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June 28, 2004

Eyeing the Target

John P. Hussman, Ph.D.
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A quick note of thanks to the shareholders and advisors who visited us at the Morningstar conference in Chicago last week. I was particularly grateful that some of you drove from other states to attend a two-hour talk, or “just to say thank you,” which was very kind. Meeting you all was a real pleasure.

In most sports, there are two ways to handle the ball. If the ball is coming toward you and it has to be hit or caught, the idea is to keep your eye on it so you know where you have to be (rather than dislocating your finger on it as it speeds in, unwatched, which was the standard outcome during my tortured adolescence). On the other hand, if the ball is not moving and the goal is very specific – a pool shot, or a basketball throw, for example – the idea is to keep your eye on the target. You imagine the ball being at the desired location, and then “replace” the imagined ball with the real one. That idea works for most goal-setting too. Everything gets created twice – first in the imagination, then in reality.

This week, Fed governors meet to decide the path of the Federal Funds rate. Since the Fed Funds rate has not been punted, pitched, or otherwise set in motion, it's clear that the proper way to handle the ball is to eye the target. Looked at from this perspective, however, even my own expectation (that the Fed will only move rates by a quarter point this week) suddenly comes into question – not that our investment positions are driven by, or dependent on any particular path for the Fed Funds rate.

The issue is this. Given current levels of economic activity, the Federal Funds rate would normally hover between 1% and 1.5% above the rate of inflation. That would put the Fed Funds rate in the neighborhood of 4%, not 1% as it is now. Clearly, from the standpoint of economic slack, the Fed would be perfectly reasonable in moving only a quarter of a point, and to gradually normalize the level of short-term interest rates (not out of any need to slow down demand growth). But if “normalized” rates are about 3 percentage points above current levels, it would take a dozen quarter-point rate hikes to get us there. Barring that, a quarter point hike now, followed by half-point hikes at some point in the future, might create the perception that the Fed was panicking later.

All of which leaves the Fed in a bit of a dilemma. To raise rates by a half percent now seems fairly unnecessary from the standpoint of demand growth, but it might have the benefit of increasing the Fed's inflation-fighting credibility (a moot reality, in my view – see my June 14 comment – but still a perception worth considering). In contrast, raising rates by only a quarter point seems more consistent with a “dampened trajectory,” but it does have the feature of not getting the Fed very far, relative to where it ultimately wants to go.

As The Economist notes in its latest issue (Back to the 1970's? Inflation returns, worldwide), “it seems bizarre that the financial markets are worrying about whether interest rates will be raised by a quarter or half a percentage-point at the Fed's meeting on June 30th . The real questions are: why has the Fed not tightened sooner? And how high do interest rates need to rise?”

I still believe that the most probable outcome of the upcoming meeting will be a quarter-point hike, but once we eye the target instead of the ball, it's not at all clear that the Fed won't try to make some extra distance on its first play. Fortunately, we have no particular attachment to either decision.

How does uncertainty about the Fed move affect us? To a large extent, it doesn't – the combination of valuations and market action in both stocks and bonds already places us in a defensive position, and that position wouldn't change in anticipation of one Fed move or another. It does, however, make us very aware of the possibility that the markets may receive a surprise in the coming days. And surprises always carry dispersion with them – market action that departs in various ways that create opportunity or require adjustment. Since we're relatively defensive here in both stocks and bonds, the primary opportunities and adjustments at this point could be ones that might make us more constructive.

For example, a substantial broadening of stock market action (even without a rally of significant extent) could move us to lift a portion of our hedges. Certain shifts in bond market action and the yield curve could create opportunities to take additional interest rate risk. Though we would not take either risk preemptively on the hope that the Fed might move one way or another, I am looking forward to new information flow in the coming sessions, after weeks of dull, uncommitted trading by investors.

Market Climate

The Market Climate for stocks remains characterized by unusually unfavorable valuations and unfavorable market action. Last week, we observed a substantial rally in small capitalization stocks. As Carl Swenlin of DecisionPoint ( www.decisionpoint.com ) notes, however, the percentage of S&P 600 small caps above their 200 and 50 day moving averages has been in a series of declining peaks, meaning that the strength in small caps has displayed less and less plurality. We see a similar stall in the participation of large-cap stocks, though not quite as pronounced. In addition to our own measures of market action, which remain unfavorable, the uneven market action also appears from other perspectives, such as Dow Theory. Richard Russell ( www.dowtheoryletters.com ) notes that the Dow Transports achieved successive new highs last week, but the Dow Industrials are a significant distance from confirming those highs. While such technical considerations may appear arcane and unimportant, the historical record indicates otherwise. Though I clearly follow our own measures of market action over other indicators, the uneven behavior of stocks deserves close attention here.

On the bright side, I've noted that there is at least some chance for a shift to more favorable market action if we do observe a broadening of market action in the weeks ahead. I don't look at that as a probability, and I certainly would not reduce our hedges preemptively, but it is always important to be open to all possibilities, and to have no attachment to a “bullish” or “bearish” stance. For now, the Strategic Growth Fund remains fully hedged, and I do view the major indices as substantially overvalued. In the event of more favorable market action (that is, a favorable shift in the willingness of investors to take risk), I would be willing to either lift a portion of our hedges, or to establish a small call option position in the major indices to dampen those hedges. Either way, if the market has a lot of speculative upside left, it's going to have to show at least some initial broadening first. Until such initial evidence is in hand, we'll remain defensive in stocks.

In bonds, the Market Climate remains characterized by neutral valuations and unfavorable market action. The Strategic Total Return Fund has a duration of about 3.25 years (meaning that a 1% change in interest rates would be expected to affect the Fund by about 3.25% on the basis of bond price fluctuations). That duration remains primarily in Treasury Inflation Protected Securities. On a day-to-day basis, the main factor affecting very short-term fluctuations in the Fund remains our roughly 12% allocation to precious metals shares, for which the Market Climate remains favorable on our measures.


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