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July 18, 2011

Dabbling with Support

John P. Hussman, Ph.D.
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Very little change in market conditions this week; stock valuations imply expected 10-year S&P 500 total returns of about 3.8% annually, based on our standard estimation methodology, market action remains mixed, and advisory bearishness remains too low for comfort in the context of current valuations. The overall set of conditions implies a slightly negative expected return/risk profile for stocks, which would turn sharply negative on a broad decline much below about 1280 on the S&P 500 (particularly if that sort of decline had broad participation from industries, sectors, and security types). By contrast, a further pullback toward that level, sufficient to generate oversold conditions and more bearish sentiment, but not much deeper and not coupled with broad further deterioration in market internals, might be associated with a brief improvement in the expected return/risk profile.

The overall market picture continues to have the look of a broad topping process, in which it's very common to see the market confined to a trading range of about 5-7% for 6-8 months. Still, our investment position isn't driven by the expectation of an oncoming bear market, and we'll remain flexible to changes in the ensemble of market conditions. Near-term, tests of widely-recognized "support" are often met by a bout of short-covering, similar to what we observed two weeks ago. Given the moderate improvement in market internals produced by that rally, a retest of those lows that isn't overly hostile to market internals might provide some latitude for modest market exposure. Suffice it to say that constructive opportunities are likely to be limited, moderate, but not impossible to achieve, and the downside risks below roughly 1280 on the S&P 500 (about where the popular 200-day moving average is running these days) could be fairly violent if internals weaken again.

In Strategic Growth and Strategic International Equity, we're well defended against the impact of general market fluctuations, but continue to be open to moderate exposure if only the average expected return profile implied by the full ensemble of market conditions would peek above zero.

In bonds, conditions are similar in that long-term expected returns (which in this case can be directly observed as yield-to-maturity) remain poor, while near term returns rely on a further flight to safety on debt concerns of other countries, but not our own. Per unit of risk, the present ensemble of conditions is far more sympathetic to accepting exposure in precious metals shares. In the Strategic Total Return Fund, we continue to carry a duration of about 2.5 years, mostly in near- and intermediate-term Treasury securities, with the bulk of the Fund's day-to-day fluctuations driven by our position in precious metals shares, at just under 20% of assets.

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