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November 28, 2005

"Whipsaw" written all over it

John P. Hussman, Ph.D.
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For any market analyst who pays attention to data, one of the challenges is to define conditions in a way that you can distinguish one environment from another. Technical analysts sometimes do this with things like “moving average crossovers” – for example, defining the market to be in an uptrend when it breaks above a 50-day or 200-day moving average, and defining a new downtrend when it breaks below. Dow theorists, on the other hand, are very keen on breaks above or below prior intermediate highs or lows, especially when there has been some sort of “non-confirmation.” So for example, if the Dow Industrial Average hits a new low but the Transportation index fails to confirm by also reaching a new low, then the indices have an initial advance, back off, and then break above the closing highs of those prior, initial advances, a good Dow theorist will get very excited.

At the same time, no method of inferring information is perfect, so it's often the case that analysts will get a “whipsaw” – for example, some sort of event that gives them a “buy” signal, followed immediately after by a “sell.” These can be costly if they are repeated a few times. In my own analysis, I never define information as a “buy” or “sell signal,” since those terms imply something about future direction. Rather, I think in terms of shifting from one “probability distribution” to another. And while I focus much more on the “big picture” not only across a variety of indicators but also based on my best evaluation of reality as it is (in other words, you never use indicators blindly or ignore the actual context of what is going on), there are still decisions to be made about when enough information is enough information to define a “shift.”

At present, stock valuations remain unusually unfavorable, with the S&P 500 at 19 times fresh record earnings (also top-of-channel earnings if you draw a long 6% growth line across earnings peaks going back nearly a century). Market action in some ways looks good, particularly on the basis of the popular indices. But internals continue to tell a different story. Breadth (as measured by advancing issues versus declining ones) has persistently failed to confirm the strength in the indices, while a peculiarly large number of new lows even among a large number of new highs (345 highs versus 240 lows last week) also indicates internal turbulence and a lack of uniformity. It's not just speculation in garbage that makes a market robust – it's the willingness of investors to take risk across a very wide range of assets, and that's expressed as a sort of “in-synch” behavior across a wide variety of security types and sub-groups. This may be a speculative market in terms of speculative "garbage stocks," but it's not a robust sort of willingness to take risk.

That conclusion isn't limited to my own analysis. Lowry's also notes in its price/volume analysis that any technical “buy signals” that might emerge at this point would be viewed “with a high degree of skepticism” and “will in no way reverse the warning signals of a maturing bull market that have developed over the past several months.”

For our part, the current market condition is extremely overbought, and the constellation of internal divergences and interest-rate action has “whipsaw” written all over it. A few historical points that match this constellation include January 1962 (just before a fairly steep and abrupt market plunge), July 1998 (just before the Asian crisis), and May 2001 (after a very good intermediate rally in the midst of the bear market, which failed spectacularly over the following few months). That's not to say that the market must or “should” decline in this particular instance, but the precedents are very serious and almost universally negative. It's certainly possible that more evidence – particularly better internal action – will emerge to “clear” this condition. But I don't like this market at all in terms of the typical return/risk profile that similar conditions have historically provided.

Again, that assessment might very well be incorrect in this particular instance, but as long-term investors, we align ourselves with the average profile of return and risk based on the particular Market Climate we observe. For now, based on current evidence (which might resolve by something other than a market decline) the Strategic Growth Fund remains fully hedged.

Short-term performance influences

In order to interpret day-to-day fluctuations in the Strategic Growth Fund, it's important to recognize that when the Fund is fully hedged, it is holding a fully invested position in a broad portfolio of stocks, and has a roughly equivalent short position in the S&P 500 and Russell 2000 (in a proportion that closely resembles the capitalization mix of the stocks we hold at any particular point in time). The stocks we hold, however, don't precisely mirror the indices we use to hedge – if they did, we'd have an essentially risk-free position that would earn roughly the Treasury bill rate (as a result of how option combinations and futures contracts are priced). Instead, when the Fund is hedged, its primary source of risk, as well as its primary source of expected return, is the difference in performance between the stocks we hold long and the indices we use to hedge.

