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November 3, 2008

Value Dinosaurs

John P. Hussman, Ph.D.
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2008 Capital Gains Distributions: The Hussman Funds generally pay capital gains distributions in November of each year. As our long-term shareholders may remember from the 2000-2003 bear market, IRS rules for mutual funds require hedging gains on options to be booked annually for tax purposes (even if the positions are still open), which affects the timing of our distributions from one year to the next, but doesn't increase their amount over the complete market cycle. Fortunately, because of the way the computations work, this year's distribution will also be primarily long-term in nature (taxed at currently favorable long-term rates), and should substantially reduce the amount of distributions next year (when tax rates may well be higher).

My expectation is that 2008 distributions in the Strategic Total Return Fund will amount to about 4.5% divided between short-term and long-term capital gains. In the Strategic Growth Fund, we anticipate a distribution of about 12-14% (our current estimate is 11.9%), about nine-tenths of which we expect to be long-term gains taxable at a top rate of 15%. The actual amounts will be posted to the Fund News section when those distributions are paid. This is not an estimate of the taxes payable - it is an estimate of the distribution itself. Given that the S&P 500 has lost 32.8% year-to-date while Strategic Growth is down 1.2%, the gain on our option hedges could certainly have required a larger distribution, but we were able to sell a number of holdings when they could be replaced by more desirable candidates.

It is important to understand that while mutual fund distributions result in a tax event, they also lower the NAV of a fund when that gain is paid out, resulting in an offsetting reduction in future liability. The net taxable gain is usually a reasonable reflection of the actual gain that an investor achieves, particularly for long-term investors – it's just that the timing gets altered. That said, long-term investors in the Strategic Growth Fund having an expected holding period of more than a few years may wish to defer new purchases until after the distribution.

Finally, we recognize that a good number of financial advisors and shareholders use the Hussman Funds as part of a broader diversification strategy that includes periodic rebalancing. For advisors with multiple clients investing at different times, the 6-month redemption fee period can cause some difficulty even for incremental changes. The Board of Trustees spent a lot of time evaluating this issue within the context of the Funds' determination to discourage short term investments. After evaluating the transactions data, the redemption fee period has been shortened to 60 days (from the prior 180 day period), effective November 1, and retroactive to earlier investments still held as of November 1 (which means that an investment made more than 60 days ago, but still held by the shareholder, is no longer subject to redemption fees). This is expected to discourage short-term trading in the Funds while allowing somewhat more flexibility for investors and managers using the Funds as part of a disciplined investment strategy that includes periodic rebalancing.

Where are we now?

In early 2007, I wrote a piece called Rip Van Winkle, noting “advances in overvalued markets are regularly given back at great cost to investors who overstay, and can be avoided at no cost to long-term investors. I believe that there are ways to capture a reasonable portion of such advances at controlled risk. But there are also times when the attempt to capture speculative gains in overvalued markets would demand too much precision and leave risks poorly controlled. At those times, investors can and should sleep through them (or at least hedge their portfolios), comfortable that any missed, incremental market gains are unlikely to be retained over time.”

A few weeks later, I posted another commentary titled Fair Value - 40% Off. Since then, the stock market has produced decidedly negative returns, but from the standpoint of lessons learned, it is even more important to recognize that the total return of the S&P 500 has now lagged Treasury bills since the beginning of 1997. Stock market gains that originate from rich valuations simply aren't retained over the full cycle.

Over the past few weeks, the improvement in market valuations has become so significant that we altered our hedges in the Strategic Growth Fund by covering our short position in index calls and lowering the strike prices of our put options. Presently, about 75% of the Fund's portfolio remains hedged with out-of-the-money put options. These puts are there to hedge against any abrupt and deep continuation of recent market losses, which I don't expect, but can't rule out if only because of recent volatility. We are not hedged against smaller, local movements of several percent, so the Fund will tend to fluctuate both higher and lower with the market for now, though in a slightly muted way.

I should emphasize that I don't believe the recession in the U.S., or its global counterparts are over, or even that they are coming to a close. Not by a long shot. I do believe that current valuations already discount a severe recession. I also believe that the eye of the storm is passing over us in terms of the mortgage crisis, in the sense that the foreclosure rate is most probably peaking in the current quarter. Fortunately, the Treasury finally came around to the correct, effective approach to handle the banking crisis, which was to provide capital directly by purchasing senior securities from the banks.

As a side note, there is some amount of chatter that banks should be forced to lend out the capital provided by the Treasury, rather than using it to acquire other institutions. Frankly, these concerns miss the point entirely. The objective of the capital provision was to replenish something called “Tier 1” capital – the cushion that stands between a depositor and bankruptcy of the institution. As confidence is restored, loanable funds will be made available by willing depositors, in amounts far beyond anything that the Treasury could provide. If solvent banks go out and acquire other institutions under that same umbrella of solvency, so what? Really. What matters is the existence of the capital cushion.

