All contents copyright 2002, John P. Hussman Ph.D.
Excerpts from these updates should include quotation marks, and identify the author as John P. Hussman, Ph.D. A link to the Fund website, www.hussmanfunds.comis appreciated.
Sunday December 29, 2002 : Weekly Market Comment
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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The Market Climate for stocks remains characterized by unfavorable valuations and unfavorable trend uniformity, holding us to a defensive position. While we remain fully invested in favored stocks, we have removed the impact of market fluctuations from the portfolio through hedging, leaving us with the portion of risk inherent in our favored stocks that is a) not correlated with overall market fluctuations and b) cannot or should not be diversified away. It is that portion of risk that we expect to be compensated for taking. We have hedged the market risk because such risk has historically not been compensated during periods with both unfavorable valuation and trend uniformity, and we have diversified away much of the random movements of our individual stock holdings by allocating our funds to over 100 individual stocks in a wide variety of industries.
Now, it's certainly possible to fully shut down all risk taking. We could do that by holding Treasury bills. Or we could do it by holding a portfolio exactly matching some particular market index and then selling short that market index as a hedge (a riskless position that also earns roughly the T-bill rate by virtue of how options and futures are priced). But we do not want a riskless position. In a market with thousands of individual stocks, each with its own particular valuation, market action, financial strength, products, industry, management, and other factors, there are always some risks that are worth taking, so long as the undesirable risks can be avoided, hedged, or diversified away. That's our basic approach, and is why our funds are called "strategic." In short, we select particular risks that we believe will be compensated.
Our view is that no form of investment risk is always worth taking without regard to valuations, fundamentals, economic conditions, or market action. The strategy of buying and holding index funds for the long run is essentially a strategy that says that market risk is always worth taking. Yet the iron law of investing is that a security is nothing but a claim on a future stream of cash flows. Valuation is a crucial determinant of long-term returns. The higher the price an investor pays for those cash flows today, the lower the long-term rate of return earned on the investment..
The corollary is also true. The lower the long-term rate of return demanded by investors, the higher the price moves today. So clearly, changes in investors' attitudes toward risk will strongly affect short-term returns. If investors become more willing to take market risk, it is equivalent to saying that they are demanding a smaller risk premium on stocks (that is, a lower long-term rate of return). Prices rise as a result. Now, the fact that current stock prices are higher also implies that future long-term returns will be lower, but that's part of the deal.
So clearly, the returns to market risk can be expected to vary, depending on investment merit (favorable/unfavorable valuations), and speculative merit (favorable/unfavorable investor preferences for risk taking). Rather than assuming that these are always favorable, we read them out of actual market conditions. Given a set of future expected cash flows and a current price, we can read out the long-term return that stocks are priced to deliver. If it's high, either in absolute terms or relative to suitably alternative assets, we say that stocks are favorably valued. If it's low, we say that stocks are unfavorably valued. We read out investor preferences for risk taking by analyzing market action - specifically, this thing that I call "trend uniformity." Investors leave the footprints of their information and preferences through the action of prices and trading volume across a wide variety of security types and market internals.
At present, stocks lack both investment merit and speculative merit. That said, I'll still be surprised if the market doesn't recruit at least some degree of speculative merit (favorable trend uniformity) in the months ahead.
Shorter term, the market broke a 10-week line of consolidation on Friday, which was particularly unfavorable action. Given that stocks are fairly oversold, favorable seasonality this week may give the market some support in recovering. It's not unusual for the market to enjoy a bounce following a significant technical breakdown, and we certainly shouldn't rule it out here. Still, Friday's break was unfavorable action, and the implications could become rather ominous if the market doesn't enjoy much of a rebound in the immediate future. As always, the market conveys the greatest information when market action departs from what it should do. Already, stocks have suffered one of the poorest December performances on record, during what ought to be a seasonally favorable period and what is widely believed to be a new bull market (I'll refrain from comment, for fear of gagging). Suffice it to say that stocks should be able to recruit a bounce here, should being the operative word.
In any event, we'll only increase our exposure to market risk if stocks can recruit evidence of favorable trend uniformity. We will not substitute anything for this evidence. Not hope in favorable seasonal patterns. Not hope that the market can't decline for a fourth year, so it must be safe to buy on December 31st. Not hope in the Fed. Nothing but evidence.
That evidence remains hard to find, especially evidence of robust preferences by investors to take stock market risk. A particularly good review of recent market action comes from Dr. Bryan Taylor of Global Financial Data:
"The end of previous bear markets as in 1974, 1982, 1987 and 1990 displayed double bottoms with important characteristics that marked the end of those bear markets. First, volume declined as the market ran out of sellers at the bottom. Second, volume increased significantly once the new bull market began. Third, the move out of the bottom was sharp, with the stock market index rising dramatically, breaking the downtrend in the market, and registering several successive months of a rising stock market. The market rallied for 12 months in a row in 1935, 6 months in a row in 1942, 11 months in a row in 1949, 9 of 10 months in 1970, 6 months in a row in 1975, 9 months in a row in 1982, and 7 months in a row in 1991. Fourth, after the bull market began the time the market spent rising was greater than the time spent declining or moving sideways. Fifth, the market became significantly undervalued at the market bottom, attracting new investors.
"Unfortunately, none of these signs of a market bottom has occurred here. Despite dramatic four-day rises off of the bottoms in both July and in October, the market stagnated afterwards. The current bear market has seen heavy volume during declines, and light volume after the market rallies, just the opposite of the pattern in a bull market. The market has yet to run out of sellers, and the buying power needed to pull the market further up hasn’t appeared yet. Finally, the market hasn’t broken its downtrend, and the market remains overvalued."
Among other measures, investment advisory bearishness remains quite low, with the Investors Intelligence bearish percentage still well below the important 30% level (26.5% this week). Barron's magazine presents further bullish views in its latest poll of Wall Street investment strategists. The bullish views lean heavily on two fallacies. One is the notion that the market can't decline four years in a row, since the only other time it has done so was during the Depression, and we're not in a depression. The difficulty is that the decline from the 2000 peak began at a price/peak earnings multiple fully 50% higher than the valuation that existed at the 1929 peak (or any other bull market peak for that matter). Valuation multiples based on other fundamentals such as dividends, book value, revenues, and replacement values were even more extreme in relation to prior bull market peaks. Even today, the S&P 500 price/book ratio remains above 4.0, which is beyond anything seen in prior market cycles.
The second fallacy is related, and is based on the notion that the P/E doesn't look so bad based on forecasts of future operating earnings. But basing stock valuations on such forecasts runs into the problem that a) they're forecasts, and have a history of outlandish unreliability, and b) stocks are not a claim on operating earnings, which include items such as interest payable to bondholders and taxes payable to the government. Moreover, given that the portion of operating earnings represented by debt and tax service is now the highest in history, it's not at all clear that the P/E multiple attached to those operating earnings should be anything close to the historical multiple attached to them.
Not that I'm arguing with bullish forecasts per se. I don't have a forecast at all, so it's certainly possible that the market could advance during 2003. If trend uniformity does improve in the months ahead, we'll certainly accept a moderate exposure to market risk. That said, I do disagree with the reasons that analysts are giving for being bullish. Valuations, in my view, simply do not belong among any well researched bullish argument, even taking into account the multitude of "but what about"s that people like to put forward to "correct" dismal valuations (most of these are discussed in prior updates and issues of Research & Insight).
So if the market recruits favorable trend uniformity in the months ahead, we'll take an exposure to market risk. That may occur at higher levels in the market, it may occur at lower levels, and it may not occur at all. But if trend uniformity does become favorable, it will not signify a return of long-term investment merit. Rather, we will have enough short-term speculative merit to warrant some additional risk taking (by reducing our hedging). In the meantime, we are already taking certain risks that we do expect to be compensated over time.
In bonds, the Market Climate remains characterized by unfavorable valuations and favorable trend uniformity. We've reduced our exposure to interest rate fluctuations somewhat by clipping off part of our Treasury bond positions during the recent rally, shifting into shorter-term callable agency securities, Treasury inflation protected securities, and other vehicles. Until trend uniformity shifts to an unfavorable condition, some interest rate risk will remain optimal. There is still enough risk in economic and political conditions to fuel a further decline in yields. But as I've noted before, the moment that economic activity picks up, inflation is likely to experience an abrupt spike higher. Deflation in manufactured goods (particularly foreign imports) is a possibility, but barring an outright debt crisis, fears of more widespread deflation are not well-supported.
I rarely discuss political risks, but these are becoming increasingly central to the investment markets. It is difficult to discuss war in relation to finance, because such discussions often appear terribly cold to the human tragedy of it. With the understanding that politics is never a subject that evokes agreement, here are my thoughts.
On a historical basis, war has not been particularly bad for the markets, because early uncertainty has been followed either by a certain numbness or by resolution. In both cases, risk premiums have initially spiked higher, followed by a decline. Prices move opposite to risk premiums, of course, leading to the characteristic sharp selloff and prolonged recovery related to war.
With regard to current risks, however, I don't think we can be so neutral about them. A military action in Iraq is likely to lead to much wider ramifications than the Gulf War. If the greatest fear of our enemies is that the U.S. is willing to use its power to threaten or prevent their sovereignty, what stronger way to validate these fears than to overthrow one of their governments? As a result, a military action in Iraq carries with it a much greater risk of retaliation in the form of renewed terrorist attempts. This would most probably drive risk premiums to high and fairly sustained levels, with economic effects on profits further depressing equity values.
The human risks to a war in Iraq are of far greater concern. Many of the "hawks" favoring war seem to have little combat experience, and are relying on a cakewalk to Baghdad - convinced that the U.S. made an error by failing to "finish the job" in the Gulf war. One wonders whether they recall that Eisenhower chose not to "finish the job" by making a northern push to Berlin in World War II. The Russians pushed ahead, and lost roughly 400,000 soldiers doing so - more than the U.S. lost in the entirety of World War II. The Iraqi army is certainly not the German army, but war, if it comes, will not be confined to the desert as it was during the Gulf War. The U.S. would certainly minimize casualties by destroying as much as possible from the air before land troops were deployed. But I doubt that the total number of casualties on both sides would be reduced by such destruction. Though we are Americans first, every life lost in war is a tragedy.
It strikes me that the U.S. has lost much of the international support and sympathy that it enjoyed last year, largely because of a White House foreign policy team that seems intent on escalation of conflicts to the exclusion of diplomatic alternatives. That's unfortunate, because already the White House's unfathomable doctrine of "preventive war" has provoked a destabilization of nuclear risks in North Korea. To a great extent, our enemies hate us not because of our freedoms, but because they believe that we are willing to deny them the same freedoms that we defend for ourselves. If our enemies understood America from the standpoint of its principles, its ideals, and its people, they would see these fears as unreasonable. But such fears can certainly be fanned by the foreign policy of a particular Administration, and this one is doing a good job of it.
The heightened nuclear tension in North Korea is a predictable response from a country identified as the third vertex of an "axis of evil," in the face of a planned military overthrow of one of the other vertices. What country, so identified, would not move to defend itself in the face of a potential invasion of Iraq? Understanding this, the best answer from the White House would be some gesture to assure that the U.S. does not intend a preemptive attack on North Korea as well. The resolution of any dispute requires one to ask "To what is each side entitled?" - and North Korea has asked for a nonaggression pact. Even if our response falls short of such formality, there are certainly some gestures that the U.S. can make along those lines to de-escalate the threat there.
All peace is based on a willingness - however distasteful - to understand one's enemy. Hate and evil typically have their origins in fear, ignorance, suffering, and perceptions of injustice. It is always possible to make gestures that address these without compromising one's own security or justice.
Is the group of hawks in the White House wise enough to understand its enemies? Maybe not. U.S. foreign policy is increasingly based on the notion that enemies should be eliminated. But if our enemies believe the same thing, the equilibrium cannot be peace without devastating losses first. Escalation is a long road, and the end of that road may not be peace after all. As Zen master Thich Nhat Hanh says, there is no way to peace - peace is the way. Understanding our enemies requires us to contemplate their fears, ignorance, suffering, and perceptions of injustice - however distasteful that is to imagine. Understanding does not prevent us from defending ourselves, or from seeking justice, but it informs a multitude of decisions and actions that can help, and as a result, that can stabilize our world.
As we enter a new year, there seem to be no fewer risks than in the year that is ending. But always, we can be full of hope.
I want to thank you for the opportunity to come into your computer monitor every week to analyze, discuss, teach, rant, and occasionally make no sense at all. (Those of you who have flat panels are also forcing me to buff up, so thanks for that too). As always, I appreciate your business, and I hope that I have served you well. But most of all, I am thankful for your trust.
Wishing you health and happiness in the New Year. - John
Sunday December 22, 2002 : Weekly Market Comment
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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The Market Climate for stocks remains characterized by unfavorable valuations and unfavorable trend uniformity, holding us to a defensive position - fully invested in favored stocks with an offsetting short position in the major indices. The purpose of this hedge is to remove the impact of market fluctuations from our portfolio, not to speculate on market direction or a potential market decline. As usual, I have no short-term forecast regarding market direction. While we remain defensive at present, it is important to understand that we'll immediately take a constructive exposure to market risk when the market eventually does recruit favorable trend uniformity, regardless of valuation levels. I'll be fairly surprised if the market doesn't recruit favorable uniformity at some point in the next few months, but I have no forecast of whether that will occur at higher or lower market levels. Our investment discipline simply doesn't attempt or rely on such forecasts.
With the New Year approaching, it is popular for investment advisors to produce year-ahead forecasts of where the market will be headed in 2003. Except for broad discussions of prevailing conditions and risks, we don't participate in this sort of forecasting. The reason is that we see only two reasons for taking market risk: investment merit (which means favorable valuation), and speculative merit (which means favorable trend uniformity). But valuation only determines long-term returns, and is virtually useless for horizons as short as one year. Meanwhile, trend uniformity tends to shift an average of just twice a year, but these shifts are not predictable even from one week to the next. To offer a forecast beyond a week would ignore the constant potential for market trend uniformity to shift. To offer a forecast of less than a week would ignore the overwhelming impact of randomness on such short horizons. So we are left with no need to forecast at all. We simply align our position with the prevailing Market Climate, and shift our position when sufficient evidence emerges.
For now, the Market Climate for stocks remains hostile. But again, I'll be fairly surprised if we do not see a favorable shift at some point in the coming months. As I've noted before, it would be somewhat easier to generate favorable trend uniformity as a result of a hard market decline with relatively firm internals, rather than a rally from current levels. In either case, a shift in market leadership toward something other than technology would also be helpful. We'll take our evidence as it emerges.
In bonds, valuations have become quite unfavorable, but trend uniformity remains somewhat favorable. Since bonds are not as susceptible to speculative waves as stocks, the impact of favorable trend uniformity is not enough to overwhelm poor valuations. For that reason, we've clipped off a portion of our Treasury note position on the latest rally, though we still hold some exposure there. Conditions remain favorable for investment vehicles that are driven primarily by falling real interest rates. These include precious metals, foreign government notes, and inflation-protected securities.
Wishing you a Merry Christmas, Happy Holidays, and a joyful New Year.
Sunday December 15, 2002 : Weekly Market Comment
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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The Market Climate for stocks remains characterized by both unfavorable valuations and unfavorable trend uniformity, holding us to a defensive position - fully invested in a well diversified portfolio of favored stocks, with an offsetting hedge to remove the impact of overall market fluctuations from the portfolio. What remains is a certain amount of risk, relatively uncorrelated with market movements, that we expect to be compensated by virtue of the specific valuation, market action, products, financial strength, management, and other features of the individual stocks we favor. This is the primary form of risk that we have taken over the past few years, given that market risk has been generally unattractive.
That said, I would be surprised if the market did not recruit favorable trend uniformity at some point in the next several months, at which point we will accept a moderate amount of market risk (by closing down a portion of our hedges). My opinion is that such a shift is somewhat more likely to occur at lower levels than higher ones, but our position is not at all based on that opinion. When the market produces sufficient evidence of favorable trend uniformity, at whatever level that occurs, we will accept a moderate exposure to overall market risk. Ours is not a timing approach or a forecasting approach. It is an identification approach, in which we focus on properly measuring valuations and the quality of prevailing market action.
