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September 21, 2003

John P. Hussman, Ph.D.
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The Big Picture: Speculative Merit Without Investment Merit

At least brokerage analysts are entertaining. When they are intent on recommending stocks in an overvalued market, they just can't bring themselves to say that stocks are overvalued and that they're willing to take market risk for speculative reasons. Instead, they create new and theoretically unsound definitions of "value" in order to justify their case. The Fed model and its variants are one class of these models. P/E and other valuation multiples based on "operating earnings" are another (operating earnings arbitrarily ignore expenses that would make earnings appear less predictable).

Here, we take a different approach. If stocks are overvalued by sound measures, we say that they are overvalued. Historically, valuations have a great deal to do with the long-term return that an investor can expect. But in themselves, valuations are weak tools for navigating the markets over shorter periods. When we look back over a century of market history, it is clear that there were many periods of overvaluation when stocks continued to advance for months or even years, and other periods of overvaluation when stocks plunged dramatically. In our work, the best way to distinguish these periods is by examining the quality of market action accompanying these valuations. Combinations of overvaluation and favorable market action tend to be accompanied by resilient markets; though valuations are high, investors are so eager to own stocks and take risk that these valuations become largely - though only temporarily - irrelevant. Combinations of overvaluation and unfavorable market action (particularly a pattern of internal divergences and breakdowns across a variety of industries and security types) tend to be accompanied by very poor returns.

In any event, it's clear that the willingness to take market risk need not be based on investment merit (undervaluation), but can be based solely on speculative merit (favorable market action). That's the situation we've had in recent months, and we've been content to take a moderate amount of market risk on that basis, without resorting to intellectually dishonest analysis of valuations ("This stock looks attractive based on projected 2006 operating earnings..."). The attendant responsibility, however, is to carefully monitor the quality of market action.

To put this in the context of risk premiums, we're willing to take market risk even when it is priced to deliver a fairly low long-term return, so long as investors appear willing to take on even greater levels of market risk. We read that willingness out of market action. In contrast, there is little sense in accepting low risk premiums when investors are becoming skittish about risk. That's when plunges occur. At present, we're not in that situation, but it is essential to monitor the character of market action for subtle breakdowns that might signal increasing skittishness among investors.

New divergences

As of last week, the Strategic Growth Fund continued to hold a nearly fully invested position in favored stocks (as we always do regardless of market conditions). Of course, these stocks are affected by fluctuations in the overall market. To reduce this impact, we held an offsetting short sale in the S&P 100 and Russell 2000, intended to remove over half of our exposure to market fluctuations.

Given that position, it should be clear that market internals displayed some unusual divergences last week. Specifically, we didn't participate as much in advances as one might have estimated from our net market exposure, yet the Fund also tended to gain value on market declines.

Here's what's going on. In recent sessions, market advances have been increasingly dominated by two groups - speculative growth stocks, and financials. Both of these groups receive relatively low weight in our holdings. So that strength doesn't filter through to our own returns. In contrast, market declines have been increasingly accompanied by a flight to safety in value and stable growth stocks. On those days, our returns have been better than one might have predicted by looking at our "net" market exposure.

Historically speaking, these divergences between speculative growth and stable value have not tended to work out well for the market. Periods like this can last for weeks or even months, but they tend to be associated with what are often seen in hindsight as "blowoffs." To the extent that we're also seeing the heaviest ratio of insider selling to buying in 17 years, and a surge in Nasdaq margin debt (see Alan Abelson's latest column in Barron's), it strikes me that there are a whole lot of investors out there who are intent on getting back to even, quick. Performance-chasing has evidently become an important feature of the stock market here. That's a dangerous goal to have in an overvalued market.

The importance of measuring growth from peak-to-peak

As I've frequently noted, investors should rarely put much faith in growth rates that are measured from trough-to-peak or from peak-to-trough. This is true regardless of whether one is measuring earnings growth, economic activity, or investment returns. The most robust estimates of true growth are derived by measuring from peak-to-peak or from trough-to-trough across market cycles.

For example, measured from the trough of a recession to the peak of an expansion, earnings growth can often seem breathtakingly high. Investors who extrapolate those growth rates and price them into stocks can find themselves paying profoundly high valuations, with equally profound disappointment as those expectations prove incorrect. Measured from peak-to-peak across economic cycles, S&P 500 earnings have grown no faster than 6% annually over the past 10, 20, 50 or 100 years. Similarly, it is enticing to extrapolate the strong performance of, say, the Nasdaq from the October low to the recent highs. But this calculation implicitly assumes that an investor has extraordinary timing ability; that the investor could purchase at the exact low of the Nasdaq and hold to its high. We don't believe that markets can be timed in this manner.