What the U.S. economy now needs most is for Congress to come around to the proper way of dealing with remaining foreclosures, which is to allow judges to reduce the principal of foreclosed homeowners in return for a “property appreciation right” (PAR) to the lender. This would reduce the burden of monthly mortgage payments for homeowners, while still making the original lenders whole, by giving them a claim on some amount of future home price appreciation. This alters the type of payments and their time profile without destroying the present value of the obligation. It allows people to stay in their homes, but without forcing further write-downs, and without debasing the entire incentive structure of the housing market. Approaches to simply reduce mortgage principal will fail miserably: if the government or banks become willing to write down mortgages that go delinquent, you can be sure that nearly every mortgage in the U.S. will suddenly go delinquent. This is a subject important enough to warrant contacting your elected representatives. Seriously. The potential depth and duration of the current recession hinges on getting this one policy right.

When will stocks enter a new bull market?

While stocks are now clearly undervalued, there is a reasonable chance that we will observe a retest of recent lows, or even lower lows, most probably early next year. Still, it's also possible that we have seen the lows, and that stocks might move substantially higher in the months ahead. The market is a discovery process, and information develops slowly. How do you invest in that environment?

From my perspective, the whole issue of bull market versus bear market doesn't get investors anywhere. Asking whether stocks are in a bull market or a bear market is like asking Columbus what kind of trees are planted along the edge of the earth. The question itself makes a false assumption about how the world works. My view is that bull markets and bear markets don't exist in observable reality – only in hindsight. What gain is there to investing based on something that's unobservable when you can manage your investments based on directly observable evidence?

What we can observe directly is the prevailing status of valuations and the quality of market action. We can also look at more than a century of market history and get an idea of what the return/risk profile of the market has been, on average, given that prevailing evidence. As of today – not two weeks ago, not two weeks from now, but today – the prevailing status of valuations and market action is one that has historically provided a strong average return/risk profile, but with rare “outliers” that encourage us to retain a hedge several percent below the current level of the market, strictly to insure against an unlikely further breakdown.

Looking past today and into next week, next month, or next year, I have no idea where the market is headed, because I don't know what the valuations and market action will be at any future date. There is good reason to expect that market returns over the next decade are likely to be satisfying, but we don't know how near-term policy decisions will affect the evolution of this recession or the risk tolerance of investors over the next few quarters. Fortunately, we simply don't need to forecast those things – most of the information we need will be reflected in the quality of market action. We will respond according to what we observe. As my friend Thich Nhat Hahn says, if we understand the past, and take good care of the present moment, we will take good care of the future.

Based on typical historical market behavior, my guess is that valuations will remain on the favorable side, but that market action may begin to generate fresh divergences once we recover, say, 30%-40% of the losses since last October's high (perhaps somewhere in the general area of 1100 on the S&P 500). My guess is also that the recession in the U.S. will be enough to keep the stock market from “breaking away” into a sustained bull market until well into 2009, if not 2010. For more perspective on this, be sure to read Bill Hester's latest research piece Stock Performance Following the Recognition of Recession (additional link at the bottom of this page)

Commodities will probably snap back for a while as the U.S. dollar weakens, and the XAU is so depressed relative to gold itself that gold stocks could advance another 70% or so without even hitting their 200 day average. Even so, I certainly don't expect a sustained resurgence in commodity prices in general. In particular, I still expect that oil prices will break below $60, probably substantially, as the economic downturn wears on. So we'll have rallies and retracements within a wide trading range as wide as 20% or more, but my sense is that most of whatever discomfort lies ahead will most probably come as a result of declines from overbought rallies to similar or moderately lower levels than we've already seen (as opposed to significantly lower lows in the immediate future).

Bond yields remain generally unattractive, outside of TIPS, where real yields have climbed to the 3-4% range. Though near term inflation pressures should slow substantially, TIPS yields vastly understate the prospects for longer-term inflation, particularly given the huge expansion in government liabilities worldwide. Corporate yields are relatively high, but my impression is that as lower tier debt defaults, even A-rated yields will press even higher as the recession wears on. Suffice it to say that while stocks are now undervalued, investors should expect a somewhat drawn out recovery as the economy grinds through a very real recession. The good news is that I expect that we are entering an encouraging period for value-conscious stock pickers.

In any event, our actual investment positions will continue to reflect the average return/risk profile associated with prevailing market conditions. As those conditions shift, so will our investment stance.

