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November 24, 2003

Force of Habit

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

Market Climate

The Market Climate for stocks remains characterized by unusually unfavorable valuations and modestly favorable market action. The Strategic Growth Fund remains fully invested in stocks having evidence of favorable valuation and market action on the measures we use, but we have also hedged nearly 60% of that portfolio against the impact of market fluctuations. We continue to be positioned in a way that will benefit most from further advances in the market, but our exposure is not aggressive.

Stock market action is displaying fewer signs of robust strength, but the deteriorations we've seen have not been decisive. A number of past bull markets, including 1987 and 1990, have ended closely following deterioration in interest-sensitive sectors such as bonds and utilities, so those are areas of concern. In addition, overall market breadth has deteriorated somewhat, and I would be concerned by a substantial increase in the number of stocks registering new 52-week lows, particularly if it occurs when the major indices such as the S&P 500 remain relatively strong. Corporate insiders have increased the pace of selling to strikingly high levels – averaging 6.74 sales for every share purchased over the past two months, according to Vickers, with the latest week registering 8.59 sales for each share purchased. Heavy insider selling does not always pose immediate risks, as it tends to be a somewhat leading indicator, but these figures are far from benign.

As always, we are exposed to market risk because our favored stocks are generally sensitive to overall market fluctuations. We've hedged some of this risk due to unusual overvaluation and early deterioration in market action. But again, we remain positioned in a way that will benefit primarily from further advances in the stock market.

In bonds, we've shortened our portfolio duration even further. The Strategic Total Return Fund currently carries a duration of about 3.25 years, meaning that a 1% (100 basis point) fluctuation in long-term interest rates would be expected to result in a 3.25% fluctuation in asset value. Recent deteriorations center on the weakness in utilities, combined with evidence of stronger inflation pressures than previously.

At a macroeconomic level, my comfort with the bond market was not helped by reports that foreign purchases of U.S. securities plunged in September to less than one-tenth of August's pace. Of course, we saw what happened to the U.S. dollar versus the Yen at that time. Needless to say, the shift was partly a response to demands by Treasury Secretary Snow regarding the need for currency revaluations in Japan and China. In light of the enormous dependence of the U.S. economy on foreign financing of the massive U.S. current account deficit, the economic recovery may encounter difficulty if this reduction in foreign investment continues. The heavy dependence of the U.S. economy on foreign investment flows and a steep yield curve may be a subtle argument here (see Freight Trains and Steep Curves), but that does not make it any less critical.

We are what we habitually do

Over the years, I've written a lot about “daily action.” You decide on a set of actions that you believe will lead to good results if you follow them consistently. Then you follow them consistently. Unless a goal translates into daily, present action, focusing on that goal is simply a way of escaping reality. As Jean Paul Sartre wrote, “Je ne suis rien autre que mes actes” – I am nothing other than my actions.

If an investor consistently takes positions based on forecasts, and changes those positions only when the market proves those forecasts wrong, that investor's life will predictably be dominated by hope, uncertainty, disappointment, reaction and frustration. If an investor constantly takes positions by responding to opportunities and conditions as they develop, with equanimity to what will happen next, making a habit of purchasing favorable value or early strength, and a similar habit of selling overvalue and early weakness, that investor's life will most probably be dominated by a sense of peace and control. Though it is not obvious which investor will have better results, my own opinion on that should be fairly clear.

This doesn't mean that an investor who responds – rather than reacts – will know what will happen next. Rather, it means that this investor will be able to accept what happens next, knowing how to respond whatever the outcome. The point is to live in reality, and to take the next action from where one stands, without ignoring inconvenient aspects of reality in the hope of justifying one's position, and without wishing for the starting point to be somewhere else. The greatest source of human frustration is the desire for reality to be something other than it is.

The Big Idea is to avoid the need for Big Ideas

Occasionally, I am asked which “bets” or “calls” have accounted for the performance of the Hussman Funds. After recovering from my gag reflex, the answer I give is always the same – our performance is the result of literally thousands of small actions, taken deliberately day-after-day following a carefully planned discipline. It is very difficult to trace our returns to any “big idea” or specific investment position. We are what we habitually do.

For example, we're currently comfortable holding between 150 and 200 stocks in the Strategic Growth Fund, most in the range of 0.5% of assets, and very few in excess of 2%. Changes in our stock holdings are driven by day-to-day opportunities to buy higher ranked candidates on short-term weakness, and to sell lower-ranked holdings on short-term strength. These positions aren't “bets” on the direction of particular stocks, but transactions to constantly build better value and market action into the portfolio at opportune prices. Plant seeds day after day into fertile ground, tend to the weeds day after day to make room, and you've got yourself a garden. Not every attempt produces fruit or flowers, so you don't rely on one seed.

Likewise, we select our exposure to market fluctuations based on the condition of valuations and market action that we observe at any given time. Occasional changes in our exposure to market fluctuations are not “calls” or “forecasts” about the future, but responses to observable conditions. While some conditions are associated with much better expected return/risk than others, on average, it is impossible to reduce this “average” behavior into reliable forecasts for any specific period of time.