At present, that quality remains insufficient to justify exposure to market risk. This is particularly true given current valuation levels. Very simply, the S&P 500 is priced to deliver a total return over the coming decade between 3-6% annually. We'll detail this view in the January issue of Research & Insight. But suffice it to say that no extraordinary assumptions are required to arrive at this conclusion. Still, valuation only implies poor long-term investment merit. When trend uniformity is favorable, stocks have speculative merit sufficient to warrant an exposure to market risk.
As I've frequently emphasized, the market may go nowhere in the coming years, but it will almost certainly go nowhere in an exciting way. We can expect many alternating periods of favorable and unfavorable trend uniformity between now and the point that stocks achieve durable undervaluation. Our approach will take substantially different exposures to market risk during those periods. While our unwillingness to accept market risk during periods of unfavorable valuations and unfavorable trend uniformity certainly exposes us to the possibility that we will occasionally fail to track certain short-term rallies in the market, I believe that this occasional defensiveness substantially increases - rather than compromises - our ability to generate long-term returns.
Investors who frantically expose themselves to market risk for fear of "missing the boat" to long-term returns simply do not understand the concept of peak-to-trough. Historically, when stocks begin a period at a high level of valuation, one can always find a point substantially later in time when the market touches a trough valuation. Between those two points (historically spanning between 4 and 17 years), the total return on stocks has always been well below average - typically less than the Treasury bill yield - regardless of the rate of intervening earnings growth.
We are always willing to take some amount of market risk when stocks are undervalued (regardless of trend uniformity), or when stocks display favorable trend uniformity (regardless of valuation). When both factors are favorable, our approach takes a particularly aggressive position. But we are quite willing to avoid market risk altogether when both valuations and trend uniformity are unfavorable.
One of the essential elements of good investing is patience, and the key to patience is perspective. Maintaining a long-term perspective is very difficult in the face of excruciatingly short-term attention to quarterly, weekly, or daily results. It is notable that Coca Cola announced last week that it would stop giving quarterly guidance altogether, in order to focus its (and its shareholders) attention on long-term strategy. My impression is that this is exactly right (although it would be inappropriate for technology companies, whose competitive advantages are often so unsustainable that even a few disappointing quarters can mean extinction). Coke also expenses its options when reporting earnings. While Coke's valuation is still too high for our preference, its willingness to do the right thing is impressive. The only other major company that follows such a policy is Gillette (both heavily owned by Berkshire Hathaway). This move is pure Warren Buffett. Coca Cola will continue to provide information regarding its strategy, major initiatives, and other matters crucial to its shareholders' understanding of the business. What Coke is really saying is that it refuses to micro-manage short-term results if doing so would compromise its long-term strategy. Sounds a lot like what we do here.
The notable elements in the market picture here include: overvaluation, unfavorable trend uniformity, a record current account deficit, an unusually high dependence on consumption as a fraction of GDP, rising bankruptcies, overdependence of the U.S. economy on a steep yield curve, an ominous breakdown in the U.S. dollar following four months of consolidation (which I expect to be mirrored by the U.S. economy as a whole), a fresh decline in the Help Wanted Advertising Index to a new low of 40, war risk, pervasive bullishness among investment advisors and market strategists, and hope-driven adherence to the tech sector.
None of these elements are favorable. The overall implication is that both U.S. consumption and investment are likely to grow at a much slower pace than widely expected, that this lack of robust economic growth is likely to keep profit margins constrained for quite some time, and that barring a resumption of trend uniformity based on purely speculative merit, market risk should be approached very defensively.
The most frequently quoted "bullish" arguments (usually delivered breathlessly each morning on CNBC from the floor of the NYSE) emphasize easy monetary policy, the possibility of a fiscal stimulus, the potential for companies to boost underfunded pensions with their own shares, and the amount of money market funds on the "sidelines." All of these views are based on a misunderstanding of concepts such as market clearing and equilibrium.
For instance, when a company issues shares to put into its pension fund, or uses its free cash flow to repurchase shares on the open market to do so, the interests of shareholders are diluted. Shareholder value is not created through such actions. Well-anticipated trades that do not create shareholder value are not generally rewarded by higher share prices.
Now consider the "money on the sidelines" argument. When Ricky sells his money market fund to buy stocks, money does not go "into" the stock market. All that happens is that previously issued securities change hands. See, Nicky has to buy the commercial paper that Ricky's money fund liquidates, and the cash that Nicky previously held now goes to Ricky, who uses it to buy shares of stock from Mickey. In the end, Mickey gets the cash that Nicky used to hold, Nicky gets the commercial paper that Ricky used to hold (via the money market fund), and Ricky gets the shares that Mickey used to hold. Money doesn't go into the stock market - it goes through it. After these trades, there is exactly as much money on the "sidelines" as before - exactly the same number of dollars, exactly the same number of shares, and exactly the same amount of commercial paper.
Now, if Ricky is more eager to buy stock than Mickey is to sell, the share price increases, which means that Ricky has to sell more of his money market fund to buy the shares than otherwise. Thus, compared to the alternative where Mickey is the eager party (in which case the stock price declines), Nicky ends up with a little more commmercial paper and a little less cash, Ricky ends up with a little bit less in money market funds, and Mickey ends up with a little more of the cash that Nicky used to hold. So even if the stock price changes, it does not follow that there is any more or less money on the sidelines. It's just that the final distribution of existing securities among various individuals may be a bit different, depending on who was the eager party. Regardless, every buy trade that actually executes in the market is matched with a sell.
It is fairly difficult to find favorable elements in the market picture that don't rely on purely seasonal patterns. This is not to say that these seasonal patterns are irrelevant. Indeed, seasonality is really the only thing that tempers an otherwise terrible set of conditions. But as I've noted in prior updates, unfavorable valuations and trend uniformity overwhelm the otherwise favorable implications of seasonality, on average.
In bonds, the Market Climate continues to be characterized by unfavorable valuations and favorable trend uniformity. The producer price index dropped last week, but this is largely to be expected from a very weak manufacturing sector. I continue to expect inflation to be relatively low but persistent, emphasizing inflation in services and labor, with any deflationary pressures confined to the manufacturing sector. Conditions remain favorable in the precious metals markets here, as well as other asset classes that benefit from falling real interest rates such as Treasury inflation protected securities (TIPS), and short-maturity foreign government notes.
Overall, we're seeing signs of fresh weakness that are widely overlooked. Notable among these are the breakdown in the U.S. dollar after a 4-month line of consolidation, the breakdown in the Help Wanted Advertising Index to the lowest level in 40 years, and according to the latest quarterly report from the FDIC, the highest rate of credit card defaults since banks began recording data.
I suspect that the economy remains in recession, and that this recession has not exerted its full impact. This might be considered a "double-dip," but I really think it's more an extension of a single downturn that has reached the end of a consolidation period. Our investment positions do not rely on this view. Rather, this view is based on the information that can be inferred from market action. As always, when the quality of market action shifts, our investment position will shift as well. No forecasts required.
Sunday December 8, 2002 : Weekly Market Comment
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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Just a note: The most recent due diligence report for the Hussman Funds is now posted to the website. This report contains answers to frequently asked questions about the Funds and our investment approach for investment professionals and institutional investors (PDF file - click here). The report also contains a discussion of trend uniformity that we hope will enhance our shareholders' understanding of our analysis.
The Market Climate in stocks remains characterized by unfavorable valuations and unfavorable trend uniformity, holding us to a defensive position for now. Unfavorable valuation is essentially an indication that the long-term return derived from stocks is likely to be unsatisfactory.
To get an idea about valuations here, note that the year 2000 peak in S&P 500 earnings was about $50 (the current level is $26.74). When we form P/E ratios for the major indices, we typically use prior peak earnings on the belief that the steep decline in earnings during recessions is temporary and fails to reflect sustainable earnings power. On the basis of peak earnings, the S&P 500 P/E is currently over 18, compared to a long-term historical average of 14 and a historical median of 11.
Importantly, stocks are very long-term assets. Fluctuations in current inflation and short-dated interest rates have far less impact on appropriate P/E ratios and stock yields than is widely believed. Even a 30-year bond has an effective "duration" of only about 16 years. The effective duration of the S&P 500 (related to the ratio of price to free cash flow) is currently over 50 years. Current interest rates and inflation are no lower than they regularly were prior to 1965. Yet compared with historical periods of low inflation and interest rates, stock valuations are at levels only seen near the 1929 peak.
Of course, the change in stock prices is the result of both changes in the P/E ratio, and changes in earnings. Over the past 10, 20, 50 and 100 years, peak-to-peak earnings growth for the S&P 500 has averaged just under 6% annually. So let's assume that S&P 500 earnings quickly recover to their year 2000 peak, and then continue to grow at a rate of 6% peak-to-peak into the future. Now do the inconvenient math. Even if the S&P 500 P/E ratio was to reach its historical average P/E a full 20 years from now, the average annual capital gain on the S&P 500 index over that period would be ( [1.06][14/18]^(1/20) - 1 = ) 4.7% annually. Add in an average dividend yield of about 2%, and stocks are priced to deliver a return over the coming two decades of less than 7% annually, even if stocks never see a below-average P/E ratio again.
Carrying that same analysis to the median price/peak-earnings ratio of 11 (the average bear market has ended at a multiple below 9, but 11 was the low of the 1990 bear), the S&P 500 would earn an average annual capital gain of about 3.4% over the next 20 years, and a total return of less than 5.5% annually, even if stocks simply touch that median of 11 even 20 years from now. A lot can happen over 20 years that might prompt such contact.
All of which is to emphasize how little investors should be concerned about missing long-term returns with stocks at these levels. The real concern, and one that we take seriously, is the potential to miss short-term, speculative returns. Historically, valuation has not exerted a significant drag on short-term returns (and even returns over a period of several years) when trend uniformity has been favorable. This is why we always take some exposure to market risk when trend uniformity is favorable. Even if overall market returns are unsatisfactory over an extended period of time, the market will enjoy many intervening periods of favorable trend uniformity in which we will eagerly take market risk. Stocks may go nowhere over the coming years. But they'll almost certainly go nowhere in a very exciting way.
Still, when both valuations and trend uniformity are unfavorable, stocks have delivered negative returns with very high volatility, on average. High volatility means, by definition, that this Climate has certainly experienced sharp advances as well as sharp declines. But the negative average return in this Climate indicates that overall, this risk has not been associated with any reward at all.
In short, our currently defensive position is driven by the lack of both investment merit and speculative merit for overall market risk. There are certainly risks worth taking in individual stocks, once their market risk has been hedged away. But until we observe a shift to favorable trend uniformity, we'll remain defensive with regard to overall market risk. This position does not compromise any potential for long-term returns, in my opinion, but it does invite the potential for short-term tracking risk in which we may not closely track short-term movements in the overall market. Any approach which hopes to defend capital during significant market declines must periodically accept tracking risk. And as with all of the risks we accept, we take this risk because we expect it to be rewarded, on average.
So where is the market going? As usual, I have no forecast, and our approach does not require one. The quickest way for stocks to generate favorable trend uniformity, however, would be for the market to take a hard short-term hit followed by quick stabilization and preferably a shift in leadership to something other than tech. That's not a forecast, but it would be the most constructive action the market could produce here.
Trend uniformity is essentially a signal about the risk preferences and information held by other investors. Given the overall status of market internals here, there would simply be very little information content in a continued tech-dominated rally, and little chance of quickly improving trend uniformity on that basis alone. It is notable that of the four "bear market rallies" that stocks have enjoyed since their year-2000 peak, the only one not led by technology was the rally off of the July 2002 low. That one recruited favorable trend uniformity almost immediately.
In the bond market, the current Climate reflects unfavorable valuations but still favorable trend uniformity. Friday's unemployment report added to that, by triggering a breakdown in the U.S. dollar. If the dollar index falls even a couple of percent further, we could see a very sharp follow-through, with a corresponding spike in precious metals shares. As I note in Going for the Gold on the Research & Insight page, the best periods for precious metals stocks, hands down, are periods in which the inflation rate is rising, bond yields are falling (the combination indicating downward pressure on real interest rates), a Purchasing Managers Index below 50, and a gold/XAU ratio over 4.0. Indeed, when these factors have all been in place, as is currently the case, precious metals shares have historically appreciated at an average annualized rate of over 100%. However, these shares are also among the most volatile of any industry group, so moderation is essential. Accordingly, both the Strategic Growth Fund and the Strategic Total Return Fund are carrying moderate positions in precious metals shares (our largest allocations to a single industry rarely exceed 10% of assets).
Strategic Total Return also holds moderate positions in foreign government bonds, select utility stocks, Treasury inflation protected securities, and near-term callable agency notes. Our primary interest rate exposure here is in 6-7 year Treasury notes, which is currently the point on the yield curve having the best return/risk profile in our analysis. Overall, we're holding the duration of the Fund at about 3 years. This leaves our returns fairly insensitive to interest rate fluctuations. The bulk of our day-to-day risk, and our primary source of expected return, is in those alternative assets. While the majority of the Strategic Total Return Fund is always invested in U.S. Treasury and agency securities, our investment approach also has the flexibility to vary the average maturity of our holdings and hold moderate positions in alternatives such as TIPS, foreign government notes, utilities, and precious metals shares. It's that flexibility that gives us the potential to generate returns over time, even in the face of the relatively low yields available in Treasuries.
While it's certainly possible that bond yields have seen their lows, our measures of trend uniformity remain favorable for bonds, holding us to a modestly constructive position (our 6-7 year Treasuries being the bulk of that stance). My opinion is that Treasury yields may enjoy yet another spike lower in a flight to safety. The potential for such a flight lies in the prospects for further economic weakness, a fresh spike in corporate defaults, and concern about war risk. While our modestly constructive bond market position is based strictly on the prevailing Market Climate, these factors provide background reasons to be comfortable with our stance.
Sunday December 1, 2002 : Weekly Market Comment
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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A quick note on mutual fund distributions. When a mutual fund pays a distribution, the net asset value of the fund is reduced by the amount of that distribution. For example, suppose that a fund has $10,000 in net assets and 1000 shares outstanding, for a net asset value of $10 per share. Suppose that according to tax regulations, a fund has to distribute $1000 in capital gains as a distribution to shareholders. In this event, the fund will distribute $1 per share to holders of the fund. This leaves the fund with $9,000 in assets, and still 1000 shares. So with that $1 per share distribution, the net asset value of the fund drops to $9 per share (to be perfectly accurate, the fund's net asset value also changes by whatever amount the underlying investments fluctuate on the day of the distribution, but for simplicity, we'll assume that the investments were unchanged). Now, suppose that a shareholder owns 1 share of the Fund, and reinvests that $1 distribution. Prior to the distribution, the shareholder had 1 share valued at a net asset value of $10. After the distribution the investor takes that $1 and buys 0.1111 new shares at $9 each (rounding to 4 decimal places). So the investor now has 1.1111 shares at $9 each. Total value, still $10.
With regard to the Strategic Growth Fund, we paid a distribution of 0.925 per share on Friday, November 22, 2002. To compare current net asset values with pre-distribution net asset values, the current values should be multiplied by a factor of 1.0754 (again rounding to 4 decimal places). In other words, the most recent net asset value of 12.29 is equivalent to a pre-distribution net asset value of 13.2167 (which compares nicely with the 11.94 net asset value of the Fund at the beginning of this year).
Since the Fund's inception on July 24, 2000, the Fund has earned a total return of 47.75%, with double-digit returns in 2000, 2001, and 2002 year-to-date. On average, the Fund has gained value during advancing months in the market. On average, the Fund has gained value during declining months in the market. Of course, the Fund does take risk. For investors inclined to see the glass as 5.8% empty, I should note that we are down that amount since mid-August. About 4% of this pullback occurred because we were 40% unhedged during the initial portion of the markets' decline from its August peak (which the major indices have not surpassed). Despite this pullback, our willingness to accept market risk during August-September of this year added about 1% to returns overall. We expect to increase our exposure to market risk in the months ahead when the market recruits sufficient evidence of speculative merit (whether at higher or lower levels in the major indices).
At present, the Market Climate for stocks remains characterized by both unfavorable valuations and unfavorable trend uniformity, holding us to a defensive position - fully invested in favored stocks, with an offsetting short position in the Russell 2000 and S&P 100 indices. Importantly, this position is not intended to speculate on a market decline, nor should our stance be interpreted as an expectation that the market will fall. Rather, this position is intended only to remove the impact of market fluctuations from our portfolio. The proper interpretation is simply that we do not have sufficient evidence to take market risk.
