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July 5, 2005

Gestalts and Aunt Minnies

John P. Hussman, Ph.D.
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Fund News: I'm pleased to report that last month, your Board of Trustees approved fee reductions in the advisory, administration and custody schedules of the Hussman Funds, which allows us to reduce the expense ratio of the Strategic Growth Fund again, to 1.17% as of July 1, 2005. The expense ratio of the Strategic Total Return Fund remains capped at 0.90%, but the fee reductions substantially lower the breakpoint at which we expect to be able to reduce that expense ratio as well. As usual, the expense ratios of the Funds are affected by the amount of fund assets and fee breakpoints, and may increase or decrease over time. Please note that ratings services typically base their expense information on the figures published in annual reports, which look back to the prior year. For that reason, figures reported by these services can substantially lag changes in the actual expense ratios for each Fund.

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I grew up in a family of medical doctors. Dad was a general practitioner and a surgeon. Mom was a pediatrician (which made it pretty easy to get an appointment). Both taught me that the art of making a good diagnosis is in asking the right questions. You don't just run a bunch of tests. You look to understand the patient holistically enough to recognize characteristic patterns.

In German, a pattern like this is called a “Gestalt” – a grouping of elements that is sufficient to identify a unified whole when viewed together, even though it might be impossible to recognize the whole or discover its characteristics from a simple summation of parts.

Evidently, there are many complex phenomena that have an underlying “signature.” In many cases, a particular set of symptoms can be “pathognomonic” (distinctly characteristic) of very specific condition, even if each of the individual symptoms might themselves be common.

For example, low grade fevers are common, as are nausea, stomach ache and difficulty eating. But if, in addition, you press the lower left side of the abdomen and it hurts on the right side when you let go, and the person can't even imagine being able to jump, there's a very high probability that the person has appendicitis.

My brother Karl (a radiologist) calls these “Aunt Minnies” – patterns on an X-ray or MRI that can only mean one thing. You might observe a tumor on the nerve of the inner ear, but if you've got them on both sides, it's the Aunt Minnie for Von Recklinghausen's disease.

In his fascinating book Blink, Malcolm Gladwell talks about “rapid cognition” and “thin slicing” – the ability of our unconscious to find patterns in situations based on very narrow or brief slices of observation; to capture in the blink of an eye the essential information necessary for a sophisticated judgment.

Gladwell notes that in one study, three factors had a 95% accuracy in discriminating whether patients admitted to the ER with chest pain were at high risk of heart attack or not: 1) is the patient experiencing unstable angina? (spasmodic attacks of suffocative pain due to reduced oxygen to the heart); 2) is there fluid in the patient's lungs? (which typically produces a crackling sound in the stethoscope) and; 3) is the patient's systolic blood pressure below 100? Those three symptoms are an Aunt Minnie. Today, if a patient is admitted to Cook County hospital in Chicago , the more of these factors a patient has (particularly with an abnormal electrocardiogram), the greater the chance they'll be sent directly to the cardiac care unit.*

The whole is more than the sum of the parts

If we look at individual characteristics of the current stock market environment, we see at worst an ambivalent picture – valuations are awful, but interest rates and inflation are not particularly hostile; credit spreads are widening, but not exploding; economic growth seems to be slowing, but the Purchasing Managers Index is still holding up; trading volume is dull on rallies and becomes active on declines, but market breadth as measured by advances vs. declines is acting very well, as is leadership as measured by new highs vs. new lows; the current account deficit is strikingly unfavorable, but except in relation to Asian currencies, the U.S. dollar doesn't appear significantly overvalued on the basis of prevailing interest rates and international price levels. From this standpoint, it's clear that market risk isn't likely to be enormously rewarding, but also doesn't seem that the market's condition is precarious in any near-term sense.

Consider, for example, the following observations. First, among investment advisors, Investors Intelligence reports that only 19.1% are bearish, which seems dangerously low. Still, if you look at times since the 1960's when bears were fewer than 20%, the market has historically followed with positive returns over the following weeks at a rate of about 7.3% on an annualized basis – that's clearly lower than the historical norm, but not profoundly so.

Next, we observe the market at a price/peak-earnings ratio of nearly 20. As I've noted frequently however, high valuations aren't particularly informative of near-term returns. In fact, if you look at near-term (not longer-term) returns, price/peak earnings ratios over 18 have historically been followed by positive returns averaging about 8.9% on an annualized basis. It's only over longer horizons that high valuations produce predictably unsatisfactory returns.

What about rising short-term interest rates? Surely the series of tightenings by the Fed must be important. What about 3 steps and a stumble? Well, as it turns out, rising short-term interest rates haven't historically exerted much effect on near-term returns either. When Treasury bill yields have been above their level of 6 months earlier, the S&P 500 has followed with returns over the following few weeks averaging 7.3% annualized. Again, somewhat below average, but still OK.

Finally, we can look at the S&P 500, which remains above its 200-day moving average. When this has been the case, stocks have actually advanced at an above-average rate over the following weeks, averaging an annualized return of about 11.8% under these conditions.

So again, taking all of those together, it doesn't seem like there's much cause for concern.

Except that I've just described an Aunt Minnie.

If we look historically, there are only a handful of occasions when we've seen a richly overvalued, still advancing market, with extremely low bearish sentiment, despite rising short-term interest rates. The only instance in recent history was early last summer, just before the market's mid-year plunge. The instance prior to that was August 1987, at the market's pre-crash peak. Before that, December 1972, just before the start of the 1973-74 bear market plunge. Before that, mid-1965, just before the market lost over a quarter of its value in a bear market, and began a 17-year period of tepid returns.

Now, that's not to say that we can take these prior outcomes as forecasts, but it certainly does feed into a certain comfort with our relatively defensive stance at present. I did re-establish a modest contingent call option position early last week on market weakness, but this position remains only a fraction of 1% of assets. That gives us some potential to participate in any near-term market strength that might emerge, and adequately reflects the positive features (e.g. breadth, leadership) that I still observe. With respect to our broad investment position in the Strategic Growth Fund, however, the Fund remains well hedged against the impact of any major market fluctuations that might emerge, particularly if they are to the downside.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and modestly unfavorable market action. As noted above, the Strategic Growth Fund does have a small contingent position in call options, in recognition of the fact that breadth and leadership remain generally firm, credit spreads have stabilized modestly, and so on. Still, the broad Gestalt of the market here is not very compelling in terms of the average return that market risk can be expected to deliver. For now, the Strategic Growth Fund remains well hedged.

In bonds, the Market Climate remains characterized by unfavorable valuations and relatively neutral market action. I continue to believe that positive inflation surprises should not be ruled out, and that the bond market is too quick to accept the premise that muted economic growth will easily translate into stable or lower bond yields. Credit spreads have been behaving better in recent weeks, which combined with higher short-term interest rates is likely to raise monetary velocity, and with it, inflationary pressures.

Think of velocity as the extent to which currency is a hot potato. If people are worried about bankruptcies, and interest rates are very low, there is a much greater willingness to hold onto cash balances (or stuff them under a mattress), which means that the government can create more money without inflationary consequences. In contrast, when credit risks are not viewed as a near-term problem, and short-term interest rates are rising, money becomes something of a “hot potato,” and its value declines relative to the value of goods and services, which we observe as inflation. In short, despite the benign CPI and PPI figures in the latest reports, investors should not become too comfortable that inflation is a non-issue.

* Nothing in this article should be construed as medical advice. Then again, anyone who would seek their fund manager for medical advice probably does need their head examined.


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