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July 16, 2012

The Third Law of Randomness

John P. Hussman, Ph.D.
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On March 5th, our estimates of prospective return/risk conditions in the stock market fell to the most negative 2.5% of all historical observations (see Warning - A New Who's Who of Awful Times to Invest). On March 26th, those estimates fell to the most negative 0.5% of historical observations (see A False Sense of Security), and have remained in that range since that time. Market conditions have now been in this hostile set of conditions for 16 weeks. This situation might continue on to 20 weeks, or to 24 weeks. It might continue longer - though I doubt it. What we do know, however, is that when conditions have been similarly negative historically, the S&P 500 has plunged at an annualized rate of over 40%, distributed over some of the most awful outcomes in market history.

How do we know that the present instance will turn out similarly? We don't. Proper investing doesn't rule out randomness and unpredictability, particularly when it comes to individual events. It instead diversifies against randomness both across holdings at each point in time, and across time by repeatedly acting on the basis of averages instead of individual forecasts. Random events behave predictably in aggregate even if they're not predictable individually - a fact that Charles Seife calls the Third Law of Randomness. "To say something is random is not equivalent to saying that we can't understand it. Far from it. Randomness follows its own set of rules - rules that make the behavior of a random process understandable and predictable. These rules state that even though a single random event might be completely unpredictable, a collection of independent random events is extremely predictable - and the larger the number of events, the more predictable they become."

For us, what matters is the "conditional return" and the "conditional risk" - the average return, and the range of returns, that is associated with a specific set of market conditions. When the average return is highly negative, and the range of outcomes is narrow because those outcomes are almost invariably disastrous, you end up with a profoundly negative ratio of expected return to variability of return. This is where we stand.

In the meantime, our main risks are twofold. First, while our stock selections have historically outperformed the S&P 500 substantially over complete market cycles, there will be some periods in which those selections lag the S&P 500 and other indices we use to hedge. This is occasionally an inconvenience, but our stock selections are very deliberate, and we have a strong record on this aspect of our strategy.

Second, because of the extremely negative nature of present conditions, Strategic Growth Fund also has a "staggered strike" configuration that raises the strike prices of the long-put side of its hedges. Over the past two years, central banks have done their best to provide the equivalent of free put options to investors, which has reduced the benefit of paying for real ones. A few months ago, we responded by tightening our criteria for these positions, requiring not only strongly negative return/risk estimates, but also either negative trend-following measures or the presence of hostile indicator syndromes (Aunt Minnies). These criteria have the effect of reducing the historical frequency of these positions by more than half (and would have deferred our establishing these positions until March 5th of this year, when those hostile indicator syndromes became overwhelming). Many of the most damaging market losses in history fall into the set of instances that survive those criteria, as do market conditions at present.

At present, these hedge positions are both intentional and strategic. The risk here is that if the market does not decline significantly, the higher strike put options will incur time decay of a fraction of a percent per month while market conditions remain hostile (our estimated "theta" presently works out to about -0.3% monthly, which can vary depending on our choice of option strikes and maturities). Because these positions can also be expected to confer significant gains on extended market declines, they will also give up some of those gains in the event of subsequent advances if we don't have good opportunities to reset our strike prices. Again however, the outlay for these positions works out to a fraction of a percent per month in time value while conditions remain strongly negative.

Our investment strategy is intended to outperform our benchmarks over complete market cycles, with smaller periodic drawdowns. We pursue that objective by establishing investment positions that are roughly proportional to the expected return/risk profile that we estimate at any particular time. The peak-to-peak cycle from 2000 to 2007, and the trough-to-trough cycle from 2002 to 2009 provide instructive examples of how we pursue that strategy.

Over the most recent cycle from the 2007 peak to the recent 2012 peak, we succeeded in substantially limiting drawdowns, but Strategic Growth also lagged the total return of the S&P 500 by a cumulative amount of just under 13%. This was frustrating, but here is the point. If you understand the unusual nature of the most recent cycle, my decision in 2009 and early-2010 to make our methods robust to Depression-era data (and the "miss" that resulted as we addressed that "two data sets" problem), and the restrictions that we've placed on our defensive stances in order to better navigate periods of extraordinary monetary intervention, then you understand both the cause of our lag in the recent cycle, and the reason we don't anticipate such a lag in future cycles.

Again, the 2000-2007 peak-to-peak cycle and the 2002-2009 trough-to-trough cycle should reveal common characteristics of our approach, one which includes the tendency to be defensive during periods of exuberance when other investors are still drinking the Kool Aid. We avoided drinking it in 2000 because of bubble valuations, in 2007-2008 because of hostile market conditions and a probable credit-driven recession, and avoid it now because of clear evidence of unfolding global recession in the context of rich valuations, an army of negative indicator syndromes, and what are already largely unsolvable sovereign debt risks. From a historical perspective, present, observable market conditions give us no option but to be strongly defensive here.

Undoubtedly, the most recent market cycle has been frustrating, not only because Strategic Growth lagged the S&P 500 by just shy of 13% on a cumulative basis from the 2007 peak to the recent peak, but because the lag was much greater when one measures from the 2009 trough, including a loss of several percent in a net market advance year-to-date. Again, if one understands the extreme nature of the most recent cycle, and the steps we took to make our strategy robust against the potential for extraordinary economic and market strains (which Wall Street seems all too happy to rule out), it should be clear that we have already addressed the most significant issues that we faced in the most recent cycle, and why we don't expect those challenges in the future.

