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October 31, 2005

Daily Action, Noise, and Ben Bernanke

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

Just a note - The Hussman Funds generally pay their required capital gains distributions during November, which I expect to represent a few percent of each Fund's net asset value. The net asset value of each Fund, of course, declines by the amount of the distribution on the ex-day (thus reducing later capital gains liability). Since part of the gains will be long-term in nature and the distribution is expected to be less than the one-year appreciation in the Funds, investors trading to avoid the distribution would generally increase their tax liability, though we would still reserve the right to prevent new investments from such investors even if this were not the case, in the interests of our long-term shareholders. This is also why we don't preannounce the exact date of the distribution. As a personal matter, I'll make my regular monthly investments in the Funds in early November, both in taxable accounts, which represent my only investments aside from a small amount in money market funds.

There's a lot of misinformation about mutual fund distributions. Investors seem not to take into account the tax impact of the offsetting reduction in NAV. If you work through the math (see the formula at the bottom of this comment), you'll find that when a distribution is partly long-term in nature, the true tax cost of taking the distribution is negative for short-term holders, meaning that short-term investors actually have an incentive to buy the Fund in order to capture the distribution, while long-term holders have no incentive to avoid a distribution if they have more than minimal unrealized gains, and even potential long-term investors have little incentive to defer investment unless the anticipated return over the deferral period is small.

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Daily Action

I've often noted that in most things, success isn't the result of monumental leaps, extraordinary insights or excruciating efforts – it's the result of daily action. You find a set of actions that you believe will produce outstanding results if you follow them consistently, then you follow them consistently.

Among my daily actions are those that align our investment position with the current combination of valuations and market action (the "Market Climate"), and which take daily opportunities to buy attractively situated securities on short-term weakness and sell less attractively situated holdings on short-term strength. If the action of buying low and selling high is an element of long-term investment success, then that practice absolutely has to be an element of daily action as well.

If you choose and control your daily actions carefully, the results will come, though not always on a predictable schedule. In contrast, if you try to control outcomes without focusing on daily actions, you'll find yourself constantly reacting and overreacting to insignificant deviations from what you think you “should” be achieving. There is no such thing, in a world of randomness and uncertainty, as exquisite control of outcomes.

The simple fact is that in the financial markets as in other areas of life, outcomes are surrounded by “noise,” so there's not a tight one-to-one link between causes and observed effects. If you're guided only by short-term results and judge the quality of your actions each day based on the outcome you observed that day, you can never get a durable feeling of success. Instead, your actions are going to be dictated by an enormous amount of noise.

In short, the objective is to control day-to-day actions, not day-to-day outcomes. Good results are just the accretion of small, careful actions that you believe will produce success if you take them consistently. The Buddha said, “joyful is the accumulation of good work. Hold not any deed to be of little worth, thinking ‘this is little to me.' The falling of drops of water will in time fill a water jar. Even so the wise man becomes full of good, although he gathers it little by little.”

Day-to-day Fund movements

As a result, as long as I'm comfortable that our overall risks are well managed, I pay almost no attention to small day-to-day fluctuations in the Funds. They are, for all intents and purposes, noise. For example, the Strategic Growth Fund holds over 200 stocks, most with investment positions ranging from 0.5% to 2% of assets. Even when the Fund is fully hedged against overall market fluctuations, a particularly large move in two or three of these stocks can easily induce a fluctuation of a fraction of a percent in the value of the Fund on any given day. Often these movements are positive, and account for the substantial margin by which our stock holdings have outperformed the major indices over time. Last Wednesday, as also happens from time to time, we saw weakness in a few stocks, including Biosite (BSTE), which combined to induce a decline of about half a percent in Fund value. This sort of day-to-day, positive or negative “tracking error” should be expected particularly when there is a lot of dispersion in the action of the major indices and various industry groups.

