An Absence of Moderates

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

An absence of moderates is often the prelude to seismic events. This is true enough in a geopolitical context to cause concern here. It is equally true of financial markets.

Most investors are familiar with the Investor's Intelligence figures on advisory bullishness and bearishness. Two weeks ago, I noted the influence of past market movements on these figures, noting that bullishness was unusually extreme relative to the level that could be expected on the basis of prior market action.

Importantly, the Investor's Intelligence survey includes not only bullish and bearish percentages, but also a group of moderates, called the "correction" camp - regardless of whether such corrections are expected in the upward or downward direction. While the bullish and bearish figures get a lot of attention from analysts, that "correction" figure is virtually ignored.

Moderation is more important than investors think. One of the things we know about earnings estimates is that the wider the range of estimates, the greater the subsequent volatility of stock prices. The same is true of sentiment. Specifically, when there is an absence of moderates - generally less than 20% of advisors in the "correction" camp, stock prices have historically been about 30% more volatile than when there has been equanimity among advisors.

Indeed, a lack of moderation among investor opinions seems to have been an important ingredient in numerous major market reversals. The direction of those reversals depended mainly on two factors - the level of valuations, and whether bulls dominated bears or vice versa.

Specifically, if we look over history for points when the S&P 500 price/peak earnings multiple was 18 or higher, short-term interest rates were rising, the percentage of advisory bulls exceeded the percentage of bears, and the percentage in the correction camp was 20% or less, we only find three instances: December 1972 (just before the devastating '73-'74 grizzly), August 1987 (the market's peak just prior to the October crash), and today.

The reverse extreme - a very low price/peak earnings multiple of 8 or lower, falling short-term rates, more bears than bulls, and again less than 20% in the correction camp - accompanied both great secular buying opportunities of the past generation: September 1974, and July 1982, as well as numerous other good investment opportunities. If the valuation criteria is relaxed to allow any valuation below the historical median, the list also includes the 1990 bear market low, which was the last undervalued bear market low seen by the S&P 500 in recent history.

As usual, these remarks should not be taken as forecasts of future market direction. Still, valuations are already sufficiently high, economic conditions sufficiently tenuous, and market action showing enough early divergence to warrant a reduced exposure to market fluctuations. We're still effectively constructive in the Strategic Growth Fund, but with time premium very inexpensive here, we are willing to hedge "directionally."

Our constructive position owes mainly to the fact that have not matched our long put options with offsetting short positions in call options (when we are hedged, the numbers are matched, producing what is in effect an interest-bearing short sale on major indices to offset the impact of market fluctuations on the stock portfolio held by the Fund). Suffice it to say that I expect that we'll participate in further market advances should they emerge, but that we allow for the potential for very negative market developments.

As for my personal opinion , which I don't speculate on and neither should you, I suspect that the market is forming what will eventually turn out to be the high of the corrective bull market that started in March 2003. Bear markets generally begin about a half-year before recessions do, and in the economic figures, we would still require more deterioration (primarily a decline in the ISM Purchasing Mangers Index below 50) before anticipating substantial economic trouble. From that perspective, even the potential for a peak here doesn't preclude the possibility that the market will make another attempt at marginal new highs a few months from now. Against that hope, the geopolitical situation threatens to deteriorate within a matter of weeks, on the basis of escalation in Falluja, as well as destabilization from a post-Arafat Palestine. That instability could accelerate negative economic developments.

Again, I don't trade on this sort of opinion, but it would be consistent with what we're seeing in valuations and market action. For now, overall conditions are constructive enough to maintain a moderate exposure to market fluctuations here, but given the Fund's put option exposure, a substantial market decline would automatically take us to a fully-hedged position.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and modestly favorable market action. As noted above, the Strategic Growth Fund is directionally hedged. At present, that means that the full value of the Fund's stock portfolio is hedged against the potential of substantial market losses with put options, but only part of that position is matched with short call options, leaving the Fund with continued exposure to market fluctuations, particularly in the event of a further extension of the current (reasonably overbought) market advance. So the Fund remains well hedged, but for now, we retain a modest constructive bias overall.

