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June 8, 2009

Context Matters

John P. Hussman, Ph.D.
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In early 2003, with the S&P 500 near the 900 level, we fully removed about 70% of our hedges in the Strategic Growth Fund, shifting from a tightly defensive stance to a constructive investment position. Having purchased a large number of call options at lower levels, sufficient improvement in our measures of market action prompted a removal of much of our put option hedges as well. At the time, I received a number of very critical notes from shareholders and other readers of these weekly comments, who interpreted our shift to a constructive position as a betrayal of sound risk management. Though the new bull market quickly moved to a point where stocks were again strenuously overvalued, and while the S&P 500 has ultimately provided a paltry total return in the 6+ years since the 2002-2003 lows, removing our hedges near 900 turned out in hindsight to be an effective shift.

During the fourth quarter of last year, as the S&P 500 plunged downward toward the 900 level, we did not remove hedges outright, but did cover a large portion of the short-call-option side of our hedge. That shift cost us considerably over the short-run, though certainly far less than the losses suffered by the S&P 500 itself. As usual, we base our positions not on our expectation of where the market is headed in any particular instance, but on the return/risk profile that the market has demonstrated, on average, in similar conditions of valuation and market action (though we don't ignore relevant economic facts of course). That instance was very uncomfortable in any event. Ultimately, the market recovered nicely by year-end, and the Fund narrowed its 2009 loss to a single digit.

In January, as the S&P 500 advanced from its 2008 lows and moved above the 900 level, we abruptly shifted back to a fully hedged investment stance based on a variety of measures of market internals and pressures on risk premiums. That shift helped us to avoid a steep plunge in the market below the 700 level on the S&P 500 into March of this year. Late in that decline, accumulated a good number of call options as an “anti-hedge,” and have held a moderate call option through much of the recent advance. We did not, however, remove downside put protection (and have no expectation of doing so in the near future). That call option position did help to compensate for the disproportionate strength in financials which we did not, and do not hold to any meaningful extent, since we still view them as speculations, not as sound investment vehicles. Last week, we abandoned the last of our index call options on strength, and are now back to a fully hedged position.

The upshot of this is that we have repeatedly been both motivated buyers and motivated sellers near the 900 level on the S&P 500. Context matters – not simply price. Investing is largely a “signal extraction” problem where there is a certain amount of observable data, but where many of the things that matter are largely unobservable. For instance, when a stock price declines, it might be that the stock is a better value, or it might be that other informed investors anticipate negative long-term developments for the company which imply a substantial reduction in future cash flows, or it might be that investors are becoming generally skittish, and while the stock is not particularly mispriced, it may still be vulnerable to steep losses in the context of general investor fears. All of those factors are important – valuation measures, probable long-term cash flows, and risk aversion.

In 2003, we could comfortably remove 70% of our hedges even though the market was much more overvalued than it is at present, because our measures of market action were clearly favorable. While economic conditions were still negative, major structural impediments to a sustained economic recovery were not in place.

Late last year, we removed a portion of our short call options because at the time, stock prices were strenuously oversold and compressed, and after more than a decade of overvaluation (which proved itself by producing no durable return over that period), stocks were finally in the "reasonable range." A variety of factors that measure price compression, coupled with the still open possibility of proper policy responses, prompted me to cover our short call positions. Unfortunately, that move was unrewarding, and the market plunged even further. Even after the substantial advance we've observed since March, the S&P 500 is at the same level it was when we were removing those calls last year (and is up only 5.36% year-to-date). It's hard to call it an error, since we align our stance with the average outcome associated with a given set of conditions, but in that instance, becoming even modestly constructive was clearly wrong in hindsight. I've done a lot of things wrong, and a lot of things right, in hindsight, by following our investment discipline. Our confidence in that investment discipline is based on averages, not instances.

At the time, the menu of policy responses still allowed a good chance for proper government decisions. The possible policy responses might have included pressing bank bondholders to swap debt for equity in lieu of receivership, prompt regulatory action toward near-insolvent institutions with deep capital shortfalls, legislative changes to allow rapid “whole-entity” conservatorship and subsequent sale of non-bank financial entities (which should have been initiated at the time of Bear Stearns, and could have saved us from the disorderly unwinding of Lehman), restrictions and capital requirements relating to credit default swaps, and not least, aggressive efforts to mitigate foreclosure risk by helping to administer property appreciation rights (what are in effect debt-equity swaps on the mortgage side).

As it happened, rather than following policies that would have allowed for a sustainable recovery, our policy makers opted for a stunningly unethical strategy of making bank bondholders whole with well over a trillion dollars in public funds, watering down accounting rules to allow banks to go quietly insolvent while reporting encouraging “operating profits,” looking beyond the continued shortfall of loan loss reserves in relation to loan defaults, and doing nothing meaningful with regard to foreclosures, whose rates continue to soar and which face a fresh wave later this year and well into 2010 and 2011. These policy responses have more than doubled the U.S. monetary base within a period of months, added a trillion more in outstanding Treasury debt, and virtually assure that the value of those government liabilities will be repriced in relation to goods and services over the coming decade. A range of different methodologies suggest a doubling in U.S. consumer prices over the coming decade, though with the majority of this pressure occurring 3-4 years out and beyond.

In January of this year, a fresh deterioration in market action was sufficient to prompt us to re-hedge the Strategic Growth Fund just about where the S&P 500 is at present. That shift helped us to avoid a great deal of discomfort, but aside from accumulating an “anti-hedge” in index call options, we did not take down our defenses at the March low. Subsequent market action has been of relatively poor quality more closely associated with bear market advances than with durable bulls, leaving our overall measures of market action still defensive, and there are profound economic problems that remain unresolved. So unlike 2003, we have not followed with a major removal of our hedges here.

