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May 2, 2005

The Sound of One Hand Clapping

John P. Hussman, Ph.D.
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Among the more difficult lessons of investing is that securities should generally be bought on weakness, unless it's the sort of weakness that should be sold.

To ask whether a falling price is bullish or bearish is like asking the ancient Zen koan “What is the sound of one hand clapping?” The question seems absurd if you take it at face value, but can lead to enlightenment if you stare at it long enough to see the interconnectedness of things.

The fact is that strength or weakness can be favorable or unfavorable, depending on the source of the strength or weakness. On one hand, weakness can mean that a stock is a better value. On the other, weakness can mean that investors are becoming risk averse, or that the market expects negative developments such as earnings shortfalls or a recession ahead. The only way to understand – to discern which of those possibilities represents the truth – is to evaluate the movements of the market in the context of everything else.

It's not enough to ask whether prices are falling. One needs to ask which prices are falling, which are not, and how does each movement differ from what one would expect given everything else that's going on? As I frequently say, the information is always in the divergences - you can only understand one thing in the context of other things.

Dualistic (bull/bear, good/bad, us/them) thinking keeps us from looking deeply, understanding the situation, and discovering truth – which might be simple, but might also be complicated, uncomfortable, uncertain, and messy. Unfortunately, investors try to create the illusion of black-and-white certainty by taking sides, and interpreting things only from the standpoint of their current position. They decide that it's a bull market and look for cheerful evidence to confirm that belief. Or they decide that it's a bear market and wake up every day, hoping for news of disaster. When our interpretation of events depends on the position we have, we're taking sides rather than seeing truth.

Taking this back to finance, look at the 10-year Treasury, for example, and you'll see a moderate dip in yield, but nothing that presents much information. Combine it with observations on T-bill yields and corporate yields, and you immediately see a flattening yield curve and widening credit spreads – both important indicators of potential economic weakness.

Look at the S&P 500 index, for example, and you'll see a moderate decline from its peak – which has generally been associated with good buying opportunities over the past two years. But combine that with observations of weakening market breadth, an increasing number of new lows, sharp expansion of trading volume on declines with dull volume on advances, uniform breakdowns across a wide variety of industry groups, rich market valuations, and other context, and it becomes clear that this decline is qualitatively different in character from prior ones. Investors appear to be displaying a growing skittishness toward risk. In general, the combination of rich valuations and increasing risk aversion has been a dangerous one for stocks.

That said, we have absolutely no attachment to a defensive position, and will change our investment stance as the evidence changes. No forecasts required. To take a side and look at the markets through a "bearish" or "bullish" lens would just prevent us from seeing things as they are, as they develop, as they relate to each other.

Everything exists in context of other things. As the Buddha said, "This is, because that is. This is not, because that is not." There is no sound of one hand clapping – no existence, no information, no truth without interconnectedness to everything else.

Precious metals stocks appear increasingly attractive

One of the areas in which we've observed price weakness recently has been among precious metals stocks. Indeed, weakness in this group has been the main source of the modest -3.36% decline in the Strategic Total Return Fund since its most recent high on November 22, 2004. Though a periodic sideways lack of progress is neither unexpected nor of concern, it's a little bit tedious – particularly when it emerges as a result of a single group. Why not just sell the gold stocks and be rid of them?

The short answer is that there's a good possibility that precious metals shares may produce stellar returns over the coming year. Last week, I added modestly to our precious metals positions in the Strategic Total Return Fund, to just short of 20% of net assets. In the Strategic Growth Fund, I increased our exposure to nearly 5% of net assets, which I view as a sufficient overweight relative to the market for a diversified stock fund.

Probably the simplest way to emphasize conditions in the precious metals shares is to examine a simple valuation indicator that is, surprisingly, nearly as useful as much more sophisticated indicators: the ratio of the spot price of gold to the Philadelphia XAU Index. On Friday, spot gold closed at 434.39, while the XAU closed at 83.51. That put the Gold/XAU ratio at 5.20.

To put some historical context on this measure, since 1974, the Gold/XAU ratio has been greater than 5.0 about 15% of the time. When the ratio has been this high, the XAU has followed with annualized gains of 89.6%, on average – a figure that remains high even if the data is split into multiple samples. When the ratio has been greater than 4.0, the XAU has followed with average annualized gains of 27.4% (though the finer profile of returns has been sensitive to other conditions such as interest rates, economic trends, and inflation). In contrast, when the ratio has been less than 3.0 (meaning that the gold stocks are very elevated relative to the actual metal), the XAU has declined at an annualized rate of -36.6%, on average.

