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July 20, 2009

Tending Seeds - Reacting, Responding, Planting, and Watering

John P. Hussman, Ph.D.
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In recent weeks, I've emphasized the very mixed nature of market conditions, which regardless of longer-term headwinds, remain very ambiguous regarding near term direction. For investors, the shifts in trend and the lack of clear direction create some difficulties, particularly for those who tend to react rather than respond to market fluctuations.

For our part, our focus is to ask the same basic questions every day – “What is the opportunity,” and “What is threatened?” We rarely have any sort of forecast for the market, and certainly don't have short-term forecasts here. Instead, we are responding to market fluctuations as they occur. For example, in response to last week's powerful rally, which brought the market again to overbought conditions, we took profits on the index call option position we established the prior week, and moved back to a fully-hedged investment stance. I certainly don't know whether that shift will be “right” in this instance, but it is the appropriate response from the standpoint of our investment discipline. Meanwhile, we continue to focus on individual stocks demonstrating favorable valuation and market action on our measures, with an eye toward buying higher ranked candidates on short-term weakness, and selling lower ranked holdings on short-term strength.

The distinction between reacting and responding is one that I've emphasized often over the years. To react is essentially to change one's plans abruptly based on what the market has just done – usually involving a certain amount of panic or worry that essentially forces one's hand. In contrast, to respond is to take the most recent market move as a piece of information, and to change the investment position accordingly, following a very specific discipline (ideally which allowed for the move in the first place).

For example, a reactive investor tends to reverse existing investment positions only when provoked by pain. Investment positions are sold when they have declined enough to trigger fear or panic. Investment positions are purchased in a rush to “catch” or “ride” them. My impression is that the single best mark of a reactive investor is the tendency to measure investment success by the amount gained or lost on any particular day. In contrast, the investor who responds puts much more emphasis on daily actions than on daily outcomes. That doesn't mean ignoring outcomes, but it means following a specific, well-studied discipline with the expectation that the results will emerge through repeated application. As usual, those results are best measured in terms of long-term return and risk over the complete market cycle.

As I wrote years ago in Force of Habit

"Over the years, I've written a lot about “daily action.” You decide on a set of actions that you believe will lead to good results if you follow them consistently. Then you follow them consistently. Unless a goal translates into daily, present action, focusing on that goal is simply a way of escaping reality. As Jean Paul Sartre wrote, “Je ne suis rien autre que mes actes” – I am nothing other than my actions.

"If an investor consistently takes positions based on forecasts, and changes those positions only when the market proves those forecasts wrong, that investor's life will predictably be dominated by hope, uncertainty, disappointment, reaction and frustration. If an investor constantly takes positions by responding to opportunities and conditions as they develop, with equanimity to what will happen next, making a habit of purchasing favorable value or early strength, and a similar habit of selling overvalue and early weakness, that investor's life will most probably be dominated by a sense of peace and control. Though it is not obvious which investor will have better results, my own opinion on that should be fairly clear.

"This doesn't mean that an investor who responds – rather than reacts – will know what will happen next. Rather, it means that this investor will be able to accept what happens next, knowing how to respond whatever the outcome. The point is to live in reality, and to take the next action from where one stands, without ignoring inconvenient aspects of reality in the hope of justifying one's position, and without wishing for the starting point to be somewhere else. The greatest source of human frustration is the desire for reality to be something other than it is.”

In short, as Robert Louis Stevenson wrote, “Don't judge each day by the harvest you reap, but by the seeds you plant.”

Tending Seeds

If you'll forgive the discourse (and at the risk of wandering a bit afield), over the years I've found thinking about the world from the standpoint of seeds to be enormously helpful. My friend Thich Nhat Hanh puts it this way:

“Consciousness is said to be a field; a plot of land in which every kind of seed has been planted – seeds of suffering, happiness, joy, sorrow, fear, anger, and hope. The quality of our life depends on which of these seeds we water. The practice of mindfulness is to recognize each seed as it sprouts, and to water the most wholesome seeds whenever possible.”

The basic idea is that, confronted with a whole host of seeds in our daily lives, the ones that we water will generally (though not always) be the ones that grow. So if we tend and water the negative seeds; worry, anger, disappointment, fear, and so on, the energy we put toward those seeds will tend to make them grow and become very big in our daily lives. If instead we tend and water the positive seeds; friendship, gratitude, discipline, peace, and happiness, then those are the seeds that will grow. That doesn't mean walking around like a Polyanna (which is unlikely for a crusty skeptic like me), but it does mean that there is some tendency, however imperfect, to reap what we sow, even just by what we choose to habitually think about. As the Buddha said, “with our thoughts, we create our world.”