In bonds, the Market Climate remains characterized by unfavorable valuations and modestly favorable market action. We added slightly to our exposure in Treasury Inflation Protected Securities on last week's weakness, though the overall portfolio duration in the Strategic Total Return Fund remains less than 2.5 years (meaning that a 100 basis point change in interest rates would be expected to impact the Fund by less than 2.5% on the basis of bond price fluctuations). The Market Climate for precious metals continues to be favorable, though sufficiently overbought over the short-term that we clipped a small percentage off of our precious metals holdings to take some profits, placing the Fund's precious metals exposure at about 15% of assets.

Performance update

With the S&P 500 Index achieving a new high for 2004 on Friday, it's a good time to review the relative performance of the Strategic Growth Fund. As I've frequently noted, the most appropriate way to measure earnings growth, investment returns, and other financial variables is to examine peak-to-peak changes, preferably across market cycles, but at least using peaks separated by a year or more.

When investors evaluate their investment performance over a period representing a trough-to-peak move in the market, those comparisons will always favor high beta, high volatility strategies (often enticing inexperienced investors into these investments near bull market highs). In contrast, peak-to-trough comparisons always favor short-selling strategies with negative betas (often encouraging investors to go short at market lows). Using unrepresentative performance comparisons like this can repeatedly lead to unfortunate investment decisions.

Given the new 2004 peak, we can make a fresh and minimally long-term peak-to-peak analysis. On the basis of total returns, the 2002 peak in the S&P 500 occurred on March 19, 2002. From that point through Friday's 2004 peak, the S&P 500 has achieved an overall total return of 4.28% (1.60% annualized), with a deep intervening peak-to-trough drawdown of fully -33.00%. By comparison, from March 19, 2002 through last Friday, the Strategic Growth Fund has achieved an overall total return of 33.57% (11.61% annualized), with its deepest peak-to-trough drawdown being a relatively shallow -6.98%. On the basis of straight calendar periods, annualized total returns of the Strategic Growth Fund for periods ended 10/31/04 have been: one-year 5.41%, three-year 13.60%, since inception (July 24, 2000) 15.81%.

The Fund's investment strategy and objectives emphasize long-term growth (e.g. over complete market cycles) and risk-adjusted performance, with added emphasis on defending capital against substantial losses during unfavorable market conditions. Despite modest year-to-date returns, I strongly believe that the Fund has served those objectives well. Still, for short-term investors who might otherwise invest in the Fund, please do not imagine that the Fund's objective is to outperform the market over brief horizons. I assure you that I will periodically disappoint those expectations without remorse.

Tax math

The Strategic Growth Fund generally pays its required capital gains distribution during November, which I expect to represent a few percent of the Fund's net asset value. The net asset value of the Fund, of course, declines by the amount of the distribution on the ex-day (thus reducing later capital gains liability). Since part of the gain will be long-term in nature and the distribution is expected to be less than the one-year appreciation in the Fund, investors trading the Fund to avoid the distribution would generally increase their tax liability, though we would still reserve the right to prevent new investments from such investors even if this were not the case, in the interests of our long-term shareholders. As a general matter of course, I made my regular monthly investment in HSGFX early last week in a taxable account.

Geeks note: the true "tax cost" of taking a distribution versus avoiding it is equal to (Ts - dTp)SD + (Tg - dTp)LD - (Tc - dTp)UG where Ts is the tax rate on short-term gains; Tg is the tax rate on long-term gains; Tc is the tax rate that would apply to the investor in the event of a current redemption; Tp is the short or long term rate depending on the holding period actually planned by the investor; dTp denotes the discounted value of tax rate Tp, for example, on a 10-year planned holding period at a 10% discount rate, the present value impact of future taxes is only about 39% of the future tax rate, so if Tp is 15%, dTp would be about 5.8%; SD is the short-term distribution; LD is the long-term distribution; and UG is the unrealized capital gain on the holding prior to the distribution date, which is zero for new investments. If you work through the math, you'll find that when a distribution is partly long-term in nature, the true tax cost of taking the distribution is negative for short-term holders, meaning that short-term investors actually have an incentive to buy the Fund in order to capture the distribution, while long-term holders have no incentive to avoid a distribution if they have more than minimal unrealized gains, and even potential long-term investors have little incentive to defer investment unless the anticipated return over the deferral period is small.

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The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

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

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