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July 23, 2007

Garbage and Potatoes

John P. Hussman, Ph.D.
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One of the frequent themes of these weekly comments is the importance of thinking in terms of probability distributions rather than individual outcomes – averages versus instances. If you think about whether market risk is worth taking or not, the main question is always whether (or not) probable market returns are likely to be above Treasury bill yields, on average, given prevailing conditions. The immediate follow-up is to estimate the likely risk.

It's clear that some amount of exposure to market fluctuations is warranted when expected market returns are strongly above Treasury bill yields. In those conditions, the amount of exposure an investor takes in response to a given expected return depends on the range of uncertainty around the expected return, and the depth of periodic losses that a given level of exposure has historically produced. When expected returns are only slightly above Treasury bill yields, the situation allows somewhat more discretion, but generally speaking, it is still appropriate to accept some amount of risk.

Once expected returns fall below Treasury bill yields, the preferences of an individual investor matter much more strongly. If an investor is very sensitive to “tracking risk” and is averse to “missing out” on market advances, including those that ultimately end in abrupt losses, that investor should still stay invested - even in conditions that have historically produced expected returns below T-bill yields. Needless to say, that investor may experience lower long-term returns and deeper periodic losses, on average, but those outcomes are essentially the cost that investors pay for the luxury of participating in every market advance (and it is a luxury because it is clearly uncomfortable to do otherwise). In contrast, if an investor does not value tracking the market up and down in round-trips that tend to be profitless, on average, then it is far more useful for that investor to avoid market risk once expected returns fall below Treasury bill yields.

Though market conditions have been characterized by overvalued, overbought, overbullish features since late 2006, the set of historical precedents has been relentlessly narrowing in recent months, to the point where the only historical precedents remaining are instances that invariably turned out badly (see last week's comment - A Who's Who of Awful Times to Invest). Having constantly encouraged shareholders to think in terms of averages and probability distributions, this puts me in the somewhat awkward position of emphasizing that this is not a forecast of an imminent market loss, even though every prior historical instance has produced such a loss.

Probably the most useful guidance is to say that the probable return to market risk is sufficiently below Treasury bill yields to warrant a fully hedged position, but for risk management purposes, it's never a good idea to rule out an advance. Overall, investors should not position their investment portfolios in ways that would have the effect of relying on a market decline or a market advance.

Value versus price

The Strategic Growth Fund remains fully invested in a broadly diversified group of stocks that I view as reasonably valued (in the sense that their prices are appropriate given the probable stream of future cash flows that the companies can be expected to deliver to investors over time), with an offsetting hedge in the S&P 500 and Russell 2000 to remove the impact of general market fluctuations. The stocks held by the Fund also generally reflect favorable "sponsorship" in that price/volume behavior, estimate revisions, and other factors suggest that other investors have a favorable inclination or positive information about these companies (I don't seek out raw “momentum,” which I think is a dangerous investment strategy).

It's important to recognize that there is often an astounding gap between price and value among individual stocks. Recall that during the bubble, many companies traded for hundreds of dollars per share, while at the same time they had zero value, in the sense that they ultimately did not deliver any cash flows to investors at all. In other words, it was not at all inconsistent to say that the share price of a company was in the hundreds of dollars, and yet its value was an order of magnitude less. In many cases, the bulk of their tangible assets represented IPO proceeds, and a large proportion of earnings (when companies had them) were quietly given away to employees and corporate insiders through stock and option grants (this can be quickly estimated from footnotes in the financial statements).

It seems that investors have learned no durable lesson from what happened next – not only to the stocks, but to many companies that were profitable leaders in their industries, yet traded at prices that depended on untenable assumptions. I recall in early 2001 getting a bit of grief on CNBC over an analysis that Alan Abelson circulated in Barron's, noting that the values I calculated for Cisco, Sun, EMC and Oracle were small fractions of their prices at the time (as usual, these were not presented as forecasts). As it happened, those stocks collapsed, and anyone using my value calculations as forecasts would have found them, in hindsight, to have been slightly optimistic.

Lest I give the impression that my defensive investment view is congenital, I should at least note that I've also been vocally optimistic at times, sometimes in a clear minority – the Los Angeles Times called me “one lonely raging bull” in the early 1990's. Suffice it to say that I have no aversion to significant investment exposures if market conditions warrant them (as they have in a significant portion of market history). The ability to take unhedged investment positions, and even to use a modest position in call options as leverage, is intentionally provided in the Prospectus of the Strategic Growth Fund and is likely to be relevant at some point in the future. Still, with the exception of a largely unhedged stance in 2003, I've admittedly been averse to market valuations for some time. Then again, given that the cumulative total return on the S&P 500 has lagged Treasury bills for the past 8 years, I'm comfortable that this aversion has a reasonable basis.

Discounted cash flow can be a long-term proposition for any particular stock, but it can be supportive when the speculative air is being let out of lower-quality companies. Fortunately, it's also true that even if there are challenges estimating the valuation of any particular company, or lags in the recognition of that value, these variations average out in a well-diversified portfolio. For that reason, a disciplined, value-conscious approach to stock selection typically produces very good return/risk characteristics.

