April 26, 2004
Market Climate - Increasingly Fragile
This week's comment moves straight to the Market Climate discussion because I don't want these remarks to be embedded in anything else.
The Market Climate for stocks is now characterized by unusually unfavorable valuation and market action so tenuous that it is statistically indistinguishable from an unfavorable condition. The Strategic Growth Fund is now fully hedged against the impact of market fluctuations. Lacking an obvious breakdown in market action, our paean to the possibility of a recovery takes the form of a tiny contingent call option position, near term and slightly out of the money, but capable of moving the Fund back to a nearly 40% exposure to market fluctuations in the event the statistical uncertainty resolves back to favorable market action in the next few weeks. So locally, and on declines, the Fund will appear fully hedged. In the event of a sufficiently strong recovery, the Fund will appear close to 40% exposed to market fluctuations.
The Strategic Growth Fund continues to hold a fully invested position in a widely diversified portfolio of stocks, with an offsetting short sale of equal dollar value in the S&P 100 and Russell 2000 indices. The dollar value of our shorts never materially exceeds our long holdings, and a fully hedged position should not be interpreted as a "bearish position" or a forecast of a market decline. The intent is strictly to remove the impact of market fluctuations under conditions when market risk has not historically been rewarded.
Of course, we continue to accept the risks in our overall stock portfolio that are not closely correlated to overall market fluctuations. This is often termed "active risk," and it is the portion of a portfolio's return that is driven by factors specific to the particular stocks being held (valuations, industry conditions, balance sheet strength, management, products, etc). This is where stock selection, as opposed to market exposure, is an important determinant of performance.
When the Strategic Growth Fund is fully hedged (and provided that our long-put/short-call index option combinations have identical strike prices and expirations), its returns are driven entirely by the difference in performance between the stocks we own and the indices we use to hedge. This difference can and will vary on a daily basis. The Fund was similarly hedged from its inception in July 2000 through March 2003. An examination of Fund returns during this period will make it clear that Fund returns need not be “a wash” in this position.
The fact that we have attempted to remove the impact of market fluctuations means that it will be virtually impossible to infer the Fund's returns on any particular day based on the change in the market that same day. From experience, I strongly advise against trying to detect any particular patterns in this regard, because they will invariably be based on superstition. To the extent that we are successful in removing the impact of market fluctuations, no such patterns will persist for long.
In bonds, the Market Climate remains characterized by modestly favorable valuation and modestly favorable market action, but again, the condition of market action has become particularly tenuous.
The bond market continues to be dominated by theme trading – demonstrating a much closer link to movements in the U.S. dollar than is consistent with normal historical relationships. In a similar pattern, bond market movements have become more heavily driven by Federal Reserve pronouncements than with economic data that usually have more relevance (as Bill Hester put it “The bond market has lost its ability to think for itself”). Theme trading in the bond market is evidence that investors have adopted a very short-term perspective; trading on knee-jerk cause-and-effect theories, rather than careful analysis.
Just as overvaluation in the stock market can be temporarily irrelevant when investors have a robust preference toward risk, reasonable valuation in the bond market can be equally irrelevant when investors adopt very skittish and formulaic views. Nearly 3% of the pullback in the Strategic Total Return Fund over the past few weeks has been driven by bond market weakness (the remaining 2% is attributable to gold and utility shares). The fact that bonds and the dollar have displayed an unnaturally tight link means that the normal diversification benefits across these asset classes has been lacking. Gold is inversely correlated with the U.S. dollar. Since dollar strength and bond market weakness have gone tightly hand-in-hand during recent weeks, there has been a tendency for straight bonds, TIPS, gold, foreign government bonds and utilities to move in the same direction in recent weeks.
While I view the yields on long-term bonds as reasonable in the context of overall economic conditions, investors' trading behavior in recent weeks threatens to shift the Market Climate for bonds to one of modestly favorable valuations but modestly unfavorable market action. That would force us to shorten our duration. Suffice it to say that the Market Climate for bonds remains favorable here, but an essential feature of our approach is an unwillingness to be stubborn if and when the evidence changes. Bond market action in the next few weeks will be important to that determination.
Our measures of market action are driven more by the quality of market action than by the raw performance of specific bonds, so it's quite possible that the Market Climate could deteriorate on strength, rather than weakness in the bond market. That's always preferable, and it occurs often enough that we can't say, for instance, what yield on the 30-year Treasury would “trigger” a Climate shift. There's simply no such trigger. In any event, if market action provides sufficient evidence that investors have abandoned their willingness to accept bond market risk, we'll adjust our investment stance accordingly.
Provided that we do not observe much upward pressure on real interest rates from here, further weakness in the gold market would actually tend to increase our position in gold shares, which remains less than 10% of the Strategic Total Return Fund's assets. While some investors appear to be concerned that gold shares could plunge with the overall stock market as they did in 1987, it is notable that even on the basis of simplistic valuation measures, the 1987 plunge in gold shares began with the gold price/XAU ratio below 3.0, and took that ratio just above 5.0 (the historical norm on the gold/XAU ratio is about 4.0). Currently that ratio is 4.48, and on the basis of other measures, gold stocks also look reasonably inexpensive. Again, unless we observe further upward pressure on real interest rates, our inclination would be to add lightly to our precious metals shares on further price weakness.
As always, we align ourselves with the prevailing Market Climate at every point in time, adjust our positions when that Climate shifts, and do nothing to “correct” our positions when we experience a pullback without such a shift in the Market Climate. That discipline can be frustrating for investors who rely on market forecasts and predictions or believe that the market can be exquisitely timed, but that discipline is also the foundation of our investment approach and the strong risk-adjusted performance that has accompanied it.
One of the essential features of the Hussman Funds is that the investment positions of the Funds are adjusted as Market Climates change. While I note these changes so that our shareholders will be well-informed and able to properly interpret the day-to-day performance of the Funds, shareholders need not make any portfolio alterations in response. The objective of the Funds is to invest in a way that allows our shareholders to confidently pursue a disciplined program of saving and investing, without too much concern about market volatility; to achieve strong long-term returns; and to manage risk effectively enough so that timing concerns never get in the way of saving decisions.
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