Value Dinosaurs

While many investors appear frantic about the market's recent losses, and are extrapolating that fear into visions of economic Armageddon, I have to say that I'm more comfortable with the market's valuation here than I've been in about 15 years. As for the economy, this downturn is something we anticipated and understand. The lingering question what sort of policy response we'll see in relation to foreclosures, which will affect the depth and duration of this recession.

After more than a decade of “outlier” valuations, stock prices are finally back to a historically normal, even favorable, relationship with probable long-term cash flows. Note that long-term cash flows often have little to do with near-term earnings. Stocks shouldn't be priced based on this year's or next year's earnings, unless those earnings reflect normal profit margins and business conditions.

Frankly, I haven't enjoyed the market's behavior in recent years at all, because the stocks that were embraced by investors – first the high debt, low quality garbage and then the industrial and commodity stocks – consistently struck me as speculations rather than investment values. I try to ensure that the net asset value of the Fund is “backed” by a reasonably priced stream of long-term corporate cash flows; in other words, by stocks that have stable long-term cash flows and appear to be undervalued, on average. I had a very open aversion to “holding my nose and buying garbage,” so we didn't “ride” those speculative stocks higher. Of course, the dollar value of our index shorts never materially exceeds our long holdings and we don't sell short individual stocks (which I continue to believe is an appropriate policy for an equity growth fund), so we didn't gain from their subsequent collapse either. All of that made for a somewhat frustrating cycle.

Rich market valuations also posed challenges in recent years, because they held us to a far more hedged investment stance than I would have preferred. As I wrote in the 2006 Hussman Funds Annual Report, “ It is important for shareholders to recognize that the relatively defensive position of the Strategic Growth Fund since its inception is not typical, nor is it preferable as a “standard” investment stance. Historically, there have been periods in which stock market risk has been well worth taking. In a normal market cycle with appropriate valuations, not only would the S&P 500 typically achieve higher returns, but the Strategic Growth Fund would also typically accept greater levels of market risk. While the Fund has achieved strong returns given the constraints of rich valuations since 2000, these valuations have held back the performance of the major stock indices, as well as the flexibility to accept risk that the Strategic Growth Fund would have under typical valuation conditions.”

In my view, we are entering an environment that provides good conditions for value-based stock selection, because the speculative garbage has been increasingly shown to be exactly that. I also expect that we will be able to accept a much more typical exposure to market risk in the next market cycle than we were able to take in the recent one.

For anyone with a sense of long-term market history and an understanding of what drives sustainable long-term investment returns (as opposed to the ephemeral type we've seen in recent years), current valuations are like old friends. That's why “value dinosaurs” like Warren Buffett, Jeremy Grantham, and John Neff have come out of what seemed like extinction. Grantham recently noted that he is “filtering money in slowly” because, as he puts it, “If stocks are attractive and you don't buy, you don't just look like an idiot, you are an idiot.”

“New Era” investors have convinced themselves for more than a decade that discounted cash flows and normalized earnings were simply “outdated” measures of value. They relied on “forward operating earnings,” ever-expanding profit margins, debt-ridden balance sheets, cyclical garbage stocks, speculative commodity plays, and the “Fed Model,” but they generally have little to show for those convictions. Meanwhile, the value dinosaurs have achieved reasonably good returns with even greater stability.

Just like Rip Van Winkle, the value dinosaurs are beginning to wake up. There might still be some amount of winter left. But even so, after all these years, they haven't missed a thing.

Market Climate

As of last week, the Market Climate for stocks remained characterized by favorable valuations and tentative market action – still unfavorable on measures that develop slowly, but with a clear improvement in “early” measures of market internals. The fact that internals have improved (in some areas such as breadth we've even seen clear reversals) doesn't indicate that conditions are “all clear,” and in fact we continue to carry out-of-the-money put option protection against about 75% of our holdings. Rather, we have conditions that for now, on average, have been associated with favorable return/risk profile, though with enough variability that it still makes sense to hold an out-of-the-money hedge simply to defend against abrupt and unexpected weakness.

In bonds, the Market Climate last week was characterized by relatively unfavorable yield levels, and now modestly unfavorable yield pressures. The improvement in credit conditions has put upward pressure on Treasury yields because of reduced “safe haven” demand. This is a healthy sign of a normalizing credit market, but continued upward pressure on yields would be a negative for the equity markets. As I've noted periodically over the years, we are much more willing to respond to early improvements in internals (such as breadth reversals) when interest rate trends are declining. Rising interest rate trends make stocks vulnerable, so it takes much more favorable market action to offset that effect.

The Strategic Total Return Fund continues to have the majority of its assets invested in Treasury inflation protected notes, the majority of which were purchased in response to recent price weakness in those securities, with just under 30% of assets diversified across precious metals shares, utility stocks, and foreign currencies.

New from Bill Hester: Stock Performance Following the Recognition of Recession

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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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