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October 9, 2006

Outside the Oval

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

In the financial markets, analysts are constantly evaluating relationships between one variable and another – inflation versus economic growth, interest rates versus P/E ratios, yield spreads versus earnings, and so forth. One of the ways we can think about these relationships is in terms of something called a “joint probability distribution.”

For example, if you were interested in the relationship between people's heights and their weights, you could take a piece of cardboard and draw a big grid, with heights along the left hand side from say, 3 feet tall to 9 feet tall, and weights along the bottom from say, 50 pounds to 500 pounds. If you measured 1000 people and put a poker chip down on the board in the square matching each person's height-weight combination, you'd get a slightly skewed mountain of poker chips. Most of the data could be contained within a fairly limited “oval,” but you'd also have some observations on the periphery, and a few points would be extreme “outliers.” For instance, a 9 foot person weighing 75 pounds would definitely fall outside the oval.

Essentially, there are some combinations of two or more variables that are “typical” and others that are not terribly likely.

Currently, investors seem to be placing a great deal of hope in the idea that the Fed is done tightening. The basic scenario is that the economy is slowing modestly, so inflation pressures will slow as well, allowing the Fed to cut interest rates while earnings continue to grow.

Unfortunately, that scenario is way outside the oval. Historically, if we look at points where the Fed has cut rates at least twice, it has invariably been either during or just prior to a period of substantial earnings weakness. We don't typically observe strong earnings growth coupled with fresh Fed loosening cycles, except on the back-side of recessions.

Similarly, since July, we've observed an inverted yield curve, with the 10-year Treasury yield below the 3-month Treasury bill yield. Bill Hester observed last week that whenever the Fed has raised the discount rate by at least 1%, ending in a yield curve inversion for more than a few weeks, the U.S. economy has entered a recession after a median lag of 8 months. We can't rule out the possibility that the current yield curve inversion will be followed by further economic growth, but such an exception would be outside the oval.

On the valuation front, the current P/E ratio for the S&P 500 is 18 times record earnings (on record profit margins). Historically, the combination of an inverted yield curve and a P/E ratio over 15 has been associated with negative market returns, on average. The current observation, moreover, is even further outside the oval. The only time we've observed an inverted yield curve and a P/E at or above 18 times record earnings was at the 2000 market top. The runner-up (just below 18) was near the heights of the “Go-Go” market leading into the '69-'70 bear market.

Constructive factors

All of that said, there are two factors on the side of a speculative position (not an “investment” position – stocks aren't priced to deliver favorable long-term returns, but strictly a speculative position). First, our measures of sponsorship (particularly those associated with price-volume behavior) have improved moderately in recent days. Whether or not we agree with the market's “Goldilocks” thesis, the fact is that investors have put at least some sponsorship behind it lately.

If these market internals remain resilient on a reasonable pullback, we could move about 1% of assets into call options (essentially maintaining our defense against losses but allowing some participation in advances at the cost of modest time decay if the market is flat). I executed a bit of that on early weakness last week, but again, until the market experiences a more substantial correction, the stock selection aspect of our investment approach will probably have more potential to drive Fund returns than a speculative exposure to market fluctuations could.

The second constructive factor these days is the seasonal pattern that Bill Hester noted in his piece on the 4-Year Cycle last December ( http://www.hussmanfunds.com/rsi/prescycle.htm ). In post-war data, there have been 15 favorable seasonal periods running from October of the 2nd year of a presidential term, through September of the 3rd year. That's the seasonal period we've just entered. Of those periods, not one has seen a market loss. Indeed, the average gain has been nearly 30% annualized.

Of course, there's a distinction between analysis and superstition. Wall Street is littered with the ruins of people who mined for patterns in the data and invested on them without knowing why they should work. In terms of the 4-year cycle, the typical explanation for the strong seasonal returns is that fiscal and monetary policy often become accommodative during this part of the Presidential term. That was certainly the case in late-2002 and 2003, but isn't quite so likely here.

Beyond that, there are other factors at work. In 12 of the 15 cases, the S&P 500 had been at least 10% below its prior 52-week high within several weeks (and no more than 6 months) before the seasonally favorable period. At present, the market is strenuously overbought, and long overdue for a 10% correction.

Of the 11 recessions in the post-war period, 9 were in force a year or less prior to the seasonally favorable period. Evidently, the majority of the strength was linked to post-recession recovery momentum.

Only 4 of these periods began at P/E ratios above 15 on the S&P 500, and of those, none began with the S&P 500 above its 6-month moving average (as it clearly is at present). Once again, you generally build sustained rallies off of prior losses, not off of overextended advances.

Of the 9 cycles since 1963 (when Investors Intelligence began publishing its advisory sentiment data), all but one began at a lower level of advisory bullishness than today.