It is both more realistic and more robust to measure growth and performance from peak-to-peak or trough-to-trough. These peaks or troughs should preferably span several market cycles, but at minimum, the peaks or troughs should be at least a few quarters apart.

To us, a good investment approach is one that performs well from peak-to-peak without intolerably deep drawdowns in the interim. The goal of the Hussman Funds, for example, is to substantially outperform the major indices over the full market cycle - from one bull market peak to the next (or one bear market trough to the next), with smaller periodic losses than a buy and hold approach would have produced. I think that's a reasonable objective, and it's largely equivalent to targeting both high return and high risk-adjusted return.

My students were always happy to be tested on the same material that they learned. Similarly, we're always happy to be evaluated on the same criteria that we target. For us, those criteria are full-cycle return (bull market plus bear market), and return per unit of risk, measured over any reasonably extended period of time. Unless an investor can reliably call market peaks and troughs in real-time, evaluating our approach by asking whether we match the trough-to-peak performance of highly volatile indices is to thoroughly miss the point.

Even looking at shorter periods than a full market cycle, the analysis of peak-to-peak returns can be instructive. For example, consider the total return of the S&P 500 (including dividends). Friday's close (September 19, 2003) on the S&P 500 was the highest level seen over the most recent 12-month period. During the preceding 12-month period, the highest point for the S&P 500 was achieved on March 19, 2002. Between these two peaks, however, the S&P 500 actually lost -9.1%. Over the identical period, the Strategic Growth Fund gained 24.6%. Turning to drawdown losses, the S&P 500 suffered a decline of -14.3% following the March 19, 2002 peak, on the way to its October 2002 low. The total return of the Strategic Growth Fund has not moved below its March 19, 2002 value at all.

Again, we're still fairly constructive, but hand in hand with our willingness to take market risk is the willingness to constantly monitor the quality of market action. Our ability to defend capital is best when we are willing to build defenses on the basis of subtle deterioration, before the need for defense is clear from broad and obvious weakness.

Smoke without fire

On the economy, there's still a strong likelihood that growth in the second half will be faster than we've seen in several years, but there's still very little evidence of sustainable improvement. The "surprisingly good" data on new claims for unemployment that sparked Thursday's rally barely dropped below the 400,000 level, and the 4-week average actually moved up to the highest level since mid-July. Other early indicators of labor market improvement remain anemic, including flat weekly hours worked and only modest improvement in the hiring of temporary workers. On the capital investment side, the latest data on capacity utilization came in flat once again, at a weak 74.6%.

Most likely, we'll see some improvement in capital spending. But as I've frequently noted, all investment must be financed out of savings. Given deep current account and fiscal deficits, and the fact that the majority of earnings "growth" we've seen is actually the result of layoffs (which tend to depress personal savings) and the absence of massive "extraordinary" losses of a year ago, the prospects for a boom in domestically available savings are very weak. As a result, any growth we see in capital spending is likely to be matched by contraction in other forms of investment - primarily housing.

[It may seem that fiscal and monetary policy can change the savings investment identity, but in equilibrium they do not. Monetary policy doesn't increase savings - it simply changes the mix of publicly held government assets from government debt to monetary base and vice versa. To see why the savings-investment identity must hold, think in terms of real output. Consider an economy that produces goods either for consumption or investment. What is savings? Output minus consumption. What is investment? Output minus consumption. S = I by definition. The same holds true even if we introduce more complications into the economy.]

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and moderately favorable market action. The diversified portfolio of stocks held by the Strategic Growth Fund was slightly more than 50% hedged against the impact of market fluctuations.

The Market Climate for bonds remained characterized by modestly favorable valuations and modestly favorable market action. The Strategic Total Return Fund continued to hold an overall duration of about 6 years (that is, a 100 basis point change in interest rates would be expected to affect the value of the Fund by approximately 6%).

Past performance is not predictive of future returns. For the one year period ended June 30 2003, the Hussman Strategic Growth Fund earned a total return of 11.25%, compared to returns of 0.25% and -1.64% for the S&P 500 Index and the Russell 2000 Index, respectively. From inception on July 24, 2000 through June 30, 2003, the Fund earned a total annualized return of 18.83%, compared to annualized returns of -11.65 and -3.18 for the S&P 500 Index and the Russell 2000 Index, respectively.


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