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May 30, 2011

Small Windows in an Unfavorable Long-Term Picture

John P. Hussman, Ph.D.
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Last week, advisory bullishness pulled back moderately to 43% according to Investors Intelligence, but advisory bearishness also fell to 19.4%, with the remainder boosting the "correction" camp to 37.6%. That's not much of an easing in overall sentiment, but it was enough to give us a bit of latitude (as we've periodically seen in recent weeks) to allow us to vary our exposure between a tight hedge and a 10-15% exposure to market fluctuations. That's been of help, but mainly to offset a shallow correction in a few defensive sectors like health care. While the greater range of exposure is not really large enough to observe in day-to-day Fund movements, our latitude to accept risk will vary in proportion to the average market return/risk profile associated with prevailing conditions at any given time. The more variation in market conditions (particularly valuations), the more latitude we will get. Meanwhile, my hope is that despite our unfavorable view of valuations and cyclical market prospects here, we'll have enough opportunities to accept modest, if transitory exposure to market fluctuations to achieve a sort of "all-weather" profile of performance even if the market goes essentially nowhere for a while.

On that note, regardless of how one looks at present market conditions from a cyclical perspective, it is clear that stocks are not in a secular bull market (in the 1950-1965, or 1982-2000 sense). Secular bull markets comprise a whole series of cyclical bull-bear combinations, where each bull market achieves a successively higher level of valuation. Historically, they have started at Shiller-type P/E multiples of about 7 (about 40% below we saw at the 2009 low), and have ultimately ended about 18 years later at multiples above 24, which is, well, about where we are now. That said, I should note that the 2000 peak - at over 40 - was a huge outlier in that regard, with predictably unfortunate consequences for subsequent market returns for a very extended period of time.

The algebra of returns in secular bulls is easy to grasp. Given that S&P 500 earnings have grown at a very consistent peak-to-peak rate of about 6% annually across economic cycles (as have normalized earnings), an 18-year period where the PE moves from 7 to 24 produces overall capital gains of about (1.06)*(24/7)^(1/18)-1 = 13.5% annually. At a Shiller multiple of 7, the dividend yield on the S&P 500 has typically been around 6% or more, while a multiple of 24 puts the yield below 3%, so the average dividend yield over the course of a secular bull has been something over 4%, putting the average total return for the S&P 500 at close to 18% annually over a period of nearly two decades. Since earnings expansion and valuation expansion move in the same direction in a secular bull market, the cyclical bull markets tend to be longer than average, with extended periods of modest, largely sideways returns taking the place of deeper declines, and outright bear markets running somewhat shorter than average.

The algebra of returns in secular bears, in contrast, is predictably hostile. As long as one allows for valuation levels to vary over the long-term, as they have historically, it is very difficult to escape very extended bouts of poor overall returns for stocks once valuations become as elevated as they are today. The canonical 18-year secular bear, again assuming long-term earnings growth is unaffected, produces overall annual capital gains of about (1.06)*(7/24)^(1/18)-1 = roughly zero. In general, dividend income (again, somewhere in the range of 4% over the full course of time) is the primary source of return for passive investors in a secular bear market period. Since the long contraction of valuations offsets the benefits of long-term earnings growth during secular bear periods, the cyclical bull markets tend to be shorter than average, and cyclical bear markets tend to be extended and often brutal.

Despite the "lost decade" since the extreme valuations of 2000, valuations are now presently at about the same level from which prior secular bear markets have just started. There is no basis to expect a secular bull until we observe the valuations from which they have invariably started. Meanwhile, the recent cyclical bull market from the 2009 low has already run the same duration and slightly further than the typical cyclical bull in a secular bear.

[I realize that a paragraph like that is difficult to read, but it is important to recognize these distinctions in order to understand the market's position from a long-term perspective.]

As Nautilus Capital recently underscored, the typical cyclical bear in a secular bear averages about 19 months and a decline of about -39%. Given that advances from overvalued levels are almost invariably surrendered during the subsequent bear market decline, whenever it occurs, it's clear that accepting market risk at present levels has to be largely dependent on the belief that there will be a speculative opportunity to exit at a higher price. It is easier to make a case for that on temporary weakness (as long as it isn't severe enough to break broader "internals" and market support), but it's still speculative, and isn't appropriate to attempt with a sizeable portion of one's portfolio, in my view.

