April 19, 2004
Perception is reality
I'm pleased to note that on April 8th, the expense ratio of the Hussman Strategic Growth Fund was lowered again, to 1.29% annually. The expense ratio is affected by a number of factors, including the amount of net assets and fee breakpoints, and may increase or decrease over time.
There's an old saying that perception is reality. The basic idea is that we base our actions on what we believe, and rather than on what is necessarily true, yet those actions can create a world that reinforces our perceptions.
The simplest example of this is a “self-fulfilling prophecy.” As Zig Ziglar says, whether you set out believing you'll be a success or a failure, you'll probably be right.
The same notion is true for Federal Reserve policy. I've previously explained why the Fed is irrelevant when it comes to actually affecting the volume of lending in the banking system. Essentially, if you look closely at the actual policy objects that the Fed can manipulate (primarily the monetary base) it's clear that there is no traceable mechanism by which Fed actions have an effect (except during financial crises when the Fed has an essential role in liquidity, as individuals panic to hold currency and liquid reserves). Moreover, in terms of interest rate movements, market interest rates are far better at predicting subsequent changes in Fed-controlled rates than vice versa.
[Geek's note: There are some “causality” issues that arise from rational expectations – i.e, the possibility that market yields are so forward looking that the actual Fed moves become uninformative. Yet absent a clear transmission route from Fed actions to market yields, the issue is still one of perception.]
Yet the fact that investors believe the Fed is important leads to a self-fulfilling prophecy that should not be ignored, and has certainly had an impact on the financial markets lately. The issue at present is the great concern that the Fed will tighten monetary policy soon. Following the March employment report, bond prices dropped sharply on that possibility. Though our own moderate stance in bonds here (currently a portfolio duration of 5.25 years in the Strategic Total Return Fund) is driven by what we measure as modestly favorable valuation and market action in the overall bond market, the particular security choices and tactical decisions I make are not unaffected by the overall economic picture, and Fed policy is an element of that.
Presently, I believe that fears about a substantial and near-term series of Fed tightenings are misplaced. Under considerable pressure from market expectations, the Fed may very well change its verbal policy “guidance” and may even raise rates one-quarter to one-half percent in the months ahead. But to believe that the Fed is on the verge of an aggressive policy of serial-tightenings like 1994 is to miss both the general basis of Fed decisions, and the substantial differences between then and now.
How the Fed thinks about policy
Probably the most important thing to understand about Fed policy is that rate hikes are not intended to slow down the economy, but rather, to slow down demand growth that threatens to outpace the ability of the economy to produce supply. An understanding of this is essential to interpreting Fed actions. It is simply wrong to believe that the Fed has any interest at all in slowing the rate of economic growth. Its objective, when it hikes rates, is strictly to ensure that demand growth does not outstrip capacity constraints by so much that inflationary pressures emerge and cut sustainable growth short.
So the key questions when you consider Fed actions are those that involve the strength of demand growth, the amount of slack in economic capacity (unemployment, capacity utilization and the “output gap” between actual and “potential” GDP), the existence of inflationary pressures (including the valuations of stocks, housing, and the U.S. dollar), and the Fed's estimate of sustainable economic growth (based on population growth and productivity trends). Once you understand these considerations, it is easy to place the Fed's actions in proper context, and to understand the distinctions between 1993-94 and today.
Economic conditions: 1993-94
If you look back to the minutes of 1993 and 1994 FOMC meetings, it is clear that the driving considerations behind possible Fed tightening included:
The desire to reduce the rate of inflation, which was an active concern for the Fed;
The view that the economy was reaching its capacity constraints.
Here are a few quotations from that period:
Mr. Mullins: “I think our objective ought to be to continue to make progress on reducing inflation – core inflation has run 3 percent over the past 12 months – in order to secure a sustainable low interest rate environment and associated benefits. In my view our objective should not be simply to avoid a re-acceleration or an upturn in inflation. I think there's a real payoff not just from stabilizing inflation in the 3 to 4 percent range but in moving it lower… This thing has momentum; the economy has grown at a rate of 3 percent for 8 quarters now. Mike mentioned overall capacity utilization: at the end of the second quarter of ‘92 it was 79.5 [percent], now it's 83. The peak in the last cycle in the late 80's was 84.8 and it's now 83.”
Mr. Parry: “It's possible that the gap between potential and actual GDP may be diminishing at a rate faster than is anticipated.”
Vice Chair McDonough: “In general, we think the gap between actual and potential GDP is now quite small, and certainly that which remains will be used up in 1994 based on our forecast. Consequently… we do have reason to be considerably concerned with inflation.”
Ultimately, the Fed began tightening monetary policy in the first quarter of 1994, at a rate that surprised the financial markets, particularly bonds. At that point, the economy had been consistently generating about 325,000 new jobs monthly, not just for a single month as we saw in March 2004, but regularly. In effect, it was the combination of observed inflation, high capacity use, persistently rapid job growth, and the elimination of the GDP output gap that forced the Fed's hand.
