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October 29, 2007

A Fragile Dependence on Foreign Capital

John P. Hussman, Ph.D.
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A few Fund notes: The Strategic Total Return Fund achieved its highest level since inception on Friday (including reinvested distributions). The Strategic Growth Fund also reached its all-time high on Tuesday, at an NAV of 16.64. Over the past 3 sessions, the Strategic Growth Fund has pulled back by a cumulative 2.4%. Frankly, a pullback of that size isn't unusual in the investment world, but this is one of only a dozen 3-day periods since the Fund's inception in 2000 where we've experienced a decline of more than 2%. The largest such pullback was a temporary 3.69% pullback in January 2001. The deepest overall pullback in the Fund since inception, regardless of duration, has been less than 7%.

Just to provide some insight, about a third of this pullback can be attributed to abrupt profit-taking in a small handful of holdings that had performed well in recent weeks – mainly Plantronics, Amazon, and Broadcom, each of which represent only 1-2% of Fund assets. The remainder was due to a single stock – Wellcare Health Plans (more below). When I noted this on the Fund's website, shareholder services immediately received a call asking how we could possibly be holding Amazon, given my extreme aversion to Google. The answer is that both the valuations and the business model are different.

A good internet business, in my view, is one that creates a “black hole,” of what network theorists call “preferential attachment.” Some companies, particularly Amazon and Ebay, have done a remarkable job of creating hubs where buyers come because sellers are there, and sellers come because buyers are there. In contrast, Google is much more vulnerable to competitive entry, because the technology is well known, server farms are becoming less and less expensive, and users don't become more likely to use Google based on what other users do. Little prevents competitors from gradually sniping market share except the slight neuromotor conditioning created by repeatedly typing the company name. I can't stress enough that the vast majority of corporate value is determined by what is in the “tail” beyond 5-10 years. Google is essentially built on applied mathematics, and will probably have ample competition within a decade.

[Geek's Note: Google's PageRank is essentially the solution to a fixed-point problem x = Ax (with a little bit of “random surfing” noise added), where A is an adjacency matrix indicating which page links to which, and x is the PageRank vector. The basic idea is that the ranking of a webpage is determined by the ranking of the pages that link to it, which means that the PageRank vector is a function of itself. It's a huge sparse-matrix eigenvector extraction, but it's also possible to get at the solution iteratively. Stanford apparently does a good job of preparing its Ph.D. students to solve these monsters. I wrote my economics dissertation on a similar fixed point problem b = f(b) where b is a set of information processing rules of differently-informed investors and f() imposes a rational expectations equilibrium. In that context, the beliefs that investors hold are based on observing economic variables and stock prices that are, in equilibrium, driven by the beliefs that investors hold.]

As a more general stock selection point, it's important to recognize that we value stocks based on the discounted stream of expected cash flows that will be delivered to investors over time. Many stocks with apparently high P/E ratios are solid values on the basis of reasonable assumptions, while other stocks with modest P/E ratios are often quite overvalued. In the early 1990's, Personal Investor Magazine asked me to write two pieces about growth stocks that I viewed as having the best long-term potential. One of those stocks was Cisco (the other was Apple). At the time, Cisco sported a P/E of 35, which many investors viewed as extreme, at least in those days, but Cisco's profits were easily expected to double and triple within a short number of years (which is also likely for AMZN, and without the major risks to market share that GOOG is likely to face). It was already clear that Cisco's products were being readily adopted as part of a growing trend of computer networking, and that there was preferential attachment – once one client used Cisco, the next client became more likely to do the same. Windows/Intel had similar features, especially in the 1990's. These stocks finally became hypervalued in the late 1990's even on generous assumptions.

Suffice it to say that while we've gradually taken profits in AMZN on short-term strength, I don't view the company as wildly overpriced. We continue to show gains in the stock and will adhere to our normal buy/sell discipline to manage this particular position.

Aside from a small number of positions that experienced profit taking, by far the main cause of the pullback in the past few days was a decline in Wellcare Health Plans (WCG) – a position that represented about 2% of our assets and abruptly lost three-quarters of its value in two days, based on panic regarding a Medicare/Medicaid probe. On this, there are few details. The class action suits filed by eager law firms include nothing but the standard catch-all allegations. Florida's own Medicaid program appeared surprised by the investigation.