In short, the favorable 4-year seasonal period has a “snap-back” component to it, where the market was typically recovering from a recession, a substantial market drop, or at least a period of consolidation. Indeed, many of the start-years (e.g. 1970, 1974, 1982, 1990, 2002) are familiar exactly because they represented memorable bear market lows.

Again, that doesn't rule out the potential for another instance of 4-year seasonal strength, given the historical record. But given that same record, it's clear that the present instance is outside the oval in terms of the conditions that have accompanied that strength in the past.

Is the market's thesis wrong?

In recent weeks, I've emphasized the view that (barring a widening of credit spreads) inflation pressures are likely to remain persistent, while the economy is likely to slow further. This is a much more “stagflationary” view than the “Goldilocks” thesis that investors are aggressively pricing into stocks and bonds. Our investment positions don't rely on these views, being driven primarily by prevailing valuations and market action, but the potential for investors to abruptly shift their thesis translates into a potential for market action to change abruptly as well, and that's not something we can afford to ignore.

I continue to view the “Goldilocks” idea as a conclusion in search of evidence, and at present, that evidence remains thin. My impression is that even a handful of adverse economic reports, particularly on the inflation front, would have the capacity to sharply change investor behavior.

Apparently, Fed officials agree.

As Reuters reported last week, “Philadelphia Federal Reserve President Charles Plosser said Thursday that the FOMC's current policy of leaving interest rates frozen while it assesses U.S. economic growth and inflation may not be sufficient to address the country's long-term economic interests. Plosser told the CFA Society of Philadelphia, ‘There remains some risk that policy is not yet firm enough to ensure a return to price stability over a reasonable time horizon.'"

Meanwhile, John Mauldin's weekly newsletter quoted Fed Vice-Chairman Donald Kohn (who spoke Tuesday night at New York University): "In the current circumstances, the upside risks to inflation are of greater concern...I am surprised at how little market participants seem to share my sense that the uncertainties around these paths and their implications for the stance of policy are fairly sizable at this point."

Mauldin's recent pieces have highlighted the rate of inflation in personal consumption expenditures (which was Alan Greenspan's preferred inflation measure). He notes that the latest one-month raw PCE looked OK, but those figures are highly volatile (witness May at 4.2% annualized, June at 1.7% and June back at 4.1%, for example). Meanwhile, August's core PCE figure was the highest in 5 months, at 2.8%. Mauldin also reports a Fed statistic called the “trimmed mean PCE.” This attempts to find the “central tendency” of inflation based on the average inflation rate in PCE components after trimming away the components that are unusually extreme (positive or negative) each month. In other words, it's more robust to outliers than the raw PCE. Statistically, it also turns out to be a better measure of underlying inflation trends. Note that on a 6- and 12-month basis, the trimmed mean PCE inflation rate has not slowed at all.

On the economic front, suffice it to say that Friday's revised employment data does nothing to bolster the case for a “soft landing.” Based on the new data, the 6-month growth in total non-farm payroll employment is now 0.52%. Historically, every previous decline in employment growth below 0.55% (the red line) has been associated with a recession. A single indicator isn't enough to make a strong conclusion about recession risks, but increasingly, the hope for a “soft landing” is at odds with the data.

Market Climate

As of last week, the Market Climate for stocks was characterized by unfavorable valuations and modestly favorable market action. Given a new high in the Dow, it might seem that market action is “obviously” favorable, not just “modestly” favorable. As always, however, we are not simply measuring obvious trends of the major indices (which may or may not continue), but internal strength across a variety of measures of breadth, leadership, industry behavior, asset classes, price/volume characteristics, and so forth. On those measures, “modest” is the appropriate qualifier. As I've noted in recent weeks, probably the most aggressive we would become on the basis of better market action would be a removal of about 25% of our hedges (or changes having similar effect, for example, placing about 1% assets into index calls).

When the quality of market action improves during or closely following a substantial decline in the major indices, an immediate constructive shift in our investment position is usually warranted. In overvalued, overbought markets, the potential for whipsaws is much higher, so we'll tend to establish an initial constructive position (as I did on weakness early last week), and work into a larger position over a period of weeks, or more quickly if the market retains good internal strength on the next meaningful decline in the major indices. Though our exact investment position will vary depending on market action here, the general profile of the Strategic Growth Fund will remain substantially hedged, with a tendency to build modest constructive positions on weakness, provided that market internals hold up. Frankly, my impression is that the recent improvement in market action won't last, but again, our investment positions are driven much more by objective measures of prevailing market conditions. In any event, our discipline of establishing desired positions on short-term weakness is already a good defense against a potential whipsaw here.

In bonds, the Market Climate remained characterized by unfavorable valuations and relatively neutral market action. The Strategic Total Return Fund's duration remains about 2 years, mostly in Treasury Inflation Protected Securities. Conditions for gold shares improved, based on increased evidence for economic softness and a further pullback in gold stock prices. Accordingly, we added modestly to the precious metals holdings in the Strategic Total Return Fund last week, to just over 20% of assets.

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