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November 29, 2004

Watching Breadth

John P. Hussman, Ph.D.
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After a modestly positive, holiday-shortened week, the investment picture remains largely unchanged. The market's breadth was quite strong, however, with nearly 2000 more issues advancing than declining on the NYSE.

Probably the main near-term issue for the market is that it remains overextended, with most indices well above typical trend-following moving averages. That creates something of a risk for trend-followers, mainly that the market would have to decline some distance before breaking any of those supports. So trend followers are probably acutely aware that they have no reliable way to limit potential losses here aside from taking a few profits. At the same time, the market's modest 2004 performance left managers very eager to chase stocks during the recent rally, in an attempt to achieve decent comparative returns. Now that prices are elevated, there may be some tendency to sell equally quickly in order to defend the crumbs that have been so hard won. Investment advisory bullishness remains high. Insider selling has accelerated to 5.5 shares sold for each purchase. And again, watching major indices will be of little help in giving useful indications of risk, unless and until prices have already declined quite a bit.

All of which leads me to place heightened attention on market breadth for the next few weeks. Of most concern would be a substantial reversal in the momentum of breadth, which we would observe on even a single week of breadth featuring a preponderance of declines compared with advances. Coming off of a speculative rally like we've experienced in recent weeks, a strong breadth reversal would take on added importance. Not a prediction, but something to watch.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and still moderately favorable market action. This is clearly a market supported by speculative merit, not investment merit. While such conditions are generally associated with positive returns, on average (keeping us holding a modest positive exposure to market fluctuations here), the very overextended condition of the recent rally does mean that commonly used trend-following approaches will not be very effective in defending capital here.

For our part, we continue to focus on the finer behavior of market internals, currently with a particular emphasis on breadth (noted above), industry action, interest rate spreads, and other factors noted last week. For now, the Strategic Growth Fund remains modestly constructive, with a roughly 20% exposure to local market fluctuations. That exposure continues to be the result of fully hedging the Fund's stock positions with put options, but not completely offsetting those puts with corresponding short call options. The result is a position that looks fully hedged on a substantial market decline, looks about 20% exposed to local fluctuations, and looks about 35-40% exposed to market fluctuations in the event of a strong further market advance.

Suffice it to say that our investment position remains modestly constructive. Still, I am comfortable with the fact that the Fund would be fully hedged against the impact of market fluctuations in the event of a significant downturn. Of course, even if the Fund is fully hedged against overall market fluctuations, we always intentionally accept a certain amount of "active risk" inherent in our stock selection. When the Fund is fully hedged, the potential for our stocks to perform differently than the market is both our primary source of risk, and our main source of potential return.

In bonds, the Market Climate remains characterized by modestly unfavorable valuations and modestly favorable market action. The Strategic Total Return Fund continues to hold a portfolio duration of about 2.5 years (meaning a 100 basis point change in interest rates would be expected to impact the Fund by about 2.5% on account of bond price fluctuations). The Fund continues to hold about 17% of assets in precious metals shares, which at present is the primary source of day-to-day movements in net asset value.


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