Economic conditions: 2004
Before contrasting those past discussions with the tenor of remarks made by Fed governors more recently, it is useful to note that the latest reading on capacity utilization remained a tepid 76.5%. Moreover, according to the CBO, the current GDP “output gap” is currently almost 2%, while its estimate of “potential GDP” is growing at 3%. This means that the economy could accommodate fully 5% GDP growth in the coming year without closing the output gap. In this context, consider the following quotations:
January 28, 2004 FOMC Meeting:
“In the Committee's discussion of the outlook for inflation, the members agreed that increases in core consumer prices were likely to remain muted this year, with ongoing strength in the expansion only gradually reducing the current output gap, and anticipated gains in productivity exerting downward pressure on costs and prices. In the view of many, some modest further disinflation appeared to be the most likely prospect. They stressed that unused labor and other resources remained substantial, that inflation was at a very low level, and that inflation was not expected to change appreciably in either direction over the year ahead. Members acknowledged that there were risks in maintaining what might eventually prove to be an overly accommodative policy stance, but for now they judged that it was desirable to take risks on the side of assuring the rapid elimination of economic slack.”
More recent statements by Fed governors:
March 25, 2004: Mr Kohn (quoted by Bloomberg): “Patience in policy action” might take several forms. One would be for the Fed to wait before raising rates. Another would be to raise rates at a “dampened trajectory” once a cycle of increases began. A gradual increase, starting sooner, might prevent economic “overshooting.” However, it also runs the risk of “prematurely truncating the expansion.” Kohn took issue with some Fed critics who charged the central bank is waiting too long to raise rates: “The hurdle is high, and appropriately so, for a central bank to tighten policy, and in the process damp an expansion of economic activity in the short run, on the suspicion that movements in asset prices and increases in debt threaten economic stability over the longer run.”
April 4, 2004, Mr Broaddus: “The apparent firming of the job market if it continues, will moderate the decline in labor costs that I think has driven a good bit of this recent disinflation. But with the credibility of the Fed's commitment to price stability at this point still high, with considerable slack still out there in the labor markets and in many industries, I'm not personally unduly concerned with the risk of a significant resurgence of inflation in the near-term future.”
April 15, 2004: Mr. Bernanke: “In my view, there is still an output gap that will continue to create some downward pressure on inflation.” The output gap and productivity gains “suggest inflation will remain under control in the immediate future.”
April 15, 2004: Mr Stern (Minneapolis Fed President): “Analysts tend to make too much of a few numbers. We are not going to get carried away by two or three months' worth of numbers in either direction. I do think the inflation outlook is certainly benign for the next year at least.”
April 15, 2004: Mr. Ferguson (Vice Chairman): The March increase of 308,000 in non-farm payroll was “an encouraging sign. But the question of whether this improvement is fundamental and durable will take some time to answer.”
In short, it's certainly possible that the Fed may change its “guidance” at one of the upcoming FOMC meetings, and may even begin tightening rates at a “dampened trajectory” in order to satisfy critics and defend its inflation-fighting credibility. But that's where the comparison between today and 1994 most probably stops. While our own position in bonds is driven by the Market Climate that we observe at any particular point in time, I have to say that I am not uncomfortable at all with our modest portfolio duration of 5.25 years on the basis of current economic trends or Fed policy.
As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and tenuously favorable market action. The fragility of this Climate is palpable, and there is a reasonable possibility (though not assurance) that we could observe a shift in the coming weeks. That does not translate into any sort of market forecast, but it does indicate that I no longer believe that investors have a robust willingness to take market risk here.
Interest sensitive stocks are clearly deteriorating, and it's not clear that all of that is traceable to fears of Fed tightening. To some extent, bank, mortgage, REIT and other interest-sensitive stocks have priced in business conditions that are not likely to be sustained even in a benign interest rate environment. In any event, interest sensitive sectors are important, and were the major initial divergences that marked both the 1987 and the 1990 market peaks. While we don't attempt to “catch” market turns, it's clear that the deterioration in the market here is not benign. Breadth (as measured by advancing versus declining issues) has also stumbled notably in recent sessions. A substantial increase in the number of stocks registering new 52-week lows would provide further evidence of deterioration. In short, market action has to be observed with unusual care here, because further divergences at these levels of valuation could trigger a shift in the Market Climate that could be very costly to investors if ignored.
For now, the Strategic Growth Fund remains fully invested in a broadly diversified portfolio of individual stocks, with about half of its exposure to market fluctuations hedged using offsetting short positions in the S&P 100 and Russell 2000 indices, and the remaining half hedged with a “contingent” put option position that currently represents about 1.5% of Fund value. We would still expect to participate in further market advances, though we would probably not participate fully in rapid advances of substantial extent. Still, the current return/risk profile of the market does not warrant a significant exposure to market risk, and as usual, our exposure to that risk is roughly proportional to the return/risk tradeoff indicated by the prevailing Climate. So we're moderately defensive, but not completely so.