The return on any stock is derived from three risk factors:
1) Alpha. This is the expected return from "idiosyncratic risk" that is specific to a particular stock and a particular company. Alpha is dependent on the company's valuation, products, earnings, financial strength, management, and other "stock selection" considerations;
2) Beta. This measures the sensitivity of a stock to overall market movements. The expected return from beta risk depends on the expected return on the market itself. From the standpoint of our investment discipline, this varies considerably depending on the particular Market Climate we identify;
3)Epsilon. This is pure "noise" - random day-to-day fluctuations which may be substantially positive or negative over the short-term, but average to zero over the long-term.
Essentially, our investment discipline selects and manages each of these risks individually. Our intent is always to hold a portfolio of stocks having characteristics that we believe will generate a positive "alpha." We do this by focusing on stocks having some combination of favorable valuation (an attractive price in relation to the discounted stream of future free cash flows expected from the stock over the long-term) and favorable market action (subtle price and volume behavior that allows us to infer positive information about future earnings).
When our measures of valuation or market action are favorable for the stock market as a whole, we are also willing to take beta risk. Otherwise, we hedge that portion of our total risk away. Notice that unless our stock portfolio exactly matches the composition of the major indices, hedging the market risk of a stock position does not eliminate all of the risk. The only investment that represents pure beta is an index fund.
Finally, we manage epsilon - portfolio "noise" - through wide diversification across a large number of individual securities in a large number of industries. Although each stock still experiences noise fluctuations, these influences average to nearly zero when a portfolio holds a large number of individual stocks.
Since we attempt to minimize the impact of random noise (epsilon), the overall return on our portfolio is determined by return to the idiosyncratic risk we take (alpha), and the extent that we wish to take market risk (beta). In short, we take specific risks that we expect to be compensated for taking, on average, and we avoid, hedge, or diversify away risks that are not associated with sufficient expected return, on average.
The fact that we have hedged our market risk does not mean that we necessarily expect the market to decline in this particular instance. We don't rely at all on short-term market forecasts. Rather, we simply do not have evidence that market risk has been rewarded during the currently identified Market Climate, on average.
When the Market Climate becomes favorable, whether at higher or lower levels in the major indices, we will accept a measured amount of market risk in addition to the broadly diversified idiosyncratic risks that we are already taking. Nearly all of the return to the Strategic Growth Fund since inception has been pure alpha, as a result of effective stock selection independent of market movements. This is not a "standard" position however, and shareholders should understand that the Fund can take a substantial amount of market risk (beta). Indeed, when both valuations and trend uniformity are favorable (as has occurred in about a quarter of historical data), the Fund will take a leveraged exposure to market risk. For more detail on the Fund's investment strategy, please read our Prospectus carefully.
Currently, there is no investment merit to market risk from the standpoint of valuations, so the only reason to take market risk would be based on speculative merit. While the market has had a speculative run from its early October low, this rally has been driven largely by a retreat of sellers, rather than a measurable and robust shift in the willingness of investors to take risk (as measured by trend uniformity). It's certainly possible that this will change. The easiest way for trend uniformity to become positive on a further market advance, would be a substantial broadening in leadership beyond technology and semiconductors. Even easier would be for trend uniformity to become positive through a substantial decline in the major averages which displays good internal strength. My opinion (which we don't trade on and neither should you) is that this second outcome is more likely. In either event, however, there is little question that we will accept some exposure to market risk in the coming months. What we will not do, however, is substitute fear of regret for objective evidence.
Fear of regret - there are a few factors that drive investors to utter failure, and this is one of them. Fear of regret is why investors piled into dot-com stocks in the late 1990's, in the belief that leaping price advances were sufficient evidence that a new era of unprecedented earnings growth had arrived. Fear of regret is why those same investors refused to sell despite losses that wiped out their financial security. Fear of regret is the primary reason they have been chasing those same battered technology stocks since early October, frantic that they will miss the recovery that could make them whole again. So eager are they to label this rally a new bull market that only 17% of investors surveyed by AAII are bearish - an unusually low level. Bearishness among investment advisors is similarly low. Yet this dearth of bearishness is not universal. As Mark Hulbert of the Hulbert Financial Digest notes, "The stock market timers with the best long-term records are - on balance - quite cautious right now, if not outright bearish. In fact, these top-performing timers are today just as wary of the market as they were last February... And we all know how the stock market has behaved since then."
If there is one thing that is painfully clear, it is that economies running record current account deficits (as the U.S. does today) don't enjoy sustained investment booms. No sustainable investment boom, no sustainable recovery in tech profits. No sustainable recovery in tech profits, no sustainable leadership from tech stocks. This point is consistent with what we are seeing in market action. Specifically, in order for market risk (beta) to have reliable merit, we have to see leadership from something other than tech. In my opinion, the recidivism that drives investors back to information technology stocks on every market rebound is one of the major signs that we are not through this mess. The industries that lead one bull market are never the industries that lead the next.
Our discipline does not require us to make short-term market projections. But as I have noted many times, the long-term behavior of the market is determined heavily by valuations. Unfavorable valuations don't have much impact on short-term returns, but they very reliably indicate that long-term returns are likely to be unsatisfactory. Depending on how one defines bull and bear markets, we will probably experience several bull and bear cycles over the coming decade, with valuation levels reaching more normal (and lower) levels on each successive decline. This is the meaning of a "secular" bear market, and would be similar to what the market experienced between 1965 (when the Dow approached 1000) and 1982 (when it finally bottomed below 800). I certainly expect that we'll have the opportunity to take market risk during many of the intervening advances, but at current valuation levels, there is very little risk of missing much in the way of long-term returns even if we miss certain short-term advances (in hindsight) for lack of sufficient evidence.
As a side note, if pressed, my opinion is that the leadership of the next secular bull market will be companies that operate at the molecular and atomic levels - genetics and nanotechnology, for example. Such technologies are likely to represent true opportunities, because unlike the dot-com bubble (where competitors were unlimited), the availability of patents is likely to create sustainable competitive advantages and profit opportunities. The internet boom represented outstanding technology, but because there were few restrictions preventing competitors, nearly all of the benefits of that technology accrued to consumers, rather than producers. This remains true today. Outstanding technologies are also profitless unless there are barriers to entry. This is one of the things that many current tech investors fail to understand. Still, there will indeed be another "tech" boom, and in my opinion, a much more sustainable one, in the future. Unfortunately, biotech valuations remain too high, and nanotechnology is still years from flourishing even as an emerging growth industry.
In the intervening years, the U.S. current account deficit will come more closely into balance. There are only two ways to do this. Either the U.S. substantially increases its exports, or the U.S. substantially reduces its imports How? Through a reduction in consumption as a share of GDP, a further decline in U.S. domestic investment (probably housing as well as business investment), a substantial devaluation of the U.S. dollar, and a gradual strengthening of foreign economies. But all of this takes time. And if there's one thing that the tech bulls are short on, it's time. If the profit outlook does not improve from the perspective of the coming quarter or two, the current rally would seem quite vulnerable. As always, that's not a forecast, but the foregoing comments are consistent with the information that we infer from market action (trend uniformity). Until this changes, we will unrepentantly avoid market risk.
For the three quarters ended September 30, 2002, the Hussman Strategic Growth Fund gained 13.90%, compared with a 25.09% loss in the Russell 2000 and a 28.16% loss in the S&P 500 Index. For the 12 months ended September 30, 2002, the Fund gained 20.28%, compared with a loss of 9.30% in the Russell 2000, and a loss of 20.49% in the S&P 500. From the Fund's inception on July 24, 2000 through September 30, 2002, the Fund gained 52.03% (21.12% annualized), compared with losses of 27.32% in the Russell 2000, and a loss of 42.64% in the S&P 500. All figures include dividend income. Past performance is no guarantee of future results. The return and principal value of an investment in the Hussman Strategic Growth Fund will fluctuate so that shares, when redeemed, may be worth more or less than their original cost. For additional information about the Funds, including fees and expenses, please obtain our Prospectus, and read it carefully before you invest or send money.
Sunday November 24, 2002 : Weekly Market Comment
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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Just a note: The Hussman Strategic Growth Fund paid its annual capital gains distribution on November 22, 2002. The distribution of 0.925 per share represents 0.52 classified as long-term capital gains, and 0.405 classified as short-term capital gains. Short-term gains are typically taxed as ordinary income. Long-term gains are taxed at a lower rate. Since the Fund's NAV is reduced by the full amount of the distribution, this also results in a reduction in future tax liability. Given that over half of the distribution was classified as long-term, a short-term shareholder who sold the Fund the day before the distribution in order to avoid it may face a larger total tax liability (or enjoy a smaller tax benefit) than a shareholder who took the distribution, regardless of whether the sale resulted in a realized gain or a realized loss. This underscores the fact that tax avoidance trades are frequently uninformed. As a rule, we don't announce distributions in advance, in order to discourage such trades.
Also, I am pleased to note that the expense ratio on the Strategic Growth Fund has been reduced again, to 1.42%, due to the achievement of fee breakpoints and additional economies of scale. Since expense figures in regulatory documents such as the Prospectus must look back on the prior year, the recent series of expense reductions will not appear in these documents until next year.
The Market Climate for stocks remains characterized by unfavorable valuations and unfavorable trend uniformity. This places the Strategic Growth Fund in a hedged position; fully invested in stocks exhibiting favorable valuation and market action on the measures we emphasize, with an offsetting short position in the Russell 2000 and S&P 100 index. This position is not intended to speculate on a market decline, but strictly to remove the impact of market fluctuations from our portfolio. This is not a risk-free position however. When we are hedged, as we are here, our primary risk as well as our primary source of return is the possibility that our favored stocks will perform differently from the market indices we use to hedge. With minor exceptions, the overall return of the Fund since inception measures the extent to which our favored stocks have outperformed the major indices over time, while the relatively low volatility of the Fund reflects the appropriateness of the indices we use to hedge.
Our discipline is based on testable, identifiable, evidence rather than forecasts or opinion. We are continuously conducting research into extensions to our approach that might add value, but we rarely find useful alterations. This is a good thing. The reason is simple - anytime something is close to its optimal value, it becomes more and more difficult to optimize it further, and new improvements are typically minuscule. If it is very easy to find new ways to substantially improve an approach, it is a signal that the approach is quite far from an optimal strategy. That said, we're always trying. As Zen philosophers have emphasized throughout history - we should never be too certain of anything. Complete certainty is the sign of a closed mind.
Generally speaking, we consider an indicator to be useful if it is effective in three samples of data - one sample used to actually derive and optimize the indicator, and two separate samples (preferably very different in their overall characteristics) used to verify the measure "out of sample" - that is, outside of the sample of data used to create it. Alternatively, if the approach is based on purely theoretical grounds (so there is no first sample used to derive and optimize it), we generally require it to show good characteristics when the data is split into two samples.
Far too often, analysts "mine the data" in the belief that any relationship is worth following. A typical mining shaft is to take risk on the basis of a signal that worked during some short period of time, without testing it on other samples. We get a lot of well-intended "advice" based on signals of this sort. Occupational hazard. Another approach is to run a kitchen-sink "regression model" using a very large number of variables to forecast market direction. The problem with these models is that they are excruciatingly over-optimized. The smallest shift in the relationship between variables in the model typically throws the output of the model far beyond any value actually seen in-sample. For example, Norman Fosback of the Institute for Econometric Research used to run a "major trend model" that was supposed to range between 0 and 1, depending on whether stocks were in a bear market or a bull market. After a few years, the model started generating values far beyond 1.5, even during bear markets, indicating that the relationships between the variables had blown apart. Yet the model was kept in publication for more than a decade, as it continued to go berzerk. This is a version of how the geniuses at Long Term Capital Management blew themselves up. They took huge positions on the assumption that the relationship between a wide range of securities (such as emerging market debt) would be very stable. But when these relationships changed even a little bit, it quickly wiped out their capital, which was leveraged 40-to-1. Suffice it to say that it's easy to come up with all kinds of seemingly effective approaches to the market. But few are actually robust to broad changes in market conditions.
To see this, one need not look further than models that generated a very good historical record by using margin following two consecutive interest rate cuts by the Fed. Unfortunately, the relationship between stocks and rate cuts has not been reliable in an investment-led downturn following a valuation bubble. And margin calls have a tricky way of ending investment careers.
With respect to the advance from the October 9th low, we do not find evidence that the market has recruited favorable trend uniformity - at least not yet. This does not imply a forecast that stocks must decline. It's certainly possible that this rally will fail, but that's not the basis of our position. We are hedged only because we don't have enough evidence to warrant exposure to market risk. The core of our approach is simple: based on our analysis of valuations and market action, we take risks that are associated with a favorable return/risk profile, and we avoid, hedge, or diversify away risks that are not. Absent evidence of favorable valuation or trend uniformity, we simply do not take risks just because recent returns to those risks have been favorable. We would just as soon bet our financial security on a craps table in Vegas because the dice are hot.
One of the reasons we are so adamant about taking a defensive position during hostile Market Climates is that large losses are extremely difficult to recover, and the current Climate includes every market crash on record. This is not a forecast, but a recognition that substantial declines cannot be ruled out in this Climate. It is impossible for an investment strategy to maintain a high annualized long-term rate of return if it experiences deep losses.
For example, suppose a strategy enjoys four consecutive years of 20% annualized returns. Clearly, the annualized return is also 20%. But allow that strategy to take a 35% loss in the fifth year, and the overall annualized return drops to just 6.2% for the full period. So in order to generate a high annualized return, it is essential to avoid very large market losses, even if one has to occasionally forego short-term gains to do it. Major market losses have historically emerged much more frequently when both valuations and trend uniformity have been unfavorable, as they are now. Though every Market Climate we identify includes periods of both positive and negative market moves, sometimes substantial ones, the average return to market risk has been negative in this Climate. Given these facts, it is appropriate to avoid market risk in this Climate, regardless of whether a particular period has generated positive returns in hindsight. We are extremely sensitive when conditions indicate a possibility of large market losses, and such losses have historically been far too frequent in the Market Climate we currently identify.
In recent sessions, the market has displayed fewer signs of distribution. Advancing volume has been better on strong days in the market, and declining volume has been more restrained on weak days. Against this generally positive feature of market action, sentiment indicators have become increasingly unfavorable. Investment advisory bearishness has dropped below 25%, which is relatively rare, while the CBOE volatility index has finally dropped as well, indicating a reduction in bearishness among option market participants. Historically, such declines in bearishness during periods of unfavorable trend uniformity have often preceded abrupt plunges, including much of 1973, the 1987 market crash, the 1998 Asian crisis, and the summer 2001 decline. However, the record is not strong enough to draw a sharp conclusion - there are a few instances when the market continued higher, such as late-1999. Generally speaking, low bearishness during periods of unfavorable trend uniformity is associated with exhausted rallies. Again, however, this view is not the basis of our investment position.
A favorable shift in trend uniformity here would require a further improvement in internal market action. It would actually be easier for the market to generate this by way of a substantial decline in the major averages accompanied by relatively firm internals, rather than from a further market advance. For trend uniformity to quickly turn favorable on a near-term rally, we would have to see fresh leadership beyond technology and semiconductors.
At this point, there are a few interesting things to watch (even if they don't directly influence our own investment position). The August peak of the Dow Industrials was 9053.64, while the Transports peaked at 2463.96. From a Dow Theory perspective, if both indices can better those highs, the case for a fresh "bull market" would be more compelling. That said, I don't really think of the market in terms of bull/bear distinctions, since the whole concept is not operational - bull and bear markets don't exist in observable reality since they can only be identified in hindsight. We require testable, observable evidence, so our own positions are based on our identification of the prevailing Market Climate. When that shifts, regardless of whether it occurs at higher or lower levels, we will shift our position. No distinction between "bull" or "bear" markets, and no forecasting required.
Finally, with respect to day-to-day fluctuations, provided that the long-put / short-call index options we use to hedge have the same strike prices and expiration dates, a fully-hedged position is generally neutral to market direction, not "bearish" or "bullish." If it occasionally appears as if we are net short or net long on a particular day, look at which industry groups are pacing that day's action. When technology and financials are extremely strong, we'll tend to lose a bit of value regardless of market direction, since we are intentionally somewhat light on these groups compared with the major indices. When technology and financials are particularly weak, we'll tend to gain a bit of value regardless of market direction. Again, this is strictly a day-to-day tendency based on intentional stock selection. Over more extended periods of time (say, months or quarters), our stock selections have tended to outperform the market on average, regardless of market direction.