Importantly, the return/risk profile for precious metals shares is strengthened further if the economy is experiencing weakness. For example, when the Gold/XAU ratio has been greater than 5.0 and the ISM Purchasing Managers Index has been less than 50 (indicating a contracting U.S. manufacturing sector), gold shares have appreciated at an average annualized rate of 125.6%. In contrast, when the Gold/XAU ratio has been less than 3.0 and the Purchasing Managers Index has been greater than 50, precious metals shares have plunged at an average annualized rate of -49.9%.

Given increasing evidence of a potential economic slowdown, there's a good likelihood that precious metals may remain in a very favorable set of conditions for perhaps a year or more, first by reason of unusually favorable valuation measures, and subsequently by the combination of moderately favorable valuation measures combined with economic weakness.

Unfortunately, against the favorable profile of expected returns, it's important to emphasize that precious metals are among the most volatile industry groups in the market. For that reason, any given expectation for potential returns has to be tempered by risk considerations. It would be one thing to have an expected return potential of say, 50% for the S&P 500, which in context of typical market volatility, might warrant a leveraged investment position. It's another thing entirely to have that expected return potential in an industry with several times the volatility as the general market.

As usual, the size of our investment position is aligned not simply with the expected return, but with the expected return per unit of risk. In that context, I am very comfortable with a 20% exposure to precious metals shares in the Strategic Total Return Fund, and about 5% in Strategic Growth. If we observe some combination of better valuation and/or economic weakness, those exposures might increase by a few percent.

That said, these comments are intended only to articulate part of my thought process in establishing our moderate positions in precious metals shares, and should absolutely not be used as investment advice, or as any suggestion that investors should establish additional or aggressive investment positions in precious metals elsewhere.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully invested position in stocks, with an offsetting hedge of equal size in the S&P 100 and Russell 2000 indices. This means that on average, I expect the Fund to experience little impact from overall market fluctuations. When the Fund is fully hedged, its returns are driven primarily by the difference in performance between the stocks that we own and the indices we use to hedge. Since the inception of the Fund, this difference in performance has been a significant contributor to overall Fund returns.

As usual, however, I have no expectation that our stocks can or will outperform the market consistently on a day-to-day basis. Depending on the specific performance of individual stocks or industry groups, we can and will experience consecutive days or weeks of outperformance or underperformance. So the Fund may decline on a declining day for the market, and then decline again on an advancing day for the market. It may advance on an advancing day as well as on a decline. Every sort of combination is possible, and none should be interpreted as a typical “pattern.” Again – and I can't emphasize this enough – the whole point of a hedged position is to reduce the impact of market fluctuations on the Fund. But the hedge certainly will not eliminate day-to-day fluctuations in Fund value, or ensure consistent short-term returns.

In bonds, the Market Climate remains characterized by moderately unfavorable valuations and moderately unfavorable market action, holding the Strategic Total Return Fund to an overall duration of just under 2 years (meaning that a 100 basis point move in interest rates would be expected to impact the Fund by about 2% on the basis of bond price fluctuations). The primary source of day-to-day volatility in the Fund is likely to continue to come from the Fund's nearly 20% exposure to precious metals shares. On a day-to-day basis, this group can be volatile, so in the interest of perspective, it is useful to remember, for example, that even a further 25% decline in this group would impact the Fund by just 5% (20% x 25%). Though I view such a potential loss as unlikely, it can't be ruled out. However, that risk is, in my judgment, commensurate and acceptable given the potential returns in precious metals shares here.

As a final note, the spread between LIBOR and Chinese interbank rates has now widened to a 4-year high, while the Treasury bill – Eurodollar spread hit a new low on Thursday. As I noted in my March 28 comment, the pattern of these spreads is indicative of increasing risk of a yuan revaluation. I don't view a revaluation as quite imminent, but it does appear that the timeframe for revaluation is shortening. A shortfall or reversal of foreign capital flows to the U.S. in that event will probably be an important contributor to whatever U.S. economic slowdown might lie ahead.


     
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