August 30, 2004
There Is No Such Thing As Free Money
In my years teaching economics and finance at the University of Michigan, I often emphasized that even in an inefficient economy or financial market, free money rarely exists. Profit requires two elements scarcity and usefulness. Produce something useful that is not scarce, and there will be no sustainable profit (this was one of the harshest yet most easily predictable lessons of the dot-com bubble). Produce something scarce that is not useful, and again there will be no profit. The fundamental characteristic of a profitable activity is that it serves the unmet needs of others. As Zig Ziglar frequently notes, you can have everything in life you want if you'll just help enough other people get what they want.
Looking at the stock market with that mindset, I've frequently noted over the years that profits are not free money, but rather, compensation for making trades that provide some scarce, useful service to other investors and the economy as a whole. The essence of buying an undervalued stock is to provide capital to, or incrementally lower the cost of capital for, a company that faces a higher cost of capital than warranted by the efficiency of the business. It is a service to the market to step in and buy, to bear risk in appropriately priced businesses when other investors are averse to bearing that risk to provide scarce demand when other investors are eager to liquidate.
To the extent that purchases and sales affect price behavior and trading volume, the information held by other investors becomes aggregated into market action one of the reasons we analyze market action so carefully. In a perfectly efficient market with only rational traders, all information becomes impounded instantly without trading actually taking place (the mere willingness to buy or sell at a given price perfectly reveals a rational trader's information). Typically, however, information can be a scarce, useful resource in the financial markets too, but only if it is not already discounted into prices (this is not often obvious or simple to discern).
Similarly, an investor provides a useful service to the market by stepping in and providing supply when investors are over-eager to purchase at overvalued prices. Selling into such demand serves several purposes. It helps to raise the cost of capital for companies that are likely to use excessive capital inefficiently (Google comes to mind, but maybe that's just me), and it provides liquidity to investors who are frantic to chase a concept. Supplying shares at that point can help to keep an overvalued security from becoming even more overvalued.
In short, profits in the financial markets accrue by consistently and systematically providing three scarce, useful resources liquidity, risk-bearing, and information.
Our parents were right
There's a story about a finance professor walking with his students when one of them spots a $10 bill lying on the sidewalk. The finance professor looks straight at it and walks past, saying that if there was really a $10 bill lying on the sidewalk, somebody would have already picked it up.
I've always had a little trouble with that story. In the financial markets, there really aren't any $10 bills on the sidewalk. Our parents were right. Money really doesn't grow on trees. The people who think otherwise live under the illusion that making money in the market is easy, and can be done with effortless consistency that there is some clever system that doesn't require patience, discipline, and risk-bearing. To believe there can be investment success without occasional frustration is to ensure a lifetime of it.
That's not to say that there aren't a lot of $10 bills around. But they are usually under rocks in the middle of the road. To get at one of those bills, you usually need to take a risk and move a rock to the side (there may be snakes) and by doing so, provide a useful service to drivers by making the road more efficient. You get your hands dirty. You get bit occasionally. You move a lot of rocks that have nothing underneath. But consistently taking actions that provide some scarce, useful service to others is the only sustainable source of profit. There truly is no such thing as free money.
Analyze any successful investment approach and you'll probably discover that the roots of that success are in making trades that are scarce (or unpopular) and useful (toward making the market more efficient). Warren Buffett is a good example of this. Conversely, analyze most simple, intuitively appealing, but ineffective investment strategies (moving average systems, stop-loss systems, momentum investing, buying hot mutual funds based on short-term strength and abandoning them on short-term weakness, buying upside breaks and selling downside breaks, etc). You'll be mystified at what useful service investors think they are providing by trading like that.
In the context of the current financial and economic environment, it is difficult to see how bearing a substantial amount of market risk here provides either the economy or other investors any particularly scarce or useful service. Aside from short-term fluctuations, the big picture is one of a historic overvaluation not as amateurishly giddy as the bubble peak in 2000, but still over 21 times peak earnings on the S&P 500. That's already beyond the multiple of 20 previously registered only at the 1929, 1965, 1972 and 1987 peaks.
That said, in our discipline, we don't sell purely because of overvaluation. As long as other investors are showing an increasing willingness to bear risk (which we read out of the quality of market action), selling strictly because of overvaluation often means parting with valuable merchandise on the cheap, so to speak. Buying undervalue and selling overvalue still works out over the long run, but it can be excruciatingly frustrating over the short run, as value investors discovered in the early 1980's, purchasing inexpensive stocks that subsequently become even more undervalued before recovering, and as they also discovered in the late 1990's as an overpriced market simply went on to develop into a spectacular bubble. Paying attention to the quality of market action helps to reduce, though not eliminate, those periodic frustrations.
