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November 21, 2005

Diminishing Participation and Garbage Stocks

John P. Hussman, Ph.D.
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Just a note: The Hussman Strategic Growth Fund paid its annual capital gains distribution of $0.5013 per share last Friday (November 18th), representing $0.0013 in long-term capital gains, and $0.5000 in short-term capital gains. The Hussman Strategic Total Return Fund paid a capital gains distribution of $0.295 per share representing $0.180 in long-term capital gains, and $0.115 in short-term capital gains. (The actual distribution amounts in the Strategic Growth Fund are difficult to predict in advance because the hedge portion of the portfolio must be marked to market for tax purposes). For investors reinvesting distributions, new shares in Strategic Growth were purchased at Friday's NAV of 15.66, while new shares in Strategic Total Return were purchased at Friday's NAV of 10.97. So for every share of HSGFX previously owned, reinvesting shareholders now own approximately 1.0320 shares, while HSTRX shareholders now own approximately 1.0269 shares. Those factors can be used to compare current NAV values with pre-distribution NAVs (multiply current NAV values to compare with prior NAVs, or divide prior NAVs by these factors to compare with current NAVs).

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I'll cut straight to the chase this week. Market valuations remain untenably rich here, at 19.7 times peak earnings (again, when trailing net earnings for the S&P 500 have been at a fresh record, the average P/E multiple for the S&P 500 has been just 12, an average which doesn't vary much even if you restrict the data to periods of low inflation and interest rates, which at present aren't particularly low anyway). I say “untenably” because market action continues to display internal divergence that isn't characteristic of robust bull markets, and on a short-term basis, the market appears substantially overbought too.

Last week, for example, despite the fresh high in the S&P 500, the number of stocks registering new 52-week lows expanded to 422, easily outpacing the 286 achieving new highs. Breadth was also unimpressive for a push to new highs, with the weekly advance/decline figures at 1893 versus 1609, respectively. Nasdaq, which was the strongest index, actually exhibited more decliners than advancers on a weekly basis (a good part of that strength was thanks to Google – and I'll say it again – if Google is worth $300 a share - not to mention $400, capitalism is broken).

It's also important to recognize that over the past 6 months, the market has given a serious preference to “garbage stocks,” with stocks having low return on equity, return on assets and return on invested capital being stellar performers, while more stable and durably profitable companies have been relatively flat. Likewise, companies with high betas and those ranked “C” by S&P 500 for financial stability have performed strongly, while lower beta stocks and those with financial quality rankings of “A” have stagnated. Historically, garbage stock rallies like this are a hallmark of the late, narrowing, impatient, speculative phase of a bull market. In other words, we're not seeing the sort of robust willingness to sponsor stocks and take market risk that you typically see in healthy markets. Rather, market action suggests a broad pattern of distribution and diminished sponsorship, even as investors chase a narrow field of garbage in hopes of somehow making a buck.

Bottom line – we've got diminishing participation from the broad market. Meanwhile, despite the appearance that the major indices are making substantial progress, Friday's close for the S&P 500 was just 0.87% higher than its prior August 3rd high, while the Russell 2000 remains 1.27% below its level on that date on a total return basis. Both figures fall short of the 1.20% total return for Strategic Growth over that same period. Though this is an excruciatingly short span in any event, it does underscore the general usefulness of considering market fluctuations from peak-to-peak, rather than isolating trough-to-peak or peak-to-trough movements as if they were informative.

A note on performance evaluation – not just for the Hussman Funds, but for mutual funds in general. When you use “standard” performance horizons like 1 year, 3 year, 5 year and so forth, it's useful to keep in mind whether each particular evaluation period is full-cycle or if instead it is restricted to a peak-to-trough or trough-to-peak move. Presently, for example, 1-year returns are somewhat interesting in the sense that they represent a “normal” sort of return for stocks near 9 or 10%, but they're not interesting otherwise since the market has been in a long, dull trading range without much major cyclical movement over that horizon. Three year returns are particularly misleading, since they represent a move from the market's 2002 trough to the recent highs, so that return comparisons over that horizon will invariably favor high-risk, high-beta funds that could very well get creamed in a strong market decline. Meanwhile, five-year returns, at present, are much more useful than normal, since they encompass a move from one bull market peak to another bull market peak, with an intervening bear market in-between.

Even here, however, the unusually good performance of small cap stocks during that span should be taken into account depending on what sort of fund you're analyzing, given that small caps started that period at substantial undervaluation relative to the S&P 500, and are now among the most overvalued areas of the market.

For disclosure purposes, as of October 31, 2005, the Strategic Growth Fund achieved annual total returns of 8.93%, 10.93%, 15.22% for the most recent 1, 3 and 5 year periods, respectively, compared with total returns of 8.72%, 12.85%, and -1.74% for the S&P 500 over those same periods. The average annual total return of the Strategic Growth Fund since its inception on July 24, 2000 was 14.47%. Past performance does not ensure future returns, and the value of the Fund will fluctuate so that an investor's shares, when redeemed, may be higher or lower than their original cost.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and still unfavorable market action. For now, the Strategic Growth Fund continues to carry a fully hedged investment position – fully invested in a diversified portfolio of individual stocks, and hedged with an offsetting short position in the S&P 500 and Russell 2000 indices. The hedge acts as an interest-bearing short sale, so the Fund's returns when hedged are approximately equal to the difference in performance between the stocks we own and the indices we use to hedge, plus a small interest accrual that's fairly close to the 90-day Treasury bill yield.

Think of it this way. If our stock holdings exactly mirrored the S&P 500, and we used only the S&P 500 to hedge, a fully hedged investment position (equal dollar values long and short) would be a purely risk-free combination. That risk-free combination would earn the risk-free interest rate. To the extent that our stock holdings are not identical to the indices we use to hedge, we also have potential risk but also potential return from the difference in performance between our stock holdings and the indices we use to hedge. (Regardless of how unfavorable the Market Climate, the Fund never takes a net short position where the short side would be materially larger than the long exposure, so the Fund is never in a position where we would expect substantial, predictable losses in the event of a market advance).

In bonds, the Market Climate remained characterized last week by unfavorable valuations and unfavorable market action, holding the Strategic Total Return Fund to a roughly 2-year duration, mostly in Treasury Inflation Protected Securities. On the strength of gold shares, I did clip off a couple of percent from our precious metals holdings, which currently represent about 18% of the Fund's investments. The ECB voted to raise rates last week, which could potentially impact the U.S. dollar negatively and commodity prices positively, but any real difficulty for the dollar will probably require more evidence of oncoming economic weakness. On that front, credit spreads, and to a lesser extent, the ISM figures, are among the more important indications to monitor.


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