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March 28, 2005

By a Thread

John P. Hussman, Ph.D.
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Straight to the Market Climate – as of last week, the Market Climate for stocks was characterized by unusually unfavorable valuations and market action so fragile that it can only be called tenuous and borderline – the term “favorable” can no longer be applied in good conscience, but there hasn't yet been a clear breakdown (nor would it be advisable to wait for such a breakdown to defend against market risk here).

The primary factor that sustains any benefit of doubt for the market is that stocks are deeply oversold, and the potentially fast, furious character of a rebound from that condition could – depending on the quality of the bounce – be enough to demonstrate a continued willingness of investors to take risk. Suffice it to say that the quality of such a bounce, if it occurs, will be crucial. A strong rally in the major indices with weak participation from breadth, volume, and leadership, or worse, with continued deterioration in financials or credit spreads, would be a strong negative.

At present, then, the prospects for the market hang not on economic data, interest rates, or valuations, but on a single question: are investors still willing to accept increasing levels of risk? For our part, valuations and existing deteriorations are sufficient to warrant a substantial hedge against the impact of market fluctuations on the stocks we hold in the Strategic Growth Fund.

About 70% of the value of our stocks is hedged with matched long put / short call option positions. The remainder of the portfolio is hedged with now well in-the-money put options, so these too are behaving as nearly full-hedges. The one allowance that I've made for retention of a favorable Market Climate is a small but important call option position which I executed near Thursday's close, representing less than one-half percent of assets. It's not a major source of exposure, but will help to move the Fund toward a more constructive market exposure in the event of a recovery from the current oversold condition.

[Geeks note: As a result of a tightly enforced arbitrage relationship called “put-call parity”, buying a put option and simultaneously selling short the call with the same strike and expiration does not have time decay. Rather, it is a “conversion” or “synthetic short sale” that replicates a short futures contract, or equivalently, an interest-bearing short sale on the underlying security. The combinations require little capital, reduce the back-and-forth day-to-day cash settlement flows required with futures, are cheaply executed, and have more flexibility to alter the position than futures allow – for instance, I periodically cover a portion of the Fund's short calls in certain environments where the downside protection remains important but market conditions have potential to improve, for example, March 2003].

In short, if the market continues lower here, the Fund's returns should be within about 1/2% of what they would be if the Fund were, in fact, fully hedged. However, we retain a small allowance for the possibility that the quality of market action could improve enough to demonstrate a continued preference for risk by investors.

Among the recent deteriorations, the quality of broad market action has weakened significantly on the basis of the number of declining issues versus advancing ones; expanding trading volume on declines with dull volume on advances; a “flip” in leadership, with more issues recently achieving new 52-week lows than new highs; a marked breakdown in bank and financial shares, which represent the largest industry share of market capitalization; and widening credit spreads, including corporate versus Treasury yields, and BAA versus AAA yields, as well as a few others discussed below.

Market action has also been clearly negative in bonds, while valuations are still not close to the level where bonds can be viewed as good investment values. The Strategic Total Return Fund continues to carry a limited duration of about 1.8 years, primarily in Treasury Inflation Protected Securities (a 100 basis point move in bond yields would be expected to impact the Fund by about 1.8% on the basis of bond price fluctuations).

The main source of day-to-day volatility in the Strategic Total Return Fund, as anticipated, remains its modest holding of precious metals shares, currently representing about 16% of net asset value. Though this group has settled back from its highs in recent weeks, our measures of valuation and market action remain strong, and I view our investment position as moderate, not aggressive. It's important, though, not to overly extrapolate periodic weakness (or strength) from precious metals shares. Considering our 16% exposure, for example, even an unexpected plunge in this group of 20% from already depressed levels would be expected to impact the Fund by about 3.2% (20% x 16%). As usual, it's useful to distinguish “local” risks from “extended” risks in that way. Again, precious metals exposure will probably continue to drive much of the day-to-day fluctuation in the Fund, but I continue to view this exposure as an important part of our investment stance, given current conditions.

Why worry about yuan?

One of the more eclectic concerns I have is being stoked by the spread between LIBOR and Chinese interbank rates, which has moved up to the widest gap in three years.

Without going into… aw heck, let's talk about Eurocurrencies. When we think about bank deposits, we usually think about deposits involving the currency of a particular country, held at a bank in the same country, for example, U.S. dollars in an account at Bank of America, or British pounds at the Bank of England. In contrast, a “Eurocurrency” is a bank deposit held in one country, but denominated in the currency of another country. So for example, a bank deposit denominated in Japanese Yen, but held at Citibank in New York would be a Eurocurrency deposit. (Notice that a Eurocurrency deposit need not have anything with Europe, much less with the European currency, the Euro. Of course, a deposit of Euros at a Swedish bank would be a Eurocurrency deposit in Europe, denominated in the European currency).

The interest rates that banks charge to lend these funds to other banks (much like the Fed Funds rate) are called “interbank offered rates” or IBORs. Normally, the Eurocurrency market looks to London for the benchmark interest rate on U.S. dollar deposits held outside the United States. This interest rate, not surprisingly, is called LIBOR (the London interbank offered rate). There are technically LIBORs on U.S. dollars, Japanese Yen, and other currencies that London banks might hold, but unless another currency is specified, talking about LIBOR is basically equivalent to talking about the interest rate on U.S. dollar deposits held at foreign banks.

Now, when you see LIBOR rising sharply, you can infer that U.S. dollar deposits held internationally are getting scarcer. Importantly, this appears to be more than just Fed tightening. The spread between U.S. Treasury bill yields and LIBOR (the “TED” spread) has gone negative in recent weeks, so foreign interest rates on U.S. dollar deposits are rising even faster than domestic yields. Evidently, either foreign investors are eager to borrow dollars or fewer are willing to save them as time deposits. Meanwhile the depressed level of Chinese interbank rates implies that there is a relative glut of yuan deposits.

Now, why would international financial market participants want to hold onto their yuan but get rid of dollar holdings (or even borrow them)? Hmm.

While I don't yet anticipate an abrupt revaluation of the Chinese yuan (a change in the currency peg that would make the yuan appreciate, or equivalently, the U.S. dollar depreciate), suddenly all of this talk about China and other central banks wanting to “diversify” their holdings away from U.S. dollars seems to be having more bite. Anticipation of that type of event would tend to create just the sort of yuan hoarding and dollar borrowing that's reflected in Eurocurrency spreads (you want to borrow dollars if they're expected to depreciate, of course, so you can pay them back with cheaper dollars later).

The risks of a shift in Chinese currency policy are heightened by the still-polite but increasingly palpable tension between China and the U.S. revolving around Taiwan's hints at independence. It doesn't help that the Administration is filling important international finance and diplomatic posts with judgment-impaired political hacks rather than individuals with suitable talent to address the risks.

In short, international interest rate spreads are useful to watch here. In addition, credit spreads (corporate minus Treasury or low grade corporate minus high grade corporate) are also important. At this point, a further deterioration in credit spreads would be a very strong signal to batten the hatches.

The information is always in the divergences.

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New from Bill Hester: Misfit Stocks


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