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March 8, 2004

Theme Trading

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

New expense ratio and trading impact data for Hussman Strategic Growth

I'm pleased to report that the expense ratio for the Hussman Strategic Growth Fund has been reduced again, to 1.31% annually. The expense ratio is affected by a variety of factors including fee breakpoints and net assets, and may increase or decrease over time.

I continue to observe no difficulty in trading, nor measurable changes in market impact, based on the current net assets in the Strategic Growth Fund (just below $1 billion). In Berkshire Hathaway's latest annual report, Warren Buffett remarks that increased funds under management typically have the effect of reducing investment performance. While I am certain this is true well before the point that a manager navigates $180 billion in assets, as Buffett does, I also believe that there is generally a wide range of values, depending on investment style, before the amount of assets under management begins to measurably affect performance.

To update the trading impact figures I reported in Mutual Fund Brokerage Commissions and Trading Costs, since September 30, 2003 the Fund's overall trading impact (measured as the adverse difference between execution price and last sale at the time of order placement) has averaged 0.15% for all assets (including options), and 0.08% for equities only (which amounts to about 2.4 cents of market impact from trading tens or hundreds of thousands of shares of say, a $30 stock). Our average commission cost is 2 cents per share, which compares to typical mutual fund commission costs of reportedly 5.5 cents per share.

That overall trading impact of 0.15% compares with the value of 0.12% we calculated prior to September 30, 2003. The difference is statistically insignificant, resulting primarily from our use of “convex” option positions such as straddles, which surrender a small spread to market makers (market makers cannot risklessly hedge straddles as they can with long put - short call combinations). The 0.08% trading impact for stocks is actually less than the 0.10% stocks-only impact we calculated prior to September 30, 2003, but the difference is again statistically insignificant. Trading impact does not increase proportionately with size, particularly for approaches like ours that attempt to provide liquidity to other market participants through the predominant use of limit orders.

Finally, even among the ten largest holdings in the Strategic Growth Fund, the median stock holding represented just 20% of a single day's average trading volume (the median figure across all of our holdings is just 10% of a single day's average trading volume). This compares with top holdings representing over 3 days of average daily trading volume for many actively managed funds with solid performance records, including Legg Mason Value Trust and Oakmark Select, and even more for larger funds like Fidelity Magellan. Suffice it to say that I recognize how important long-term performance, risk management, and execution are to shareholders, and that I am experiencing no difficulty at all in those objectives as a result of current net assets. I am grateful for the trust you have placed in me, and I will continue to provide this sort of information about our trading costs and estimated market impact in the future.

Theme Trading

Last week's trading in the bond and currency markets was fascinating. As usual, I look at these markets as part of a “general equilibrium,” rather than operating separately. Early last week, bond prices experienced weakness. At the same time, market action was improving on a number of measures that I use to gauge the Market Climate for bonds. As a result, I used that price weakness as an opportunity to increase the duration of the Strategic Total Return Fund (which now stands at just under 5 years, meaning that a 100 basis point change in interest rates would be expected to affect the Fund by about 5% on the basis of bond price fluctuations.)

Probably the most frequent observation noted about bonds last week is that they were moving almost exactly inverse to movements in the U.S. dollar. The basic notion was that the dollar was strengthening, and therefore, foreign countries such as China and Japan that have been buying Treasuries to support the dollar suddenly found less reason to do so. As a result, the argument went, strength in the dollar was leading directly to weakness in bond prices.

This is what I call “theme trading.” You can recognize it by a short period of tight correlations between markets that really don't track each other very tightly in general. That's certainly true of bonds and the dollar. You'll also see theme trading from time to time in other markets. For instance, when the markets are very concerned about the possibility of Fed tightening, you often see unusually tight correlations between the movements of Fed Funds futures and the stock and bond markets, where normally the relationship isn't nearly as pronounced.

A toy model of bond and currency movements

The iron law of equilibrium is that every security issued must also be held. For every sale of a security, there must be an offsetting purchase. Money never goes into or out of any particular market, merely through it. Price changes are therefore not the result of money flow, but are instead a statement about who is more eager; the buyer, or the seller.

Take that iron law to the bond and currency markets, and you'll see how market action allows you to infer information about what is driving price movements. First, we know that the U.S. is running the deepest current account deficit in history. In order to finance that deficit, we are essentially eager sellers of Treasury securities to foreigners. By itself, this would tend to produce downward pressure on both bonds and the U.S. dollar, except that we currently have a wrinkle: China and Japan are very eager to support the dollar by purchasing Treasury securities. Essentially, that foreign demand has supported both bond prices and the dollar to a much greater extent than if these foreign countries weren't so eager to accumulate U.S. Treasuries.

Let's build a little toy model of this. We'll call the eagerness of foreigners to buy our securities EF. We'll call the eagerness of the U.S. to sell those securities EUS. Since higher real interest rates tend to support the value of the dollar, and depress the value of bonds, we'll also introduce a real interest rate term R. Finally, each market has its own (often independent) speculative pressures, and we'll call these SPD for the dollar, and SPB for bonds.

