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August 3, 2009

Profiting from the Tooth Fairy

John P. Hussman, Ph.D.
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It is a general investment rule that by the time that a particular thesis makes it to the cover of national news magazines, it is largely discounted by the markets. On that note, this week's Newsweek cover “The Recession is OVER!” might be taken as an occasion for investors to reconsider the potential upside from this theme here. The subtitle on the cover does note “Good luck surviving the recovery,” but in general, the article is about how “smart people” in government will produce a “smart economy” with bundles of government spending. The cover artist had a sense of humor though, putting the title on a big balloon, with a push-pin next to it.

Although the stock market's advance since March is taken as evidence that the economy is on the mend, the extent of that advance represents just over one-third of the prior bear market loss, which is somewhat standard (if not reliable or predictable) for bear market rallies. Interestingly, the advance since March has almost exactly matched the size and duration of the rally that followed the initial market plunge in 1929, just before the stocks and the economy suffered fresh deterioration.

That's not to say that we are assuming that stocks are still in a bear market. Nor do we assume that they are in a bull market. I don't think we can rule out a further advance, nor should we rule out a fresh loss from these levels of over 40%, extending well into next year, before this adjustment is durably behind us. We aren't investing on either as an expectation. As I've noted before, the bull/bear distinction is not a useful concept except in hindsight. The prevailing status is not observable in real time, so we rely instead on variables that are continuously measurable, focusing on full-cycle performance, and accepting that hindsight will only sometimes be kind to our assessment, and will sometimes be utterly cruel.

The recent rally never recruited the sort of price-volume sponsorship that has usually occurred very early on in prior bull markets, and we have been defensive in recent months (other than a periodic but helpful allocation to index call options). The evolution of the market's advance to recover a full one-third of the market's prior losses has been frustrating given that position.

Looking back over the past decade, there is something of a pattern to the periods of frustration that we've experienced. Specifically, neither I nor our investment methods have historically enjoyed much success profiting from the Tooth Fairy. We are not very good at “catching” gains from speculative investment themes that have a high probability of collapsing (for my part, I view the thesis of a sustained economic recovery as one of those themes). Trend following strategies do track the market well during some of these periods, but we have not found ones that outperform our existing approach.

Though I was characterized as a “lonely raging bull” in the early 1990's, by the late 1990's I missed the bubble in the dot-com stocks, and avoided the last part of the bubble in technology stocks in 1999 and 2000. Though our stock selection didn't suffer much relative to the major indices, we clearly could have earned more, at least during the rising part of those bubbles, by playing with fire. We similarly missed the boom in what I repeatedly called “garbage stocks” during the bull market that ended in 2007, avoiding financial stocks entirely, and missing the big runup that commodity stocks and other cyclicals enjoyed before they collapsed.

Momentum-based, trend-following, simplistic thinkers with a speculative bent generally do very well during bubble periods (though not over the full cycle). Such analysts appear to have no reservation about jumping in here, because they assume that there will be no consequences to the overhang of deteriorating mortgage and commercial debt, even when coupled with “trigger events” such as rising unemployment (not to mention a median duration of unemployment that is far in excess of that of previous recessions).

Such analysts – some of whom we could name because they are the same ones who recommended jumping in with both feet at the 2007 highs on the basis of the “Fed Model” – have an affinity for simple rules, and ratios, and formulas, apparently without thinking through how those relate to what matters, which is the long-term stream of deliverable cash flows that investors will receive over time from their securities.

Such analysts have no intellectual difficulty with non-equilibrium concepts, such as “government resources” (which they seem to think is just money from heaven, but is in fact merely a redistribution) and “cash on the sidelines” (which represents a mountain of money-market securities that somebody has to hold “on the sidelines” until they are retired, because they were issued in return for funds that have already been borrowed and spent).

Such analysts are often able to do what we can't bring ourselves to do, which is to risk other people's financial security on raw price momentum, or on speculative themes that are contradicted by historical data, or that logically cannot be true.