Garbage and potatoes

To offer an idea of how much the recent advance has represented a speculative run on “low quality,” Bill Hester put together the following chart. It presents the performance of stocks rated “high quality” by Standard & Poor's, compared with the performance of all stocks with an S&P quality rating. Presently, the capitalizations being awarded to “garbage stocks” are very rich. Historically, these extremes haven't persisted.

The chart above is through the end of 2006. The same relative performance can be observed in the debt markets, where junk has clearly outperformed higher rated debt in recent years. It's notable that the “quality spread” in stocks has begun to reverse in recent weeks, along with risk spreads in the corporate bond market. Note that the yield spread on the CBOT's new credit default swap (CDS) index has just moved to a fresh high. A credit default swap is a way of transferring credit risk from one holder to another – a rising spread indicates increased concern about default risk. This will be important to monitor in the weeks ahead.

As I've often noted, the worst situation for an investor is when risk premiums are low and are being pressed higher. When that happens, stock and corporate bond prices can weaken significantly because the only way to get the yield (and risk premium) up is to drive down the price, and it takes a substantial amount of price decline to bring a low yield to higher levels.

A seasoned investment analyst once put it to me this way in an easy southern drawl. Suppose you've got a 100 pound sack of potatoes. Now, since there's a lot of water in a potato, suppose what you've really got is 1% pure potato, and 99% water. Now suppose you let that bag sit out in the hot sun, and finally you go get it, and now it's 2% pure potato, and 98% water. What do you guess that sack weighs?

50 pounds.

That general principle is why speculating in a richly valued, overbought market with rising interest rates is typically a bad idea. This instance may turn out to be different, but the average outcomes are sufficiently poor to keep us fully hedged.

Market Climate

As of last week, the Market Climate for stocks was characterized by unusually unfavorable valuations, neutral market action on the basis of price trends and internals, and continued overbought, overbullish factors that have historically been associated with market returns below Treasury bill yields, on average. Market internals have deteriorated further in recent sessions, credit spreads have shot higher, and we are beginning to observe higher intra-day volatility and large numbers of both new highs and new lows. These features are characteristic of a growing internal “turbulence” or lack of “uniformity” that often, though not always, precedes periods of market weakness. Again, again, that's not a forecast, but that lack of uniformity is often a sign of elevated risk.

Just a note on our current hedge, which I hope will be useful in understanding the day-to-day movements of the Fund. The Strategic Growth Fund continues to carry a “staggered strike” hedge that provides somewhat stronger defense against market weakness at the cost of less “implied interest” earned on the hedge. Importantly, the Fund is not positioned in a way that would be expected to experience sustained losses if the market advances over time, yet we would expect to observe modest gains on days where the market declines below our strikes, and may give back some of those gains if the market advances back through our strikes before we have a good opportunity to reset them.

To understand the distinction here, suppose that you have a certain amount of assets on which you would normally expect to earn $100 of interest. Now suppose you take a portion of that expected interest and purchase a put option, say for $80. Notice that on a day-to-day basis, you'll tend to gain on market declines and give back on market advances, but even if the market advances relentlessly, you'll still end up accruing a net $20 of interest. That's essentially what's going on here.

In a matched-strike hedge (long put / short call at the same strike price and expiration), a hedged investment position earns the difference in performance between the stocks we own long (after expenses) and the indices we use to hedge, plus implied interest on the hedge equal to roughly the 3-month Treasury bill yield. Of course, the Fund can vary the strike prices of the short call and the long put, provided that only one of them is “in the money” when the position is initiated. In a “staggered strike” position, we essentially raise the strike prices of the long puts closer to the level of the market. Given the current level of interest rates, this is equivalent to buying a certain amount of additional option premium with the implied interest we would otherwise earn on the hedge.

Though a hedged position is not particularly unusual for the Fund, our current “staggered strike” position is not typical, and is not one that I would expect to carry for a long period of time. Rather, it is a response to market conditions that are unusually hostile from a historical perspective. Still, the Fund does not establish short positions that exceed the dollar value of our long stock holdings (though losses might still occur if our stocks were to perform poorly or if we experience a net decay in option time-value), so we can allow for both market strength and market weakness here, without relying on either.

At present, the difference between the Fund's “staggered strike” position and a flat hedge amounts to about 1% of assets, essentially financed with the implied interest on our overall hedge. Provided that our stocks perform reasonably in line with the major indices, the Fund's returns (aside from modest day-to-day fluctuations) are expected to be roughly flat in the event of a continued advance, and moderately positive in the event of market weakness. The Fund's actual returns may be higher or lower depending on the performance of our stocks relative to the indices we use to hedge.

In bonds, the Market Climate was characterized by unfavorable yield levels and unfavorable yield pressures, holding the Strategic Total Return Fund to a short duration of about 2 years, mostly in TIPS. On further strength in the precious metals shares, I pared the Fund's exposure to about 10% of assets in this area. The Market Climate is still generally positive for precious metals, but is now at a much more moderate level following the strong advance in these shares. As usual for our precious metals holdings, we tend to increase our exposure following short-term weakness and reduce it on short-term strength, around a core position informed by the prevailing Market Climate.


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