July 26, 2004
As is the case from time to time, I'm going to skip immediately to a discussion of the Market Climate.
As of last week, the Market Climate for stocks has shifted to a more constructive stance. This is not a forecast about market direction, but rather an identification of present conditions. On average, the market's return/risk profile has been reasonably favorable in the Climate we now identify, but this is different than saying that stocks must (should, or even are likely to) advance in this specific instance. We don't invest based on forecasts for this specific instance. We invest based on the average return/risk profile in the Climate we observe.
Stocks remain unusually overvalued, but despite a substantial decline in the major indices, we've observed an improvement in the quality of market action. Valuation matters tremendously in determining the long-term return that stocks are priced to deliver, but it has very little effect on the course that the market takes over shorter periods. Essentially, looking at a wide variety of stocks, industry groups, and security types, breakdowns that would normally have been expected to occur during the recent decline, if investors were skittish, have not in fact occurred. Accordingly, our measures suggest that investors have adopted a more favorable attitude toward risk taking.
One of the most important aspects of our investment discipline is our lack of attachment to any particular outlook for the market. We observe the present rather than attempting to forecast the future. Among the important features of the market at present, stocks continue to be overvalued on a fundamental basis, and sentiment is quite bullish, which is a concern I noted last week. At the same time, the market is now very oversold. With the Dow below 10,000, most indices are near the bottom of their recent, extended trading ranges. Implied volatility in index options also remains quite low. All of these factors are important in understanding how I have responded to the recent shift in the Market Climate.
Weighing the options
In a more favorable Climate, the objective is to establish an appropriate exposure to market fluctuations, but I have a certain amount of latitude in doing that. One possibility would be to simply lift a portion of our hedges. Since we generally hedge using long-put / short-call combinations in major indices like the S&P 100 (one put/call combination is equivalent to being short $100 times the index value in S&P 100 stocks – about $53,000 currently), lifting a portion of the hedge would involve buying in short calls and selling out long puts. Given current valuations, and the fact that stocks have sold off to the point that a sufficient extension of this decline would shift us back to a defensive position (by virtue of other elements in our market analysis), the appropriate amount of hedges to lift, if I did it this way, would be between 25-40%, leaving us with a reasonable but not extensive exposure to market fluctuations.
Still, the fact that option volatility is unusually low (especially following a decline of recent magnitude) allows us an alternative. At these volatilities, and particularly given the potential for a reversal back to a defensive Climate if the major indices decline much further, it doesn't make much sense to sell out those put options.
The more appropriate way to establish a 25-40% exposure to market fluctuations was to leave the puts in place (though I did roll some of their strike prices down a bit) and lift a larger portion (about 2/3) of our short call options, at a cost of about 1.7% of net assets. That leaves us with an investment position that looks about 35% net long here, but with “curvature.” In the event of a strong advance, the impact of the puts will decline as they become further out-of-the-money, so that our effective net long position could approach nearly 70%. In the event of a strong decline, the puts would move in-the-money and buffer our exposure to market fluctuations back toward 0%. In that event, or if volatility in the coming months is lower than the implied volatility of the options, we would expect a modest amount of time decay in our puts not offset by short calls, so the returns on the Fund would be as much as 1.7% lower than they might otherwise have been.
Don't try all of this at home (especially since I can't announce shifts in the Market Climate until we've established the necessary positions for the Fund), but all of this is fairly standard stuff for us.
In effect, the Strategic Growth Fund has shifted to a more constructive position, without giving up its defense against any sort of major decline that might emerge. It is essential to understand that this is not a forecast, that I have not become “bullish,” that I am not “calling a low” or any other such nonsense. None of this implies any sort of investment advice for what shareholders might do outside of the Fund. The interpretation of this shift is simple: despite market overvaluation and a recent decline in the major averages, investors appear to have recovered a willingness to accept market risk. In this Climate, the return/risk profile of the market has historically been favorable, on average, though both advances and substantial market declines are possible. I'm not forecasting whether an advance or a further decline will emerge in this particular case. Rather, I've aligned the Fund with that positive average return/risk profile by accepting a moderate amount of exposure to market fluctuations.
In bonds, the Market Climate remains characterized by neutral valuations and modestly unfavorable market action. The Strategic Total Return Fund continues to carry a duration of about 3.25 years (meaning that a 100 basis point move in interest rates would be expected to impact the Fund by about 3.25% on account of bond price fluctuations). That duration is primarily in Treasury Inflation Protected Securities. On a day-to-day basis, the primary factor affecting the daily NAV is likely to be fluctuations in precious metals shares, which continue to represent about 14% of Fund value.
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