In bonds, the Climate is characterized by unfavorable valuations and favorable trend uniformity. This places the Strategic Total Return Fund in a modestly constructive position, with about 35% of funds in Treasuries near the 7-year maturity, about 25% of funds diversified across foreign government bonds, utility stocks and precious metals shares, about 10% of funds invested in Treasury inflation-protected securities, and the remainder of assets in relatively short maturity Treasury and agency securities.
In short, we remain strongly defensive toward overall stock market risk, and moderately defensive toward interest rate risk. Long-term assets are simply not valued in a way that makes strong long-term returns and durable price support likely. While there are certainly major debt problems still to be resolved in the U.S. economy, there is no requirement that they must be resolved in the short-term. So we remain willing to increase our exposure to market risk when trend uniformity eventually shifts to a favorable condition. Our current level of defensiveness should not be interpreted as a general policy, but as a measured response to prevailing conditions.
Past performance is no guarantee of future results. The return and principal value of investments in the Hussman Strategic Growth Fund and Hussman Strategic Total Return Fund will fluctuate so that shares, when redeemed, may be worth more or less than their original cost. For more information about the Funds, including fees and expenses, please download a Prospectus and read it carefully before you invest or send money. The Distributor of the Hussman Funds is Ultimus Fund Distributors, LLC.
Friday Morning November 22, 2002 : Special Update
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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Fund news: The Hussman Strategic Growth Fund paid its annual gains distribution on November 22, 2002. The distribution included $0.52 per share classified as long-term capital gains and $0.405 classified as short-term capital gains (generally taxed as ordinary income). The total distribution was $0.925 per share.
The Market Climate in stocks remains on a Warning Condition. While some of the most spectacular historical market declines have begun from an overbought condition in a hostile Market Climate (as is the case today), our currently hedged position is decidedly not based on an expectation or forecast of a market decline. Rather, it is based strictly on the fact that we do not have sufficient evidence that market risk is worth taking.
With regard to current market action, the major indices are very overextended. This kind of action often makes investors very insecure about anything but an aggressively invested position. But the impulse to buy into an overbought rally, in an overvalued market, in an unfavorable Market Climate, is generally not useful.
It is important to understand that our approach has an inherent "bullish" bias - the only market condition that warrants a fully hedged position is when both valuations and market action are unfavorable. Historically, this has occurred in less than 25% of the long-term market record. The fact that this condition has generally been in effect since the inception of the Strategic Growth Fund should not be taken as evidence that this condition, or a fully hedged stance, is typical. It is true, however, that the last time that leverage was warranted from the perspective of our approach was between October 1990 through October 1993. This is also the last time I was characterized as a "raging bull" in the media. Still, on the measures we currently use to define the Market Climate, the market exhibited favorable trend uniformity for most of the period between 1990 and 2000.
Since our approach is objective, we can examine exactly how often our measures have been favorable or unfavorable on a historical basis. And while bull markets and bear markets cannot be identified with certainty in real-time, they can always be identified in hindsight. (In the following discussion, we count "bear market rallies" in excess of 20% as "bullish periods").
Looking at bullish periods since 1940, 79.2% of these periods were characterized by favorable trend uniformity, while 20.8% displayed unfavorable trend uniformity. Of course, a constructive stance is also warranted when valuations are favorable. Fully 91.4% of past bullish periods were characterized by either favorable valuations, favorable trend uniformity, or both.
Looking at past bearish periods, 74.9% of these periods were characterized by unfavorable trend uniformity. This does not, however, mean that a fully hedged stance would have been appropriate during all of these periods. A fully hedged stance is indicated only when both valuations and trend uniformity are unfavorable. These periods account for just 38.7% of all historical bear market periods. Fortunately, these periods capture every historical market crash of note. This remains true when we examine vintage data that includes 1929.
Of course, there is also a certain number of periods in which the Market Climate was completely opposed to the major trend (as identified in hindsight). These account for about 10% of historical periods. During 8.6% of bullish periods, both valuations and trend uniformity were unfavorable, indicating a defensive position. During 14.6% of bear market periods, both valuations and trend uniformity were favorable, indicating an aggressive position. How does an investment approach defend against these unfortunate events? Simple: investment restrictions. The dollar value of our shorts never materially exceeds our long holdings, so even a defensive stance in a bull market period does not result in substantial capital losses. By avoiding the use of margin (and taking leverage only using limited-risk call options), even an aggressive stance in a bear market does not result in unacceptable losses. This is why we've written exactly these restrictions into our Prospectus. In short, we have no fantasy that our investment position will always be profitable over the short term. So we never take an investment position that relies on a particular stance being right, at the risk of unacceptable losses otherwise.
There is, of course, no assurance that future Market Climates will be aligned as closely with bull and bear market periods as in historical data. But in terms of theoretically sound, objective models, the Market Climate approach sets a very high bar. This is why, with rare exceptions (the last being a small innovation in May 2001), nearly all of our attempts to further refine our approach are unproductive. And that's a good thing.
The stock market is still emerging from the largest valuation bubble in U.S. history. Neither the excesses of that bubble, the overhang of low-quality corporate and consumer debt, nor the massive U.S. current account deficit have been resolved. Yet we would still be inclined to expose ourselves to market risk if trend uniformity was favorable. We've now had four substantial rallies since the year 2000 market peak. Three of them produced evidence of favorable trend uniformity on the measures we currently use. The rally from the October low did not. As I noted last week, we've tested a broad range of criteria which would have captured the rally off the October low. But if we apply those same criteria to historical data, they deteriorate the performance or deeply increase loss exposure of our approach in every case. We've emphasized for years that we do not attempt to "correct" short-term pullbacks in our approach if doing so would require us to violate our investment discipline.
So while we are always researching potentially useful extensions to our approach, we never allow opinion or adverse short-term movements to undermine our discipline. The reason the Fund has performed as it has since inception is precisely because we refuse to do so. Most fund managers are petrified at the prospect of missing any rally. With the market still sporting deep losses for the year, these managers are looking for any reason to buy stocks, which largely explains their eagerness to take highly volatile data like weekly unemployment claims as a sign that the economy is turning. We're not among them, and it is precisely the willingness to take short-term "tracking risk" that creates the possibility of outperforming the market by wide margins over the long-term.
The bottom line is simple. The Market Climate remains characterized by conditions that have occurred in less than one-quarter of all historical periods, and less than one-tenth of historical bull market periods. Over 90% of historically "bullish" periods have generated evidence supporting exposure to market risk. Market returns during the other 10% of bullish periods have been less than half the average for bull markets. Suffice it to say that we steadfastly avoid market risk when we lack sufficient evidence of its merit. At present, we remain fully hedged.
Sunday November 17, 2002 : Weekly Market Comment
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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The Market Climate for stocks remains on a Warning condition, characterized by unfavorable valuations and unfavorable trend uniformity. In bonds, the Market Climate is moderately constructive, characterized by unfavorable valuations but favorable trend uniformity. As I've noted before, favorable trend uniformity in bonds is not generally as beneficial as it is in stocks. So while Strategic Total Return holds a moderate exposure to medium-term Treasury securities in the 6-7 year maturity range, our remaining assets lean to short-term securities and alternatives such as 2-year foreign government notes, precious metals shares, utilities, and even TIPS (Treasury inflation-protected securities) based on their still-competitive real yield, which we would receive even if the inflation rate goes negative (while short-term deflation causes the inflation-adjusted principal of TIPS securities to decline, the final principal values aren't adjusted below par even if long-term deflation takes place).
Frankly, I believe that deflation remains less likely than low and persistent inflation, unless default rates spike much higher. As I've long noted, inflation has to do with the relative scarcity of goods versus government liabilities. So rapid growth in the supply of goods (i.e. strong economic growth) should be, and is, well-correlated with lower inflation. Indeed, the inflation rate has historically been higher when the Purchasing Managers Index is falling than when it is rising. Inflation is primarily the result of government spending that simultaneously draws on the available supply of goods while increasing the supply of government liabilities such as bonds or currency. It hardly matters which, since an increase in government debt that places upward pressure on interest rates also reduces the desirability of holding currency (which doesn't bear interest). In either case, the "marginal utility" of goods rises, relative to money, and the result is inflation. Given that government spending is rising rapidly, along with both debt and currency, the only thing preventing inflation here and now is a relatively strong appetite for safe assets like cash.
This puts the U.S. economy on a tightrope. If the economy suffers fresh weakness, rising bankruptcies may very well push inflation rates lower (though even then, I don't anticipate steep deflation). This would create something of a "deleveraging" spiral, since the worst thing that can happen to a borrower is to borrow on the assumption of high inflation and have to repay in an environment of low inflation (where the "real" burden is much heavier). At least this risk is widely recognized. What's not recognized very well, in my opinion, is what is likely to happen if the economy strengthens. In that event, the somewhat deflationary effect of greater economic output is likely to be swamped by a sharp reduction in the demand for safe-haven Treasuries and currency. This is particularly true since incipient economic growth will drive up short-term interest rates significantly, raising what is known as the "velocity" of money. The end result would probably be a sudden upward jolt in the inflation rate, seemingly out of nowhere.
Which outcome is more likely? Well, the NBER Business Cycle Dating Committee recently delayed any determination that the recession is even over. In addition, capacity utilization dropped again last month to 74.4%; not much higher than the trough of the recent economic downturn. As I've noted before, with the notable exception of the short and quickly-failed 1980 recovery, past economic rebounds have always generated a very strong jump in capacity utilization and help-wanted advertising. Both remain near their recessionary troughs here, placing the widespread view of an imminent recovery in question. So defaults and deleveraging appear more likely than a quick recovery (not that we base our investment positions on such opinions - in general, the Market Climate drives our opinions, not the other way around).
As for prices, rather than substantial inflation or deflation in the overall economy, we're likely to see a dispersion in inflation rates, with relatively weak pricing in manufactures, and relatively strong pricing in labor and services. Overall, I expect positive and persistent inflation, though not much acceleration. Also, even with the pop in the Producer Price Index last week (largely a result of discontinued 0% auto financing, which is counted as a price increase), labor prices continue to rise faster than output prices, which reduces the likelihood that profit margins will widen much anytime soon.
An environment of weak profit margins and high P/E multiples, with an interest rate climate that is slightly constructive but prone to upside surprises, really isn't a situation that makes substantial risk-taking advisable. This is unfortunate, because we take absolutely no joy in defensive positions. Still, we've earned good returns from the risks that we have chosen as appropriate. As usual, it is important to emphasize that even when we hedge away the market risk of our positions, there are always other risks that we do take. So a defensive position should not be confused for a riskless one. Also, it is important to understand that we will experience substantially more volatility when we do take market risk than when we hedge it away. The 4.6% pullback in Strategic Growth since mid-August is almost entirely due to the fact that we were partially unhedged during the initial part of the market decline since then. As of Friday, the Russell 2000 remains down 5.8% from its August peak, while the S&P 500 remains down 5.5%.
The goal of these updates is to provide insight, context and perspective about the markets, and also to increase our shareholders' understanding of our approach (without compromising proprietary aspects, of course). Broadly speaking, favorable valuation and favorable trend uniformity warrants a leveraged position, unfavorable valuation but favorable trend uniformity warrants a partially hedged position, and the combination of unfavorable valuation and unfavorable trend uniformity warrants a fully hedged position. The Market Climate approach grew out of research between 1996-1999, and has been tested on data as far back as 1871. But the past decade is sufficient to get the basic flavor of our approach, and the frequency of shifts in the Market Climate.
On our criteria, stocks were undervalued from late-1990 through late-1993, and have been overvalued ever since. Of course, as I always emphasize, overvaluation implies nothing about short-term returns. It only indicates that long-term returns are likely to be disappointing. And indeed, from October 1993 to October 2002, the Russell 2000 and Nasdaq Composite roughly matched the 4.7% annualized return on Treasury bills. Since late-1996 when Alan Greenspan made his "irrational exuberance" comments, Treasury bills have outperformed the S&P 500 as well. However, on the basis of the criteria we actually use, trend uniformity was generally favorable from late-1990 through September 2000, with the only significant exceptions being 1994 (a flat year in the market), mid-1998 (very weak - Asian crisis), and several months in 1999 (strong, particularly in the Nasdaq). The sharpest loss of trend uniformity occurred at the beginning of September 2000. While we've seen a few modestly positive shifts since then, we have not seen strong trend uniformity for over two years.
From this, a few things should be clear. First, the Market Climate does not shift frequently. The historical average is about twice a year, and these include moderate shifts from, say, a fully hedged position to a partially hedged position. Our approach does not involve any attempt to forecast market direction. In fact, we believe that such efforts are counterproductive. We will be defensively positioned during some rallies. We will be exposed to market losses during some declines. This fact will frustrate short-term market timers to no end.
Second, the period from late-1990 through late-1993 is the only portion of the past decade in which stocks actually retained their gains over-and-above Treasury bills. This emphasizes the fact that valuations matter. Valuation certainly does not determine short-term returns, but it has a profound impact on the long-term returns that an investor earns over time.
Finally, markets that enjoy favorable trend uniformity warrant a reasonable exposure to market risk, even when stocks are overvalued. Although an investor with a long enough horizon can capture the bulk of long-term market returns by being invested only during undervalued periods, such an approach is inferior to one that continues to take market risk as long as market action remains sufficiently favorable. Market risk should only be avoided completely when both valuations and trend uniformity are unfavorable. Though this has largely been the case over the past two years, this is not the norm. Indeed, this particular Climate has only occurred in about 20% of market history. So while we're adamant about a fully hedged position while both valuations and trend uniformity are unfavorable, this position should not be considered "standard" for our approach.
Until market conditions shift, however, the Climate for stocks remains fully defensive, while the Climate for bonds remains modestly constructive. Neither of these rely on forecasts. Rather, they are derived from an identification of prevailing conditions. Our evaluation of trend uniformity is not based on the extent or duration of a particular move, but on its quality. In general, durable market advances generate excellent quality very quickly on the measures we use. Some, like the advance in the stock market from its October trough, fail to do so. This is often a signal of potential failure, but again, the Market Climate should not be taken as a forecast. It's quite possible that the internal action of the stock market will improve enough to warrant a constructive investment position. We simply don't have that evidence now. In the meantime, we are very pleased to take those risks that we do find attractive.
At present, we remain fully invested in stocks that we view as favorably valued and having favorable market action, while hedging away the impact of broad market fluctuations on that portfolio. In bonds, we are taking a moderate amount of risk in 6-7 year Treasury securities, with the remainder of our portfolio emphasizing short maturities and alternative assets such as foreign government notes, utilities, precious metals shares and inflation protected securities. "Defensive" certainly does not mean "riskless," but those risks that we take, we expect to be compensated over time for taking.
Sunday November 10, 2002 : Weekly Market Comment
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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The Market Climate for stocks remains on a Warning Condition, characterized by both unfavorable valuations and unfavorable trend uniformity. The Climate for bonds remains moderately constructive, characterized by unfavorable valuations but favorable trend uniformity.
In each case, it is possible that we could observe a shift in the Market Climate in as little as a week, or perhaps not for a month, a quarter, or a year. We don't require forecasts about future market conditions - we simply identify current ones. Now, historically, only 10% of bull market periods have been characterized by both unfavorable valuations and unfavorable trend uniformity. So either this is a very unusual segment of a bull market, or a fairly typical segment of an ongoing bear market.
Still, bull and bear markets are identifiable only in hindsight, so the distinction is not operational. Any attempt to identify whether stocks are actually in a bull or bear market is sheer speculation. In contrast, we focus on what is actually identifiable, objective, and historically testable (both on a full data set since 1940, and on a more restricted set of data going back as far as 1871). This is why we can rattle off statistics regarding exactly how the market has performed under various Climates. Based on the criteria we use to measure valuations and trend uniformity, we know what the Market Climate was at any point in history, what the average historical return and risks were in each Climate, and which Climate is currently in effect. Everything is observable. When investors instead focus on concepts like "bull market" and "bear market", which exist not in observable reality but only in hindsight, they invite frustration, uncertainty, emotion, subjectivity, indecision, hope, attachment to forecasts, fear of regret, and ultimately, failure.
As the ancient Zen master Hsueh-yen wrote, "If you want your mind to be clear, it is important to put opinions to rest. If the mind is not clear, reality and illusion are confused." As Yun-ku wrote, "If you have awakened correctly once, you see mountains are not mountains and rivers are not rivers; then after that you see mountains are mountains and rivers are rivers. If you are not awakened, when you see things you are obstructed by seeing, influenced by things, confused by objects."