Given that the facts are not in, the 75% markdown appears more related to a temporary reluctance of buyers to match sellers in the face of uncertainty rather than a true reduction in corporate fair value. To paraphrase Ben Graham, we aren't forced to trade with Mr. Market if we don't like the price he offers on a given day. It turns out that we are in some pretty good company on Wellcare. According to regulatory filings, the largest holders include Renaissance Capital (Jim Simons), George Soros, AQR (Cliff Asness), D.E. Shaw, Jeremy Grantham, and other managers with strong track records. Many health care companies have rebounded strongly from similar investigations, and it wouldn't be surprising to see the stock advance significantly over the next few months on relieved fears, but we'll adhere to our normal buy/sell discipline to manage this position: adding higher ranked candidates on short-term weakness, and selling lower ranked holdings on short term strength.

We generally don't “average down” when a decline moves a stock sharply outside of its normal trading range. We also don't employ mechanical “stop loss” rules (unless you use leverage, such rules are typically not optimal). There are always cases where chasing a stock higher or selling into a panic would have turned out well in hindsight, but those practices aren't effective as a regular discipline.

Finally, I should note that my discussion of individual stocks is intended to provide some context for the mild pullback of recent days, not to focus undue attention on individual holdings that represent just 1-2% of Fund assets or less. We break out the results of our stock-selection separately in the Fund's performance chart, so the overall record of our stock selection discipline is easy to review.

Tax Planning Note: Distributions of short-term and long-term capital gains for the Funds are normally made in November. In the interests of long-term shareholders, we do not provide a specific distribution date. Presently, we anticipate the distribution of long-term gains only in the Strategic Growth Fund of in the range of 3-4% of NAV, but this figure may change from day-to-day depending on fluctuations in the Fund's hedge positions between now and October 31, which must be marked-to-market for tax purposes. We anticipate a distribution of 3-4% of NAV in the Strategic Total Return Fund, divided approximately evenly between long-term and short-term gains.

An “improving” current account is a warning of weaker domestic investment

In recent months, we've begun to observe “improvements” in the U.S. current account deficit (essentially the trade balance). This has been attributed to the weakness in the U.S. dollar. Analysts have quickly jumped on these improvements saying that they will represent an “addition” to GDP growth. While this is algebraically true, it overlooks the fact that there is virtually a 1-to-1 correspondence between “improvements” in the U.S. trade deficit and deterioration in U.S. gross domestic investment.

To understand why this is true, bear with me through some very simple equations, which give us what's called the “savings-investment identity.” Start with the GDP identity ("Y" is GDP, which is equal to consumption + domestic investment + government spending + exports - imports):

Y = C + I + G + X – M

Rearrange

I = Y – C – G + M – X

Subtract and add taxes, which changes nothing, and add a few parentheses

I = (Y – C – T) + (T – G) + (M – X)

In the first parentheses are “private savings:” income minus consumption minus taxes. Next are “government savings:” taxes minus spending (currently a large negative value since the U.S. is running massive budget deficits). Finally, if imports of goods and services are greater than exports, we call (M – X) a “trade deficit.”

Now, notice that if we import $100 of goods and services and only export $70 of goods and services, it must be true that we are exporting $30 of other “stuff.” That stuff is U.S. securities – predominantly U.S. Treasury notes. We call that $30 our “current account deficit” – it measures the amount securities we have to sell to foreigners in order to finance our trade deficit. We can also call (M – X) our import of “foreign savings.”

Look carefully at the identity above. It says that gross domestic investment is equal to private savings, plus government savings, plus our import of foreign savings. Every dollar of investment in the U.S. (we're speaking here of real investment like factories, equipment, housing, etc) must be financed by a dollar of saving either from domestic or foreign sources. Over the past decade, U.S. private savings have been so paltry and U.S. government deficits have been so severe that virtually all of the growth in U.S. gross domestic investment has been financed by foreign capital inflows – that is, a massive and growing U.S. current account deficit.

That's a problem, because it places the U.S. economy at the mercy of foreign willingness to continually accumulate U.S. securities and to finance ever expanding current account deficits. Unfortunately, even a stabilization of our current account deficit (not closing it, just stabilizing it) would cause U.S. domestic investment growth to fall sharply. Most likely, we'll continue to observe some amount of continued growth in capital spending, offset by substantially lower investment in the form of housing.

Here is what the data look like since 1960. The graph below plots the year-over-year change in the U.S. current account (billions of U.S. dollars) against the year-over-year change in U.S. gross domestic investment. The slope of the best fitting line is literally -1.0. Every $1 “improvement” in the U.S. current account is typically associated with $1 of deterioration in U.S. gross domestic investment. Indeed, if you look in the lower right quadrant, you'll notice that major year-over-year improvements in the current account are almost always associated with plunging gross domestic investment.

