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December 15, 2003

Unrepresentative Samples

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

If you look up at the sky on a clear night, you'll see a completely unrepresentative sample of what our universe contains. As astronomer Glenn LeDrew notes, that's because what you're really seeing is a collection of rare, bright stars. Most of the closest objects in the sky are invisible to us. The stars are beautiful to look at, but they aren't the substance of the universe. Unrepresentative samples can lead casual observers to entirely incorrect conclusions about reality.

The same is true in the stock market. Looking at some of the stars since last October's low, there are lots of beautiful, shining objects to admire. But unless you reasonably believe that you could have completely avoided the plunge that allowed for these stellar rebounds, that you could have reliably bought the lows, and would not have been led to even partially defend yourself by the very approach that allowed you to avoid the initial plunge in the first place (and we certainly don't believe that one), those stars are an unrepresentative sample of reality. For investors, they simply aren't the substance of the universe.

If you want to get a proper measurement of long-term growth, you have to measure from peak-to-peak across economic cycles. Though corporate earnings can surge at rates upward of 30% in a year coming off of an economic trough, the fact is that earnings for the S&P 500 has never significantly outpaced 6% annual growth measured from peak-to-peak.

Similarly, if you want to properly evaluate an investment approach, you have to examine its results over a representative period. In stocks, that means looking at performance between two reasonably separate peaks in the market, or over some period in which the overall market earned reasonably typical returns (say, about 10-11% annualized). If instead you look at the brightest stars during a hot period in the market you'll be led to entirely incorrect conclusions. The penalties can be harsh once the full market cycle reveals itself.

Needless to say, we hold our own approach to the same standards. It is not our objective to outperform short-term market advances, and we may not track the market at all during hostile market conditions, when we hedge against market risks. Our objectives are long-term capital appreciation and total return, with added emphasis on defending capital during unfavorable market conditions. While there is no assurance that we'll achieve these objectives, the right way to check, in my view, is to measure our returns and risks over representative samples of market history. This means looking either from market peak to market peak, or over some extended period in which the market earned fairly typical returns.

On these criteria, we have several natural periods to evaluate. Since the S&P 500 just reached a new peak last week, we can look back at 2002 and look for that year's peak (on a total return basis). That peak occurred on March 19, 2002, at 1170.29 on the S&P 500 (10635.25 on the Dow). Despite its strong performance this year, the S&P 500 remains below that 2002 peak, both on the index and in terms of total return. Meanwhile, the Hussman Strategic Growth Fund has achieved a total return of 26.02% (14.27% annualized). In terms of downside risk, the S&P 500 suffered a 33% plunge from peak-to-trough during this period. At its deepest trough, the Strategic Growth Fund had declined by less than 7% from its prior peak.

Alternatively, we can look at extended spans during which the market earned something close to “normal” returns. On that basis, the earliest starting point we can find last year was July 1, 2002. Since then, the S&P 500 has earned a total return of nearly 10% annualized. Meanwhile, the Strategic Growth Fund has achieved a total return of 12.74% annualized, again with substantially less volatility and downside risk than the market.

Looking back even further to 2001, the only starting point that year from which returns have been reasonably typical is to measure from the market's exact low of September 21, 2001. Since then, the S&P 500 has earned a total return of nearly 7% annually. Meanwhile, the Strategic Growth Fund has achieved a total return of 16.29% annualized.

While we'll certainly take greater risks in a Climate where both valuations and market action are favorable, the record of the Strategic Growth Fund since inception strikes me as neither disappointing nor extraordinary. Our results to-date have been reasonably close to what our objectives intend, given the Market Climates we've experienced.

This sort of analysis isn't confined to our own funds. Looking at your other investments in this way will give you a great deal of information about your returns, as well as the risks you are really taking. That's something that you just can't get if you restrict your analysis to unrepresentative samples.