The difficulty here is that we don't observe the sort of market action that conveys a robust willingness by investors to take risk. Trading volume has been extremely dull (Friday's sad little volume figure was the lowest turnover yet this year). Aside from preferred stocks and other interest sensitive securities, market breadth has also been unimpressive. As Bill Hester points out this week in A Stock Market Without a View, investors have been extremely reluctant to express any opinion at all in various industry sectors. Not surprisingly, few investment approaches (including our own) have been able to gain meaningful traction in recent months. As I've frequently remarked over the years, I measure progress by the extent I can take actions that I believe will produce good results for our shareholders over time. We continue to make good, if somewhat quiet progress on that basis demanding of our actions, and by necessity in this environment, patient with their consequences.
The big picture is unforgiving
The U.S. economy faces problems that are much deeper than a shortfall in GDP here or a monthly job number there. Gross indebtedness in the U.S. is now well beyond its prior 1929 peak. Equally important, the dependence of the U.S. on massive and continued inflows of foreign capital simply to finance existing levels of economic activity can't be overstated. Foreign investors (particularly Japan and China) now own more than half the float in U.S. Treasuries.
In my view, it is nearly certain that the U.S. economy will experience a deleveraging cycle in the coming years (flat or declining gross domestic investment, tepid growth in consumption, and probably substantial dollar weakness as a result of excessive debt loads and foreign capital reliance).
I've made this argument enough times that I'll let somebody else make it. Stephen Roach of Morgan Stanley recently made these remarks:
America's $531 billion current account deficit in 2003 absorbed a record 79% of the world's surplus saving. Saving is the sustenance of long-term growth for any economy. And yet America is lacking in saving as never before. It has finessed that shortfall by consuming the wealth generated by asset appreciation and by drawing heavily on the world's pool of surplus saving. In my view, there is nothing stable about this arrangement. In fact, there is a growing risk that America's saving shortfall will only intensify in the years ahead -- especially given Washington's total lack of fiscal integrity. As always, the flows will give the impression that this outcome is sustainable. In the end, nothing could be further from the truth.
Of course, the big picture is largely ignored by investors because they insist on looking at income statements rather than balance sheets, quarterly earnings guidance rather than financial stability, temporarily depressed interest rates rather than precariously elevated debt burdens, and short-term trends rather than long-term overvaluation. It's not clear that these imbalances imply any near-term pressure on the economy, the markets, or the dollar, but as long-term investors, we don't overstay a party when there's a bee's nest in the cake.
Anybody familiar with our long-term total return calculations should recognize that even a P/E of 18 times peak earnings, touched 3 years from now, would imply annualized total returns on the S&P 500 of just 2.5% over that period. Are investors really at the point where all of us want to bet that multiples will never move under 20 times peak earnings again, when 20 was the upper limit for all but the final 3 years of the past century?
The bottom line is that from the standpoint of providing scarce, useful services to the market and economy, the notion of bearing a lot of market risk here doesn't fit well. There are certainly many individual stocks that I believe are undervalued, particularly relative to the market as a whole. Many of those also display market action that suggests growing sponsorship and accumulation by other investors. But that's nothing unusual. In a market with thousands of liquid stocks, we can always find many risks that are worthwhile relative to the market as a whole. So even if market risk doesn't appear worth taking, we can remain fully invested in stocks which appear relatively attractive, and short the major indices to remove the impact of market fluctuations. That's how we are positioned here, and whether or not the market rewards that position over the near term, I do believe that our capital is being used in a way that provides something useful to the market and the economy.
Index funds? Financials? Google? Well, those are another story.
As of last week, the Market Climate in stocks remained characterized by unusually unfavorable valuations and market action so tenuous that it remains indistinguishable from an unfavorable condition. There remains a small amount of hope that investors will rekindle a risk-taking spirit. Market action would bear that out not so much by a sharp advance but by improved quality of market action (e.g. internals, industry action, breadth, leadership, expanding trading volume, and so forth). That sort of action is still wanting here, so the diversified stock portfolio held in the Strategic Growth Fund remains fully hedged with an offsetting short sale in the OEX and Russell 2000 not to speculate on a market decline, but simply to remove the impact of market fluctuations as much as possible. We also continue to hold a fraction of 1% of assets in call options strictly to hedge the contingency of a favorable shift in market action, given that we have not yet observed a definitive amount of deterioration there.In bonds, the Market Climate remains characterized by modestly unfavorable valuations and market action, holding the Strategic Total Return Fund to a limited duration of about 2.3 years, mostly in Treasury Inflation Protected Securities. The Fund also holds about 15% of assets in precious metals shares, for which the Market Climate remains favorable. Further economic weakness would be a substantial positive for precious metals shares, as the share valuations remain fairly reasonable, and precious metals typically fare best during periods of declining real interest rates and dollar weakness. I don't view the U.S. dollar as particularly overvalued from the standpoint of inflation (PPP) or interest parities, but our massive external financing gap remains an important source of risk for the dollar.
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