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August 9, 2004

Local Risks vs Extended Risks

John P. Hussman, Ph.D.
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Skydiving and basketball involve two very different risks. Skydiving risks the entire outcome on one trial. A single error can be catastrophic, and the potential risks are virtually unlimited. These are what I call “extended risks.” Basketball, in contrast, is a game where the outcome depends on dozens and dozens of individual actions. If a particular action doesn't work, the result is a two-point loss. Even a great team can have enough of those to affect a particular game, but the results at the end of the season represent the return from hundreds or even thousands of individual risks - all important contributions, but none decisive nor catastrophic. These are what I call “local risks.”

Investing is the same way. Aggressive investing is a lot like skydiving. If a particular risk doesn't work out, the result can be painful. Risk-controlled investing is more like basketball. The idea is to take lots of actions that are effective on average, without relying on one play or “big idea.” You build substantial diversification and investment restrictions into the approach, in order to reduce the impact of investment positions that turn out to be incorrect. Effective risk-management doesn't eliminate occasional losses. Instead, it tries to make their impact local rather than extended, so that actions that are effective on average can gradually produce results that are satisfactory overall.

That's why we hold over 200 individual investment positions in Strategic Growth, why we diversify across industries, why I left complete put option coverage underneath the Fund's portfolio even in response to a favorable shift in our measures of market action two weeks ago (now neutral), why the dollar value of our shorts never materially exceeds our long holdings, and why even in the most favorable conditions, the Fund can establish leverage only by investing a small percentage of assets in call options (never on margin). All of those restrictions exist because investing involves risk, and risk sometimes turns out to be exactly that. The key is to take mostly local risks, rather than extended ones, particularly when market conditions are generally unfavorable. .

That's not to say that small exposure to risk is always preferred. If valuations are favorable and quality of market action suggests that investors have a robust preference to take risk, a substantial exposure to market fluctuations can be very rewarding. But even here, risk management for us takes the form of diversification, while the use of call options (rather than margin) means that the effect of any leverage would be limited to the few percent paid for those calls. An unhedged position does take a certain amount of extended risk in the event of a deep and abrupt market crash, but as I've frequently noted, those have historically been confined to conditions of both unfavorable valuation and unfavorable market action. For us, aggressive positions are best confined to periods of favorable valuation and market action. So even when we strap on a parachute to go skydiving, it's because we think we're jumping out of a treehouse.

In contrast, when market conditions are overvalued and market action is poor, our performance is built largely on "basis risk" - differences in performance between our specific holdings and various market indices. When we're fully hedged, positive and negative returns can usually be traced to various basis risks that we take. These include differences in exposure to industries such as technology, financials, consumer stocks, drugs, and so forth, avoidance of low quality stocks with high debt and poor financial condition, and scores of individual stocks that we weight differently than their weight in the overall market (on the basis of valuation and market action at each point in time). Those local risks are our basket shots, rebounds, occasionally missed passes, and periodic slam dunks.

Notes on the recent pullback

From April 5th through Friday of last week, the small-cap Russell 2000 has declined by 14.3%, the S&P 600 MidCap Index has declined by 10.6%, and the equal-weighted all-cap Value Line Arithmetic has declined by 11.7%. Meanwhile, the large-cap S&P 100 index has declined by 7.3%, and the Hussman Strategic Growth Fund has declined by 6.5%.

If not for the fact that I write these weekly comments to address everything – favorable and unfavorable – with my shareholders, I wouldn't consider a pullback of 6.5% as meriting much discussion. We've seen pullbacks in excess of 5% in Strategic Growth before – two separate ones in 2001 and a 6.6% decline in 2002, so this setback is certainly not uncharacteristic. This is, after all, still an environment in which we've been willing to accept market risk. Still, recent market action is interesting enough in its own right that some analysis is useful.

There are three basic factors that have contributed to the recent 6.5% pullback in the Strategic Growth Fund. First, both at the beginning and end of the period since April 5th , the Fund had a positive exposure to market risk (specifically, from April 5th to April 23rd and again from July 23rd to August 6th ). Second, the broad market, including much of the portfolio held by Strategic Growth, has had a harder time since April 5th than very large cap stocks have experienced. Third, during the recent pullback, some of our larger sector holdings – pharmaceuticals and consumer stocks – came under somewhat more pressure than other groups, so our holdings looked somewhat more like the broad market than the S&P 100 (where we have about 70% of our hedge, based on normal correlations with our stocks).

The upshot is that we did have a modest amount of market exposure during this period, and due to the skew between large cap stocks and the broad market, we didn't recover enough from our hedges to fully offset the pullback in our portfolio holdings since April.