It would be nice if oversold bounces were predictable, but unfortunately, oversold markets can become stunningly more oversold – as we saw in 2008. In hindsight, the advance since March has been strong, but not unusual in relation to the prior decline (where 25% -33% retracements of prior bear market losses have historically been standard). That retracement is largely behind us, and a variety of measures are clearly overbought here. With stocks no longer undervalued (except on measures that assume a return to 2007 profit margins), and subtle deterioration in some of our risk measures, any basis for accepting market exposure here is largely speculative.

So again, the 900 area on the S&P 500 has been both a buy level and a sell level for us, depending on the context of market action and economic fundamentals. The same will probably be true of other levels on the S&P 500 except for the most extreme over- and undervalued possibilities. It is not possible to identify where we would be buyers and where we would be sellers. Context matters.

What about the March low? Given the recent advance, shouldn't investors treat that as an “absolute” buy level now? While it may sound absurd, it is not at all clear to me that the March low was the final low of the current cycle. Yes, it might have been (and we are willing to accept some amount of market exposure if our measures of internals improve), but I believe that investors should not rule out even the 500 level on the S&P 500 as a plausible outcome over the coming 18 months. If you study the fundamentals of this economy – particularly the debt burdens, the narrow margin by which many debtors are above water, and the adjustable rate reset schedule – there is far more to be concerned about than might be gleaned from sentiment surveys like consumer confidence or even the ISM numbers.

Moreover, there is a far weaker prospect for a return to 2007-like profit margins than investors seem to recognize. Economic expansions are paced not by major growth in consumption (which tends to be fairly smooth even during economic downturns), but instead by gross investment in capital goods, technology and housing, as well as debt-financed durables such as autos. Yet our policy makers have aggressively crowded out private investment through this bailout policy, which allocates good capital to the worst stewards, and they have done virtually nothing to abate the housing downturn. Add deleveraging pressure to that mix, and an absence of opportunity for mortgage equity withdrawals (which fed GDP growth during the last expansion), and we have an economy that is likely to produce a very stagnant recovery even if one has begun – of which I am also skeptical.

As I've noted before, recent months have represented a lull in the reset schedule, which was accompanied until recently by a moratorium on new foreclosures. Those foreclosures are now ramping up quickly, and a fresh surge in resets will add to the difficulties beginning later this year.

Loan Resets

So what now? First, I should be clear that there is no particular level on the S&P 500 that I would consider a “buy” or a “sell.” Context matters. My impression remains that the market is likely to remain in a very wide 25-35% trading range for much longer than investors seem to expect. We can't rule out a further advance, or a decline below the March trough, but a very wide and extended trading range is the “median” expectation. In any event, there are substantial economic difficulties ahead, and there is very little evidence that they are discounted in current prices. Things that are fully discounted by investors are also things that are on everybody's tongue. Investors do recognize the potential for the unemployment rate to peak above 10%, but it is not at all clear that they are familiar with the debt fundamentals of this economy, or that they recognize how much deeper the losses are likely to become.

Now, in the event of a 25-35% trading range – again a reasonable scenario in my view – then there will be bases from which to advance, as well as levels where we should be alert to the potential for fresh weakness. I noted last week, but should elaborate on – if the S&P 500 was to decline to the 700-800 level without a terrible breakdown in market internals, that area might be a potential base from which to advance, again within the context of a wide and extended trading range. On the other hand, if internals break down considerably, we could threaten or break the March lows. If internals improve sufficiently, we would establish a moderate amount of exposure through call options.

In any case, what will matter at any given time is the full context of valuations and market action, as well as economic fundamentals, sentiment, and other factors. We have no “buy” level or “sell” level for this market. Context matters. At present, that context holds us to a defensive stance.

Market Climate

As of last week, the Market Climate for stocks was characterized by modest overvaluation (except on earnings-based measures that assume a quick return to 2007 record profit margins) and a modest deterioration in already tepid market action, but sufficient to put us on alert. The Strategic Growth Fund is fully hedged here – invested in a broad range of individual stocks, with an offsetting short sale of equal size in the S&P 500, Russell 2000 and Nasdaq 100 indices.

In bonds, the Market Climate last week was characterized by modestly favorable yield levels and still unfavorable yield pressures. Long-term bonds are certainly not priced to deliver adequate compensation for inflation risk over the coming decade, but I don't believe that there is any likelihood whatsoever of any sort of tightening move by the Federal Reserve in the foreseeable future either. So to the extent that short-term pressures on bond yields are driven by expectations of positive economic progress, my impression is that those pressures will not be sustained for long. For our part, we prefer TIPS, as real yields on longer duration issues are still reasonably good. The Strategic Total Return Fund also continues to have about 25% of assets in foreign currencies, precious metals shares, and utility shares.

It is important to recognize that while I have some very pointed views on the economy and now on longer term inflation risk, there is a great deal of ebb-and-flow in the weekly, monthly, and quarterly data. So just as my concern about U.S. financials in recent years has provided a backdrop that preferred some positions over others, but did not determine our entire investment stance, the prospects for further debt problems and inflation pressures is a context and backdrop that affects some of the decisions we make, but does not determine our entire stance. Both the stock and the bond markets are likely to experience a wide and extended trading range, and there is little reason to expect sustained one-way movement. Given that, I expect to oversee the Funds as we always have – conscious of the larger picture, but determined week by week according to the overall profile of valuations and market action that exist at any particular point in time.

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