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October 23, 2006

Skeptical, Limited Benefit of the Doubt

John P. Hussman, Ph.D.
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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 (about a third) of the distribution 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. The Strategic Growth and Total Return Funds represent my only portfolio 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, 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. Potential long-term investors may have a small incentive to defer investment until the distribution is paid, but only if the Fund's return during the deferral period is expected to be small.

Market conditions continue to be mixed

•  From a long-term perspective, normalized valuations (i.e. correcting for record profit margins) and other factors suggest relatively unsatisfactory 3-5 year total returns for the S&P 500.

•  From an intermediate-term perspective, the quality of market action is good enough to indicate that investors aren't particularly skittish about risk. Option volatilities are low, so premiums remain fairly cheap. Trading volume isn't quite up to par, and corporate insiders have substantially ramped up their selling activity, but these aren't necessarily immediate dangers. A larger intermediate risk is that the market is long overdue for a 10% correction.

•  From a short-term perspective, the market is strenuously overbought. Historically, overvalued, overbought and overbullish markets have been vulnerable to sizeable corrections.

The profile of conditions suggests a response strategy of adding modestly to investment exposure on moderate market pullbacks (of say, 1-4% in depth). Given low option volatilities at present, any exposure to market fluctuations is best taken using limited positions in index call options (up to 1-2% of assets), while retaining the downside protection afforded by index put option coverage against our stock holdings. A significant deterioration in market internals, however, would eliminate the rationale for a constructive investment position, so we would then liquidate that small call option exposure and move back to a fully defensive stance.

In its latest weekly report, Vickers noted that among stocks traded on the NYSE, corporate insiders sold 6.50 shares for every share purchased, compared with a ratio of 3.02 the prior week. The 8-week average for NYSE/ASE listed stocks is now 3.94 and rising, with an 8-week ratio of 3.39 for the Nasdaq. Insider selling isn't a very precise indicator of near-term market action, but has a decent record of preceding flat or declining markets, often with a lead-time of several months.

The American Association of Individual Investors shows bullish sentiment among investors at the highest level since the market's May high. Overall, indicators of sentiment are elevated enough to suggest either a flattening of returns or a potential correction, but it's difficult to take them as urgent warning signals.

Major shifts in market direction are typically related to a change in the “theme” that investors have adopted. During the late 1990's, for example, the prevailing theme was that technology had created a “new era” in which old valuation metrics simply didn't apply, and where earnings could advance at 30% annual rates indefinitely. During the fourth quarter of 2000, investors were suddenly shocked as companies began to lower earnings guidance. Over the following two years, they learned the lesson (now long forgotten) that profit margins are cyclical and rich valuations rarely persist.

The strength of the market over the past few months has been fueled almost entirely by the belief that the economy has entered a “soft landing” where earnings will continue to grow, profit margins will remain strong, and high oil prices are behind us. There is no allowance for any narrowing of profit margins, much less reductions in valuation multiples. If anything, analysts these days are pushing the idea that a “Goldilocks” economy will prompt the Fed to cut interest rates, which they assume will automatically translate into even higher P/E multiples on record earnings on record profit margins.

So the real question, in my view, continues to be whether the “Goldilocks” scenario, which the market has adopted part-and-parcel, will be rejected by the data over the next few months. It's clear enough from current market action that investors are in a speculative mood, but we don't have much information about when (or how abruptly) the “Goldilocks” theme might be contradicted by new evidence.

As I've emphasized in recent comments, I believe that the theme is wrong. But that doesn't require us to hope for bad news or to “fight” prevailing market action. At the same time, we don't want to base our investment positions on an improbable theme if those investment positions would lead to material losses if that theme turns out to be wrong.

Given low option volatilities and the correspondingly low cost of option premium, I believe the best response is to accept market exposure through “one-sided” positions such as call options, without compromising downside protection. As always, we look to add to desired positions on short-term weakness, and that's been the case with our selective exposure to call options. We did have an opportunity to do that on market weakness early last week, but those call positions in the Strategic Growth Fund are still less than 1% of assets at present. It's difficult to quantify that into a “percent hedged” figure because the “delta” of the options changes as the market changes. Presently, the Fund will tend to look fully hedged if the market declines a few percent below current levels, and as much as 25% unhedged if the market rallies significantly above current levels.

Trading into and out of positions

I try to follow a specific discipline for executing trades when the Market Climate improves or deteriorates. If prevailing conditions turn favorable when the market is depressed, I try to establish constructive positions immediately. If conditions turn favorable when the market is overbought, I'll generally establish a starter position and work into the remainder on short-term weakness (or immediately if longer term considerations clearly outweigh short-term ones).

Likewise, if prevailing conditions turn unfavorable when the market is elevated, I try to establish defensive positions immediately. If conditions turn unfavorable when the market is oversold, I'll generally establish a starter position and work into the remainder on short-term strength (or immediately if longer-term considerations clearly outweigh short-term ones).

But what if the market continues higher here without the slightest correction? Simple – we'll retain the modest exposure we've already established, since a persistent “overvalued, overbought, overbullish” condition would continue to be associated with negative short-term returns on average. Whether or not the market weakens in this particular instance will only be observable only in hindsight, but it is bad investment policy to chase the market for fear that it will “run away” in conditions when it has not historically done so.

What if the market declines modestly while preserving favorable internals, and we add another percent or so to our call option positions, and then the bottom drops out? Again, simple – at the point where market internals deteriorate (whether at higher levels or lower levels on the major indices), we will revert back to a full hedge with no constructive call positions (operationally, we would generally sell a portion of the call positions, and attempt to close the remainder on any short-term strength).

Overall then, our refusal to “fight” generally favorable market internals, even in overvalued markets, leads us to accept at least some amount of exposure to market fluctuations here. Fortunately, option volatilities are low so we can take that exposure using small positions in index call options rather than removing downside protection.

Again, my personal opinion is that the recent advance has been based on a flawed “Goldilocks” theme that is at risk of being undone in the months ahead. We also have an overvalued, overbought, overbullish market that only “seems” reasonably valued if we assume that profit margins will remain forever elevated. I don't believe the Goldilocks theme is reasonable, but as in the late 1990's, nothing prevents investors from operating on a flawed theme for a while, or from driving overvalued stocks to even more elevated valuations before pandemonium breaks loose. I do think that responsible analysts ought to know better when it comes to the sustainability of profit margins.

I personally don't trust this market at all, but with the Fund well hedged against the impact of substantial market losses, prevailing market action compels us to give a carefully limited benefit of the doubt to the investors passing out the Dow 12,000 party hats. The hedges, however, are essential.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and modestly favorable market action. In bonds, the Market Climate remained characterized by modestly unfavorable valuations and relatively neutral market action. The Market Climate remains relatively favorable for precious metals shares, which continue to represent about 20% of assets in the Strategic Total Return Fund.

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Prospectuses for the Hussman Strategic Growth Fund and the Hussman Strategic Total Return Fund, as well as Fund reports and other information, are available by clicking "The Funds" menu button from any page of this website.

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