September 28, 2003
John P. Hussman, Ph.D.
All rights reserved and actively enforced.
New Information Can't Be Predicted
One of the reasons that I don't make market forecasts is that I rarely have confidence about which Market Climate we will identify even a few weeks into the future. So our approach is to align ourselves with the prevailing Market Climate (the combination of valuations and market action at any particular point in time), and to change our position when there is a change in Market Climate.
Our measures of market action are driven by new information, and new information can't be predicted. New information is the portion of the "news" that could not have been anticipated based on information already in hand. Statistically speaking, there are "decomposition theorems" assuring that if we process the data right, today's data can be written in terms of past surprises, plus the current surprise ("mutually orthogonal innovations"). The "random walk theorem" is a trivial version of this, saying that the entire change between yesterday's price and today's price is one of those surprises. The Buddha put it more generally: The present is made up of the past. The future will be made up of the present. If we look deeply into the present, we can see the past, and we can find the best actions to take care of the future.
Investors are very aware of this concept as it applies to earnings and economic reports. The "new information" in these reports is the portion of that news that was unanticipated. It's the surprise that contains the new information.
Similarly, when we analyze market action, the information is contained in divergences that are "out of context." If Treasury bond prices are rising, and corporate bond prices are also rising, you've got interest rate information. But if Treasuries are rising and corporates are falling, the divergence gives you information about bankruptcy risks.
At present, I have no idea when or whether the Market Climate will shift to an unfavorable condition. Still, we are beginning to see which divergences would move us to a defensive position most rapidly. Right now, the worst market action would not be a further broad decline. Rather, the worst action would be substantial strength in the S&P 500 and other large-cap indices not reflected in the broad market. This outcome would be particularly negative if it occurred on dull volume, weak breadth (advances vs declines) or eroding leadership (new highs vs new lows).
To put it another way, the fastest way that investors could signal a substantial increase in their aversion to risk would be to drive up large blue chip stocks in a relatively narrow advance. With risk premiums very thin here, any indication of increased risk aversion by investors would be a very strong warning signal. Something to watch.
Tag, you're it
Last week, I noted that performance chasing appears to have been an important element during the recent market advance Michael Santoli's latest column in Barron's supports the belief that this performance chasing was also an important element of last week's decline (the S&P 500 lost -3.81%, while the Nasdaq dropped -5.96% and the Russell 2000 fell by -6.71%):
"The tempting conclusion suggested by last week's losses is that portfolio managers' performance anxiety is now manifesting itself in different types of behavior. While the zeal to grab a fair share of the market's upside has for months spurred the pros to chase the highly valued market leaders, last week there were hints that money managers were eager to preserve their gains..."
"If indeed investor psychology is beginning to take on a more defensive cast, then larger, more stable stocks might be expected to grab the lead, at least temporarily, from the long-shot, highly leveraged bets that have been rewarded for some time now... stocks with high-quality earnings and attractive valuations [have] underperformed the market since its March low. In examining past periods back to 1966 when this quality screen has trailed the market this badly, its laggard behavior tends to last five or six months before rebounding strongly. It's been just over six months this time."
The one word that I am concerned about in that quote is the word "larger." If a broad group of attractively valued, stable growth stocks - across a wide range of capitalizations - begins to perform well, great. Greater traction from those stocks would be very welcome. Indeed, recognition of quality and value by investors is generally how our bread is buttered. In contrast, if the market's leadership in the coming weeks becomes isolated solely to large blue-chip safe-haven names, the heightened activity might turn out to be the last gasp.
In the economy, the recent surge in the Japanese Yen was important. I've noted frequently that periods of softer economic growth were likely to have their onset with weakness in the U.S. dollar. We're already seeing initial signs of this. In recent weeks, there has been a marked shift from U.S. economic reports coming in better than expectations and toward reports that are worse than expectations. In its report to institutional investors, Bridgewater occasionally releases its "economic surprises index", which is something of an advance-decline line tallying whether various economic indicators have come in better or worse than expected. After inexorably rising for months, this index has abruptly turned down. Again, something to watch.
The Market Climate for stocks remains characterized by unusually unfavorable valuations and modestly favorable market action. Our fully invested position in individual stocks is just over 50% hedged against the impact of market fluctuations. Again, the most negative development for stocks here would be a sharp advance in the large blue-chip indices, without an equivalent follow-through in the broad market. For now, we remain positioned to gain primarily from market advances. We may forego a portion of short-term returns as a result of our moderate defensiveness here, but as I noted a couple of weeks ago, there's no historical reason to believe that defensiveness at these valuations will compromise long-term returns. Quite to the contrary.
In bonds, the Market Climate remains characterized by modestly favorable valuations and modestly favorable market action. With the recent rally in long-term bonds, valuations are near the cusp of becoming unfavorable once again. A further revaluation of Asian currencies also threatens to reduce buying activity in U.S. Treasuries by foreign governments. At the long end of the yield curve, the outcome is uncertain. Lower foreign buying interest would be unfavorable, but the attendant economic weakness could soften the blow to long-term bond prices. At the short end of the yield curve, I would expect that slower foreign capital inflows would take precedence. For this reason, any shift in the yield curve ahead will most likely be a flattening, with short and near-term yields rising - possibly substantially - while long-term yields rise less or remain stable.
As usual, we don't rely on such forecasts. Given the current, observable status of the Market Climate in bonds and the current status of the yield curve, our holdings in the Total Return Fund include very little in the way of intermediate bonds. Our position is instead split between short and long maturities, with an overall portfolio duration of just over 5 years. That is, a 100 basis point change in (long term, at this point) interest rates would be expected to impact the value of the Fund by just over 5%.
In gold, there's some potential for U.S. dollar weakness to translate to higher gold prices, and possibly even to higher gold stock prices. But investors should not rely on this translation being direct or instantaneous. Until we see an actual shift to economic contraction (watch for an ISM Purchasing Managers' Index below 50) and the feedback of more expensive import prices on the CPI (all of which could take a few months) it's not clear from a historical perspective that we've got enough factors in place to warrant fresh exposure to gold market risk just yet. That's not an argument for long-term investors in precious metals shares, but it's an important comment to investors inclined to "chase" gold stocks. Given their volatility, it is greatly preferable for precious metals investors to build positions on weakness rather than strength. Gold stocks generally aren't a rewarding group to buy on "technical breakouts" and such. At present, we remain on the sidelines here, having liquidated our positions on strength a few weeks ago. We do accept the risk of remaining on the sidelines in the event that gold advances strongly from here. But again, we don't have the evidence to place assets at risk on the basis of that possibility. Suffice it to say that we'll be quick to reestablish positions on weakness in gold stocks, provided it is accompanied by identifiable signs of fresh economic contraction. For now, we don't have enough of this evidence in hand.
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