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February 20, 2007

Rip Van Winkle

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

Just a note: the most recent Semi-Annual Report of the Hussman Funds will be posted to the website following Board review, probably on Thursday of this week. Barring substantial market volatility, that report, including an extensive letter to shareholders, will stand in lieu of my regular weekly comment.

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“Today,” said Rip Van Winkle, “is nice.” And with that, after a game of bowling and drinking in the mountains with a band of dwarves, he fell asleep for 20 years. When he awoke, he found that the world had changed.

At a point where investors' attention is dominated by a hyperactive, minute-by-minute, open-to-close focus on market fluctuations, it's easy to forget that speculators failed to keep the hot money that they chased during the late 90's.

If frantic day-to-day attention to market movements serves to do anything, it is to convince investors that they cannot afford to miss any short-term rally; that they can't afford to miss the latest utterance from the Fed; that they can't afford to miss the latest “hot play” offered up to the masses. It does not, however, serve to earn investors sustainable profits.

"You want my top 10 stocks for who is going to make it in the new world?" said one of today's popular speculative heroes at the February 2000 Electronics and Internet Conference (eight days before the Nasdaq peaked). Stocks that could be bought and held and put away for financial security in that brave new world, in preference to all others? Here they were. 724 Solutions, Ariba, Digital Island, Exodus Communications, Infospace, Inktomi, Mercury Interactive, Sonera, Verisign, and Veritas. I needn't review the carnage that followed – the names alone tell the story. Think "10-for-1 reverse split."

At the other extreme is Papa Van Winkle, asleep beneath a shady tree. He's made just 11 trades in a half-century. He falls asleep for years at a time. I'd never recommend his approach in practice – there are far better ones, with less risk. Also, it would be excruciatingly difficult to live through at times, if you were awake, because it would seem that you were missing opportunities of a lifetime.

Nevertheless, old Rip has come out pretty well over the years. He's outperformed the S&P 500 since 1960, 1970, 1980, 1990, and even over the past decade. And though he's earned over three times what the S&P 500 has achieved, including dividends, his deepest pullback over that period has been less than half of what the S&P 500 has periodically lost. He slept through most of the 1973-74 bear market, through the '87 crash, through the 2000-2002 bear market. Shhhhh. He's asleep now too.

What's Papa Van Winkle's secret? Simple. He doesn't overstay his welcome in overvalued markets.

Once the price/peak earnings multiple on the S&P 500 hits 19, he looks for minimal confirmation to get out – a decline in the S&P 500 below its 10-week moving average, and investment advisory bearishness (Investors' Intelligence) below 30% bears. Then he goes to sleep. Once he does, he snores through everything – even improvements in valuations – until the S&P 500 drops 30% from its highs on a weekly closing basis. No less. Sometimes he sleeps for years on end. Sometimes he misses enormous short-term advances. No matter. They're never retained by investors anyway.

Again, I wouldn't recommend old Rip's strategy in practice. It would be psychologically impossible to follow, and there are far better ones that capture greater gains with more controlled risk.

Still, the Rip Van Winkle strategy illustrates an essential point: advances in overvalued markets are regularly given back at great cost to investors who overstay, and can be avoided at no cost to long-term investors. I believe that there are ways to capture a reasonable portion of such advances at controlled risk. But there are also times when the attempt to capture speculative gains in overvalued markets would demand too much precision and leave risks poorly controlled. At those times, investors can and should sleep through them (or at least hedge their portfolios), comfortable that any missed, incremental market gains are unlikely to be retained over time.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations, moderately favorable price action, and overbought, overbullish conditions that have historically combined with rich valuations to produce an unsatisfactory return/risk profile for the stock market. The Strategic Growth Fund remains fully hedged here.

In bonds, the Market Climate remained characterized by relatively neutral valuations and relatively neutral market action. At present, the 10-year Treasury yield is near the low of its recent trading range, and given other features of the present Market Climate, I would expect a somewhat skewed response to any economic or inflation surprises, with negative bond market reactions to unfavorable news being stronger than positive reactions to favorable news. In any event, the Strategic Total Return Fund continues to carry a relatively short 2-year duration in bonds, mostly in Treasury inflation protected securities. On strength in the precious metals market last week, I clipped a few percent of our exposure in those shares to bring our exposure back under 20% of assets. The Market Climate for precious metals shares continues to be favorable, and the prospects of a strengthening of the yen are fairly good, but precious metals shares are volatile enough that I prefer not to let our exposure expand much beyond 20% except in the singularly most favorable environments.

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