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November 5, 2007

Pump It Up

John P. Hussman, Ph.D.
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Just a note - The Hussman Funds generally pay their required capital gains distributions during November, which I expect to represent in the area of about 4% of each Fund's net asset value. The net asset value of each Fund, of course, declines by the amount of the distribution on the ex-day (thus reducing later capital gains liability). In the Strategic Growth Fund, the entire distribution is expected to be long-term in nature. In the Strategic Total Return Fund, the distribution is expected to be about half long-term and half short-term in nature. In both cases, the distribution is expected to be less than the one-year appreciation in the Funds, so investors trading to avoid the distribution would generally increase their tax liability.

There's a lot of misunderstanding about mutual fund distributions. Investors seem not to take into account the tax impact of the offsetting reduction in NAV. If you work through the math, you'll find that when a distribution is partly long-term in nature, the true “tax cost” of taking the distribution is negative for short-term holders, meaning that they have an incentive to hold the Fund in order to capture the distribution. Meanwhile, long-term holders have no incentive to avoid a distribution if they have more than minimal unrealized gains. Potential long-term investors may have a modest incentive to defer investment until the distribution is paid, but only if the Fund's return during the deferral period is expected to be small.

Pump it up

Last week, the Associated Press reported: “The Federal Reserve pumped $41 billion into the U.S. financial system Thursday, the largest cash infusion since September 2001, to help companies get through a credit crunch… it was the largest single day of operations since $50.35 billion was pumped into the system on Sept. 19, 2001, following the terror strikes on New York and Washington. Since August, the Fed has been pumping cash into the financial system to help ease strains from the credit crunch.”

Wow. You can almost hear the pumps. That sounds like an impressive and calculated example of the Fed moving to intervene in order to ensure the solvency of our markets. Various reports said the injection was intended “to help stem the deepening crisis in the mortgage markets.” Some even suggested it was a “Citigroup bailout.”

The truth is that the entire $41 billion was nothing more than a predictable rollover of existing repurchases to maintain a stagnant $40-$45 billion pool of bank reserves – a pool that experiences almost no variation over time and has no material relationship with the volume of bank lending.

If you examine the NY Fed's releases on open market operations, you'll find that in fact, the Fed drained $1.5 billion in reserves on Thursday. Specifically, a total of $42.5 billion of temporary repurchase agreements came due on November 1, only $41 billion which were rolled over. The expiring repos were: a $5.5 billion 1-day repo from October 31, a $12 billion 2-day repo from October 30, a $19 billion 7-day repo from October 25, and a $6 billion 14-day repo from October 18. Those repos, in turn, were rollovers of prior repos, and so on.

Fed Open Market Operations: http://www.ny.frb.org/markets/openmarket.html
Total Discount Window Borrowings: http://research.stlouisfed.org/fred2/data/TOTBORR.txt
Total Bank Reserves: http://research.stlouisfed.org/fred2/data/TRARR.txt

The Fed has injected no “liquidity” at all into the banking system for months. As of Friday, there were a total of $41.25 billion in repurchase agreements outstanding, $3.5 billion less than at the end of September, though $2.75 billion more than at the end of August. That's the range of variation that the Fed has been managing. The total amount of outstanding repurchases has ranged between $40-$45 billion in recent months, only modestly above the average for the year as a whole. Meanwhile, the total amount that the Fed has lent to banks through the discount window fell again last week, to $283 million. Contrast that with $6 trillion in total bank loans outstanding, and you get the point.

If you tie out the repos currently outstanding, you'll find that $27 billion will come due again this Thursday, November 8. Depending on what the Fed does with 1-3 day repos between now and then, we could see another huge apparent “intervention” on Thursday. Some investors will be happy to imagine that the Fed has their back. Some will be frightened to think that the Fed must be very concerned to make such large “injections of liquidity” two weeks in a row. The truth is that we'll be observing a meaningless, automatic, predictable rollover of existing repos.