At present, the investment stance that we are taking is intentional, and in line with what I view as optimal strategy from a theoretical, historical and current-events perspective. Our two primary risks are 1) the risk that our stock selections underperform the indices we use to hedge, despite a long-term record of substantial outperformance, and 2) the risk of time-decay in our staggered-strike position amounting to a fraction of a percent on a monthly basis, which we are willing to accept given the historical tendency for the S&P 500 to decline at an annual rate of over 40% under similar market conditions. In the day-to-day hyperfocus that the financial media places on small movements of 2-3%, and even intermediate fluctuations of 10-20%, it is important to keep in mind that the average bear market wipes out more than half of the preceding bull market advance. Those losses are substantially worse when the market decline begins from rich valuations on normalized earnings, emerges in the context of economic recession, and occurs during a secular bear instead of a secular bull, all which are relevant considerations here.

I expect that the Federal Reserve will initiate QE3, though only after more substantial market and economic weakness. It doesn't really matter that QE does little but help stocks recover their prior 6-month losses, and does next-to-nothing for the real economy. Fed governors evidently prefer superstition to evidence on this. Besides, unless the Fed violates the Federal Reserve Act again - as it did in 2008 - QE is the shiniest tool they have. As for structure, I would expect the next round to be in the $400 billion area (due to balance sheet and duration risks for larger amounts), possibly involving mortgage securities, and will most likely be sterilized (requiring banks to hold the proceeds on reserve with the Fed) unless implied inflation expectations decline sharply. It remains unclear that the securities of Fannie Mae and Freddie Mac are actually legal objects for open market operations under Section 14(b) of the Federal Reserve Act, as the government's conservatorship doesn't imply that these securities are "fully guaranteed as to principal and interest" indefinitely, and unlike Ginnie Mae, Fannie and Freddie are not government agencies. Despite the statement of Congress that "the hybrid public-private status of Fannie Mae and Freddie Mac is untenable and must be resolved," it's clear that the backstop for Fannie and Freddie is assumed by the Fed to be both explicit and permanent.

Regardless, my impression is that QE3 along the foregoing lines will be a disappointment to investors, and will in any event be unhelpful in materially reversing a global recession. Our investment response will be driven by observables such as market action - particularly any latitude that may exist between the point where trend-following measures turn positive and the point where the market establishes an overvalued, overbought, overbullish syndrome. At present, there is little distance between those likely points, but that may change and we'll take our evidence as it comes.

As a side note, I continue to believe that the FASB suspension of mark-to-market accounting was far more important than quantitative easing in driving the market advance of 2009. Relieving banks and other financial institutions of the need for transparency relieved them of the risk of being seized as insolvent by regulators, and also relieved them of the immediate need to build capital buffers. European banks are now in a situation where receivership is the only option. It is not at all clear that global financial linkages are so weak as to immunize the U.S. banking system from European financial turbulence.

What's fascinating is that in a world where accounting irregularities are typically viewed with with concern, JP Morgan actually advanced on Friday despite an 8K that included the following disclosure: "the recently discovered information raises questions about the integrity of the trader marks, and suggests that certain individuals may have been seeking to avoid showing the full amount of the losses being incurred in the portfolio during the first quarter. As a result, the Firm is no longer confident that the trader marks used to prepare the Firm's reported first quarter results (although within the established thresholds) reflect good faith estimates of fair value at quarter end. The Firm has consequently concluded that the Firm's previously-filed interim financial statements for the first quarter of 2012 should no longer be relied upon." Given that the widely-reported losses at JP Morgan appear to have been losses on the hedge, of a hedge, of a fantastically large position in European mortgage-backed securities, I suspect that these troubles aren't over. None of the Hussman Funds holds a position in this company.

Market Climate

There was no material change in market conditions last week across stocks, bonds, or precious metals. Strategic Growth and Strategic International remain tightly hedged. Strategic Dividend Value remains hedged at 50% of the value of its stockholdings. Strategic Total Return continues to have a duration of about one year, about 10% of assets in precious metals shares, and a few percent of assets in utility shares and foreign currencies. In my view, this is neither the time to abandon defensive positions in the hope of magical monetary rabbits, nor the time to reach for yield in securities where risk premiums are compressed across the board. The full catastrophe of global recession, sovereign risks, overvaluation, and bank insolvency is being held at bay by the hope that liquidity can produce solvency; that the world's problems can be meaningfully addressed by the Fed buying a small fraction of the growing mountain of government bonds that already yield next-to-nothing, and replacing them with currency and bank reserves that yield precisely nothing. I continue to believe that this is ill-advised, but it is important to emphasize - as usual - that our present defensiveness is not based on our view of the global economy, but is instead based on observable evidence and the record of historical outcomes that have accompanied similar conditions. When that evidence shifts, so will our investment stance.

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Prospectuses for the Hussman Strategic Growth Fund, the Hussman Strategic Total Return Fund, the Hussman Strategic International Fund, and the Hussman Strategic Dividend Value Fund, as well as Fund reports and other information, are available by clicking "The Funds" menu button from any page of this website.

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