To take this back to the practice of investment, it's clear that an investor who constantly waters a particular seed – fear of being wrong – will be forced into a particular set of daily actions, specifically, the investor will tend to hesitate when faced with opportunities that require deliberate, active choice, and at the same time, the investor will panic to adjust the investment position in reaction to every significant disappointment. While those adjustments can very well be rewarding when the market is running in a very clear direction, it is more generally a recipe for buying on strength and selling on weakness, and the cost of doing that on a repeated basis will tend to whittle down returns over a long period of time. Investors who tend the seeds of greed tend to reduce their returns more quickly and often spectacularly, but not without some amount of excitement and victory first. Tending and watering greed translates into the daily action of looking for improbable outliers and long-shots, and of accepting far more risk than can ultimately be tolerated.

But there are all sorts of other seeds to water. An investor who waters the seed of curiosity will not be content with investment platitudes and will stare at lots of data to figure out what actually works in the markets, and what the pitfalls are. An investor who waters the seed of discipline will emphasize consistency and persistence over one-off decisions and attempts to “make a killing” on a particular trade. Tending the seed of patience, on the other hand, can be either a help or a hindrance, depending on whether it is coupled with sober analysis or instead with blind hope. Patience, coupled with discipline and analytical curiosity, is not a bad combination of seeds from my perspective.

All of this may seem silly or simplistic on its face, but the reason for spending some time with this idea is that it can also be very powerful in re-orienting your actions and perspectives. It's worth the time to ask which seeds you habitually plant, tend and water, and what you expect them to grow to become as a result. This is true for investing, and isn't completely removed from relationships or parenting either.

Seeds not planted or tended by choice tend to be weeds, so at least for me, it's very helpful to consciously and periodically choose which seeds I want to water, and to think through what I expect to happen from that watering. Investors can spend a lot of time and energy reacting to the latest bits of news and trying to predict the next surprise, rather than choosing a consistent set of daily actions that they can carry out as things develop, regardless of how they develop.

Market Climate

As of last week, the Market Climate for stocks was characterized by modest overvaluation (though not significant overvaluation), and mixed market action. On one hand, investor sponsorship of stocks, including during the advance over the past several sessions, has been very tepid from the standpoint of price-volume behavior. On the other hand, breadth (the number of individual stocks advancing versus declining) has been, and continues to be, a standout. A large number of individual stocks have enjoyed persistent recoveries, though again, not on convincing volume – the overall impression being that investors have significantly backed off from the heights of their risk aversion in March, but have not found reason to commit enthusiastically except on very short-term horizons.

The major indices enjoyed a strong advance in recent sessions, coming off of a modest oversold condition. Still, what we were looking for was a burst of trading volume, and that was decidedly absent. As I noted last week, “the measured nature of this decline, at least thus far, still holds out the possibility that investors could gather their nerves and provide more sponsorship (which we would look for first as a decided shift toward heavy trading volume). To allow for that possibility, we re-established a small “anti-hedge” in index call options last week, amounting to about 1% of assets. Certainly not a huge commitment or a constructive investment stance (we're otherwise fully hedged), but now that the market has cleared its overbought condition, at least on short-term measures, we wanted to allow for a broader range of potential outcomes here.”

Having returned to an overbought condition on the recent rally, we shut down those call option positions late last week, returning to a fully hedged stance. As noted above, I don't know whether that shift will be “right” in this instance, but our tendency is to increase exposure on weakness and to clip it off on strength, unless there is reason to expect (on the basis of valuations and market action) that the return per unit of risk will remain persistently high. That's not the case at present. So while I am emphatically not forecasting a fresh spell of weakness (or forecasting anything for that matter), prevailing market conditions aren't associated with a sufficient expected return/risk profile to accept the impact of market fluctuations here. As usual, we continue to focus on stock selection, which has generally been our bread-and-butter when the Fund is hedged.

In bonds, we observe a similar ambiguity of market conditions. Yields to maturity on Treasury bonds are low enough to remove much investment merit beyond the simple extra yield that can be picked up versus Treasury bills, but the risk of credit strains is strong enough that we may very well see additional flights-to-safety from time to time.

That said, the yield pickup versus T-bills, not the anticipation of sustained capital gains (which would require persistently falling yields), is the main reason we continue to hold an average duration of about 3 years in the Strategic Total Return Fund. That is a relatively modest level of interest rate exposure, and even here, most of our exposure is in Treasury Inflation Protected Securities. I continue to believe that any significant inflation pressure is most likely several years out, but since variability in nominal bond yields is largely due to the expected inflation component, and the probable inflation surprises will tend to be on the upside over time, there is really not much need to accept a lot of interest rate risk tied to inflation uncertainty. TIPS remain the core of the Fund's portfolio, with a modest exposure to straight Treasuries, and about 15% of assets allocated to precious metals shares, foreign currencies, and utility shares.

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