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June 30, 2008

Projected Long-Term Market Returns are Still Tame

John P. Hussman, Ph.D.
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Last week, the Dow Industrials and the S&P 100 Index broke their March lows, partly on concerns about oil, but primarily, I suspect, on rapidly changing perspectives about recession and upcoming earnings reports. Short-term, stocks are oversold, but they are oversold in an unfavorable Market Climate coupled with generally firm interest rates. That combination has not typically produced strong returns from bottom-fishing expeditions. Still, the market is compressed enough that we should allow for the typical fast, furious, prone-to-failure bounce to clear that condition.

Meanwhile, despite the weakness, investors are displaying very little panic, in the continued faith that the March lows represent if not the bottom at least a relatively supportive safety net from which stocks will bounce and sustain an extended trading range. That faith is demonstrated by the still-contained level of 23 on the CBOE volatility index. I expect that we'll gradually cover portions of the short-call option side of our hedges (leaving the defensive puts in place) if the market continues lower without a significant volatility spike.

With an employment report and second-quarter earnings reports (and most importantly, second-half guidance) due in the next few weeks, the faith of investors in those March lows may be tested. My impression is that stocks will not see a durable intermediate-term low until the point where a recession in progress is taken as common knowledge, without the debate that persists even now. That's not to say that acceptance of a recession would mark a long-term bear market low, particularly because the S&P 500 hasn't even lost 20% from its peak. On that subject, I'm not inclined to form any expectations at all, preferring to take our evidence as it comes.

For now, the Strategic Growth Fund remains fully hedged. We'll accept some amount of speculative market risk if internals improve sufficiently, and some amount of investment risk if valuations improve sufficiently. Ideally,  we'll observe both a further decline sufficient to raise the expected long-term return on stocks toward say, 9% or more, coupled with a better interest rate environment and a uniform strengthening of internals off of that weakness. That is generally the pattern observed at prior bear market lows through history.

If current levels were to turn out, in hindsight, to be the final lows of this decline, I suspect that the overall return over the next cycle (by the time we do observe a full 20% loss) will be as tame as we've seen since the bull market started in 2003. Over the past 5 years, still with no 20% bear market completed, the total return of the S&P 500 Index has averaged 7.5% annually. A market low here and now would compete with the 2002-2003 lows for the highest valuation observed at a cyclical market trough. Suffice it to say that the decline has improved prospective long-term returns, but the most likely 10-year return for the S&P 500 (standard method) is still only in the range of 3-6% (with -0.5% and 8.5% as the extreme bounds except in the event of a 2000-type bubble or a 1974-type trough).

On the bright side, the dismal 2.85% annual total return of the S&P 500 over the past decade has actually exceeded the return of roughly 0% that we projected a decade ago, so maybe we'll get equally lucky over the coming decade. My preference would be a standard, run-of-the-mill bear market of about 30% from last year's highs, which would give us a good chance at long-term returns closer to 9% annually, provided a modest amount of multiple expansion over time from the final low.

[Legend: the dark blue line depicts the actual 10-year annual total return of the S&P 500 Index. The four bands represent projected returns based on sustained long-term earnings growth at a 6% annual peak-to-peak rate, coupled with terminal valuation multiples on mid-channel earnings of 7, 11, 14 and 20, representing trough, median, average and peak multiples on that measure.]

Unfortunately, for the S&P 500 to be reliably priced to deliver long-term returns of 9% or more without relying on multiple expansion, the index would have to move below 900. That said, there is no reason that a full revaluation of stocks has to occur in this particular cycle. Secular bear market periods, which I believe the market began in 2000, generally involve a series of cyclical bull-bear cycles which gradually take valuations lower at each successive cyclical trough (even if prices don't fall below prior troughs)..

In any event, the S&P 500 is presently not a compelling value taking the index as a whole, though there are individual stocks that we hold in the Fund that do appear to be undervalued.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action. The Strategic Growth Fund continues to be fully hedged against general market risk. As always, the day-to-day returns of the Fund will be driven by the difference in performance between the stocks we hold long and the indices we use to hedge. That difference may be positive or negative and therefore represents our largest source of risk, but over time, it has also represented the primary source of long-term Fund returns.

In bonds, the Market Climate was characterized by relatively neutral yield levels and slightly unfavorable yield pressures. The Strategic Total Return Fund currently carries a duration of about 2 years, primarily in U.S. Treasury securities, with just over 15% of assets allocated to foreign currencies.

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