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September 26, 2005

The Moon is in the Sky

John P. Hussman, Ph.D.
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There are several Buddhist stories where a novice approaches a Zen master with some very theoretical or metaphysical question. The Zen master's response is usually simple:

“Drink your tea”

or

“Wash your bowl”

or

“Look at the cypress in the courtyard.”

The point of these answers is to discard the questions as useless subjects – to instead encourage the person to wake up and be fully present in reality.

Asking “Where will the S&P 500 be at year-end?” is the same sort of question. The proper answer is something like: “The moon is in the sky.”

To ask where the market is going next is to imagine that we have a way of knowing or controlling short-term events that are unknowable and uncontrollable. If the past few weeks have demonstrated anything, it is that the markets are influenced by events that can't be accurately predicted even a few days in advance.

The best we can do is to focus on what is observable in the present, including all the “causes and conditions” we can observe today that have the potential to affect the markets in the future. Even if our objective is to achieve future returns, the attention still belongs on what is observable right now. We don't align ourselves with some specific forecast. We align ourselves with what those prevailing causes and conditions imply on average about return and risk.

Valuations contain reliable information about the long-term returns that stocks are priced to deliver. In addition, elevated valuations make us aware of the potential for volatility and disappointing losses in the intermediate term, while depressed valuations make us aware of the potential for strong, sustained appreciation.

Likewise, market action contains an enormous amount of information about what others know, and about the current preference or aversion of investors to risk.

Most of the time, attention to prevailing, observable reality is enough to make good investment decisions. Making specific predictions and planning out detailed market “scenarios” has no added usefulness.

Staying open to new evidence

Considering valuations and market action together isn't a restrictive approach, but rather a way of saying that the market has to be looked at as an integrated whole. However useful valuations and market action may be, it still doesn't mean that we can become overly attached to specific rules. The objective is to understand reality as it is, not to force it into narrow concepts or look at it through a particular lens.

More than a few investors have endured major losses by ignoring evidence that contradicts their beliefs, insisting that the market always rises after two interest rate cuts, or even that an overvalued market must go down. The current anesthetic forecast - that the market usually does well six months after a hurricane – shouldn't be insisted on either. You don't ignore that evidence, but you take it as part of a broader whole.

Jason Zweig recognized this openness to new evidence when he reviewed various editions of Benjamin Graham's book Security Analysis : “One of the common criticisms made of Graham is that all the formulas in the 1972 edition are antiquated. The only proper response to this criticism is to say: ‘Of course they are! They are the ones he used to replace the formulas in the 1965 edition, which replaced the formulas in the 1954 edition, which, in turn, replaced the ones in the 1949 edition, which were used to augment the original formulas that he presented in Security Analysis in 1934.' Graham constantly retested his assumptions and tinkered with his formulas, so anyone who tries to follow them in any sort of slavish manner is not doing what Graham himself would do if he were alive today.”

So even though we should require reasonable evidence before we ever conclude “this time it's different,” we still have to entertain the possibility by never being too sure about anything (which is also where good risk management comes in). Indicators, rules, signals, ratios, and price charts are ways of organizing reality, but they aren't reality itself. They are “a finger pointing to the moon.” The same is true of any concept. As Thich Nhat Hanh writes* “To see the moon, we use the finger, but we must not mix up the finger and the moon. The finger is not the moon.”

The moon is in the sky.

Market Climate

Reviewing the current “causes and conditions” in the markets, as of last week, the Market Climate for stocks was characterized by unusually unfavorable valuations and relatively neutral market action. There continues to be a deteriorating bias, evidenced by flagging breadth, an expanding number of new lows among individual stocks, breakdowns in the action of various industry groups, and so on. Still, the market is technically somewhat oversold, and it's common to see a certain amount of disarray in market action at intermediate term lows in the market, so we shouldn't be too quick to rule out that possibility.

Suffice it to say that while the quality of market action has continued to decline, we would have to see somewhat more deterioration before concluding that investors have become clearly skittish about market risk. Until that happens, we'll continue to accept at least a modest amount of exposure to market fluctuations.

In the Strategic Growth Fund, this exposure is currently just about 10% of portfolio value, ranging between about 5-15% depending on day-to-day opportunities. The remaining 90% of our stock exposure is hedged against the impact of market fluctuations with offsetting short positions in the S&P 500 and Russell 2000 indices.

At an 85%-95% hedged position, it's reasonably clear that I don't expect a very good average return/risk tradeoff in stocks. Still, it's not quite negative either. Among the areas I'm watching with great attention are breadth, credit spreads, mortgage/housing stocks, and transportation stocks. All of those are more important, in my view, than the price of oil. Oil prices will be predictably volatile, and therefore largely uninformative. In contrast, any substantial widening of credit spreads or deterioration in key sectors of the economy will have more pointed implications.

We'll probably get some useful information about recession risks in the ISM figures and employment data due next week. Until the market gets something solid, near term action is likely to be dependent on day-to-day news items. Rita was less damaging than expected, so we shouldn't be surprised if there's some relief there given the market's oversold condition. The quality of any such rally in terms of individual stock and industry breadth will also be informative. In short, we'll have a good amount of new information within a couple of weeks which could affect our investment stance. For now, that stance remains very slightly constructive, with a small net exposure to market fluctuations.

In bonds, the inflation picture is currently pressuring yields more than the prospect of economic weakness is helping them. Here too, a substantial widening of credit spreads would be an important development. In this case, wider credit spreads certainly wouldn't help corporates or low-grade bonds, but it would be a definite plus for Treasuries. The reason is that default risk typically induces a decline in monetary velocity (picture people stuffing cash under their mattresses, with the result that a given stock of government liabilities can be absorbed without creating inflation pressures). So increasing credit risks would likely tip the balance in favor of intermediate and longer-term Treasuries.

Currently, however, our duration is still very limited, with the Strategic Total Return Fund carrying a duration of only about 2 years, mostly in Treasury inflation protected notes, as well as Treasury bills (where yields are nearly competitive with longer-term bonds due to the flatness of the yield curve). The Fund continues to carry a 20% position in precious metals shares. It's important to recognize that despite what I still view as a favorable Climate in the precious metals market, precious metals shares are volatile, so even that 20% position will induce a certain amount of fluctuation in Fund value that I prefer not to hedge away. So at least for now, precious metals shares are likely to account for most of the day-to-day volatility in the Strategic Total Return Fund.

* Thich Nhat Hanh, Zen Keys, Three Leaves Press, 2005


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