Though my academic colleagues would hit me with a brick for something this informal, we're going to play with this model as a teaching tool anyway. Here are some little functions for the price of the U.S. dollar and U.S. bonds:

Dollar value = EF – EUS + R + SPD

Bond value = EF – EUS – R + SPB

Let's tinker around a little and you'll see how it works. Suppose that foreigners suddenly abandon their eagerness to support the dollar by buying U.S. Treasuries. In this event, the eagerness of foreigners EF falls, and both the dollar and bonds decline in value together (other things being equal). We would verify this by looking at trading volume. Specifically, we would expect to see a contraction in trading volume in which the current account narrows, and the U.S. credit markets encounter a squeeze in the availability of funds. Needless to say, this is the scenario that I am concerned about when I talk about the risks of an abrupt revaluation of the Chinese yuan.

Next, suppose instead that the U.S. became much more eager to sell securities to foreigners because of ballooning federal deficits and the need for credit. In this case, EUS increases, and both the dollar and bond prices again would fall. But in this event, we would observe an increase in trading volume, particularly as measured by the U.S. current account deficit. Notice that trading volume helps you verify the information content you've inferred.

Now consider what we saw last week (prior to Friday). The U.S. dollar was advancing, while bonds were taking it on the chin. There are a few possibilities that could explain this sort of action. The most obvious one was that there might have been upward pressure on real interest rates. That sort of pressure would support the dollar while simultaneously hurting bonds. The difficulty here is that if you look at Treasury Inflation Protected Securities (which are a reasonable measure of real interest rate conditions), they were persistently rising in price last week, so that real interest rates were clearly falling.

So, we have to look for a different explanation. The one that's most plausible to me is that the U.S. dollar got so deeply oversold that it was the recipient of short-term speculative pressure (SPD). Now, if the widely held view that foreigners were cutting back their purchases was correct, EF would have declined, leading bond prices to decline, but offsetting the upward speculative pressure on the dollar. That's not what happened at all. So given the evidence, we have to infer that the weakness of bond prices was not caused by a marked slowdown in foreign buying, but was instead driven by downward speculative pressure on U.S. bonds (SPB).

Why would positive speculative pressure in the dollar (SPD) somehow get tightly linked to negative speculative pressure in bonds (SPB)? Theme trading.

Perceptions and reality

The basic theme is that dollar strength could cause China and Japan to back off from their buying of Treasuries, thereby hurting bond prices. The real issue is whether that theme is an important one. I would argue that it is not. The simple fact is that we're running the deepest current account deficit in history, which continues to argue for dollar weakness. If the dollar was to strengthen in a way that sharply reduced foreign capital inflows, we'd get so much economic weakness that bond prices would strengthen as well. In short, upward movements in the value of the dollar don't appear to be a significant risk to bond prices.

The real risk to the U.S. markets is the potential for currency revaluation in China and Japan, leading to a reduction in the eagerness of these countries to accumulate U.S. dollar assets. The result of this would be weakness in the U.S. dollar and Treasury bonds, a squeeze in U.S. credit availability, and a corresponding decline in U.S. domestic investment. Though China has indicated that it has no plans to revalue the yuan soon, that's a risk that investors should not rule out over the longer term, and it's one that I think is far more important than the risk of a Fed tightening. For what it's worth, the labor market and capacity utilization have been so weak that I am beginning to doubt that the Fed sees any pressure at all to tighten rates in the foreseeable future.

As Warren Buffett remarks in Berkshire Hathaway's latest annual report: “ In recent years our country's trade deficit has been force-feeding huge amounts of claims on, and ownership in, America to the rest of the world. For a time, foreign appetite for these assets readily absorbed the supply. Late in 2002, however, the world started choking on this diet, and the dollar's value began to slide against major currencies. Even so, prevailing exchange rates will not lead to a material letup in our trade deficit. So whether foreign investors like it or not, they will continue to be flooded with dollars. The consequences of this are anybody's guess. They could, however, be troublesome – and reach, in fact, well beyond currency markets.”

Market Climate

The Market Climate for bonds shifted last week to a combination of modestly unfavorable valuations but now modestly favorable market action. Given the opportunity created by bond price weakness early last week, I increased our portfolio duration modestly in the Strategic Total Return Fund. At present, that duration is just under 5 years. I remain unwilling to take a much more significant exposure to interest rate fluctuations, due both to the relatively low level of yields and to currency risks. Overall, I believe that our current position appropriately reflects both the opportunities and risks in the current market environment for bonds.

In stocks, the Market Climate remains characterized by unusually unfavorable valuations but still modestly favorable market action. While we are always fully invested in stocks, Market Climates like the present one also require us to hedge some portion of our exposure to market fluctuations. Though Berkshire Hathaway “hedges” its exposure to market risk by accumulating cash without reinvesting in stocks, it's clear that Buffett has a similar opinion about stock valuations: “ Our capital is underutilized now, but that will happen periodically. It's a painful condition to be in – but not as painful as doing something stupid. (I speak from experience.)”

Presently, about half of our exposure to market fluctuations is hedged. However, we repurchased the call side of our “straddle” position (a long position in both put options and call options) on recent market weakness, moving the size of that straddle position back to about 1% of net assets. For that reason, the “asymptotic” behavior of the Strategic Growth Fund on large market movements is likely to differ from its “local” behavior on small market movements. Specifically, we would expect our “local” sensitivity to market fluctuations to be about 50%. On a substantial market decline, the put side of that straddle would become dominant, raising our hedge toward about 85%. On a substantial market advance, the call side of the straddle would dominate, lowering our hedge toward about 30%. In the event that market volatility falls short of the (relatively low) volatility implied in the option prices, we would expect some degree of time decay in that 1% option position that we could not recover through active management of the position.

New from Bill Hester: Those Bargain Days - Valuation, Anchoring, and Availability


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