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January 26, 2004

The Art of Seamanship

John P. Hussman, Ph.D.
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Somebody once wrote that the art of seamanship is to avoid situations that require seamanship. That's why we continue to avoid a full or aggressive exposure to stock market risk here.

Still, we're relatively constructive. The Strategic Growth Fund remains fully invested in a widely diversified portfolio of individual stocks, with about half the value of those holdings hedged against the impact of market fluctuations. Accordingly, we would still expect to benefit from any further advance in the overall market, and we would also expect to experience at least some portion of any market downturn that might emerge. Meanwhile, the Fund's returns are also affected by how our stocks perform, independent of market fluctuations. Selecting stocks with the potential to perform differently from the market (based on their individual valuation and market action) is an important element of our approach.

As usual, our exposure to any particular risk is essentially proportional to the return that we expect per unit of that risk. Because stocks never achieved normal (and certainly not below-average) levels of valuation during the 2000-2003 decline, we have been at least partially hedged at all times during the market's recent advance. As valuations and sentiment have become more and more extreme and various internals have begun to “roll over” (though are not yet breaking down), the return/risk profile of the market has already undergone a subtle decline. At the point when we observe clear (if subtle) breakdowns in internal market action – which would suggest that investors were becoming skittish toward risk – we would expect to fully hedge our stock holdings against the impact of market fluctuations. For now, however, a partial hedge is sufficient to avoid any sudden need for seamanship.

Bonds – don't rely on “typical” relationships

In bonds, the Market Climate remains characterized by modestly unfavorable valuations and modestly unfavorable market action. Accordingly, the Strategic Total Return Fund continues to have an overall portfolio duration of about 2 years, so that a 100 basis point change in interest rates would be expected to impact the Fund by about 2% on account of bond price fluctuations.

It is important to inquire why – despite widespread expectations for economic strength – bond prices have firmed in recent weeks.

Certainly, part of the recent bond rally can be traced to the dismal employment numbers in the December report. But looking at the Fed statistics, it's notable that during the week ended January 21, foreign holdings of U.S. debt increased by $22.2 billion, which is substantially larger than usual (the figure for the past year is 247.3 billion). Compare these to the size of Federal Reserve operations, and you'll get an idea of their importance. Over the past year, for all of the “ease” of the Federal Reserve, the U.S. monetary base expanded by $39 billion, of which $36 billion ran off as currency in circulation, leaving the banking system with a minuscule $3 billion increase in reserves for the entire year.

Meanwhile, banks had $964 billion in commercial and industrial loans on their books last year, a figure that has dropped to $898 billion. In contrast, bank holdings of U.S. Treasuries have increased by $122 billion over the most recently reported 12-month period.

So ironically, despite the notion that economic strength should be driving the bond market lower, inherent fundamental weaknesses such as our enormous current account deficit and a continued unwillingness of banks to lend to corporations have served as sources of demand. The flipside of this, of course, is that if foreign governments begin to reduce the pace of their buying, the U.S. will lose the primary factor supporting U.S. domestic investment and the U.S. bond market. Foreign accumulation of U.S. Treasuries has also allowed short-term interest rates to remain low (and has allowed corporations and mortgage holders to swap into those short-term rates). If that changes, the “carry trade” (borrow at low short-term yields and buy long-term Treasuries for higher yields) will quickly come under pressure.

In short, the U.S. economy is in an environment where its structural weaknesses have supported the bond market (despite apparent economic strength on the surface), and where some events – particularly a reversal of foreign accumulation of Treasuries – may result in economic weakness coupled with weaker bond prices and rising yields.

Suffice it to say that economic strength or weakness is not a sufficient basis on which to “call” the direction of bonds. For our part, we don't rely on such calls anyway. The Market Climate for bonds remains moderately unfavorable, and we are holding a limited duration as a result.

Though my view on economic fundamentals doesn't seem to represent the popular view here, Stephen Roach of Morgan Stanley is a notable exception. His January 12 th comment, False Recovery, is required reading.


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