In bonds, the Strategic Total Return Fund currently carries a portfolio duration of about 5.25 years. That's lower than the roughly 6-year duration that we had a few weeks ago, but the change is largely due to “convexity” – the tendency of durations to shorten as yields rise – not due to any reduction in our long-term bond holdings. At current valuations and market action, that moderate exposure to interest rate fluctuations is appropriate in my view, and certainly not aggressive.
For the sake of newer shareholders in the Strategic Total Return Fund, it's important to note that the Fund's day-to-day fluctuations do not always closely reflect the overall bond market. In addition to its 5.25 year duration in bonds (that duration being driven mostly by straight Treasuries, but partly by TIPS), the Fund holds about 9% of its assets in utility stocks, and about 9% in gold shares.
Over the past two weeks, we've observed two days in which the Fund has experienced uncharacteristically large movements of about 1%. The first was on April 2nd, when bond prices were hit hard by the March employment report. The second was April 13th, when gold shares were pounded by 6%. Neither of these movements changed the basic Market Climate that we measure in those respective markets, but they did impact our holdings in these sectors. In any event, it's important to understand that the Fund movements on those days were traceable to unusually large movements in the bond and gold markets. An understanding of the sources of that day-to-day risk is important, both so that shareholders do not assume that the Fund is a “high powered” alternative to money market funds, and also so that shareholders do not overly extrapolate those day-to-day movements.
One of the ways to get a handle on portfolio risk is to ask what would happen if everything went wrong simultaneously. This is certainly not the way to gauge “standard” risks, but it is important to understand what a “bad” loss would entail. The way you do that is to ask how a portfolio would respond in the event of large but not implausible movements in its underlying components.
For example, despite what we view as a relatively favorable Market Climate for precious metals here, those shares have substantial volatility. If we ignore expected return and focus solely on risk, we would consider an abrupt 25% loss in gold shares to be large, unexpected, but not completely implausible. For utility shares, an abrupt 15% loss would be startling but not impossible. For bonds, a quick 1% rise in interest rates would be similarly disconcerting. Now assume that all of these were to happen simultaneously. In that event, given that the Strategic Total Return Fund is about 9% in precious metals shares, 9% in utilities, and holds a 5.25 duration in bonds, the combined impact of these events would produce a portfolio loss of about 9.1%. There's no assurance that some portfolio loss could not exceed that amount, but that figure does represent a loss tolerance that would allow for large, unexpected, and simultaneous adverse moves in the assets we hold. Note that this tolerance is based on our current holdings – in a very aggressive market climate, our potential exposure to risk could be larger.
I certainly don't view such a loss as probable, but risk management isn't about what is probable – it's about what is possible . You simply never take a position that could plausibly result in an intolerable or unacceptable loss, regardless of the rate of expected return. For that reason, the Strategic Total Return Fund is not appropriate for investors who would find a loss of 9-10% intolerable. For investors who do have appropriate risk tolerances, this figure will hopefully shed light on what I consider to be a significant versus insignificant pullback in Fund value based on our current investment position.
Though the Strategic Growth Fund is reasonably hedged against the impact of market fluctuations, I would estimate that a large but not implausible loss tolerance for that Fund would be in the area of about 12% based on our current position (when the Fund is unhedged or leveraged, the typical loss tolerance could exceed 20%). Again, that's no assurance that the Fund could not endure a larger decline, but again, something outside of that tolerance would be outside of normal probabilities and would require unusually adverse events. Part of our current risk exists because about half of our hedge represents put options rather than a full short sale on major indices, which preserves the potential for gains from market advances at the cost of incomplete downside coverage. The other element of uncertainty is the “basis risk” between the stocks we are long and the indices we are short. Though this “active risk” has typically contributed to Fund performance, the potential for differences in returns between the stocks we own and the indices we are short is indeed a risk, and can periodically result in losses rather than positive returns.
The goal of the Hussman Funds is to achieve strong long-term returns over the full market cycle, with smaller periodic losses than passive investments in major stock or bond market indices. Our objectives include both long-term total return and risk-adjusted return. The limitations of our approach are that these goals require both the willingness to take risk, and the willingness to take investment positions that may not track the major stock and bond market indices, particularly over the short term. If we can serve our shareholders well on the basis of total and risk-adjusted returns, and provide enough investment stability so that they can adhere to a long-term saving and investment program without being shaken out by deep losses or unusual volatility, we will have achieved our objectives.
As usual, the Funds are always aligned with the prevailing Market Climate in a way that I expect to be beneficial. While there is no assurance that we will achieve our objectives, in view of prevailing conditions in the stock and bond markets I believe that our present investment stance is appropriate.
Thanks to Bill Hester for research support for this piece. Also new from Bill: Retirement Savings and Efficient Markets
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