarily reflect the investment position of the Funds.