So from a secular, long-term perspective, my impression is that investors are very likely to observe much better opportunities to allocate capital toward equities at better valuations and prospective returns in the years ahead. The cyclical case is driven by a large variety of other factors apart from valuations, and we can't express equal confidence about shorter-term outcomes. For us, the appropriate strategy is to allow for windows of moderate opportunity within that fairly unfavorable long-term picture.

While the concept of secular and cyclical market fluctuations is helpful in providing a long-term perspective of market movements, bull and bear markets can be identified with certainty only in hindsight. In practice, we've found that evaluating a large ensemble of indicators across multiple historical periods is useful in gauging the overall return/risk profile at any point in time. Presently, we observe only a modest amount of latitude to accept market exposure (again, about 10-15% from a tight hedge), but that will change significantly as market conditions evolve. There are certainly enough historical periods where stocks performed well despite ongoing overvaluation that we can accept larger exposures under some conditions, but as always, we're strongly focused on what conditions were in place when those opportunities were fairly dependable. Meanwhile, we remain mindful that the underlying economic conditions here could be very punishing of mistakes for investors who abandon their safety nets.

The importance of aligning investment strategy with prevailing conditions was nicely summarized by Howard Marks in a letter to investors last week (I've repeatedly quoted Marks in recent weeks, as something of an endorsement of his recent book The Most Important Thing, which is well worth reading):

"One of the things that makes investing interesting is the ever-changing nature of the route to profit, the pitfalls that are present, and the tools and approaches that should be employed. Conscious decisions regarding these things should underlie all efforts to manage capital, and they must be revisited constantly as circumstances and asset prices change. What's right today?

"First, should you prepare for prosperity or not? By prosperity I mean a return to the happy days of the 1980s and '90s, when reported economic growth was strong and consumers were eager to spend. My answer is that we're not likely to see anything like that, in large part because in those decades the gap between stagnant incomes and vigorous consumption growth was bridged through buying on credit. Instead, in the years ahead I think (a) growth in employment and incomes will be sluggish, (b) consumers should be restrained in their borrowing as a result of having experienced the crisis, (c) consumer credit shouldn't be available as readily, and (d) borrowing against home equity will be much less of a factor, especially because home equity is so scarce.

"Second, should you worry more about losing money or about missing opportunities? This one's easy for me. First, the macro uncertainties tell me we won't be seeing a highly effervescent economy or market environment. Second, other people's increasingly aggressive behavior tells me to seek cover. And third, since I don't see many compellingly cheap assets, I doubt there will be gains big enough to make us kick ourselves for having invested too cautiously.

"And that brings me to my third question: what tools should you employ? I think we're back to needing the cautious attributes, not the aggressive. An unusually large number of thorny macro issues are outstanding... with all of these, plus prices that are fair to full and investor behavior that has increased in aggressiveness, I would rather gird for the things that can go wrong than ensure maximum participation if things go right. (Of course that's not an unfamiliar refrain from me.)

"The other day, the investment committee of a non-profit on which I sit decided to take the first steps toward marshaling resources and managers so as to be ready to buy into beaten-down assets after the next round of bubble and bust. And it wasn't even my idea!

"We can never be sure what will happen and certainly not when but it's important to be prepared for what's likely to lie ahead. And understanding the inevitable pendulum swing in the way investments are viewed from weeds to flowers and back is an essential ingredient in being able to do so."

Market Climate

As of Friday, both the Strategic Growth Fund and Strategic International Equity Fund were tightly hedged. Though we've established modest, transitory market exposures in the range of 10-15% during recent weeks, in response to pullbacks and a slight easing of bullish sentiment, our latitude to accept risk remains proportional to the average return/risk profile we observe under any given set of conditions.

The pullbacks we've observed so far have been fairly shallow, and we've simultaneously observed deterioration in a number of economic factors (unemployment claims for example). Moreover, we're seeing more breakdowns across individual sectors, particularly risk-sensitive ones like small cap stocks, various emerging markets, and commodities. One or two more reasonably sloppy weeks would significantly damage market internals, so at present, any exposure we do take is with a "safety net" using a line of out-of-the-money index puts. Suffice it to say that our general view remains defensive, but we are doing our best to accept shorter-term opportunities that do emerge - fairly close to the vest - in proportion to their expected return/risk tradeoffs.

In bonds, Strategic Total Return continues to carry a duration of about 3 years, balancing the favorable downward pressure on yields against a fairly unfavorable yield level, to warrant a modest but positive overall exposure. The Fund continues to carry about 8% of assets in precious metals shares, with another 2% of assets in utility shares.

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