January 3, 2011

Setup and Resolution



John P. Hussman, Ph.D.

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Reprint Policy

Happy New Year. I'd like to begin this week's update with some investment comments specific to the Strategic Growth fund, and then move on to conditions that we expect to influence the markets in 2011.

Through mid-September of 2010, the stock market was essentially a roller-coaster with no net gains for the year, but the final months saw a speculative burst that was heavily skewed toward cyclicals, small-caps, commodities, and shares characterized by low stability of earnings and high sensitivity to market risk. The Strategic Growth Fund finished the year with a slight loss of 3.62%. The loss resulted from our defense against an overvalued, overbought, overbullish, rising-yields condition coupled with a runup in risk assets that was still uncorrected as the year came to a close. While the decline was minor from a long-term perspective, it felt excruciating in the final weeks of 2010, as stocks characterized by low-quality, low yield and high risk persistently outperformed those ranked higher in quality, yield and stability. The result was a series of small but relentless day-to-day pullbacks in the Fund, while the major indices registered a series of marginal new highs for the year.

We enter 2011 at a point where investors have pushed risk assets to a speculative extreme, on the belief that the Fed has provided a "backstop" against losses. While there's no assurance that we won't see a further extension of this over the short-term, we've found more often than not that speculative setups in the financial markets are followed by a striking degree of subsequent resolution in the opposite direction.

From a stock selection perspective, our individual stock holdings have outperformed the S&P 500 by such a wide and generally consistent margin over time that we accept these periodic stretches of underperformance as uncomfortable necessities, and continue to adhere to our selection discipline (see the most recent Annual Report for year-by-year results. Full performance information for all of the Funds is available on The Funds page).

Hedging strategy is another matter - we've wrestled with this a great deal in the past two years, and it's important to recognize the source of that difficulty. On that front, our "miss" of the advance since 2009 was not due to any difficulty with our valuation models. There has certainly been destruction of book values, revenues, and private (non-government) GDP that has set expected cash flows on a lower track than we observed prior to the recent crisis, but our valuation models have continued to perform admirably in recent years. Likewise, we're used to feeling some pressure in overvalued, overbought, overbullish, rising-yields environments, as we did in 2000 and 2007, and other points prior to significant downside resolutions. But that pressure is usually temporary, and our defensiveness in the face of these conditions has been very beneficial over time.

Examining the past two years, our main challenge has been uncertainty about whether or not the recent downturn should be treated as a standard post-war economic cycle. Data and historical outcomes from other post-credit crisis periods in the U.S. and internationally demanded much more stringent criteria for risk-taking than we observed in 2009. Restricting our analysis to existing post-war data would have encouraged greater exposure to market fluctuations during much of 2009 and the early portion of 2010. Our performance since about April would not have been altered much, because the evidence since then has been unfavorable even on the basis of post-war experience. But then, the S&P 500 is currently only about 3% higher than it was at its April peak. So the real source of difficulty was the 2009 and early 2010 period. If not for that "miss," the past few months would probably feel more like the normal pullback that I believe it is.

It's certainly arguable whether considering other post-credit crisis data was the right thing to do, given the available information. I still believe that existing post-war data was not representative of what we were observing in 2008-2009, and that significant problems were papered-over instead of resolved. But in hindsight, I was wrong to expect investors to share that assessment. The aversion of investors to risk has vanished, so every concern about risk has been unrewarding. Thanks to a tripling of the Fed's balance sheet, a suspension of fair-market disclosure by major financial companies, and an ongoing Federal deficit of more than 10% of GDP, the economy appears to be slowly recovering, and investors care little about the dangers of the policies that produced that outcome. Though my concerns about other major risks have generally been well placed, to this point, risk aversion has been a mistake.