As I've noted on the Fund Information page for several years, “these instance should be expected from time to time. They may seem unfortunate, but they are not predictable. Though we certainly attempt to limit our risks through diversification, careful hedging, and appropriate position sizes, we do not attempt to ‘correct' short-term difficulties if we would have to ignore our strategy to do so.”

Still, marginally outperforming a flat market isn't a satisfactory outcome, nor is losing less than a declining market. Absolute returns matter. But to evaluate investment returns, or expect consistently positive ones, five months really is an excruciatingly short term from my perspective. As usual, I consider a relevant performance period to be from one market peak to another, preferably across market cycles, but at least separated by a year or more. The quality of your basketball team is measured over the full season.

Large caps and the broad market briefly part ways

The recent pullback falls into the category of “local risk,” not “extended risk.” Even if the current market decline continues, our put options are now at-the-money. Even a large-scale market weakness from here is likely to have a fairly muted impact on our returns. The real issue is that the “basis” between the broad market and large-cap stocks (where we hold a significant portion of our hedge based on normal correlations with our stocks), has taken a wide swing in a short period.

To get a picture of what's been happening, I've included a chart of the ratio between the Russell 2000 and the S&P 100 since April 5th (a rising line means the Russell is outperforming the S&P 100). The two lines above and below are 21-day Bollinger bands (2 sigma). Notice that the ratio moved from the upper band on April 5th to the lower band on Friday of last week. Other indices, including mid-cap and all-cap ones, display similar patterns since April. As an investment strategy, trading these spreads using Bollinger bands isn't really advisable, but it's clear that the downside risk of a particular index (relative to the S&P 100) is greater at the top band than at the bottom. The fact that this ratio is now at the bottom band for most broadly defined stock indices suggests that the risk of continued underperformance by the broad market – versus large-cap indices – is substantially less than it was on April 5th, or even June 30th, when the most recent downdraft started. A good part of the basis risk that existed on those dates has been “taken out” by the recent decline.

Though it's not typical, to the extent that the short-term fluctuations in Strategic Growth have tracked this spread recently, I see it as a positive that this spread is trading at the lower band. While my personal investments should never be considered trading advice, I did place two additional purchase instructions for Strategic Growth last week due to the pullback - one on Thursday for purchase on Friday, and another on Friday for purchase on Monday (I invest regularly in the Fund, which is not dilutive since I regularly put new money to work, and I believe it is in the interest of shareholders for advisors to invest in the funds they manage. Though it's always a good investing habit to make purchases on short-term weakness, I don't advise timing Fund investments by waiting for such pullbacks, nor do I trade the Fund - I still own every share I've ever purchased).

Market Climate

As of last week, the Market Climate for stocks was characterized by unusually unfavorable valuations, and market action so tenuous that it is indistinguishable from unfavorable action. Quite frankly, this one could go either way – in my view, it is equally possible that the market could move higher as it could plunge. I have no attachment to either outcome. No fundamentals such as earnings or GDP will help – what matters is investors' preferences to accept risk. At present, the evidence on that from market action is as borderline as it ever gets.

So what now? Most importantly, the portfolio of stocks held in the Strategic Growth Fund is now fully hedged with put options. Last week I noted that the Fund would quickly and almost invariably lose at least 1-2% in the event of a substantial market decline, at which point I expected the put options beneath the portfolio to reduce the impact of market fluctuations on the portfolio. Those put options are now slightly in-the-money, so our exposure to further market weakness is substantially less than it was even a week ago. We still have some exposure to “basis risk” – the risk that our stocks perform differently than the indices we use to hedge, but given that both the broad market and some of our industry group holdings are oversold relative to the S&P 100, I believe that the some of this potential for basis risk was reduced by the recent decline.

In bonds, Friday's tepid unemployment report was accompanied by a substantial decline in both real and nominal yields – enough to move the Market Climate in bonds to a condition of both unfavorable valuations and unfavorable market action. We sold a portion of our Treasury inflation protected securities on the advance, moving the overall duration of the Strategic Total Return Fund to about 2.3 years. As I've noted, the most likely prospect for the bond market does not appear to be rapid noninflationary growth, but slower growth and – at least temporarily – inflationary pressures. Despite the cooling of expectations regarding Fed tightening on the basis of the employment report, there remains a significant risk of upside inflation surprises. So there is an even chance that the bond market's ebullience on Friday will be reversed on upcoming inflation reports. Barring downside surprises in inflation, the year-over-year CPI inflation rate will probably hit 3.4% or higher with the next report. To expect the Fed to hold rates at current levels or just a quarter-point higher, in the face of those inflation figures, would seem to be asking a lot.

In any event, the Strategic Total Return Fund remains positioned to benefit primarily from downward pressures in real interest rates and the U.S. dollar.

For additional information, graphs, performance figures, and reports regarding the Hussman Funds, please see The Funds page.


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