If I knew we could speculate on these themes and still get our shareholders out unharmed, I would do it. But I don't know how. It's frustrating to have missed what has turned out in hindsight to be a significant rally. We simply have not had the evidence to say “Yes, the conditions we observe now have historically been associated with a satisfactory expected return, on average, given the risks involved.” Still, I have no doubt we'll eventually see such conditions emerge as we work through this deleveraging process. Meanwhile, we will continue to pursue our investment approach, which has served us extremely well at contained risk, particularly over complete market cycles.

Investors can point to various indicators that “flashed buy signals” near the March lows. The problem is that many of those also went positive during during last year's plunge and then failed spectacularly (as also occurred in late January). More importantly, we can't find factors that would have made us more constructive since March and that would also have improved long-term returns if applied consistently on a historical basis.

To remove our hedges here in anticipation of a sustained economic recovery and bull market would be to assume that the events in the economy since 2007 have been psychological and temporary, that there will be no material effects from continuing delinquencies and foreclosures (not to mention the second wave of reset pressures due to begin later this year), and that the Fed can create more base money in one year than in the entire history of the nation, without any consequence. If we could treat the recent downturn as a “standard recession,” that might be possible. But little is standard about this downturn, and the fundamental difficulties have deeper roots than trend-following investors seem to assume.

That said, we can't ignore the potential for investors to continue to speculate for a while, despite tepid price-volume sponsorship and deep-rooted economic challenges. The Strategic Growth Fund has just under 1% of assets in index call options as something of an “anti-hedge” to soften our position and make it somewhat more constructive in the event of a further advance. We don't intend to stand in front of a train, if investors are intent on playing a recovery theme, but the way we would participate in that case would be to let the market “take us out” of our hedge by advancing further and allowing our index call options to go “in the money” (at the risk of losing those gains if the market subsequently sells off). In any event, we don't have evidence that would provoke us to remove our downside protection against significant losses, so at present, our “constructive” exposure amounts to just under 1% of assets allocated to index calls, and a fully hedged investment stance otherwise.

Market Climate

As of last week, the Market Climate for stocks was characterized by moderately unfavorable valuations and mixed market action. We estimate that the S&P 500 Index is currently priced to deliver annual returns over the next decade of about 7%, which – except for the period since 1990 – is generally a prospective rate of return consistent with market peaks, not troughs. Still, stocks “look” less expensive if one assumes a permanent return to 2007 profit margins, which were about 50% above historical norms. We can't rule out the potential for investors to invest on unreasonable and largely unfounded expectations of a return to those earnings levels, which could provoke a continued willingness to pay what in our view are already elevated valuations.

From the standpoint of market action, price-volume sponsorship continues to be decidedly tepid. Indeed, trading volume on the NYSE has declined sequentially in every month since March. The market is strenuously overbought over the short term and fundamentally overvalued on long-term measures, but unfortunately, we can't stand in front of investors and say, “no, stop, don't.” The Strategic Growth Fund holds just under 1% of assets in index call options as an “anti-hedge” to soften its defensive position in the event the market advances further. Otherwise the Fund is well hedged. As is typically the case when the Fund is hedged, the bulk of our returns here will be driven by the difference in performance between the stocks held by the Fund and the indices we use to hedge. On that front, I am very comfortable with the Fund's holdings, and continue the day-to-day practice of buying higher ranked candidates on short-term weakness and selling lower-ranked holdings on short-term strength, consistently looking to build favorable valuation and market action into the Fund's portfolio in that way.

In bonds, the Market Climate last week was characterized by slightly unfavorable yield levels and slightly unfavorable yield pressures. The Strategic Total Return Fund continues to carry a duration of about 3 years, mostly in TIPS, with less than 20% of assets allocated toward precious metals shares, foreign currencies, and utility shares. In continue to expect that the U.S. dollar will face significant pressure in the coming years as the combined result of an unsustainably wide current account deficit coupled with aggressive issuance of U.S. government liabilities. Though I don't expect near term inflation pressures, the supply of government liabilities alone have weighed on the dollar. Our investment stance in the Strategic Total Return Fund is primarily concerned with increasing purchasing power over time, and our primary activities in the current low yield environment will continue to involve adding to our exposures in bonds, precious metals and currencies on price weakness, and clipping that exposure on strength, as we don't anticipate strong and sustained directional movement in any of these asset classes until inflation pressures emerge.

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