In the coming months, it will be increasingly important not to confuse growth in aggregates like money market balances and M2 with Fed-induced liquidity. We continue to observe shrinkage in the commercial paper and asset backed debt markets. As these obligations come due, they must either go unfinanced, or they will have to be financed through other types of debt. As I've noted before, banks will most likely be the chosen intermediary, not only as a place for investors to deposit their savings as an alternative to holding riskier securities, but also as a place for borrowers to obtain alternative financing. As a result, the shrinkage in the commercial paper market will be matched by an expansion in bank financing. This will not be new “money creation” but replacement financing through an alternative intermediary. Moreover, the apparent “money on the sidelines” in banks and money market funds will not represent cash waiting to be deployed. It will represent claims on money that has already left the building and has long been spent. For a more complete discussion, see The "Money Flow" Myth and the "Liquidity" Trap .

Falling yields but increasing risk aversion

On the subject of the second cut in the Fed Funds rate, Tim Hayes of Ned Davis Research notes “the widespread view that with the Fed's second rate cut, the market will celebrate for the rest of the year. But the one sector that would normally rally the most ahead of the cut – the Financials – has remained in anything but a celebratory mood. Normally one of the two strongest sectors during the six months preceding a second cut, the Financials have been the worst performer over the latest six months, and they appear to remain suspicious that more bad news is flowing through the corporate pipeline. The weakness suggests that the second rate cut will have little, if any, bullish influence on the market. The performance of the Financials is, in fact, less consistent with a second rate cut than it is with a market that's reached a major peak.”

Since breaking down notably in July, our own measures of market internals have failed to recover despite a rebound in the major indices. We observe deteriorating internals not only in the weak behavior of financials, but in sluggish recovery of market breadth, dull volume, divergent leadership (large numbers of both new highs and new lows), and a variety of other measures. That internal weakness tends to invite abrupt losses, particularly when valuations are rich.

Currently, the behavior of Treasury yields is the most favorable element of market action, but as in 2000-2002, this appears to be related to concerns about debt quality and defaults, rather than a general willingness of investors to accept lower risk premiums and lower rates of return.

That distinction is important. Historically, the most powerful market returns have emerged from conditions of high risk premiums and yields (depressed stock prices and valuations) in an environment where there is clear downward pressure on those risk premiums and yields. That's why, for example, you'll find historically that the best long-term stock market returns have followed periods of high interest rates, not low ones. The weakest returns, hands down, have emerged from conditions of depressed risk premiums and yields (elevated stock prices and valuations) in an environment where there is clear upward pressure on those risk premiums and yields. Accordingly (but counter to common intuition) you'll also find historically that the poorest long-term stock market returns have followed periods of depressed interest rates.

Presently, the trend of Treasury yields is constructive, but that trend is in the context of very overbought conditions in bonds, born of increasing concerns about mortgage delinquencies and securitized debt. Meanwhile, stock valuations are quite high even without normalizing for profit margins. Normalizing for profit margins, the current P/E on the S&P 500 would be well above 20. To get an idea of where valuations are adjusting for the level of profit margins, it's notable that the price/revenue multiple on the S&P 500 is currently about 50% higher than it was before the 1973-74 and 1987 plunges. While it's not a grand assumption to expect profit margins to normalize, we need not make that assumption to conclude that stocks are richly valued here. Even if current profit margins are sustained indefinitely, stocks would still be priced to deliver unsatisfactory long-term returns.

Nevertheless, we're still open to establishing a more constructive investment position (though retaining our downside put option defense in any event) if the market can recruit more favorable internals, but we haven't observed such improvement as yet.

A note on returns, investment horizons and compounding

A reasonable long-term horizon (over which valuations have predictably mattered) has generally been about 7-10 years. Over that horizon, valuations have a strong tendency to dictate subsequent returns. A single complete market cycle is usually enough, so a period as short as 4-5 years can often be a sufficient “long term.” Over shorter horizons, speculative pressures, false beliefs, “new economy” hopes, and other factors can delay the impact of overvaluation. We saw this clearly in the late 1990's, and we've seen it recently as well. The quality of market action can be helpful in capturing short-term returns in speculative environments, but once overvalued, overbought, overbullish conditions are established, further speculation becomes very error-prone.

