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October 18, 2004

If Humans Only Had One Hand, 7 Would Be 12

John P. Hussman, Ph.D.
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We rarely realize how much our perception of the world depends on the way we choose to measure things, and the objects that we put at the center. Our number system is driven largely by the accident of having 10 fingers, and because of that, we end up describing the universe with all sorts of funny numbers, like pi (3.141592…) and e (2.718281…), and have to construct imaginary numbers like “i.” When you realize that all of those infinitely long transcendental numbers actually have a very simple relationship (e raised to the pi*i = -1 : geeks note - you can prove this using a Taylor expansion) you start to realize that we've probably complicated things unnecessarily by working with the wrong units.

Until Nicolai Copernicus came along, astronomers used very complicated theories to explain the movement of the planets, why they became dimmer and brighter as they circled around the Earth, and why they would sometimes stop and move backward for a while (retrograde motion) before continuing their orbit. Interestingly, even Copernicus didn't go so far as to deny that the the sun and all the planets revolved around the Earth (for fear of being condemned as a heretic). Instead, he simply suggested that you could calculate the planetary movements more easily if you assumed that the sun was at the center, even though, he took pains to emphasize, it wasn't.

Investors face similar complications when they choose earnings as the center of their investment analysis. The dimming planets and retrograde motion of investment analysis appear as a variety of “adjustments” to P/E ratios – PEG ratios, the Fed model, corrections for capital intensity and leverage, industry-by-industry benchmarks, and so forth. The end result is a twisted set of complicated rules-of-thumb to guess whether a particular stock (or the market itself) is cheap or expensive.

In my view, earnings are simply the wrong unit to place at the center of the analysis. What matters, very simply, is the stream of cash that investors actually have a claim upon, after all obligations to other stakeholders have been met. True, in order to communicate to a large number of readers, I often couch my views in terms of P/E ratios (but even then, use my own “adjustments” such as the use of peak earnings in order to filter out recession-induced swings). But ultimately, values are based on the stream of cash you actually receive as a shareholder over time.

The reason for my concern here is that earnings are currently quite elevated relative to nearly every other fundamental. That's another way of saying that ratios like price/revenue, price/dividend and price/book are still off the chart relative to historical norms, while the price/peak earnings ratio is merely at the same level as the 1929, 1972 and 1987 market highs. We observe a high ratio of earnings to revenues in the form of high profit margins, a high ratio of earnings to dividends as a low payout ratio, and a high ratio of earnings to book values as high return on equity. If current, unusual profit margins, payout ratios and returns on equity are now the norm, then fine, stocks are simply overvalued to the same degree that we've seen in a handful of previous instances. But if those margins aren't sustainable, as they historically have not been in a competitive economy, then stocks are actually even more expensive than price/earnings ratios would have investors believe.

The bottom line is that as earnings reports come out in the weeks ahead, investors should keep in the back of their minds that they are looking at a fairly unreliable measure of stock valuations. What we're really interested in is the stream of cash that investors have a claim upon. At present, that stream of cash remains unusually small relative to going prices.

Market Climate

The Market Climate for stocks remains characterized by unusually unfavorable valuations and modestly favorable market action. Despite high valuations, it does not follow that stock prices must decline anytime soon. Indeed, given that the recent decline has cleared the overbought condition of a few weeks ago, there's an even chance that stocks could enjoy one of the “fast, furious, prone-to-failure” rallies that we've seen again and again this year after oversold conditions have been cleared. That, of course, is not a forecast either. For us, it is sufficient to recognize that until further breakdowns in market action occur (which may show up in market internals rather than in substantial declines from the major indices), the Market Climate remains one that has produced a modestly positive return/risk profile on average. So while our stock holdings in the Strategic Growth Fund are well-hedged, we also hold a small but important position in call options sufficient to produce a roughly 35% exposure to market fluctuations should the market enjoy an extended advance.

In bonds, the Market Climate remains characterized by modestly unfavorable valuations and tenuously favorable market action. Again, that doesn't imply any particular directional forecast. Rather, it suggests that the overall probability distribution of returns here has a relatively mundane average profile of return and risk. I don't view bond market risks as particularly high here, but on average, the current Market Climate hasn't produced much in the way of returns either. For that reason, the Strategic Total Return Fund continues to have a relatively low duration of just under 2 years (meaning that a 100 basis point move in bond yields would be expected to have a roughly 2% impact on Fund value on account of bond price fluctuations). That duration is mostly in Treasury Inflation Protected Securities. The Fund also continues to hold about 14% of its assets in precious metals shares. I would be inclined to increase this position on credible evidence of economic softening (as I noted a few weeks ago, the main additional element for a recession warning here would be a decline in the ISM Purchasing Managers Index below 50). It is notable that consumer credit declined last month, help wanted advertising remains weak, the current account deficit continues to deteriorate, and lumber futures are suddenly falling out of bed (a concern for housing). Until we observe more definitive evidence of economic weakness, however, our exposure to precious metals will remain comfortably moderate.


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