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October 8, 2012

Number Five

John P. Hussman, Ph.D.
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Examine the points in history that the Shiller P/E has been above 18, the S&P 500 has been within 2% of a 4-year high, 60% above a 4-year low, and more than 8% above its 52-week average, advisory bulls have exceeded 45%, with bears less than 27%, and the 10-year Treasury yield has been above its level of 20-weeks prior. While there are numerous similar ways to define an “overvalued, overbought, overbullish, rising-yields” syndrome, there are five small clusters of this one in the post-war record: November-December 1972, July-August 1987, a cluster between late-1999 and early 2000, early 2007, and today. The first four instances preceded the four most violent market declines in the post-war record, though each permitted a few percent of additional upside progress before those declines began in earnest. We do not know what will happen in the present instance, particularly over the short-run. But on the basis of this and a broad ensemble of additional evidence, we estimate that the likelihood of deep losses overwhelms the likelihood of durable gains. To ignore those four prior outcomes as “too small a sample” is like standing directly underneath a falling anvil, on the logic that falling anvils are an extremely rare occurrence.

On the economic front, Friday’s employment report was interesting in that total non-farm payrolls (the “establishment survey” figure most widely quoted in news reports) came in slightly below expectations, but total civilian employment (the “household survey” figure used to compute the unemployment rate) jumped enough to produce a drop in the unemployment rate to 7.8%. While the difference was certainly an outlier in terms of typical correlations between establishment and household figures, it wasn’t the sort of outlier that would justify the suggestions of political conspiracy that were bandied about over the weekend.

The fact is that on a month-to-month basis, there is only a 50% correlation between the establishment and household employment figures, rising to about 90% correlation for year-over-year changes. The household data is notably more volatile, but the establishment figure makes up for the lower volatility with significant after-the-fact revisions, particularly around economic turning points. The month-to-month changes above and below the 12-month average are about 50% larger in each direction for the household survey than for the establishment survey. What’s interesting is that these changes are often matched by changes in the reported size of the labor force, which is why they don’t usually result in large changes in the unemployment rate from month-to-month. For example, in January 2000, the household figure jumped by over 2 million jobs, while the establishment figure increased by only 248,000 jobs. But the unemployment rate held steady at 4% because the reported labor force also increased by over 2 million workers.

From that perspective, the unusual feature of last month’s report was that the increase in reported household data exceeded the increase in the reported labor force by an amount that statistically occurs only about 6% of the time. Yes, it was an outlier, but it wasn’t even a two standard deviation event. I would expect some give-back in that “excess” household survey growth, and based on the extent of revisions to establishment survey data around economic turning points, I also expect that the September establishment survey figure will ultimately be revised to show a net loss of jobs on the month. So as a whole, my impression is certainly that the September report presents a healthier picture of the employment situation than will survive later revisions, but there isn’t evidence to suggest any manipulation of the data.

At the same time, nothing in the most recent data changes my view that the U.S. economy has already entered a recession. The ISM purchasing managers data came in slightly above expectations, but broader data from regional ISM surveys as well as Federal Reserve surveys remain well below-average. European purchasing managers data has been dismal. As Markit notes, “It seems inevitable that the region will have fallen back into recession in the third quarter.” And even if we take the recent employment report at face value, the year-over-year growth in non-farm payrolls is presently just 1.37%, and we’ve never yet seen a decline in payroll growth below 1.4% year-over-year except during or just prior to U.S. recessions. This time may be different, but is difficult to see why that expectation is sensible given the broader context of economic evidence.

Year-over-year employment growth falls below 1.4%

Meanwhile, the balance sheet of the Federal Reserve presently comes to about $2.8 trillion, with an average duration of 7.3 years, meaning that a 100 basis point change in interest rates would be expected to impact the Fed’s position by about 7.3% on the basis of bond price changes. Now, keep in mind that the Fed presently has just $54.7 billion in capital, which means that the balance sheet is leveraged by over 50-to-1, or put differently, the balance sheet has just 1.95% capital coverage. The unpleasant arithmetic here is that a 27 basis point change in bond yields (1.95%/7.30%) would effectively wipe out the Fed’s capital. While the Fed doesn’t mark its balance sheet to market, and can therefore run an insolvent balance sheet without immediate consequence, it should at least be a subject of public understanding that monetary policy becomes fiscal policy 27 basis points from here. Over time, of course, the Fed earns interest on its bond holdings, and that interest is normally handed over to the Treasury for public benefit. Presently, a 30 basis point increase in yields over a one-year period would wipe out even this interest, at which point the government would be paying interest on its debt simply to cover the Fed’s losses, with no net benefit to the public. That is, unless one believes that the Federal Reserve’s manipulation of financial markets is of equivalent benefit in and of itself. We don’t, and it is likely that investors will discover that in an uncomfortable way over the coming quarters.

