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March 5, 2007

Rapunzel Gets a Trim

John P. Hussman, Ph.D.
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“Reviewing the foregoing instances carefully, one of the striking features that emerges is the abruptness of the declines. -10.5% in 30 days, -12.3% in 50 days, -36.1% in 38 days, and so forth. The first several days of decline from a market peak has often erased weeks and sometimes months of prior net gains. It's that tendency for abrupt declines from overvalued, overbought, overbullish conditions that has held us to a defensive position despite market action that otherwise looks “good” and has repeatedly produced marginal new highs.”
Hussman Funds Weekly Market Comment - Hazardous Ovoboby! January 15, 2007

Needless to say, last week's decline had virtually nothing to do with China. While the decline in China (reflecting similarly overvalued, overbought and overbullish conditions) may have been a catalyst, blaming China for the U.S. decline is like having an open can of gasoline next to your fireplace and blaming the particular spark that sets it off. We need not investigate the personality, life history or future career path of that particular spark.

The focus on China last week was reminiscent of the extreme focus placed on the monthly trade numbers following another much worse consequence of “ovoboby” – the 1987 crash. Investors could find no news to “explain” the crash in that instance, except an unusually large trade gap with Germany, so they continued to fear that particular piece of data. But day-to-day news events rarely “cause” large market movements. They are simply catalysts. Even the decline following 9/11 was due largely to a market that was richly valued and already skittish. Once certain extremes are clear in the data, the main cause of a market plunge is usually the inevitability of a market plunge. That's the reason we sometimes have to maintain defensive positions in the face of seemingly good short-term market behavior.

International Factors

Currently, my impression is that the undervalued Japanese yen represents a destabilizing risk much greater than that of overvalued Chinese stocks. Until recently, one of the factors that suppressed the value of the yen has been the “carry trade,” whereby yield-hungry investors borrow yen at low Japanese interest rates, sell the yen for U.S. dollars, and invest the proceeds in higher yielding Treasury securities. That works provided that the yen does not appreciate – if it does, the borrowed yen have to be paid back at an unfavorable exchange rate that can offset the difference between interest rates.

I am not a fan of this carry trade precisely because I view the yen as the most undervalued among the currencies of developed nations. The yen carry trade represents a speculation rather than a sound transaction. As we saw in the stock market last week, the hallmark of bad speculations is that they tend to unwind abruptly.

The yen did strengthen enough last week that a standard “fast, furious, prone to failure” rebound in the U.S. dollar (a pullback in the yen) is a good possibility in the near-term. Longer term, however, the risk of U.S. dollar crisis (essentially a sharp depreciation of the dollar against other currencies) should not be overlooked. We've fed a habit in recent years whereby the U.S. has run enormous trade deficits with China and Japan, and these countries, in turn, have lent us back the money (by accumulating U.S. debt securities) so that we can maintain our standard of consumption through increased indebtedness. This is not an equilibrium, and disequilibrium situations have a tendency to produce painful adjustments. Once certain extremes emerge in the currency market, as in the stock market, the main cause of a market plunge is usually the inevitability of a market plunge.

Investment Posture

While the stock market continues to be priced to deliver unsatisfactory long-term returns (last week's decline was like giving Rapunzel a trim), the market is in an interesting situation with respect to shorter-term outcomes.

Specifically, we observed some damage to market internals last week, but not enough to conclude that investors have abandoned their preference for speculative risk. My best estimate is that we would require a further general market decline of about 2% (on say, a weekly closing basis) to arrive at that conclusion.

Meanwhile, last week's decline was enough to clear the persistent overbought condition of recent months and take the S&P 500 back to October's levels. It's not quite oversold on anything but a short-term basis, but the clearing of this overbought condition made it reasonable to remove a portion of our short call options last week (we continue to hold put option positions to defend against further losses).

So while the market's recent decline has the capacity to extend much lower, the evidence is not clear that investors have abandoned their speculative whims. Having cleared the recent overbought condition, we're now willing to accept a contained amount of speculative exposure to market fluctuations (using call options only). The appropriate strike prices of those calls are no lower than about 2-3% under current levels. On a further deterioration of the S&P 500 below about 1350, all bets are off. If I sound like less than an enthusiastic bull, it's because I have no enthusiasm for present conditions other than market action that allows the possibility that speculators may continue to speculate for a while.

Overall then, I would expect our current investment position to allow the Strategic Growth Fund moderate participation in a market advance, without much risk of loss (on the basis of general market fluctuations) if the market declines more than a couple of percent. As always, the actual returns of the Fund are driven not only by our hedge position, but also by the performance of our individual stock holdings relative to the market. That relative performance can be positive or negative, but over time, it has contributed substantially to the long-term returns of the Fund.

Though the markets may not experience an extreme flight to quality here, my impression is that the re-introduction of risk concerns last week may prompt a more moderate shift in investor preferences, toward higher quality stocks of the kind that the Strategic Growth Fund continues to emphasize.

Operating Earnings and OPM

A few comments about prevailing bullish themes here. Probably the main bullish theme at present is the misguided focus on “forward operating earnings,” which create the impression that stocks are reasonably priced. This piece of bait contains a very long, sharp hook, which is likely to keep many investors on the line well into the next bear market.