Since the inception of the Fund, that performance of our stock selections, relative to the major indices, has been a primary, and relatively consistent source of returns for the Fund. Even so, that source of expected returns is not assured or risk-free, especially over short periods of time, when our favored stocks can exhibit stretches of both outperformance and underperformance relative to the indices, certainly on a day-to-day basis but sometimes over periods of weeks or months. I continue to have no difficulty at all positioning the Fund in exactly the stocks that I think we should be holding at any point in time – but the fact of life is that our stocks go through periods where they are relatively quiet (as they are at present, though not disappointing either), and some where they are actively recognized by the market and achieve returns commensurate with what I see as their merits.

As a side note, I select stock investments from the “bottom up” – meaning that I focus on individual stocks, and my transactions in those stocks result in a general sector and industry profile for the Fund. So, for example, I don't say “I want to buy a lot of semiconductors here” and then go out and pick semiconductor stocks. If we own a group of semis, it's because several individual semiconductor stocks appeared worthwhile on an individual basis. Of course, I also monitor our aggregate sector and industry exposures to make sure that I am comfortable with our overweights and underweights in various areas of the market, but again, it's basically a bottom-up process, with position constraints put on top so we don't get too concentrated in any group.

A good example of this currently is that the Fund has a substantial exposure to stocks that are relatively independent of economic fluctuations, and instead have relatively stable revenue growth and profit margins. In my view, the stocks we own in this area continue to represent both the most favorably valued area of the market, as well as the most robust in terms of being less vulnerable to any economic weakness that might develop. So as an investment proposition, I think the Fund is very much in the right set of places.

The performance of stable stocks, for instance consumer stocks, has also been at least moderately strong relative to say, cyclical stocks over the past year, but it has been a somewhat choppy pattern. Between April and July, cyclical stocks performed better than consumer stocks, as they have also done over the past couple of weeks. Standard stuff.

To give you an idea of how this sort of horse race can affect short-term fluctuations in Strategic Growth Fund, Bill Hester put the following chart together – one line is the ratio of the Morgan Stanley Consumer Index divided by the Morgan Stanley Cyclical Index (so the line rises when consumer stocks are outperforming). The other is the ratio of the Hussman Strategic Growth Fund to the S&P 500 Index. Though the scale of the graphs is chosen in a way that exaggerates the impact on the Fund (numerically, a 1% change in the consumer/cyclical ratio has far less than a 1% impact on the performance of the Fund relative to the S&P 500), you can see that the Fund currently has a sort of “beta” that picks up the relative performance of the industry groups that it over- and under-weights.

The bottom line is that the long-term performance of the Fund has significantly benefited from the focus on valuation and market action that drives the stock-selection side of our investment strategy. Meanwhile, our short-term performance is largely dependent on more random fluctuations in our individual stock holdings, as well as the relative performance of various industries and sectors. For that reason, the Fund is simply not an appropriate or reliable vehicle for short-term investors, and is definitely not appropriate for investors with a strong desire to closely track short-term market fluctuations. For long-term investors, the basic goal of the Fund is to achieve strong returns over the full market cycle, with added emphasis on managing risk and defending capital during hostile market conditions. I certainly view the Fund as an excellent fit for investors who share those objectives.

Market Climate

As noted above, the Market Climate for stocks remained characterized last week by unusually unfavorable valuations, unfavorable market action, and a combination of overbought conditions, interest rate pressures and divergent internals that has historically been, well, not good at all. We'll see what happens this time around, but as always, our investment position is based on the average return and risk profile of the Market Climate we identify, so the Strategic Growth Fund remains fully hedged. Not short, not bearish, but fully hedged against the expected impact of market fluctuations on the Fund.

In bonds, the Market Climate remained characterized by unfavorable valuations and unfavorable market action, holding the Strategic Total Return Fund to a short, roughly 2-year duration, mostly in Treasury inflation protected securities (a 2-year duration means that a 100 basis point change in interest rates would be expected to impact Fund value by roughly 2%). The Fund continues to carry a slightly pared-down exposure to precious metals shares, where the Market Climate continues to be favorable on our measures. Not much change lately in credit spreads or other measures that might change our investment position, so at present, the investment stance of the Fund is relatively stable and aside from day-to-day precious metals fluctuations, relatively conservative.


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