The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Only comments in the Fund Notes section relate specifically to the Hussman Funds and the investment positions of the Funds.

Fund Notes

As of last week, the stock market remained characterized by an overvalued, overbought, overbullish syndrome and a variety of other conditions, and we continue to estimate very weak prospective returns per unit of risk on a blended horizon from 2-weeks to about 18 months. The longer-term outcomes from overvalued, overbought, overbullish syndromes have been more reliably negative than the short-term outcomes, where unfavorable long-term conditions are often ignored by speculators in pursuit of short-term momentum. That has always made our investment discipline uncomfortable in late-stage bull markets, as we saw in 2000 and 2007. That said, our “two data sets” challenge in 2009-early 2010 (see the most recent Annual Report for an extensive discussion) makes it easy to assume that our investment stance is simply pinned to a defensive mode – despite the fact that we removed most of our hedges in early 2003 when we had no such concerns about the relevance of Depression-era data.

While we place a great deal of emphasis on reducing the potential for deep capital losses, it would be incorrect to assume that our investment stance is inherently defensive regardless of market conditions. This is particularly true for Strategic Growth Fund, which has the ability not only to remove all hedges, but also to leverage its investment position using call options. While the Fund has not taken that sort of position since the inception of the Fund, that outcome is the result of market conditions that have produced a 13-year period of total returns for the S&P 500 that - even today - remains below the total return achieved by holding Treasury bills. Market conditions will change; valuations will change – and when those changes emerge, we will not have to concern ourselves again with the question of whether our hedging approach is robust to Depression-era data.

Particularly in Strategic Growth Fund, it is important to recognize that while we are conservative with respect to the risk of major capital losses, the Fund’s strategy is aggressive in its ability to vary its exposure to market risk. Presently, that aggressiveness may be on the defensive side, but there is a reason why aggressively positive exposures are part of our investment strategy and are written into the Fund Prospectus, and that reason is that we fully expect market conditions that warrant those positive exposures. I doubt that we’ll observe another market cycle that does not allow for such positions.

There is no doubt that we have been uncomfortable with a defensive stance and extremely negative return/risk estimates – as we were in 2000 and 2007, as the market comments from those points will attest. We view the market as richly valued on the basis of normalized earnings and prospective cash flows, with overbullish sentiment, overbought market action, and facing the prospect of an unrecognized recession already in progress. The evidence is not encouraging with respect to what has normally happened next.

We are very familiar with the tendency of investors to believe that prevailing conditions are immutable and that some new feature of the investment landscape has changed the way that the markets work. If anything, my impression is that we risk having overestimated the prospective growth rate of future cash flows, which would leave our estimate of 10-year S&P 500 total returns somewhat too high at about 4% nominal. Nevertheless, what matters is that valuations and prospective returns will fluctuate, and we have no need for the market to move to deep undervalue in order to justify removing our hedges. It certainly did not achieve deep undervalue in 2003. Of course, the 2009 low represented moderate undervaluation on our estimates (our estimate of 10-year prospective total returns moved briefly above 10% annually), but we had profound concerns about the out-of-sample nature of market conditions at the time. The coming cycle will have a whole range of aggressive and defensive opportunities, and we are looking ahead to those. At present, market conditions are associated with some of the most negative market outcomes in the historical record. Our investment stance is sensitive to the prospective returns and risks that we estimate. Present conditions are what they are. What is certain is that those conditions will change.

Strategic Growth Fund remains fully hedged, with the put option side of the Fund’s hedges raised closer to prevailing market levels at a cost in time-premium of just over 1% of assets looking out to early 2013. Strategic International Equity remains fully hedged, and Strategic Dividend Value is hedged at about 50% of the value of its stock holdings – it’s most defensive stance. Strategic Total Return continues to carry a relatively short duration of about 1.4 years, meaning that a 100 basis point change in interest rates would be expected to impact the Fund by about 1.4% on the basis of bond price fluctuations. The Fund also holds a small percentage of assets in utility shares and precious metals shares.

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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.

Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 reflect our standard valuation methodology, focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle (see for example The Likely Range of Market Returns in the Coming Decade and Valuing the S&P 500 Using Forward Operating Earnings ).


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