Simply put, the terms "bull market" and "bear market" are not useful concepts because they are matters of opinion except in hindsight. Why try to force the world into objects and concepts that can't be observed in reality?
While bull and bear markets are concepts that do not exist in observable experience, the prevailing Market Climate (as defined by valuations and trend uniformity) can be objectively identified at any moment in time. It is true, of course, that favorable and unfavorable Market Climates identified in real-time may not exactly overlap bull and bear markets that are later identified in hindsight. As I've noted, about 10% of historical bull market periods have been characterized by both unfavorable valuations and unfavorable trend uniformity. Though the average annualized total return for the S&P 500 during those periods has been less than half of the performance during the other 90% of bull market periods, the fact is that there is less than 100% correspondence between the Market Climates we identify and historical bull market periods.
The same is true of bear markets. The Market Climate does not capture every downmove, when bear markets are identified in hindsight. Indeed, of the less than 6% pullback in the Strategic Growth Fund since its mid-August peak, about 4% of that is attributable to the fact that we remained constructive coming off of the mid-August peak. Specifically, we were about 40% unhedged during the early part of the market's decline from that peak (which the market has still not recovered). We're also victims of low volatility. In the context of our overall performance, the pullback is nothing unusual. We experienced an equivalent pullback in early 2001. But the relative smoothness of our performance since then makes a pullback of even a few percent seem grueling and relentless. In any regard, both the defensive and modestly constructive postures that we've taken since the inception of the Fund have been very effective on balance, without the need for forecasts. When the evidence is sufficient, we expect to take fairly aggressive postures as well.
Our research is always ongoing. Over the past few weeks, for example, I've spent a great deal of time examining criteria which would have enjoyed a favorable shift early into the recent rally off the early October lows. But in every case, those criteria if applied consistently on a historical basis, would have either reduced the overall performance or substantially increased the periodic drawdown losses from our approach. Unlike the three prior "bear market rallies" since 2000 (Mar-May 2001, Sep-Dec 2001, Jul-Aug 2002), the rally from the October low failed to generate sufficient evidence of favorable trend uniformity. Indeed, in recent sessions, market action has displayed signs of distribution, with stocks advancing on dull volume and declining on heavier trading. This is not typical of sustained market advances.
While we are always researching new ideas and objective measures of market action, what we are not willing to do is substitute opinion for observable, testable evidence. We don't rule out the possibility that stocks have entered a bull market. We just don't have any evidence on which to take risk on that possibility.
Unfavorable trend uniformity is one part of that evidence. Unfavorable valuation is the other. The S&P 500 currently trades at 18 times prior peak earnings. With the exception of the recent bubble, which I am hopeful was a learning experience for most investors, every past bull market peak occurred at a price/peak-earnings ratio no higher than 20 (that level being achieved only at the 1929, 1972 and 1987 peaks). So even if stocks are in a "bull market", the upside potential would seem to be quite limited if investors have learned anything from the brutal experience of recent years.
One of the reasons we use prior peak earnings for the S&P 500 P/E is that earnings are historically much more volatile than stock prices themselves. In recessions, earnings become extremely depressed, which drives P/E multiples to misleadingly high levels. Certainly, the use of the current $19 S&P 500 "core earnings" figure falls into that category. On this basis, the P/E on the S&P 500 is close to 50; a level that certainly cannot be compared in any useful way to the historical average P/E near 14. That said, the prior peak in S&P 500 earnings was about $50, and this is what we use as the basis of the price/peak-earnings calculation. The resulting price/peak earnings ratio of 18 is only 30% over its historical norm of 14. Still high, but certainly not triple the norm.
The difficulty with that peak-earnings figure is that it assumes that S&P 500 earnings were normal at their year 2000 peak. Historically, earnings for the S&P 500 have grown at the same rate as nominal GDP (about 6% annually) when measured from peak-to-peak. The problem is that year 2000 earnings for the S&P 500 were unusually high in relation to nominal GDP. As I noted at the time, profit margins were unusually wide due to an unsustainable boom in capital spending. We've learned since that much of these earnings were indeed unsustainable and even illusory. For that reason, I've argued that P/E ratios are not a very reliable gauge of valuation, and should be used in conjuction with other valuation measures (or at least with a critical eye). On the basis of historically normal profit margins, the proper "peak" earnings level here would actually be closer to $40, which would currently place the S&P 500 at the same level of overvaluation as the 1929, 1972 and 1987 peaks.
In his latest monthly comment, Bill Gross of Pimco presents a study from ISI Group that recalculates the Fed Model. Rather than dividing the earnings yield on the S&P 500 by the 10-year Treasury yield, the study divides by corporate bond yields, with the result that stocks still appear quite overvalued. While I don't disagree with that conclusion, the use of corporate bond yields as part of the Fed Model simply makes a bad model worse. Part of the twisted logic of the Fed Model is that by using the Treasury yield in the denominator, the model ignores both the growth rate of earnings (which increases stock valuations) and the risk premium on stocks (which decreases stock valuations), implicitly allowing the two to offset. Using the corporate bond yield in the denominator re-introduces the risk premium without introducing growth. And in either case, the numerator is wrong, since a portion of earnings must be devoted to providing for future growth, and is therefore not available to distribute to shareholders. In short, the Fed Model is simply garbage, and despite ISI's valiant efforts, it cannot be easily converted to a useful measure of valuation, even if the result might otherwise support our own conclusions.
Still, valuations on the basis of fundamentals other than earnings do suggest that stocks remain overpriced. The S&P 500 index is nearly double its historical valuation norm on the basis of the dividend yield. Measures such as price/book, price/revenue ratios, market capitalization / GDP, and Tobin's Q are also unusually elevated. Moreover, as John Mauldin of www.2000wave.com notes, "the average over-run of the trend in secular bear market is 50%, which is why stocks get so undervalued. By that, I mean that stock market valuations do not stop at the trend. They tend to drop much lower. [For stocks to deliver 6-7% annual returns over the coming decade], we would have to see something which has never happened in history before. Stocks would need to drop to values 25% higher than the long-term historical average and no further."
On an individual stock basis, large-cap valuations that we find particularly difficult to justify include AIG, Amgen, American Express, Boston Scientific, Colgate Palmolive, Dell, Fannie Mae, Forest Labs, Ford, Freddie Mac, IBM, Johnson & Johnson, Coca Cola, Eli Lilly, Lockheed, Medtronic, MMM, Pepsico, P&G, Tribune, and Wal-Mart, among others. Not a short list, and certainly not exhaustive.
Regardless, we're always willing to take some degree of market risk if market action displays evidence of favorable trend uniformity. While I do view stocks as overvalued here, it is simply false to assume that this overvaluation must result in major market losses. Simply put, valuation is an outstanding tool for gauging probable long-term returns from stocks, but it is virtually useless for gauging near-term market direction. It is one thing to say that stocks are likely to deliver unsatisfactory long-term returns for a buy-and-hold approach. It is another to assume that this translates into a high probability of near-term market losses. When trend uniformity shifts to a favorable status, we will immediately shift to a more constructive market posture, regardless of valuation levels.
We don't make forecasts regarding when such shifts may occur, but historically the Market Climate has shifted nearly twice a year, on average. In addition, trend uniformity has historically been favorable during about two-thirds of the seasonally favorable periods between November and April. As noted last week, it's a favorable Market Climate you wait for, not just favorable seasonality. But given all of these tendencies, I'll be at least a bit surprised if we don't see a favorable shift in the Market Climate at some point between now and April. Given that the current Climate remains unfavorable, the historical tendency is that such a shift would occur at lower prices, not higher ones.
In any event, we'll take our evidence as it emerges. For now, we remain fully hedged in stocks and moderately constructive in bonds.
Sunday November 3, 2002 : Weekly Market Comment
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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As of last week, the Market Climate for stocks remained on a Warning Condition, characterized by both unfavorable valuations and unfavorable trend uniformity. Given that the market is also overbought, this combination is associated with particularly high risks. That's not a forecast, but rather a statement about conditions that have often preceded abrupt market declines on a historical basis. We don't rule out a continued advance, but at present, we do not have sufficient evidence to speculate on that possibility.
Our fully invested portfolio of favored stocks remains hedged against broad market fluctuations. So while we are not taking a significant amount of market risk at present, we continue to take risks that we expect to be compensated over time. Our favored stocks do not track day-to-day market movements precisely, so our hedged position may produce moderate fluctuations in value that are unrelated to overall market movements. These fluctuations may be positive or negative over the short-term. Still, the cumulative difference in performance between our favored stocks and the overall market has been our most consistent source of return over time.
In bonds, the Market Climate remains modestly constructive, with unfavorable valuations but favorable trend uniformity. This indicates that while bonds do not have much investment merit in terms of providing a satisfactory long-term yield to maturity, they continue to have modest speculative merit. So in addition to near term securities, a limited exposure to intermediate-term Treasuries (about the 6-7 year range) remains appropriate.
A key feature of our investment discipline is its lack of emphasis on forecasting. We are certainly willing to take defensive positions (though the dollar value of our shorts never materially exceeds our long holdings), and aggressive positions (not using margin) depending on the prevailing Market Climate we identify, but these positions should not be confused with forecasts, nor with attempts to "call" market turns, "catch" rallies, "play" declines, or "time" the market, as timing is generally understood. If one defines "market timing" as avoiding market risk in some environments and taking it in others, we certainly do that. But so does Warren Buffett, who frequently allows large cash positions to build when satisfactory investment values cannot be found. It's the forecasting, calling, catching, playing and timing of market movements that we disavow.
The proper way to think about our approach is in terms of probability distributions. If you take a sample of market data, say, 50 years of weekly returns, those returns will fall quite nicely into a bell-shaped curve (we'll gloss over things like lognormality and leptokurtosis...) A small set of the observations will be very positive returns and will fall in the right-hand "tail" of the bell. A small set will be very negative returns and will fall in the left-hand "tail," and the vast majority of the returns will be smaller positive and negative observations that form the "hump" of the bell.
The essence of a buy-and-hold approach is the idea that the "mean" or average return in this distribution is positive, and that the next draw can't be predicted in advance. If one believes this, it follows that an investor should hunker down and take market risk at all times, in the hope that the average return will be worth the volatility.
In contrast, market forecasters believe that they can predict whether the next draw from the distribution will be positive or negative. And they spend a great deal of effort trying to "catch" large moves that they expect to be drawn from the tails of the bell curve.
Our approach is much closer to the buy-and-hold strategy than it is to the market forecasting strategy. The crucial difference is that we believe that there are several different distributions, one corresponding to each Market Climate we identify. Still, once we have identified a particular distribution, we have no belief at all that specific draws from that distribution can be predicted in advance.
The power of our approach comes from evidence that the distributions we identify have significantly different average returns and volatility (mean and standard deviation). But it's those population features that we rely on, not the belief that any particular sample will match the average. Every one of these distributions has both a positive and negative tail. So the most positive Market Climate will still include some periods of sharply falling prices, and the most negative Market Climate will include some periods of sharply rising ones. During these movements, we will appear equally stoic as a good buy-and-hold investor. We simply don't react, because we believe that attempting to forecast short-term market movements is useless and counterproductive.
In short, our approach is not based on trying to forecast specific market movements, but instead on identifying the specific probability distribution from which those movements are drawn.
We believe that the return/risk profile of our approach is more attractive and efficient than a buy-and-hold approach which assumes that all market returns are drawn from a single distribution. But our discipline does expose us to certain risks that are different than a buy-and-hold approach, or a forecasting approach for that matter. We will simply fail to "track" short-term rallies that occur in unfavorable Market Climates. This "tracking risk" isn't of particular concern for long-term investors. Indeed, if an investor hopes to defend capital during extreme market declines (witness the past two years) the willingness to follow a strategy that doesn't always track the market is essential. Still, it is a risk that certain investors may find unacceptable, and for those investors, our approach is inappropriate. It is also inappropriate for investors who believe that all movements in the market should be timed, and that all market rallies should be "caught" - even those occurring in unfavorable Market Climates. Frankly, we'll only frustrate the heck out of investors who insist on such fantasies.
(Of course, if you actually have a well-defined investment approach that would have allowed an investor to participate in every substantial market advance and defend against every substantial market decline in historical data spanning at least the past 50 years, without arbitrarily over-fitting the data, please send it to us. We're always eager to learn.)
At present, the Market Climate for stocks remains negative. This is not a forecast of oncoming market weakness in this specific instance (though it's not unlikely), but rather a statement that market risk remains unattractive on the basis of the average return that can be expected in this Climate.
Among the many features that remain unfavorable in market action, trading volume is showing persistent signs of distribution. While we have our own way of measuring this, distribution can generally be identified by a market that advances on dull trading volume, and declines on increased volume. As Dow Theorist William Peter Hamilton wrote in 1909, "One of the platitudes most constantly quoted in Wall Street is to the effect that one should never sell a dull market short. That advice is probably right oftener than it is wrong, but it is always wrong in an extended bear swing [i.e. an overbought bear market rally]. In such a swing the tendency is to become dull on rallies and active on declines." In that context, we take recent signs of distribution seriously.
A couple of weeks ago, I noted that investment advisory bullishness had declined to a fairly low level. While low bullishness doesn't reverse the implications of an unfavorable Market Climate, it does soften the negative implications. Unfortunately, that low bullishness didn't last long. The percentage of bulls has surged in the past two weeks, while advisory bearishness has again plunged below the important 30% level (28.3% in the latest reading). As Mark Hulbert has noted, it is not characteristic of durable bear market bottoms to be followed closely by a plunge in bearishness.
As the always astute Kate Welling writes in the latest issue of Welling@Weeden, "The monster bull was, quite plainly in retrospect, a secular (once in a lifetime, or several lifetimes) phenom. And while there's no law I know of that says the correction in which we're now mired must last as long, must relentlessly grind every portfolio to dust or must be as utterly unbearable as the joyride was glorious, all of financial history says a real correction there must be. Of two things I am certain: There are still more shoes to drop, and when the broad market finally does trace out the bottom of this secular bear, very few will even notice. Or care. That's just the nature of the beast. Sorry, Maria."
If you want my opinion, I think Kate is right. To believe that the market still faces a secular bear market requires only the observation that stocks are not dramatically undervalued. The nature of markets is that at some point in each generation, stocks do indeed visit undervalued levels, at least temporarily. This fact alone is sufficient to make the argument that between now and that unknown future point in time, a buy-and-hold approach is likely to generate a disappointing return. Consider the example in the latest issue of Research & Insight. Suppose S&P 500 earnings were to immediately double, recovering all their lost ground, and then continue to grow at the same 6% peak-to-peak rate that has characterized the past century. On that assumption, even if the P/E on the S&P 500 (on the basis of peak earnings) merely touches its historical median of 11 two decades from today, the S&P 500 would deliver a total return of less than 6.5% annually over that 20 year period.
As usual, this is not a forecast so much as an observation that except when returns are measured from a point of undervaluation, one can always find some holding period, sometimes decades, over which subsequent returns from a buy-and-hold approach would have been disappointingly low.
It's certainly likely that stocks will enjoy many periods of favorable trend uniformity, and perhaps even favorable valuation, between now and some future point in time that valuations reach a durable trough. So I do expect that we will take substantially constructive and even aggressive positions in the future, even if the market is in a secular bear market. The real issue is whether current levels in the major indices represent durable support for long-term investors. In my opinion, the answer is no.
That said, we'll immediately shift to a constructive position if the market recruits sufficient evidence of favorable trend uniformity. This would not give stocks any better investment merit, but it would create enough speculative merit to warrant some exposure to market fluctuations.
Shorter term, should we worry about the possibility that stocks may have entered a new bull market, given that we remain fully hedged? Not particularly. Aside from the fact that bull markets can only be identified in hindsight (so the concept isn't even operational), when we do look in hindsight, only about 10% of historical bull market periods would have been characterized by both unfavorable valuations and unfavorable trend uniformity, and total returns during such periods, while positive, substantially lagged the performance of the other 90% of bull periods when at least one of these conditions was favorable. So even if stocks are in a bull market, I don't expect that long-term investors will miss much overall return, if any, by holding to a defensive position pending more compelling evidence. We certainly could miss some short-term return until sufficient evidence of trend uniformity appears (or lacking such evidence, until the market fails), and it's important to be realistic about that possibility as well. Again, investors who simply cannot tolerate the risk of "missing out" on short-term market advances (possibly substantial) are well advised to buy an index fund.