Similarly, it's essential to remember that the identification of a particular “Market Climate” has virtually no use in short-term forecasting. A Market Climate is essentially a “hat” which holds various positive and negative returns that have historically occurred under a particular set of conditions. Every one of those hats includes both positive and negative market movements – it's just that the average return and risk profile varies across hats. So to say that the market remains in what has historically been a very hostile Climate says very little about where the market will go next week, because short-term action is dominated by noise which only cancels out over a large number of observations. That's particularly true here, since the market remains somewhat oversold. Suffice it to say that for now, I observe market conditions that have been hostile to stocks, on average, but that my evaluation will change if the quality of market action improves. Of particular importance is the “sponsorship” that investors display toward stocks in terms of breadth, trading volume, and other indications that investors have a uniform preference to accept risk.

Ben Bernanke

One of the things I liked about Paul Volcker and Alan Greenspan was that both had fairly strong and well-integrated views about how financial markets and the economy are inter-related as part of a large equilibrium. Both took a great deal of information from financial markets, and though I occasionally disagreed on the interpretation of that information, the fact that they were looking at it created a certain amount of confidence.

While Ben Bernanke has good academic credentials, it's hard to identify the same set of core principles in his work that you'd want in a Fed Chairman. There's not the independent streak of Volcker, who believed that it was not the Fed's job to monetize the federal debt, and thereby allowed the federal debt to become an issue that had to be addressed (and was, with reasonable success, over the following 10-15 years). There's not the intellectual breadth of Greenspan, who – while taking such a benign view of asset overvaluation as to risk serious price declines and attendant economic problems down the road – had very strong views about free markets, and at least made you think.

It's still an open question whether Bernanke will incorporate attention to the financial markets into his views of monetary policy, but so far his stated views on the subject are straight from Chico and the Man – “Is no my job.”

As many shareholders are aware, I actually believe that the Fed is largely irrelevant to the determination of broad economic activity, though it plays a central role in providing liquidity during periods of financial crisis (see A Brief Primer on Economics and Why the Fed is Irrelevant). Even so, the Fed does have the ability to conduct policy in a way that either increases or suppresses noise and volatility. My concern is that Ben Bernanke will lean toward increasing volatility, particularly in interest rates.

The main issue is this idea of “inflation targeting.” I'll say it again – you can control actions, not outcomes. If you focus on controlling outcomes, you'll find yourself constantly reacting and overreacting to insignificant deviations from what you think you “should” be achieving, and your actions are going to be dictated by an enormous amount of noise.

Consider Paul Volcker and Alan Greenspan, both very successful Fed Chairmen in the context of the challenges that each faced. Though they followed very different policies, they shared one thing that was absolutely critical to their success – their policy target was something they could actually control. Volcker chose money supply targets. Greenspan chose Federal Funds targets. Importantly, these are essentially the only tools available that the Fed directly controls. By choosing one, you essentially have to let go of the other – allowing it to be a “slack” variable that does the job of adjusting to various shocks in the economy.

To see what this looks like, here are two charts, one for Volcker's tenure, the other for Greenspan's. The charts depict the monthly change in the Federal Funds rate and the monthly percentage change in the adjusted Monetary Base (which is the only monetary aggregate that the Fed can precisely determine). Notice that under Volcker, money growth is relatively stable, and the Fed Funds rate is the “adjustment variable” that flies around to absorb economic shocks. In contrast, under Greenspan, the Fed Funds rate is very well behaved, and money growth is the swing variable.

 

While each Chairman was successful in his own right, the implications for interest rate volatility and money growth (and hence the extent to which fiscal deficits took the form of public debt) were very different. Still, each focused on tools that they could actually control.

Bernanke, on the other hand, leans toward a policy target – inflation – that is not directly under Fed control. It seems to be taken as an article of faith that the Fed determines inflation, but in fact (see the articles noted earlier), inflation is not so much a monetary phenomenon as a fiscal one. It is essentially a reflection of unproductive government spending. Moreover, the belief that you should respond to inflation by tightening monetary policy is in some cases very dangerous. If you look closely at the data, you'll find that economic growth and inflation over the same period actually have a negative correlation. Greenspan was always very careful to distinguish between economic growth per se, and demand growth. The point of tightening was never, never to slow the economy – it was to slow demand under conditions where it was clear that certain constraints (such as labor markets or capacity use) were starting to bind in a way that would prevent that demand from being satisfied by new supply.