By remaining hedged in that kind of speculative environment, particularly over the past year, I've left returns on the table in hindsight. It's always my hope to reward our shareholders' trust with strong growth in their investments, and I'm disappointed that the recent performance of Strategic Growth has been more bond-like than equity-like. Still, it's dangerous to mourn missed returns in richly valued and speculative markets, because such returns are rarely durable and tend to be unexpectedly surrendered. There are certainly indicators and models that would have supported a more aggressive position in recent years, but when we test them historically, they materially underperform our existing measures, producing lower returns and deeper pullbacks. I've incorporated a few elements in recent years that do perform well (in split samples with a holdout for cross-validation), but I can't say that there are many instances where I would have hedged the Fund much differently than I actually have, given the available information.

Not that I expect our recent hedging to cost us anything in terms of missed long-term market returns. Indeed, I expect 2003 to be the only year of this entire bull market for which the gains of the S&P 500 (in excess of Treasury bill yields) will be retained over the complete market cycle. Given the 10.25% annual total return in the S&P 500 since the end of 2003, even a minimal one-year 20% bear market decline would whittle the total return of the index since then to just 3.2% annualized [0.80 x (1.1025)^3.84]^(1/4.84) – 1 = 0.032.

In any event, I'm confident that adhering to a consistent discipline is the best way to achieve our longer-term investment objective. That investment objective is to outperform the S&P 500 over the complete market cycle (bull market and bear market combined) with smaller pullbacks than a buy-and-hold approach. On that basis, the Strategic Growth Fund has strongly outperformed the major indices since 2000 without experiencing even a 7% pullback, and it remains less than 2% from a fresh high. Meanwhile, even if the Fund was to simply match Treasury bill returns in a market selloff, a one-year decline of less than 20% in the S&P 500 Index on a total-return basis would currently be sufficient to put the Fund ahead of the index not just since 2003, but since the end of 2002, when the bull market began. Clearly, my objective is to achieve much stronger performance.

A final “anti-marketing” message: As I frequently emphasize, the Strategic Growth Fund is intended for investors with the objective of achieving long-term returns in the stock market, with added emphasis on defending capital. It is a growth fund, not a bear fund, nor a market-neutral fund, and as such is managed with the intention of achieving total returns in excess of the S&P 500 Index over the long-term, measured over the complete bull-bear market cycle. However, the Fund is not appropriate for investors with investment horizons encompassing less than a full cycle, and is emphatically inappropriate for investors wishing to closely track market fluctuations. Investments by such investors are discouraged. The imperfect correlation between the Fund and other major indices may provide diversification benefit as part of a broader portfolio strategy, but this is secondary to the Fund's primary objective, which is to be an effective, risk-managed vehicle for disciplined long-term saving and investment.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action. The most constructive aspect of market action remains the behavior of Treasury yields, but this is largely a flight-to-safety effect rather than an indication of investors' willingness to accept lower rates of return more generally. Still, if we observe uniform improvement in market internals such as breadth, trading volume, leadership, industry action and other factors (the uniformity of improvement matters more than the extent), we would expect to establish a somewhat more constructive investment stance by removing a portion of the short-call side of our hedges, leaving the defensive put options in place. In this way, we would remain protected even against a sudden market collapse, though perhaps with a couple of percent of “give” at first. For now, we don't have enough evidence to depart from a fully hedged investment stance.

In bonds, the Market Climate was characterized by unfavorable valuations and generally favorable though very overbought market action. The Strategic Total Return Fund continues to carry a duration of just under 2 years, mostly in TIPS. In precious metals shares, we used last week's strength to slightly clip our exposure to about 12% of assets. The Market Climate remains generally favorable for precious metals on our measures, but given their tendency for significant volatility and abrupt corrections, we tend to trade around a core position, adding exposure on short-term weakness and clipping it on short-term strength.

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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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