Another potential concern involves seasonality. It is widely recognized that stocks have just entered a seasonally favorable November-April period. Indeed, this is so widely recognized that one might wonder whether investors have not already exhausted the upside potential by positioning themselves in advance. In this case, who will provide the buying interest to fuel a follow-through?
That question aside, if we assume that the November-April period will be as favorable as it has been in the past, shouldn't we abandon our defensive stance and move to a bullish position? One of the benefits of having an objective approach is that we can obtain exact answers to these questions. On this one, the answer is that a defensive position remains appropriate, regardless of seasonality.
Since 1945, the November-April holding period has generated annualized total returns in the S&P 500 of 18.4%. This contrasts with a substantially smaller 7.4% average return for the May-October holding period.
In addition to seasonality, however, we can partition history based on which Market Climate was in effect at any given time. When we do that, we get substantially more insight.
Specifically, when we restrict the analysis to periods during the favorable November-April span when trend uniformity was also favorable, the annualized return for the S&P 500 averages 27.8%. But during November-April periods when trend uniformity was unfavorable, the average annualized return whittles down to just 0.2%. If we further restrict those seasonally favorable periods to points when both valuations and trend uniformity were unfavorable (as they are now), the S&P 500 has averaged an annualized loss of -6.6%.
Similar patterns hold true for unfavorable seasonal periods.
In other words, historical returns have displayed a seasonal pattern favoring the November-April period. But the influence of seasonality never reverses the implications of the prevailing Market Climate. It is not favorable seasonality that we wait for - it is a favorable Market Climate.
For now, the Market Climate in stocks remains unfavorable. The Market Climate in bonds remains modestly constructive. We are positioned accordingly.
Finally, I recently noted that Fannie Mae's duration gap had very stark implications for a potentially massive loss in shareholder equity (book value). Well, in its third-quarter report, Fannie chose a controversial "reclassification" involving $135 billion of its assets, resulting in a $4 billion boost to its book value. "Even though," reports the Wall Street Journal, "the company may never sell the securities or realize the gain. Without the accounting boost, Fannie Mae's shareholder equity would have been roughly $11 billion - only a little more than half its level six months ago."
Thursday Morning October 31, 2002 : Weekly Market Comment
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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The Market Climate for stocks remains characterized by both unfavorable valuations and still unfavorable trend uniformity. In bonds, the Market Climate is characterized by unfavorable valuations but modestly favorable trend uniformity.
Just a note on Wednesday's pullback in the Strategic Growth Fund. Simple explanation - our portfolio of favored stocks was essentially unchanged on Wednesday, while the major indices advanced by about 1%. Behind this outcome was an extremely wide disparity between industry groups. Consumer-related and retail groups were down as much as 3% on the day, while networking, semiconductor and telecom groups (including many stocks that we view as bankruptcy risks) were up as much as 11%. We don't take much information away from this, other than the fact that investors are worried about consumer confidence, and at the same time are eagerly trying to pick bottoms in former high-fliers. As always, we continue to focus on those groups exhibiting favorable valuations and market action (not simply short-term trends), and to avoid those groups exhibiting neither.
As I frequently note, the main risk of a fully hedged position, as well as the primary source of our returns when we are fully hedged, is the potential for our favored stocks to perform differently than the major indices. That performance differential has been responsible for nearly the entire gain in the Fund since its inception. Had our favored stocks exactly matched the returns on the major indices, our total return over the past few years would have been equal to the Treasury bill yield.
Our strategy is based on carefully selecting those risks that we expect to be compensated, and to avoid, hedge, or diversify away risks that we view as unattractive. At present, we've hedged away the market risk of our positions, but there is still additional risk left over, because our stocks are not perfectly correlated with overall market movements. That potential for our stocks to behave differently than the market is our primary source of risk here, as well as return. It is certainly possible to close down and hedge away every bit of this risk. But by doing so, we would earn the risk-free rate (Treasury bill yields) with equal certainty. So the fact that we avoid some risks does not mean that we have avoided (or desire to avoid) all of them.
Since mid-August, the S&P 500 has declined by about 8%, and the Fund has pulled back by about 5.3% (slightly less than the 5.6% pullback experienced by the Fund in April-May 2001). During this time, our favored stocks have lagged the market by about 1.3%, while the remaining 4% was due to a partially unhedged position during the initial part of the decline from the August peak. None of this is unusual - historical tests of our stock selection approach since 1957 include several periods in which our favored stocks would have temporarily lagged the market indices by over 10%. In addition, our approach is vulnerable to losses from market declines anytime we take less than a fully hedged position.
In short, it is essential to understand that our approach involves risk. When we are not hedged, we are exposed to potential losses from market declines. But even when we are hedged, we are exposed to risk that our returns may not track the major indices from time to time. I do not have any confidence at all that our approach will generate consistently positive short-term returns. Our objective is long-term capital appreciation with added emphasis on protecting capital during unfavorable conditions. This involves certain risks that we believe are essential to achieving that objective. For investors who cannot accept these risks, the Fund is not really an appropriate investment.
We continue to do the same things here that we have done since the inception of the Fund, and that we plan to do into the indefinite future: 1) buy highly ranked candidates on short-term weakness, 2) sell lower ranked holdings on short-term strength, and 3) align our exposure to market risk with the prevailing Market Climate that we identify at any given point in time. As always, you find a set of daily actions that you believe will produce good results if you follow them consistently. And then you follow them consistently.
Sunday October 27, 2002 : Weekly Market Comment
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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The Market Climate for stocks remains on a Warning condition, characterized by unfavorable valuation and unfavorable trend uniformity, and holding us to a fully-hedged position. We remain fully invested in favored stocks, and have largely removed the market risk of that position with an offsetting short position in the S&P 100 and Russell 2000 indices. In bonds, the Market Climate remains characterized by unfavorable valuations but very modestly favorable trend uniformity. Though favorable trend uniformity in bonds is not nearly as helpful as it generally is for stocks, the current Climate is sufficient to warrant a modest exposure to intermediate maturity bonds near the kink of the yield curve (about a 7-year maturity) in Strategic Total Return. That Fund also holds about 30% of assets in alternative investments including limited maturity foreign government notes, precious metals stocks, and a few select utilities.
It is important to recognize that our definition of trend uniformity refers to the quality of market action, not the extent or duration of any particular advance or decline. We simply do not take market risk just because, say, the S&P crosses its 50-day moving average. Market action conveys an enormous amount of information. But most of this is conveyed not simply by obvious trends, but in more subtle ways - particularly how various elements of market action diverge from how they would be expected to behave, given the surrounding context. Without revealing anything proprietary, trend uniformity is best thought of as a statistical concept, not simply a trend-following one.
A few examples may be useful. Suppose I give you a series of numbers and ask you to calculate the average. If the current average is 25, and the next number I give you is 25, there is no new information in that (other than slightly strengthening your confidence in the existing average). But if the next number is 30, now you've got new information and your average changes. This new information appears because the new data point diverged from what your previous information would have anticipated. Statistically speaking, information is always in the divergences.
Similarly, suppose that Treasury bond yields are falling, and corporate bond yields are also falling. In this case, the uniform decline in yields is a fairly pure interest rate signal. But suppose instead that Treasury yields are falling but corporate yields are rising. That divergence contains important and useful information - generally about oncoming economic weakness and a rising probability of corporate debt problems.
In short, trend uniformity involves more than just obvious trends in major averages. The word "uniformity" is also essential. Though I never go into proprietary details, my hope is that these examples are helpful. We're trying to measure information content, not simply raw and obvious market trends that may or may not have run their course.
Our investment positions are based on the combination of valuations and market action prevailing at any given point in time. Valuations have a profound influence over long-term returns from a security. But alone, valuations imply very little about price direction over shorter periods of time (even several years). This is where market action is important. When trend uniformity is favorable, even extreme overvaluation is not sufficient to drive stocks predictably lower. But the combination of unfavorable valuation and unfavorable trend uniformity is often lethal.
So are stocks in a new bull market here, or is the bear still lurking? As usual, I have no forecast. More importantly, however, the distinction between bull and bear markets is not an operationally useful concept. Bull and bear markets can only be identified in hindsight. To frame one's investment views in terms of things that can't be observed is foolish enough. But to allow those perspectives actually drive positions is insanity.
Instead, we base our positions strictly on well-defined criteria that are directly observable. Since one of those criteria is driven by unpredictable divergences in market action that can occur at any time, it follows that even though we can precisely identify prevailing conditions, it is not useful to forecast future ones. This is why I constantly emphasize that any position we take, aggressive or defensive, should not be interpreted as a forecast. Very simply, we align our position with the prevailing Market Climate that we identify at any point in time. When that Climate shifts, so does our position.
Not surprisingly, I don't spend one minute worrying about whether we have entered a new bull market in a fully hedged position. We just don't have the evidence to take anything but a fully hedged position here. In a market that continues to exhibit unfavorable valuations and trend uniformity, even a new "bull market" at these levels would be unlikely to resemble historical bull markets - which invariably emerge from very favorable valuations and market action.
Investors continue to focus on earnings as the primary fundamental on which to value stocks. This is a mistake. Bears are using the S&P 500 "core" figure of about $19 to compute a P/E on the index of nearly 50. Meanwhile, bullish analysts are using optimistic estimates of "operating" earnings near $50 to compute a P/E on the index of just 17. Both of these are incorrect. First, current earnings are severely depressed due to weak profit margins. The pension and option cost adjustments made to the "core" earnings figures seem correct, particularly because these factors are much more relevant now than they have been historically (so leaving them out would overstate earnings power). But the sustainable level of earnings is probably about double what current earnings suggest. In contrast, operating earnings fail to deduct interest owed to bondholders and taxes owed to the government, not to mention options and pensions costs. Given that the share of earnings devoted to these items is the highest in history, leaving them out of valuation calculations is ridiculous.
One way to cut through the noise is to recognize that earnings were wildly skewed, relative to other fundamentals, during the second half of the 1990's. At the market's peak, the S&P 500 P/E ratio was about double its historical average, while other measures such as price/book, price/revenue, price/dividend, and market capitalization / GDP were three or more times their respective averages. In other words, earnings were wildly elevated compared to other fundamentals. High earnings in relation to book value meant that the return on equity reported by companies was unusually high. High earnings in relation to revenue meant that the profit margins were unusually high. High earnings in relation to dividends meant that payout ratios were unusually low. And high earnings in relation to GDP meant that the profit share of GDP was unusually high.
We have since discovered that much of this was either temporary (due to an unsustainable capital spending boom with predictable consequences), or fraudulent. In any event, it is very clear that future earnings are unlikely to recapture their unusual relationship with other fundamentals.
And there is the problem. Because, on the basis of any fundamental other than earnings, valuation multiples (price/revenue, price/book, price/earnings, market cap/GDP, etc) remain 50-100% higher than their historical averages (not to mention typical levels seen at bear market troughs). For this reason, we are skeptical of claims that stocks are close to fair value here.
A final note on the "Fed Model" (S&P 500 operating earnings yield divided by 10-year Treasury yield). This is a model of the stock market in the same sense that a pile of Pez candy is a model of the Taj Mahal. I've long noted that this indicator actually has no statistical relationship with how the S&P 500 performs over the following year (or any other period for that matter). Indeed, the usual way that the Fed model generates a "buy signal," particularly in recent years, is for 10-year Treasury yields to drop to abnormally low levels.
That observation led me to an entertaining statistical result. It turns out that although the "Fed Model" is useless as a stock market indicator, it's actually not a bad bond market indicator. Specifically, when the Fed Model gives a "buy signal," (particularly when earnings yields on the S&P 500 are not high) it's typically a signal that the 10-year Treasury yield has become unusually depressed. Statistically, this is nicely correlated with a subsequent plunge in bond prices. In other words, when the Fed model suggests that stock yields are "too high" in relation to bond yields, stocks don't adjust, bonds do.
Brief quotations with proper attribution are permitted. A link to the website www.hussmanfunds.comis appreciated. Thanks.
Sunday October 20, 2002 : Weekly Market Comment
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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Just a note - I'll be appearing on Wall $treet Week with Fortune on PBS this Friday evening. For those who have noticed the Hussman Funds increasingly mentioned in the media, don't be dismayed. The Strategic Growth Fund is still only about an eighth of the size of the average equity mutual fund. Even if the Fund was restricted to small-cap stocks, our approach could easily handle several billion in assets. But we are not restricted to a small-cap universe. The Fund's universe is all stocks on the NYSE, AMEX and NASDAQ.
In historical tests of our stock selection approach using data since 1957, we did not observe any significant performance deterioration even when the universe was restricted to the largest 400 traded stocks. One reason is that our approach is based on providing liquidity to the market rather than using it up. For example, a typical trade for us involves placing resting bids for stocks that we view as having favorable valuation and market action, when those stocks are under short-term pressure. Similarly, it is fairly typical for us to place resting offers on lower ranked holdings on short-term strength. As I always stress and every one of my former students should (and had better) be able tell you, profits in the financial markets are not free money. They are generally compensation for making trades which move the market toward efficiency, by providing liquidity, risk bearing, and information to other market participants.
Look carefully. Even the very largest stocks in the market fluctuate 50% to 100% or more between their annual highs and lows. In my view, a great deal of this represents valuation "noise," which is an opportunity for an approach like ours. Both the financial markets and the U.S. economy would be well served by more investment activity directed at greater market efficiency and appropriate pricing of financial risk. That's what we do. Had more of this occurred in the past 5 years, the scarce and hard-earned savings of U.S. investors would not have been misallocated to internet and telecom companies facing near-zero costs of capital. Nor would these savings have burned up as "extraordinary losses." Our approach is not a "specialty" or "niche" strategy. Rather, it is driven by a variety of elements intended to provide useful services - liquidity, risk bearing, and information - to the markets. In a stock market valued at trillions of dollars, scarcities are not eliminated very easily. And as long as a service remains scarce and useful, it generally remains profitable. We do not anticipate closing the Fund at any point in the foreseeable future.
With regard to media articles, I should also note that anytime you read an interview that includes the phrase "market call" or "bet on market direction" to describe our position, or implies that our approach is dependent on such notions, you can probably infer that the writer wasn't listening. If there's one thing that readers of these updates will recognize instantly, it is the fact that our positions are not based on forecasts. Any tendency of our portfolio changes to resemble "market calls" or "timing" is spurious and incidental. We align our position with the prevailing Market Climate that we identify at any given point in time, we change that position when the Climate observably changes, and we can't predict even the next week's Market Climate ahead of time. Our positions are based on identifying prevailing conditions, not forecasting future ones.
Despite the fact that we've been strongly defensive in recent years, we expect to have ample opportunities to take both defensive and aggressive positions in the future. Speaking in terms of my past opinions (the Fund was not in existence prior to July 2000), it's no secret that I was extremely optimistic during the early years of the bull market, starting in late 1990. This was not a particularly popular stance. Even in 1992, Tom Petruno of the Los Angeles Times described me as "one lonely raging bull", and Dan Dorfman made similar notes in USA Today. It's also no secret that I've viewed stocks as overvalued since late-1993. But as I frequently emphasize (and the late 1990's demonstrate), overvaluation does not imply anything about short-term returns. It simply implies that long-term returns will be unsatisfactory. Though trend uniformity has been favorable during much of the time since late-1993, the simple fact is that the Russell 2000 has gained just 4% annually since then. So while trend uniformity can often allow an overvalued market to become more overvalued over the short term (even several years), it is difficult to escape the ultimate long-term consequences.
Since fully hedging a stock portfolio subtracts the return from the market, and adds the risk-free interest rate (technically, about 80% of the broker call rate), a fully hedged position would have given up very little long-term return at all even if trend uniformity had been negative for the entire period from late-1993 to the present (which it was not).
Our approach clearly shares the typical risks of other growth funds, particularly when our position is not hedged. If I was to identify one additional risk as most important when we are hedged (and most potentially frustrating to investors who don't understand our approach), it is the risk that we may not track short-term market movements. When we're fully hedged, we generally will not participate much at all on days when the market rallies strongly. In fact, if our stocks are underperforming the market for several days in a row, we can lose money regardless of what the market does. If this is a risk that a particular investor cannot accept, that investor shouldn't own the Strategic Growth Fund. The Fund is intended as a core growth holding for investors following a long-term saving and investment program, and who are willing to accept this kind of "tracking risk" in order to defend capital during unfavorable market conditions. We strongly discourage investments from individuals whose investment goals, temperament, or risk preferences are incompatible with the Fund's objectives.