If you miss all of that analysis and just respond to higher inflation by tightening monetary policy, it's very possible that you'll increase what's called “monetary velocity” and worsen the situation rather than helping it (essentially, as interest rates go higher, cash becomes a hot potato and people don't want to hold as much of it on hand, resulting in further inflation). You might also be tightening just as economic growth is rolling over into a fresh recession.

If you look at Bernanke's comments a few years ago when the markets were concerned about deflation, you'll observe an inclination to be far more easy about monetary policy than Greenspan was. A further easing at that point would have made the “opportunity cost” of holding cash even less, resulting in even greater short-term deflationary pressures (essentially the same thing happened in Japan as interest rates there pushed zero), and would have resulted in even higher inflationary pressures today.

In short, by focusing on a policy target which cannot, in fact, be controlled, and can only be measured effectively with a lag, it's possible that Bernanke will find himself constantly overreacting or falling behind the curve. The predictable result will be more interest volatility than the economy deserves.

My advice to the incoming Fed Chairman: 1) Stare at the data – monetary velocity is too variable, and matters too much, to make inflation a policy target. 2) Focus on policy variables you can actually control and can observe in real time. 3) Financial markets convey very useful information, but that information is noisy. 4) Be aware of the full, general equilibrium - there is no such thing as “aggregate” supply or demand except in academia. Try to understand the factors that separately enhance or constrain supply and demand conditions in every corner of the economy. 5) Fed policy only works if it relaxes a constraint that would otherwise be binding. 6) You're just plain wrong about deflation - it's not primarily the result of weak "aggregate demand" - it's the result of plunging velocity due to perceived credit risk. 7) Underestimate the ability of monetary policy to improve the economy, and overestimate its capacity to do damage.

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 hedged investment position. That said, the Fund may experience gains and losses to the extent that our stocks perform differently than the indices we use to hedge on a day-to-day basis. These performance differentials are not predictable on a short-term basis, and it's not unusual to observe a series of days or weeks where the differential may be negative instead of positive. Though the performance of our stock holdings, relative to the major indices, have been a significant source of returns in the Strategic Growth Fund since inception, the differential is not reliably positive over a short term period, and even over periods of a quarter or more. Suffice it to say that there is extremely little information to be drawn from day-to-day flucutations in Fund value, which are typically driven by a handful of stocks or industries in any particular instance.

In bonds, the Market Climate remains characterized by modestly unfavorable valuations and unfavorable market action. The Strategic Total Return Fund continues to carry a portfolio duration of about 2 years, as well as about 20% of assets in precious metals shares and about 5% in foreign currency denominated notes (primarily yen). My inclination would be to modestly extend the average duration of the Fund if we observe a substantial widening of credit spreads, but for now, that roughly 2 year duration is comfortable.

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For investors who have asked for a mathematical formula regarding the tax impact of mutual fund distributions, the true “tax cost” of taking a distribution versus avoiding it is equal to (Ts – d)SD + (Tg – d)LD – (Tc – d)UG where Ts is the tax rate on short-term gains; Tg is the tax rate on long-term gains; Tc is the tax rate that would apply to the investor in the event of a current redemption; d denotes the discounted value of the short or long term tax rate, depending on the holding period actually planned by the investor (for example, for a 10-year planned holding period, at a 10% discount rate, the present value of future taxes is only about 39% of the future tax rate, so if the applicable tax rate is 15%, d would be about 5.8%); SD is the short-term distribution; LD is the long-term distribution; and UG is the unrealized capital gain on the holding prior to the distribution date, which is zero for new investments.


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