So the idea that an “improving” current account deficit is good for GDP growth is a lot like believing that walking across the street to the donut shop is “good” for your weight. Sure if you think of the walk in isolation, you're burning calories. But walking to the donut shop is usually directly correlated with eating a donut.

The same idea applies here. If you look at the current account deficit in isolation, the GDP equation leads you to believe that a smaller current account deficit will improve GDP. Unfortunately, the improvements that we're seeing are not coming from increased saving or productivity, but rather, from weakening domestic investment (particularly in the housing sector), which is creating a smaller demand for imported savings from foreigners. As Bill Hester notes this week, there are also growing risks in the area of fixed investment.

The current account deficit virtually always “improves” in a recession, while gross domestic investment collapses. In the coming years, it is virtually inevitable that the growth of the U.S. current account deficit will slow. As a result, it is virtually inevitable that U.S. gross domestic investment will stagnate. Again, much of this will likely represent persistent weakness in the housing sector. But if foreign investors reduce their preference for U.S. securities, we could observe more widespread difficulties in financing domestic investment. Sound fiscal policy would help to reduce these risks. Unfortunately, any hope for such policy is very thin at present.

With regard to the Fed, the amount of “liquidity” created in recent months continues to be nil. As usual, the next batch of rollovers will be on Thursday, and they will represent exactly that – rollovers of existing repurchase agreements, not “new injections of liquidity.” Total bank reserves continue to fluctuate in the $40-$45 billion range, and a total of $294 million dollars of loans are outstanding through the discount window. It is useful to keep in mind that the size and variation in foreign purchases of U.S. Treasuries swamps all Federal Reserve actions many, many times over.

Given that the effect of Fed movements is almost entirely psychological, and that we've got a long way to go as problems emerge among trillions of dollars of mortgage debt, my guess is that the Fed will want to save its weak ammunition to assuage fear in periods where crisis is more evident. So I'd expect a 25 basis point cut, not that I think it matters. Given that virtually all investors assume the same thing, but quietly hope for 50, my guess is that they'll be disappointed. If the Fed goes 50, investors will probably be disappointed shortly anyway because we'll probably observe a plunge in the dollar and a quick move to $100 oil. As usual, I don't take investment positions on expectations such as this, but such considerations do affect where I place strike prices and so forth.

Market Climate

As of last week, the Market Climate for stocks was characterized by unfavorable valuations and moderately unfavorable market action. Bonds have held up well lately, and although that has primarily represented a “flight to safety,” it does tend to be somewhat supportive for stocks unless other internals are clearly deteriorating. On that, breadth has been reasonably good, but trading volume has remained unimpressive, which continues to suggest a backing off of sellers rather than robust demand.

The Strategic Growth Fund remains fully hedged, aside from a few option positions representing less than 1% of assets, which provide a bit of “curvature” to our overall position – allowing us to be somewhat more constructive as the market advances, and tightening our defenses as the market declines. My strongest concern remains the potential for a far more serious market decline than we have yet observed, but we are open to the possibility that market action will improve enough to signal a somewhat more durable willingness of investors to speculate. We don't have enough evidence of that yet. Given present conditions, we would most likely respond to such an improvement in market internals only by lifting part of the short-call portion of our hedges, keeping the defensive puts in place in any event. Overall, the Strategic Growth Fund remains well hedged, but we are open to a moderately constructive position in the event that an improvement in market internals develops.

In bonds, the Market Climate was characterized last week by unfavorable yield levels and moderately favorable market action. Yield levels and valuations carry heavier weight in determining bond positions than they do in stocks, because the future coupon and face value payments are known, so it's harder for investors to dream up a bubble. I reduced the duration of the Strategic Total Return Fund back below 2 years, mostly in TIPS, on last week's bond price strength. The Fund continues to hold about 15% of assets in precious metals shares. While it's possible that long-term Treasury yields will move lower still on economic and credit concerns, the bond market is currently sufficiently overbought that an abrupt “pop” in yields is increasingly likely, regardless of what happens at the short end of the maturity curve. As usual, this is an environment in which I would expect responding rather than predicting to be most effective, because a trading range appears much more likely than a sustained trend. We'll continue to increase our portfolio durations in response to periodic surges in yields, while clipping our durations in periods where yields move to unusually depressed levels.

New from Bill Hester: Fixed Investment and the Technology Rally

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