That said, the performance of the Fund on a one day basis cannot be extrapolated to inferences about periods even as short as one month. For example, from the Strategic Growth Fund's inception in July 2000 through September 2002, we've seen 17 months in which the market has declined, and 10 months in which it has advanced. Taking only the months when the market declined, the Fund gained at an annualized rate of 23.3%. But taking only the months when the market advanced, the Fund still gained at an average annualized rate of 17.3%. This isn't any assurance at all about future performance, but it does suggest that excessive concern about "market forecasting" as a major determinant of our performance is both counterfactual and pedestrian.
As of last week, the Market Climate remained on a Warning condition for stocks and a modestly constructive condition for bonds. The situation for the stock market is precarious, because stocks are now overbought in an unfavorable Market Climate. Given that our approach leans strongly toward buying highly ranked candidates on short-term weakness and selling lower ranked holdings on short term strength, I view this as a good and potentially temporary opportunity to liquidate holdings that are not highly desirable as long-term investments.
Probably the most interesting indicator this week is the proportion of bullish investment advisors. The Investors Intelligence bullish percentage has declined to just 28.4%, for the first time since 1994. As a contrary indicator, such a low level of bullishness seems like a favorable development.
But how favorable? We looked at the data since the 1960's. While low levels of bullishness are generally associated with somewhat better returns than high levels of bullishness, they never reverse the implications of a negative Market Climate.
Specifically, when both valuations and trend uniformity have been unfavorable (as they are now), a bullish percentage below 30% has been associated with an annualized loss of -8.9%, compared with an annualized loss of -13.7% when bullishness has exceeded 30%. The worst case in this Climate occurs when bullishness is above 50%. In this case, the S&P 500 has declined at an average annualized rate of -22.4%.
Similar patterns hold for other Market Climates. For example, when stocks are in a favorable Market Climate, even extremely high levels of bullishnesss are still associated with reasonably positive returns, on average.
In short, the plunge in advisory bullishness is interesting, but it doesn't change the implications of a negative Market Climate. At present, the overbought condition of stocks more than offsets the otherwise favorable implications of this indicator. We remain defensive and fully hedged. While this stance is always subject to changes in the Market Climate, we have no favorable inclination toward market risk at present.
In bonds, we're still inclined to add lightly to our positions in 6-8 year Treasury maturities on declines. This is primarily on the basis of risk spreads, which suggest continuing defaults and financial problems which may prompt further demand for Treasuries. I do not think that the bond market offers particularly good investment merit here, but there is sufficient speculative merit, combined with enough steepness in the yield curve, to favor that 6-8 year maturity range while corporate risk premiums remain under pressure.
For the three quarters ended September 30, 2002, the Hussman Strategic Growth Fund gained 13.90%, compared with a 25.09% loss in the Russell 2000 and a 28.16% loss in the S&P 500 Index. For the 12 months ended September 30, 2002, the Fund gained 20.28%, compared with a loss of 9.30% in the Russell 2000, and a loss of 20.49% in the S&P 500. From the Fund's inception on July 24, 2000 through September 30, 2002, the Fund has gained 52.03% (21.12% annualized), compared with losses of 27.32% in the Russell 2000, and a loss of 42.64% in the S&P 500. All figures include dividend income. Past performance is no guarantee of future results. The return and principal value of an investment in the Hussman Strategic Growth Fund will fluctuate so that shares, when redeemed, may be worth more or less than their original cost. For additional information about the Funds, including fees and expenses, please obtain our Prospectus, and read it carefully before you invest or send money.
Wednesday Morning October 16, 2002 : Special Update
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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The Market Climate remains on a Warning condition for stocks (unfavorable valuations, unfavorable trend uniformity).
In bonds, the Market Climate is characterized by unfavorable valuations and favorable trend uniformity. As I've noted before, favorable trend uniformity in bonds is not nearly as positive as it is for stocks, but current conditions warrant a modest exposure to intermediate Treasury maturities of about 7 years, with the majority of fixed-income investments allocated to very short-term maturities. Corporate and mortgage backed bonds remain a minefield. I don't believe that the credit problems of recent years have nearly washed out. The terrible continuing action in risk spreads is one of the main factors that favor intermediate-term Treasuries here. The deleveraging cycle that follows a credit bubble takes a very long time to run its course, and this one is just getting warmed up.
Tuesday's stock market rally gave us a number of great opportunities to manage our equity positions, while the plunge in long-term bonds created a nice opportunity to slightly increase our position in intermediate Treasury maturities. Our objective is to align our position with the prevailing Market Climate, while taking day-to-day opportunities to purchase higher ranked candidates on short-term weakness and to sell lower ranked holdings on short-term strength. So while Tuesday was nothing special in terms of our one-day returns, it was the kind of day that often makes a significant difference in our returns over time. In everything, the key to success is to find a set of daily actions that you're confident will produce good results if you follow them consistently, and then follow them consistently.
As for quality, Tuesday's rally was not impressive from the standpoint of volume, and despite relatively good breadth, the ratio of advancing issues to declining issues fell short of what would be expected from a rally of this size. Also, utility stocks were weak. While one might think this is reasonable given the terrible action in bonds, it is actually inconsistent, and an important divergence in my view. From recent action, it is clear that the weakness in utilities is driven neither by interest rate action or beliefs about economic prospects. This leaves concerns about energy prices and credit risk as the primary signals being conveyed by utilities here. Though we do hold positions in a few select utilities, the majority of utility stocks continue to display poor market action on the measures that we emphasize.
As I note in the latest issue of Research and Insight, the market's enthusiasm about bank earnings (which largely drove Tuesday's rally) is misplaced. These earnings are a result of unusually wide net interest margins thanks to a steep yield curve. This is not a robust source of long-term stability in bank earnings. After the close, Intel warned that it saw no improvement in technology prospects, prompting a sharp sell-off in after hours trade. We'll see whether that follows through in Wednesday's trading.
At this point, the market has finally worked off its deeply oversold condition from the relentless declines of recent weeks. That does not mean that stocks will or must decline here, but the intense compression behind the recent market surge has now been relieved. I have absolutely no forecast about short-term market action here. The fact that stocks are no longer oversold invites the possibility of renewed weakness, but there is no reason why the market could not drift higher instead. Our fully hedged position is not driven by a "bearish" outlook, but by a Market Climate that has not historically rewarded market risk. We aren't speculating on a market decline (the dollar value of our shorts never materially exceeds our long holdings), nor should our position be interpreted as a forecast. We are simply attempting to remove the impact of market fluctuations from our portfolio, because we don't have sufficient evidence that market risk is worth taking.
For now, we're fully hedged in stocks, and generally defensive with regard to bonds, though with a modest exposure to intermediate maturity Treasuries.
Sunday October 13, 2002 : Weekly Market Comment
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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The Market Climate in stocks remains on a Warning condition, characterized by both unfavorable valuations and unfavorable trend uniformity. In this environment, our investment discipline holds us to a fully hedged position. We are fully invested in favored stocks, with an offsetting short position in the Russell 2000 and S&P 100 indices. In this stance, our returns are driven mainly by the extent to which our stocks outperform or underperform these indices. Though this kind of position has been the primary source of our returns over the past two years, this relative performance is largely random on a day-to-day basis. Thus, if our position gains value on a given day, the correct inference is that our stocks outperformed the market on that particular day, regardless of whether the market was up or down that day. If our position declines on a given day, the correct inference is that our stocks underperformed the market on that day. Short-term outperformance and underperformance occasionally runs in streaks, so when we are fully hedged, it is not at all unusual for our approach to gain on consecutive days regardless of what the market does on those days, nor is it unusual for our approach to decline on consecutive days regardless of what the market does on those days.
A few notes:
A good article by Eric Savitz in Barron's Magazine includes a section about Hussman Strategic Growth Fund (Mutual Funds section pages F2 and F3).
We've updated the performance graph for the Strategic Growth Fund through September 30, 2002 (PDF format, click here).
Our outstanding Shareholder Services staff regularly shares the most common shareholder questions with me, and except for questions regarding very technical features of our approach (which I keep proprietary), they can answer most any issue or shareholder matter that arises. We've also posted a due diligence file with the most frequent questions on the Fund Information page of the website.
One type of question we've received is fairly unusual, but emerges enough to discuss it here.
The question concerns a focus on excruciatingly short-term returns (i.e. the past seven weeks or so), during which time Strategic Growth has pulled back by about 4.5% (from a 56% gain over the prior two years). During the same period of weeks, the major indices have plunged by about 20%. Usually, questions about a short-term pullback include a theory as to why the pullback has occurred, along with well-intentioned advice on what I should do to correct the matter.
The simple answer is that our short-term returns are dependent both on the extent to which we are hedged, and on the extent to which our favored stocks outperform or underperform the market during that specific period.
As I frequently emphasize, we manage diversified, no-load mutual funds geared to long-term growth, capital appreciation, and total return. They are appropriate investments only for shareholders who take a similarly long-term perspective. To a long-term investor, even a year ought to be considered short-term. Please read our Prospectus carefully before you invest.
Still, I take every shareholder question seriously, and I assume that if we've heard the same inquiry more than once, it has probably occurred to a larger group of shareholders as well. I don't really think that it's useful to focus on short-term fluctuations, but I hope that the following discussion will help our shareholders understand the Fund better, and that's always beneficial.
The 4.5% pullback in recent weeks has two sources. First, we were about 40% unhedged during about half of the selloff from the August high. Though our stock holdings actually muted the apparent damage initially (by outperforming the market on the initial part of the decline), they kicked in to the selloff somewhat later, particularly consumer-oriented stocks. These don't represent a major weighting difference relative to the major averages (our largest sector mismatch is our very light position in financial stocks), but consumer-oriented stocks have come under some short term pressure, as have our relatively small positions in precious metals shares and utilities, which are also slight overweights relative to the market.
While all of these weighting differences are strictly intentional, the net result is that we lost less than 40% of the market's initial loss from its August high because our favored stocks held up relatively better than the market, and then once we got fully hedged, lost more than 0% of the market's further losses because a few of our favored sectors caught up with that general weakness in stocks. Thus, both periods experienced modest erosion.
Do the math. The major indices dropped by about 10% between the August peak and the point at which we reestablished a fully-hedged position. At a 40% exposure to market risk, the net result was a -4% impact on portfolio value due to our unhedged exposure to that decline. The other 0.5% of our pullback came from the difference in stock performance relative to the indices. But given that our prior 56% gain was driven almost entirely by stock selection that outperformed the major indices, an adverse move of 0.5% hardly a major change in the behavior of our stock selection.
In my view, this sort of action is short-term noise. Again, it is important to understand that our day-to-day performance is due to a whole confluence of factors that include varying exposure to market risk, and varying performance of our favored stocks, relative to the major indices.
As I've noted before, the recent bear market rally differed from normal, in that such rallies generally display subtle internal deterioration in trend uniformity before failing. This one generated the shift in trend uniformity on solidly negative action. We always allow for that possibility (which is why we were unwilling to expose any more than 40% of our portfolio value to market risk, despite favorable trend uniformity), and sometimes these possibilities actually become fact.
What am I doing to "correct" our position? Nothing different from what I always do. I follow a very disciplined set of daily actions: 1) attempt to purchase highly ranked candidates (favorable valuation, favorable market action) on short-term weakness, 2) attempt to sell lower-ranked holdings on short-term strength, 3) maintain an exposure to overall market risk that is in line with the prevailing Market Climate. A "good day" is one in which I followed those actions, and took the opportunities given to us by the market to build more favorable value and market action into the Fund. I do not have any confidence at all that these actions will generate a positive short-term return for any particular day, week, month, or quarter. Investors who require this sort of confidence about short-term returns generally purchase a money market fund. My confidence in our approach is based wholly on my research and experience over extended periods of time, and even then, past performance does not ensure future results.
In short, I do not place much weight on short-term returns, and the Funds should be held by investors only for the purposes for which they are designed: long-term growth and total return. I hope that long-term investments such as the Hussman Funds are approached with a similarly long-term perspective by our shareholders, taking into account both an understanding of our overall strategy (which is the reason I post these updates), and consideration of return and risk over extended periods of time.
In bonds, the Market Climate remains characterized by unfavorable valuations and modestly favorable trend uniformity. This keeps us with a modest position in intermediate-term Treasuries, but with the bulk of our position in short maturity Treasury and agency securities, while about 30% of our funds are diversified across foreign government bonds, select utilities, and precious metals shares.
The lack of investment merit in Treasury bonds is interesting. Despite the fact that bonds have outperformed stocks over the past decade (and depending on what happens to P/E ratios, may do so over the coming decade as well), buy-and-hold investors know with certainty the return that they will earn over the next decade from a 10-year Treasury: 3.7% annualized. That strikes us as unsatisfactory investment merit from a risky security subject to interest rate volatility, inflation, and taxes. Which doesn't mean that speculative pressures will not push yields lower still. It just means that bonds are not priced to deliver a satisfactory long-term return, in our estimation. Of course, there's no reason why investors can't seek long-term total return from strategies that differ from a passive buy-and-hold approach in fixed-income securities.
With regard to speculative pressures, the continuing flight to the safety of Treasuries remains strong, despite short-term pressures that develop on any scent of favorable economic news. Risk spreads (the difference in yields between corporate bonds and default free Treasuries) continue to widen ominously. The past week saw downgrades in the credit ratings of both Ford Motor and J.P. Morgan. These are important, because as I've pointed out in prior updates, both of these companies have troublesome debt and credit issues. While our analysis of bankruptcy risks were largely limited to internet, telecom, energy and broadcasting companies last year, I noted earlier this year that Ford had emerged on that list. My concerns about Fannie Mae, Citibank and J.P. Morgan, while not involving bankruptcy risk, focus on the continuing deterioration in credit and the mismatch of risks that is inherent in the positions taken by these firms. For more on this, see our latest issue of Hussman Investment Research & Insight.
In short, we remain fully hedged in stocks, and modestly defensive in bonds here. These positions do not entail forecasts, but rather identification of prevailing conditions. In order to establish a more constructive position in stocks, either valuations would have to improve (through further market declines) or trend uniformity would have to emerge (which doesn't necessarily require a substantial market advance, but does require an improvement in the quality of market action across various measures we use). Only an improvement in valuations would move us to a more constructive position in bonds. This would require either a decline in bond prices, or a substantial weakening of economic prospects or inflation pressures from already depressed levels.
As usual, our positions are driven by our identification of the prevailing Market Climate, and by the day-to-day opportunities offered by the market to improve the valuation and market action of our holdings.
Thursday Morning October 10, 2002 : Special Update
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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Just a note, the latest issue of Hussman Investment Research & Insight is now posted to the Research & Insight page of our website, www.hussmanfunds.com . We've also added some due diligence information and answers to frequently asked questions for investment advisors and financial planners on the Fund Information page.
The Market Climate for stocks remains on a Warning condition, characterized by unfavorable valuations and unfavorable trend uniformity. While valuations actually remain extreme on the basis of fundamentals such as dividends, book values, and revenues, the S&P 500 would have to fall only by another 10% or so to place the most optimistic measure - price/peak earnings - at its historical average of 14. This would be no major event however. The historical median is just 11 (a level that we estimate would price stocks to deliver a long-term total return of about 10% annually), and the average bear market low is less than 9. Still, it should be at least some consolation to investors (as opposed to speculators) that the investment merit of stocks is gradually improving. It's just unfortunate that so many speculators convinced themselves that they were actually investors when they were buying stocks "for the long term" at much higher valuations.
Richard Russell (Dow Theory Letters) has noted that the bright spot in the price structure in recent months has been the ability of the Dow Transportation Average to hold above its prior low of 2033.86. Under Dow Theory, like our own view of trend uniformity, divergences are important. And in Dow Theory, a move in the Industrials that is not confirmed by the Transports creates an important divergence. Until Wednesday, the failure of the Transports to confirm weakness in the Industrials was a favorable divergence. Unfortunately, Wednesday's decline wiped that divergence away, as the Transports plunged below last year's prior low. This places both the Dow Industrials and Dow Transports at fresh bear market lows, and is a reconfirmation of a prevailing bear market under Dow Theory.
