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August 28, 2006

Signs of a Downturn

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

Just a note: The 2006 annual report for the Hussman Funds for the fiscal year ended 6/30/06 will be published next week in place of the usual weekly comment. The report includes an extensive letter to shareholders. I hope the perspectives offered there will be useful. Print copies will be mailed shortly.

I am also pleased to report that following the Board's approval of additional reductions in advisory and administrative fee schedules last month, the expense ratio for the Strategic Growth Fund has been lowered again, most recently to 1.10%. (Since services like Morningstar generally base reports on the trailing expense ratio over the prior year, the current expense ratio may not appear in their reports immediately). The expense ratio is affected by Fund assets, fee breakpoints and other factors, and may increase or decrease over time.

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As August finishes and the kids head back to school, I'm optimistic that the markets will shortly wrap up this period of summer doldrums. If the next burst of activity is upward, that's fine – greater sponsorship would allow us to remove a portion of our hedges, and would most likely provide a boost to better-valued groups such as consumer, retail and technology stocks which have struggled over the past few months. If the next burst of activity is downward, so much the better, since the Strategic Growth Fund remains fully hedged here, and I continue to expect vulnerability in profit margins and earnings growth, which I would expect to disproportionately affect lower quality stocks that aren't among our major holdings.

Greater trading volume and price dispersion tends to be more favorable for our investment approach than dull periods are. So either way, I'm hopeful for a pickup in volume and activity. It's been a quiet summer.

The recent (or less probably, “current”) bull market has enjoyed an above-average duration, and hasn't produced even a 10% correction in 3 ½ years. Yet except for low-quality and small-cap stocks, only the first year (2003) of the bull market was satisfyingly “bullish” for stocks. Since April 2004, the S&P 500 index has produced an annual total return of only about 6.5% - nothing like the 20-30% annual returns that are typical of the “bull market” portion of a cycle. Needless to say, those low returns are largely related to the persistent overvaluation of the market, which was never cleared during the 2000-2002 plunge. The next substantial decline will, I expect, give the market a better valuation footing from which to produce durably high returns.

Still, given that the market hasn't yet experienced even a 10% correction, and that recession warnings continue to emerge, the likelihood of a sustained advance here seems fairly slim. Certainly stocks could advance for a while if investors focus on forward operating P/E's and adhere to the thesis that "the Fed is done and we've got a Goldilocks economy," but there's no statistical evidence that forward operating P/E's have predictive short-term value, nor that the market does anything favorable, on average, in the 18 months or so after the Fed finishes a rate-hike cycle.

With recession signals increasing (though not yet enough to predict a recession with a high probability), it's useful to remember that stocks generally turn lower before the economy, with a lead-time of about 6 months. That may very well be the window we've entered here.

On the economy, the most recent data on housing starts continues to confirm a downturn in housing, which was also evident in the 4.10% drop in new home sales last month. That gives us a new point on our housing starts oscillator, which is already at a level consistent with potential recession.

Meanwhile, a few writers including Floyd Norris of the New York Times and Jim Stack of Investech have noted that new car sales are now down on a year-over-year basis. Norris notes that declines in new car sales by more than -2% on a year-over-year basis have always been followed by recessions. The latest year-over-year figure is -2.4%.

In terms of price/volume behavior, Lowry's notes that the market's recent bounce hasn't been driven by measurably increased buying demand, but rather by a “backing off” of sellers. That's not characteristic of sustained market advances. In a solid market advance, you'll tend to see a persistence of strong upside volume and price action, rather than the tepid and sporadic “wait and see” attitude we've observed from investors in recent weeks.

As always, our investment position will respond quickly to any change in the Market Climate we observe, and I don't rule out the possibility that such a change could be favorable. Still, my impression is that the market is displaying a sort of “calm before the storm.”

Hope you had a good summer. Things may be about to get interesting.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully hedged investment stance. The major indices remain extended in an overbought condition, which in unfavorable Market Climates tends to give the markets a downside bias. Still, it's important to remember that even unfavorable Market Climates allow for short-term advances – it's just that the average return/risk profile in such Climates tends to be unfavorable.

In bonds, the Market Climate remained characterized by modestly unfavorable valuations and relatively neutral market action. Later this week, we'll get a good amount of new data on revised GDP and PCE inflation. The market has been extremely focused on the smallest surprises in this sort of data, so the market's response – positive or negative – may very well exceed the true statistical importance of the actual data.

We did see a modest widening in credit spreads over the past month, which tends to increase recession probabilities, but it is still not abrupt enough to suggest that investors are going to be clamoring for safe havens like Treasuries and currency. So for now, their effect in muting inflation pressures will probably be limited. Generally speaking, I continue to view negative economic surprises and upside inflation surprises to be the probable norm.

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