A few additional standardized figures: annualized total returns in the Strategic Growth Fund for periods ending 9/30/03 – 1 Year: 12.84%, 3 Year: 18.35%, Since Inception (July 24, 2000): 18.46%. More current performance data, as well as special reports and analysis, are available on this website. Past performance does not ensure future results.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and still moderately favorable market action. This combination holds us to a constructive investment position, with only about half of our holdings hedged against the impact of market fluctuations. While I am hopeful that the capture of Saddam Hussein will relieve some of the risks to our troops, with accompanying relief for the market, it's not clear that geopolitical risks have shifted overall, so the durability of any market advance on this news is unclear.

Most of the negatives we observe here are fundamental in nature, the most important being valuations, but extending to the massive U.S. current account deficit and the potential for credit market and inflation difficulties when short-term interest rates begin to normalize (as I've noted before, rising short-term interest rates tend to raise “monetary velocity,” triggering the inflationary impact of prior monetary ease). These fundamentals set the stage for future difficulties, but there is no telling at what point those difficulties will actually be expressed. Still, it is an overly optimistic “greater fool theory” to believe that any analytical tools, including our own measures of market action, are reliable enough to completely ignore these fundamentals without any defense at all, and simply “get out at the top.” Frankly, I don't think it's possible to identify tops or bottoms that way. It is precisely because we understand our capabilities that we are already half-hedged, despite the fact that our measures of market action remain generally favorable.

In the bond market, the Market Climate remained characterized by both unfavorable valuations and unfavorable market action. Except for moderate positions in Treasury Inflation Protected Securities, we are no longer holding positions in long-term Treasury bonds, and the duration of the Strategic Total Return Fund is down to less than two years. This means that a 1% (100 basis point) move in interest rates would be expected to impact the Fund by less than 2% on account of bond price fluctuations. The Fund currently holds nearly 15% of assets in select utility shares, and of course, we have continuing flexibility to change the portfolio duration of the Fund as interest rate conditions change, and are constantly evaluating the potential for investments such as TIPS, foreign government securities, and precious metals shares. In short, the “snapshot” of the Strategic Total Return Fund is largely defensive, with about half of the Fund's assets in short-term Treasuries, but as always, we respond to market opportunities as they arise.

I recognize the potential for shareholders to look at that “snapshot” position and ask why they should pay a management fee to hold half of their assets in T-bills. If that snapshot position was typical and ongoing, I would agree. But it is not. Our investment positions are continually adjusted to reflect the market opportunities we identify. Our objective is to achieve long-term total returns while also defending capital during unfavorable market conditions. To hold higher yielding but vulnerable assets in an attempt to look like we were “doing something” would be to abandon this objective for the sake of window dressing. You can count on us not to do that.

A few final remarks on corporate bonds, from the London Economist

“Spreads are at record lows, though they are unlikely to widen much for now because conditions are still positive. A rise in short-term rates could hurt many companies because they have not restructured as much as fans would have you believe. Moreover, debt has not fallen much as a percentage of cash flow; nor have interest payments in relation to profits (so-called interest coverage).

“It is hard to know how much companies have in fact lengthened the maturity of their debts because the interest-rate swap market allows them to swap those fixed bond payments into cheaper floating debt, a popular strategy in the investment-grade market. Moreover, the amount of money flooding into the market has been matched, understandably, by the number of companies wanting to tap it. The $112 billion of money raised in the junk-bond market so far this year is already more than double last year's figure, and is on course for a record.

“With demand so high, the quality of those coming to the market is falling. The number of weak companies (those rated B- or lower) issuing bonds was more than a third of the total in the third quarter, a level which usually spells trouble two to three years down the line, in the form of a pick-up in default rates. And although credit conditions have been so loose, S&P is still downgrading far more non-investment-grade companies than it is upgrading: 73% of its ratings actions are still downgrades.

“Which is worrying when yields have been chased so low, and investors are now so badly rewarded for taking risk.”


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