I realize that Dow Theory may strike some as quaint and arcane, but I view it as a specific version of a much broader truth - market action, particularly divergence - conveys information. Recent empirical academic work has actually validated Dow Theory to a significant extent. Researchers trained a neural network based on the published signals of William Peter Hamilton in the early 1900's. They then ran that network on subsequent data, and the resulting signals nicely outperformed a buy-and-hold approach with less risk. So I actually take Dow Theory with due seriousness. It's a little unfortunate that it is frequently mischaracterized in media articles (for instance, calling a dual low in the Industrials and Transports a "Dow Theory sell signal" even when it occurs very late in a bear market, as if the signal was the first one given). It is also unfortunate how few writers realize how intertwined Dow Theory is with values. That said, the more a useful approach is ignored (or incorrectly followed), the better it is for investors who use it well. That's also one of the reasons I am often a bit tight lipped about the specifics of trend uniformity.
What strikes me most about the recent decline is its indiscriminate nature. This isn't necessarily evident looking at the major indices, but if you follow individual stocks, the market's reaction to any potential rumor or disappointment is really very extreme. Since the August peak, the major indices have lost roughly 20% of their value. And unlike typical bear market rallies that experience subtle deterioration near the peak, the recent plunge gave no warning on the measures that typically signal that subtle loss of trend uniformity. Though we had given every benefit of the doubt to that rally, leaving as much as 40% of our stock position unhedged in order to take modest exposure to market risk, we reestablished our hedges only slightly higher than we took them off. To put this into perspective however, the Strategic Growth Fund is at about the same level as it was at the end of June. In contrast, the major indices are 20-30% lower since then.
Though we shifted back to a fully hedged position about 9% off the August rally high, the latest move underscores the fact that every Market Climate includes both periods of advancing and declining prices. Our goal isn't to try to forecast whether the next move will be an advance or a decline, but to position ourselves in line with the average return/risk characteristics of the Climate we identify at any given time. As I frequently emphasize, our willingness to take market risk at any particular time is based on that average return/risk profile. We fully expect variation around that average, and so should you. Our approach will look less brilliant at some times than others, but I am convinced that it is effective when applied with discipline over time, and the alternatives - a rigid buy-and-hold stance, or the attempt to be a market-timing guru - are both sinkholes.
I am sometimes asked why we don't allow the dollar value of our shorts to materially exceed our long holdings. The answer is that every Market Climate includes periods of advances and declines, sometimes substantial ones. And because we don't believe it is possible to forecast short-term moves within a particular Climate, material short positions would expose our shareholders to untenable levels of tracking risk. For example, bear market declines generally produce explosive rallies to clear oversold conditions. If we actually took large short positions, it is absolutely certain that we would lose value very quickly during these periods. I honestly don't believe that the average investor has much tolerance for seeing the market plow higher by 10% and to see one of their core mutual fund holdings lose that much. So yes, there might be a modestly higher long-term return available from taking short positions during unfavorable Market Climates. But that kind of position is for specialty funds and hedge funds. We are neither. In my view, the risk and volatility of large short positions are too extreme. The Fund was created to be a core, no-load U.S. equity growth fund for long-term investors following a disciplined saving and investing program. That's the population of investors that we are committed to serve.
In bonds, the Market Climate remains characterized by unfavorable valuations but modestly favorable trend uniformity. That trend uniformity isn't terribly positive given the low level of yields, but it's enough to warrant at least a modest exposure to intermediate maturities such as the 7-year Treasury. In Strategic Total Return, we've also got a modest position in 2-3 year foreign government notes (UK, Germany), callable agency notes (not mortgage pass-throughs), precious metals shares, and just about 10% in select utility stocks.
Unfortunately, the action in utilities has been brutal and almost shocking. It's not clear yet whether this decline has information content (i.e. potential risk of massive defaults, a potential spike in the cost of energy production that cannot be passed on to rate-regulated consumers), or valuation content (i.e. lower prices reflecting a higher long term rate of return). At this point, we have to infer that both factors are partly at work. The Dow Jones Utility Average has plunged by more than 25% in the span of less than a month. While I continue to have a very favorable view of the utility stocks we own, a frantic and indiscriminate selloff like this one puts pressure even on a small and selective position. We generally try to position ourselves so that we're not significantly affected even by stunning and dramatic market action in any particular sector. Nevertheless, we've taken a 2.3% pullback, mainly on the basis of unusual weakness in utilities (not surprising given a 10% exposure to a sector that's down by 25%).
In short, market action has become increasingly indiscriminate, and we've got a fresh breakdown from the standpoint of Dow Theory as well. We should not be surprised if even a fully hedged position experiences some amount of volatility, because the market is also very divergent internally. Individual stocks and industries subject to sudden and (in the case of utilities) unusually extreme pressures. While our security selection emphasizes value and market action in a way that "surprises" are quite often on the upside, we clearly have to accept certain short-term risks as essential if we are to expect anything more than a risk-free return of about 1.6% annually.
This is a dangerous market, but one that is so compressed that a fast, furious rally to clear the oversold condition should not be ruled out. Our fully hedged stance is not based on speculation about a further decline, nor are we concerned about the possibility of "missing" a rally that clears this oversold condition. From our standpoint, the Market Climate in stocks is clearly negative, and when that is true, we take steps to mute the impact of market fluctuations on our portfolio. No forecasts required.
Sunday October 6, 2002 : Weekly Market Comment
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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As of last week, the Market Climate for stocks remained on a Warning condition, with valuations and trend uniformity still unfavorable. Our holdings remained fully hedged. Since the dollar value of our shorts doesn't exceed our long holdings, our hedge should not be interpreted as a "bet" that the market will fall. Rather, we hedge in order to remove the impact of overall market fluctuations from our widely diversified portfolio of favored stocks. I have no short-term forecast regarding market action. I would not be surprised by an explosive rally to clear the deeply oversold condition of this market. And I would not be surprised by a crash. A fully hedged position is not associated with a forecast either way.
On the favorable side, stocks are deeply oversold, and with the major indices down for six consecutive weeks, there is a significant compression that could be explosive. On the unfavorable side, the sheer relentlessness of the recent decline is a negative in itself. Moreover, most mutual fund shareholders will be receiving quarterly statements this week. Given the brutality of the past quarter, these statements may trigger a sort of revulsion when investors actually get a look at actual numbers. So anything is possible here.
In the bond market, the Market Climate remained characterized by unfavorable valuations, but favorable trend uniformity. However, since fixed income markets are not as susceptible to "bubbles" as equity markets are (if only because a low yield to maturity is properly interpreted as a low yield to maturity), favorable trend uniformity is not nearly as positive as favorable valuation. So while we are taking a certain amount of exposure to intermediate term Treasuries, part of the risk we've chosen here is in alternative assets, with about 30% of our funds diversified across foreign goverment bonds, precious metals shares, and utilities.
An essential goal of the Hussman Funds is to take those risks that we believe are associated with a reasonable expectation of returns, and to avoid, hedge, and diversify away those risks that are not. We follow a very strict, theoretically rigorous and extensively tested approach in choosing these risks. Indeed, we've written various aspects of our approach directly into the Prospectus of each Fund.
We occasionally receive well-intentioned notes urging us to purchase a particular security that does not satisfy our criteria, or to deviate in one way or another from our approach. Very simply, we don't do that (I would not, could not, in a box; I would not, could not, with a fox...). The risks that we take are taken intentionally and adhere to a very specific discipline. Not every security that satisfies our quantitative requirements is purchased - that's where additional research and due diligence enters - but we don't purchase securities that don't satisfy our quantitative requirements. The fact that our approach is flexible does not mean that it is discretionary. We follow our discipline strictly.
With respect to the economy, it is important to recognize that the rate of unemployment fell in Friday's report strictly because workers are actually exiting the labor force. During the late 1990's, I frequently noted that the low rate of unemployment had not resulted in much wage inflation because labor force entry was permitting job growth even at very low unemployment rates. Indeed, labor force participation reached the highest level in history in recent years. We are now seeing the reverse effect, with workers actually leaving the labor force. This means that lower rates of unemployment should not be interpreted as strength in the labor market without looking directly to the job creation and hours-worked figures. It also means that wage inflation will probably respond much more quickly to any incipient strength in the economy, leading to a slower recovery in profits than might be expected when the economy eventually recovers.
Not that there's much evidence for that yet.
Wednesday Morning October 2, 2002 : Special Update
Copyright 2002, John P. Hussman, Ph.D., All rights reserved and actively enforced.
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The Market Climate for stocks remains on a Warning condition, characterized by unfavorable valuations and unfavorable trend uniformity. Our favored stocks remain fully hedged against the impact of market fluctuations, with an offsetting short position of equal size divided between the S&P 100 and Russell 2000 indices.
In that context, Tuesday's rally had all the hallmarks of a standard bear market rally to clear a deeply oversold condition - fast, furious, and most likely prone to failure. Failure however, should not be expected immediately. After the brutal quarter the market just finished, it would not be surprising to see a rally that carries for a bit. With valuations and trend uniformity negative, there's not a chance that we would attempt to "play" the possibility of a rally, since it may not materialize, and we would have no way of knowing when to get out if it did. As always, our discipline is to align ourselves with the prevailing Climate we identify. We do not invest on opinion, and we do not attempt to "time" short term movements within a particular Climate.
Tuesday's advance was unusually ragged, with the S&P 100 Index rising by 4.54% while the Russell 2000 advanced by just 1.61%. This kind of one-day dispersion usually triggers some kind of tracking error in a hedged approach, since it's very unlikely that a portfolio of stocks, however well chosen, will turn in a one-day return tightly matching the average performance of the indices used to hedge. Fortunately, it's also quite unusual for such wide dispersions to persist more than a short period of time.
Having just weathered the worst quarterly stock market performance since the 1987 crash, it seems like a good time to review our own performance in the Strategic Growth Fund.
I am pleased to note that the Fund ended the third quarter with a gain of 1.95%. Given that the dollar value of our shorts never materially exceeds our long holdings, and we actually held a constructive position as much as 40% unhedged during a portion of the quarter, that positive return is very gratifying, if not large in an absolute sense. For the quarter, the Russell 2000 plunged by 21.40%, while the S&P 500 Index lost 17.28%.
For the first three quarters of 2002, the Hussman Strategic Growth Fund gained 13.90%, compared with a 25.09% loss in the Russell 2000 and a 28.16% loss in the S&P 500 Index. In effect, the Fund outperformed the major indices by about 40%. Again, since the we were not net short, virtually the entire gain in the Fund since inception has resulted from the fact that our favored stocks strongly, and generally consistently outperformed the major indices.
I say "generally consistently" because our favored stocks certainly have not outperformed the market on a daily basis. Over the past few days, for example, panic about falling consumer confidence has placed unusual pressure on retail stocks, despite the fact that many of these stocks display some of the most favorable valuation and market action of the stocks we hold. This kind of short-term pressure can give us a pullback regardless of whether the market itself advances or declines. I point this out because investors can invite disappointment if they hold the Fund to an unrealistic standard that prohibits consecutive declines for a period of days or weeks. Such a standard is appropriate only for a money market fund.
For investors with an excruciatingly short-term perspective, I should point out that since mid-August, the Fund has declined by 4.42% from its highest peak. This pullback is attributable to two factors. First, the Fund held a constructive position as much as 40% unhedged during much of the market's decline from its August peak, and only recently reestablished a fully hedged position. Our approach always gives the benefit of the doubt to markets exhibiting favorable trend uniformity, but in this case, the market responded with a sorry and frail rebound which quickly failed. It happens. The second factor, as noted above, is the recent pressure on certain retail stocks that remain attractive on the basis of valuation and market action. As I regularly emphasize, we make no attempt to "correct" pullbacks that result from the disciplined application of our investment approach.
A few additional figures (required anytime we discuss performance). For the 12 months ended September 30, the Fund gained 20.28%, compared with a loss of 9.30% in the Russell 2000, and a loss of 20.49% in the S&P 500.
From the Fund's inception on July 24, 2000 through September 30, 2002, the Hussman Strategic Growth Fund has gained 52.03% (21.12% annualized), compared with losses of 27.32% in the Russell 2000, and a loss of 42.64% in the S&P 500. All figures include dividend income.
Again, the Hussman Strategic Growth Fund is, in fact, a growth fund (not a bear fund, not a hedge fund, and for goodness sake, not a money market fund) that has the flexibility to take unhedged, and even aggressive positions during favorable Market Climates. The fact that we have not seen a strongly favorable Climate since July 2000 should not lead shareholders to expect the Fund to maintain a fully hedged position indefinitely. Accordingly, the profile of return and risk in the Fund will vary depending on the Market Climate we identify. Though we will take greater risks in some Climates in anticipation of higher expected returns, these risks will certainly lead to occasional pullbacks significantly larger than the 4.42% dip we've experienced in recent weeks. As always, the best way to understand the Fund is to read the Prospectus. We spent a great deal of time trying to make the Prospectus to each of our Funds useful, interesting and informative to read, not simply boilerplate legal documents.
Moving on to the bond market, the level of yields remains too low to give long-term bonds investment merit, particularly with continued upward pressure on the inflation rate. That said, economic conditions have produced wide risk spreads (the difference between corporate bond yields and default free Treasury yields), weakness in consumer confidence, the Purchasing Managers Index, and a sluggish labor market (as measured by unemployment claims), among other factors. Combining this evidence with overall price and yield trends, the bond market has shifted back to at least modest speculative merit. Unlike the stock market, the bond market is not nearly as susceptible to valuation bubbles, so speculative merit alone is not as positive for bonds as it tends to be for stocks. Still, in addition to very short maturities, we're carrying a very modest position in Treasury bonds at the "hump" of the yield curve, near the 7-year maturity.
Finally, conditions for gold stocks have turned extremely positive, with valuations favorable as measured by the gold/XAU ratio, interest rates falling, inflation rising, and the Purchasing Managers Index below 50 (see our report Going for the Gold for more detail on why these specific criteria are effective). When all of these criteria have been favorable, gold stocks have historically advanced at an annualized rate of over 100%. There is certainly no assurance of what will occur in the current instance, and gold stocks are unusually volatile so positions should never be very large. Still, we hold precious metals shares in both of the Funds, and believe that a modest position is an appropriate diversification for both equity and fixed income investors.
Past performance is no guarantee of future results. The return and principal value of an investment in the Hussman Strategic Growth Fund will fluctuate so that shares, when redeemed, may be worth more or less than their original cost.
| Past performance does not ensure future results, and there is no assurance that the Hussman Funds will achieve their investment objectives. An investor's shares, when redeemed, may be worth more or less than their original cost. Investors should consider the investment objectives, risks, and charges and expenses of the Funds carefully before investing. For this and other information, please obtain a Prospectus and read it carefully. The Hussman Funds have the ability to vary their exposure to market fluctuations depending on overall market conditions, and they may not track movements in the overall stock and bond markets, particularly over the short-term. While the intent of this strategy is long-term capital appreciation, total return, and protection of capital, the investment return and principal value of each Fund may fluctuate or deviate from overall market returns to a greater degree than other funds that do not employ these strategies. For example, if a Fund has taken a defensive posture and the market advances, the return to investors will be lower than if the portfolio had not been defensive. Alternatively, if a Fund has taken an aggressive posture, a market decline will magnify the Fund's investment losses. The Distributor of the Hussman Funds is Ultimus Fund Distributors, LLC., 225 Pictoria Drive, Suite 450, Cincinnati, OH, 45246.
The Hussman Strategic Growth Fund has the ability to hedge market risk by selling short major market indices in an amount up to, but not exceeding, the value of its stock holdings. The Fund also has the ability to leverage the amount of stock it controls to as much as 1 1/2 times the value of net assets, by investing a limited percentage of assets in call options. The Hussman Strategic Total Return Fund has the ability to hedge the interest rate risk of its portfolio in an amount up to, but not exceeding, the value of its fixed income holdings. The Fund also has the ability to increase the interest rate exposure of its portfolio through limited purchases of Treasury zero-coupon securities and STRIPS. The Fund may also invest up to 30% of assets in alternatives to the U.S. fixed income market, including foreign government bonds, utility stocks, and precious metals shares. The Market Climate is not a formula but a method of analysis. The term "Market Climate" and the graphics used to represent it are service marks of the Hussman Funds. The investment manager has sole discretion in the measurement and interpretation of market conditions. Except for articles hosted from the web domains hussman.net or hussmanfunds.com, linked articles do not necessarily reflect the investment position of the Funds. |