Expectations for future operating earnings assume that current, record high profit margins will not only be sustained, but will expand further. Yet even when earnings ultimately fall short, analysts will be under no obligation to lower their “forward” expectations, at least initially. The resulting illusion of cheap valuations, fairly early in the next bear market, is likely to keep a great many investors holding on deep into the decline (whenever it begins in earnest). As in many other bear markets, earnings will probably decline convincingly only after a great deal of damage has already been done.

I cannot emphasize enough that price/earnings ratios, especially those based on “forward operating earnings,” are unusually poor metrics of valuation at present.

As a refresher of where the earnings picture stands at present, note that S&P 500 earnings have now slightly exceeded their long-term 6% growth trendline, while profit margins are about 50% above the norm (i.e. an earnings trendline about 33% lower would run through the middle of the data). From an historical perspective, this is about as good as it gets – once earnings have become similarly elevated, one has generally been able to find a point years later where earnings have achieved zero growth from that peak.

Given the tendency of earnings to be well-contained by that 6% growth trend over the long-term, we can create an instructive version of a “normalized” price/earnings ratio. In this case, we can ask “How has the S&P 500 index typically been priced, relative to those “top of channel” earnings?”

The chart below tells the story. For the most of stock market history except the past decade, the ratio of the S&P 500 to “top of channel” earnings has averaged just 10. Indeed, the multiple never exceeded 14 until the late-1990's (even at bull market tops).

The current multiple is 18.4, about the level it first reached in 1998. Not surprisingly, the S&P 500 has lagged Treasury bills since then, so regardless of short-term prospects, it's clearly not the case that these rich multiples are suddenly consistent with satisfactory long-term market returns. How do analysts imagine that stocks are priced to deliver anything better than Treasury bill returns over the coming 5-7 years?

A related theme is the notion that stocks must be good values because of the private equity buyouts we've been observing. It's important to understand that these buyouts are being done with OPM – other people's money – and that the main factor driving them is not low stock valuations but low risk premiums. Risky debt can currently be issued at interest rates barely above the low yields on default-free Treasuries. This will certainly end badly for investors in low-rated credits (as companies that issue sub-prime mortgages are beginning to realize). It is no indication of attractive stock market valuation.

Investors should be skeptical enough not to draw conclusions from transactions that use OPM. It's interesting, for example, that analysts wax rhapsodic about corporations repurchasing their shares, while ignoring the fact that sales of personal stock by corporate insiders have rarely been higher (recently at rates of 8-10 shares sold for every share purchased). What people do with their own money is much more informative than what they do with someone else's. When people say that some private-equity deal indicates good value in the stock market, remember that the deal is usually being done with somebody else's dough.

As a side note, I hope that our shareholders derive some measure of confidence that virtually all of my personal assets (aside from a small amount in money market funds) are invested in the two Hussman Funds.

Market Climate

As of last week, the Market Climate for stocks was characterized by unfavorable valuations and tenuously favorable market action. As noted above, last week's decline cleared the overbought condition of the market, but also weakened the technical condition of the market. Though a further decline of roughly 2% or so would complete that deterioration enough to conclude that investors have abandoned their speculative mood, we don't have that evidence in place. For that reason, we've established a moderate position in index call options with strike prices as much as 2-3% below current market levels. We don't have much at risk in the event of further weakness, but the position should allow us to participate moderately if the market recovers materially in the weeks ahead.

With regard to last week's performance, as usual, the most defensive position taken by the Strategic Growth Fund is a fully-hedged stance. As I noted in my January 29, 2007 market comment, “The Strategic Growth Fund is fully hedged against the impact of market fluctuations, holding long-put / short-call combinations against our diversified portfolio of individual stocks. As always, no more than one of those options is “in-the-money” at the time the position is established. At present, option premiums are very inexpensive due to unusually low implied volatility, so our strike prices are staggered in a way that gives us a reasonable amount of local “gamma.” On balance, this works out to imply a modest reduction in the "implied interest" earned on our hedge, in return for a stronger defense.”

Essentially, the Fund was positioned prior to last week's decline in a way that would generate moderate gains on a substantial market decline, without risking expected losses if the market would have continued higher. The cost was a modest reduction in the “implied interest” we normally earn on our hedges. The returns have clearly been worth that cost.

As the put option portion of our hedges moved substantially in-the-money last week, I quickly “gamma scalped” our hedge by lowering put strikes and taking “intrinsic value” off the table. I then used that premium to buy in a portion of our short call position. This currently gives the Fund a profile where it remains well defended against the impact of substantial further market losses, especially if the market moves more than a few percent lower, but can also be expected to benefit moderately from a recovery in the market, should it occur.

In bonds, the Market Climate is now characterized by unfavorable valuations and relatively neutral market action. The risk of unwinding in the yen carry, as well as the inversion of the Treasury yield curve, creates notable risk for the U.S. bond market.

The current Fed Funds rate is 5.25%, while the 10-year Treasury yield is 4.5%. In order to establish even a modestly positive slope to the yield curve, the Fed would have to make 6-8 quarter-point cuts in the Fed Funds rate with the 10-year yield unchanged. Unless we observe deflationary pressures (not simply a softening of inflationary ones) it appears unlikely that we'll see a substantial reduction in long-term Treasury yields even in the event of a recession. Our fixed income position in the Strategic Total Return Fund continues to emphasize a limited duration of about 2 years, mostly in TIPS, with about 20% of assets in precious metals shares.

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