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March 29, 2004

How we live our days - is how we live our lives

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

It's been said that “how we live our days, of course, is how we live our lives.” We are what we habitually do. If our daily actions contain cheer, happiness, and peace, then whatever negative things come back at us from time to time, our lives will probably contain a lot of cheer, happiness and peace. If our days contain anger, resentment, and hostility, then that is how we cast our lives. As the Buddha taught, the future is nothing but a series of present moments. If we refuse to find happiness in the present moment, how can we find it in the future?

The same principle is true in the financial markets. The only way for an investor to buy low and sell high, in a financial lifetime, is to follow an investment discipline that makes buying low and selling high a consistent practice. This does not require buying the low, or selling the high, which is impossible. But if your daily investment discipline does not regularly move you to buy undervalue or early strength, and to sell overvalue and early weakness, you are unlikely to enjoy much financial success in even a lifetime of investing.

Investors who become indifferent to overvaluation, simply because prices are rising, usually place far too much faith on their ability to get out at the top, or barring that, to get out before their instincts convince them that it's too late to sell. We have great confidence in our measures of market action, but we also understand their limitations, so we're already partially hedged.

No forecasting required

One of the principles of our investment discipline is to separate our daily actions from the need for forecasts. If you've ever seen me in a media interview, you know that I never answer the question “Where is the market headed?”

This is because I have no idea.

For instance, though I presently view the stock market as strenuously overvalued, this does not imply a directional forecast. It only implies that the long-term total return on stocks is likely to be disappointing. Shorter-term, while market action has displayed increasing signs of deterioration, there has not been enough divergence to warrant a heavily defensive position.

Even if further breakdowns do move the Market Climate to a negative condition, it does not follow that we will have become “bearish” or that we will be “forecasting a decline.” A fully-hedged position simply indicates that the current return/risk profile of the market is not favorable enough to warrant an exposure to market risk. It is as little a forecast that the market will necessarily decline as our current, positive exposure to market risk is a forecast that the market will necessarily advance.

Valuation and market action are useful in identifying the average return/risk profile in each Market Climate we've defined, but since we don't know what that Climate will be even a week from now, it's impossible to reduce that average behavior into any sort of meaningful or reliable forecast about market direction for any specific period. So we align the investment position of the Funds with the prevailing Market Climate in stocks and bonds, keeping our investment exposure basically proportional to the average return/risk profile of the market we've observed in each Climate, and holding “contingent” put or call positions from time-to-time to deal with “fat tail risks.” Our day-to-day trading activities are driven by similar considerations. We try to buy highly ranked securities on short-term weakness and sell lower ranked holdings on short-term strength. No forecasts are required.

[Geek's note: technically speaking, it would be accurate to say that we generally have a tiny, wholly unreliable, and statistically meaningless forecast about market direction for the coming week, and no forecast beyond that. Even the definition of the “present” can't be precisely of zero measure].

The market doesn't care what position you've taken

Once you invest on the basis of a forecast, you lose your objectivity about truth, because you become so focused on what's going to happen, or what might happen, that you begin to ignore what is happening now. For instance, suppose that a particular stock falls sharply in price. If an investor currently owns that stock, the drop in price may be so frightening that the investor may be prompted to sell. Yet if the investor doesn't own the stock, that same investor might use the weakness as a buying opportunity. When the same price movement could cause the same investor to take two entirely opposite actions, depending on the position the investor already holds, there can be no such thing as objectivity.

The market simply doesn't care what position you've already taken. Except for risk-management and diversification considerations (which affect the size of the investments you make), your response to a particular opportunity should not depend on the position you've taken either. When the forecast you've made prevents you from responding to opportunities the market gives you, you've lost your discipline. A sure sign of this is being extremely attached to a particular outcome in the market, to the point that you panic to imagine the market doing something different.

Richard Russell of Dow Theory Letters puts it a bit more bluntly: “Any time you find yourself hoping in this business, the odds are that you are on the wrong path -- or that you did something stupid that should be corrected… Forget the siren, hope -- instead embrace cold, clear reality.”

To an observer unfamiliar with our investment discipline, our record might appear to be the result of clever timing and forecasting. It is both entertaining and frustrating when we see investors or analysts arriving at those conclusions. Very simply, we don't make forecasts. Because of this, a sure-fire way to frustrate yourself is to interpret our investment position any point in time in the context of your own market forecasts. Investors who can't let go of the notion that market direction can be predicted really ought to trade in ETFs or similar vehicles; they should not invest in the Hussman Funds, because we find no use in making predictions about market direction.

In short, the future will be made of a series of present moments. Whatever we regularly contain in our daily actions is what we choose to contain in our lives. If we want to buy low and sell high, we should hold that in mind in our daily actions. If we want happiness and peace, we should probably do the same.

Market Climate

The Market Climate in stocks remains characterized by unusually unfavorable valuations but still tenuously favorable market action. Though we've certainly seen growing breakdowns in the internal action of the market, we do not yet observe enough to warrant a strongly defensive investment stance.

In fact, we purchased a large number of inexpensive call options on last week's decline due to the combination of still-favorable market action, a substantial market pullback, still-favorable interest rate behavior, and low implied volatility in the options. This combination is something of a “sub-climate” which allows the possibility (though not a reliable forecast) of a “fast, furious, prone-to-failure” advance to clear the market's oversold condition. [Geek's note: this is a situation in which you want to own gamma without substantially changing your delta, so near-term and modestly out-of-the-money time-premium is desirable].

Overall, the Strategic Growth Fund remains fully invested in a widely diversified portfolio of stocks, with about half of that exposure hedged against the impact of market fluctuations. We've also got what roughly resembles a straddle – long positions in both put and call options. The put options defend the portfolio from the realistic threat that the market could break down some distance before our measures of market action would reliably shift to a negative condition. The rationale for the calls is noted above. In the event that actual market volatility falls short of the relatively low level priced into these options, we would expect to experience some time decay that we could not offset through active management of the option position. Currently that position is valued at just over 1.5% of assets.

In bonds, the Market Climate remains characterized by modestly unfavorable valuations but still modestly favorable market action. We sold an additional portion of our long-term Treasury position into strength last week, taking the duration of the Strategic Total Return Fund to just under 2.5 years (meaning that a 100 basis point move in interest rates would be expected to induce a 2.5% fluctuation in net asset value on account of bond price fluctuations).

There are a great many cross-currents in both stocks and bonds here. In stocks, valuations, sentiment, and emerging deterioration in market action are set against a still oversold condition and a tenuous but still evidently intact willingness of investors to take risk. In bonds, low yields, dollar pressure and the potential for a yield curve flattening are set against a still weak employment picture and a fairly attractive “carry trade” (as measured by the difference between long and short term yields).

Whether we define risk as the range of disparity between possible outcomes, or whether we define it as the potential for substantial capital loss, both the stock and bond markets face considerable risk here. Still, there is no clear or obvious bias as to which direction the markets are likely to move, particularly in the short term. So we've got relatively neutral expectations (in terms of the average potential outcome), but within a very wide range of possibilities.

Needless to say, we're well prepared for potentially high market volatility in stocks and bonds.


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