Planning for randomness

Inevitably, we'll sometimes be defensive during a market advance that occurs in relatively unfavorable conditions, or aggressive during a decline that occurs in relatively favorable conditions. Also, various stock positions may lose value. When these events happen, we will experience losses, or achieve smaller gains than otherwise. We plan for these possibilities through wide diversification in stocks, and through self-imposed investment restrictions. Moreover, the dollar value of our hedges never materially exceeds our long holdings even in the most negative market conditions (though losses might still occur if our stocks were to perform poorly or if we experience a net decay in option time-value). Since the Fund can use leverage only by investing a small percentage of assets into call options, any additional losses resulting from that leverage is limited to the few percent paid for those calls.

In short, we don't rely on specific forecasts of market direction, or make large “bets” on individual stocks. We adhere to investment restrictions that are intended to reduce the impact of unfavorable market outcomes on our positions. To believe that our performance relies on great forecasting precision, or is hypersensitive to “bets” or “calls,” is to neglect the importance of daily action, diversification, and investment restrictions. Unfortunately, it is something of a journalistic shorthand to talk about investment managers making “bets,” “calls,” and “forecasts.” As a rule, if you ever read a piece that uses these terms in reference to my investment views, you can conclude that the writer or analyst wasn't listening.

The Big Picture is important

On a related note, it's important to emphasize that our approaches to evaluating individual stocks and market conditions are not “formulas” but methods of analysis. While the quantitative aspect of what we do is essential, we are not a “quant shop” and do not rely on a “black box” approach to investing. As I've frequently noted, investing on the basis of any particular model, without carefully understanding the quality of the data and the reasons why that approach should be effective, is to invest on the basis of superstition rather than analysis.

These weekly commentaries are intended to provide background and context to current economic and financial conditions; to discuss important developments I'm monitoring; to describe my thinking and investment process (without, of course, compromising proprietary information). In addition to quantitative information, I spend a lot of time looking at qualitative factors such as the products of the companies we invest in, features of each company that might affect the stability of their future financial results, the “big picture” characteristics of the economy at any given time, and a wide variety of economic relationships that you would expect a careful economist to think about. My hope is that these efforts are evident in the articles I write. In short, our investment process is largely quantitative, but not exclusively so.

Other comments

The notion that we are the sum of our actions is as true for nations as it is for individuals. It is difficult to achieve peace without having peace within ourselves; without taking actions that embody peace; without understanding whether our actions have planted seeds of suffering or seeds of reconciliation. If our actions, or those of our enemies, regularly contain violence, our lives will be dominated by violence. If our actions regularly contain peace, our lives will be grounded in peace.

Justice and enforcement are essential when they center on those responsible for criminal actions. Force can be effective in overcoming a specific enemy, or as a method of bringing an intransigent enemy to the negotiating table. But when there is no centralized authority to persuade, the ability to achieve peace through violence and retaliation is very limited. Force, directed broadly, does nothing but to encourage each side to spill its own fresh suffering onto the other side. Under these conditions, peace can only result from leadership, moderation, understanding, and diplomacy.

There is no shortage of advisors surrounding the Administration, particularly from the American Enterprise Institute, who have long supported regime change in Iraq, and advocate a theory of democratizing the Middle East through force. It is doubtful that the American public would have willingly bought into the idea of placing the lives of our troops at risk for the sake of these theories, regardless of the appeal of freeing Iraqis from a brutal dictator. Iraq was interminably frustrating, but the risks to America were containable. The proper and humanitarian opportunity to remove Hussein was when he was gassing the Kurds – which could have been a multinational effort with much less risk to U.S. troops. In any event, the path to war was undoubtedly paved with a blurred line of distinction between those actually responsible for our suffering on 9/11, and Iraq.

Our obligation now is to see the situation clearly; to look for truth without filtering reality through wishful thinking. There have been enough positive outcomes from the Iraq war to begin bringing our troops home with gratitude and pride, and their safety cannot be separated from perceptions of the U.S. as an occupying force. In the occupation of the Philippines in the early 1900's, the U.S. was forced to maintain over 50,000 troops and a presence for over a decade. Attacks on these troops were relentless despite successful strikes on rebel leaders and magnanimous efforts in building schools, hospitals and public infrastructure. As historian Martin Gilbert wrote, “it was the tactics of guerrilla fighting that proved impossible for even the most disciplined army to master. The guerrilla forces could melt away… as soon as they made their strike, and then regroup whenever they decided to strike again.”

The situation in Iraq will not be changed simply by running elections of candidates appointed solely by the U.S. Administration, which would probably risk widespread boycotts. It certainly will not be changed by plans to “privatize” the Iraqi oil industry. The best way to achieve peace is through actions that contain peace – limit the use of broad retaliatory strikes, shift enforcement to a NATO coalition, abandon plans to privatize Iraqi resources, and delegate civil matters to the United Nations. It is essential for this process to end in a stable and agreeable government in Iraq, but this does not require exclusive U.S. control. Our true enemies are elsewhere, and our security requires as much cooperation and peaceful action toward the broader world as it requires enforcement against those actually responsible for terrorism. The roots of terrorism lie in ignorance, hate, suffering, misperception, fear, and resentment of foreign influence. It is still possible to address these in a way that increases our security.

All of this has been said before, of course, both here and elsewhere. But each day that an American soldier's family has to bear the sorrow of a foreign policy that has ceased to advance the security of America and its troops, it becomes obvious that it hasn't been said enough.


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