January 2, 2007
Thin Risk Premiums
Just few observations given the short trading week:
The Hussman Strategic Growth Fund paid its annual income distribution of $0.13 per share on Friday (the annual capital gains distributions were paid in November). Including this distribution, the Fund gained 2 cents per share on Friday.
The Strategic Growth Fund already holds enough call options to gradually mute about 50% of its hedges in the event of a sustained continuation of the recent market advance. These calls represent just under 1% of net assets. I expect to build that position further on any material short-term weakness, provided market internals remain relatively favorable. While the Fund may or may not appear responsive to small percentage movements in the market, depending on the day-to-day performance of the individual stocks in the portfolio, I expect those calls to increase our participation in any significant further market advance.
Keep in mind that day-to-day market action is somewhat deceptive in that the S&P 500 has only gained about 2% from its late October high. The repeated occurrence of marginal new highs, minor pullbacks, and recoveries to further marginal new highs all provide the appearance of a market that is running away quickly. The truth is that even a minimal pullback would eliminate the advantage over T-bill yields that the S&P 500 has accrued since early May. Of course, as a reminder that valuations do matter, it is useful to recognize that the total return for the S&P 500 is still behind Treasury bill returns over the past 8 years.
Again, it's important to fully recognize the impact that even the most moderate bear markets have on compound returns, and how unimportant the later portions of bull markets generally prove to be on the full-cycle return. Presently, a historically minimal 20% bear market decline over a one-year period would bring the 5-year annualized return on the S&P 500 (2003-2007 inclusive) to 6.76%. Even a 20% one-year advance in 2007 followed by a still-minimal 20% bear market decline in 2008 would bring the S&P 500's 6-year annualized return since the bull market started in 2003 to a muted 8.86%. The returns that matter for long-term investors are the ones they actually keep, and the more mature the bull market, the higher risk and less retainable are those incremental returns.
That doesn't mean that we're sidelined here. Again, I want to emphasize that the Growth Fund does have enough call options here to gradually mute about 50% of our hedges in the event that the market continues significantly higher. Our risk management concerns require us to keep such speculation “close to the vest” by using call options rather than lifting off downside protection, but with option volatilities very low, it is reasonably inexpensive to carry these speculative option positions. [I use the word “speculative” to emphasize that valuations provide no legitimate “investment” merit for stocks here].
Contrary to popular assertions, the recent advance is emphatically not the result of an ocean of “liquidity.” The rate of money growth has slowed considerably both domestically and abroad, particularly on an inflation-adjusted basis. Mortgage equity withdrawal is also slowing. Foreign central banks continue to tighten. What we're seeing is not liquidity, but risk-blindness. Corporate and junk yield spreads are very narrow, which has allowed private-equity investors to acquire capital for risky acquisitions at nearly risk-free rates. If you think about it from an overall equilibrium standpoint, what's really going on in a leveraged buyout is that certificates of stock ownership are retired, and certificates of debt are created (though the holders of those certificates may not be the same). Equity risk is thereby transformed into default risk, that's all. Presently, dangerously thin equity risk premiums are being transformed into dangerously thin default risk premiums. The bagholders here will ultimately be investors who purchased that debt, either directly or indirectly through hedge funds, but it may take a while.
Meanwhile, in addition to pricing stocks at low risk premiums, investors are kicking in the added assumption that current record profit margins are durable. A multiple of 18 times record earnings is already historically quite high, but on normalized profit margins, the current P/E multiple on the S&P 500 is about 25. I should quickly note that (except in combination with overbought, overbullish conditions that will probably clear soon) valuation is not a short-term negative, because over the short-term, investors may be quite willing to continue speculating. Regardless, currently rich valuations will have a profound influence on long-term returns. The fact that the S&P 500 has underperformed T-bills over the most recent 8-year period (through December 31, 2006) should be adequately up-to-date evidence that valuations matter and that the fundamental rules of investment haven't changed.
Perhaps the most important area to monitor here is the corporate debt market (for example, 6-month commercial paper, and the yield on the Dow Jones Corporate Bond Index). An increase in the Dow corporate yield much above 6% (recently 5.71%) would represent an important warning that the current speculative binge is reversing course. As Nobel economist Joseph Stiglitz recently noted, "the prospect of risk premiums returning to more normal levels is itself one of the major risks the world faces today."
Still, until we observe some amount of deterioration or divergence in market internals, breadth, individual stocks, industry groups, or security types, I would expect to maintain a speculative call option position in the Strategic Growth Fund (and again, expect to increase that position on short-term weakness if it develops).
As of last week, the Market Climate for stocks remained characterized by unfavorable valuations, generally favorable market action, but with continued overbought, overbullish features that have been associated with short-term market returns below Treasury-bill yields, on average, until those features have been cleared. At present, a pullback of perhaps 2-4% would be sufficient prompt a further increase in our call exposure toward 2% of assets, provided that market internals remain firm.
In bonds, the Market Climate last week remained characterized by unfavorable valuations and moderately favorable market action. The Strategic Total Return Fund continues to hold a duration of about 2 years, mostly in TIPS, with about 20% of assets in precious metals shares where the Market Climate continues to be quite favorable on our measures.
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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