Still, there is a right way and a wrong way to deal with uncertainty about the "true" state of the world. The wrong way is to ignore the uncertainty altogether, and to assume that only one possibility is correct. The right way, from my perspective, is to estimate the uncertainty as explicitly as possible, and to increase the range of investment positions that can be taken in response to various market conditions. To that end, we've introduced some new methods that broaden the range of Market Climates we define, and will allow us to accept moderate (possibly transitory) exposures to market fluctuations more frequently. The main focus of this research been on robust methods to integrate the information from multiple data sets and multiple time frames. We've extensively tested this approach to uncertainty, and expect that it will contribute to future performance.

The basic approach falls into the class of what are called "ensemble methods." Our investment positions continue to be driven by our most reliable measures of valuation, market action, sentiment, yield pressures and other variables, but rather than applying a single model over the full span of history, we can proliferate multiple models and evaluate them over numerous samples of history. In that way, we can measure not only risk (the spread between individual returns and the average outcome), but also uncertainty (the possibility that any particular model or view about the world is incorrect). Suppose we look at present market conditions. The more uniform the conclusions are about expected returns, regardless of how we slice the data, the more confidence we can have about investment exposure. In contrast, the wider the dispersion of conclusions about expected returns, the greater uncertainty there is, and the smaller the proportional exposure. In an environment where we remain skeptical that the underlying economic difficulties have vanished, I believe that this is our best response.

Our investment objective remains to outperform our benchmarks over complete market cycles (peak-to-peak, trough-to-trough, bull market plus bear market), with smaller periodic losses than a buy-and-hold strategy. In the Strategic Growth Fund, we've achieved that since inception, and over the complete market cycles we've observed since then - from the 2000 peak to the 2007 peak, from the 2002 trough to the 2009 trough, and from the 2007 peak to the recent highs. The challenge will be the cycle from the 2009 low to the next bear market low, whenever it arrives, but we'll rise to that challenge day to day.

The other aspect of my job is unquestionably to achieve positive absolute returns, and I owe you more in that regard. This has been an extraordinary period, and while I anticipated the recent crisis, I did not anticipate the way it was at least temporarily resolved (largely by Fed actions that are illegal in context of the Federal Reserve Act, coupled with changes to accounting rules that obscured truthful disclosure). While we remain alert to economic and financial risks, I believe that we have tools that will allow us to manage the uncertainties better if they re-emerge.

So we're certainly not standing still, but with even the postwar evidence strongly against speculation here, we're not chasing risk assets either. That may result in some further pressure for us, but again, we're used to that occasionally. It's useful to remember that a typical bear market wipes out more than half of the preceding bull market gain, so though it rarely looks like it when the market is at fresh highs, risk management is very forgiving over the full market cycle.

Even with our strong long-term performance, I know I've probably given shareholders in Strategic Growth a case of "What have you done for me lately?" I owe you stronger absolute returns, and I'm confident that we'll achieve that. As noted below, I expect that this objective will be assisted by the unusual skew of valuations in favor of high quality stocks (stable revenues, earnings, profit margins, and balance sheets) and against speculative ones. In the meantime, my hope is that these comments provide clarity about the investment positions we are taking, and why.

Setup and Resolution

One of the striking features of the market here is the extent to which large-cap, high-quality has underperformed speculative sectors of the market, creating what we view as a multi-year "setup" in favor of high quality issues.

A few weeks ago, I noted the wide dispersion between staples and cyclicals, which is evident within the S&P 500 itself. Extremes in the relative valuation of these sectors have typically been followed by strong subsequent reversion in the opposite direction favoring the depressed sector. Moreover, even if we take the whole S&P 500 as relatively "high quality," we can observe yet higher levels of speculation in small-cap indices such as the Russell 2000, and high-beta indices such as the Nasdaq. The ratio of the S&P 500 to these more speculative indices has fallen to multi-year lows.

It's important for investors to realize that historically, such instances have typically been followed by poor relative performance in speculative stocks over the next several years, and corresponding outperformance of more stable issues.

In the chart below, the blue line is the ratio of the S&P 500 to the Nasdaq composite (left scale), while the red line is the annual return of the Nasdaq composite in excess of the S&P 500 over the following 4-year period.

Let's walk through this chart. Notice that the 1982 market low was particularly severe for the S&P 500, pushing the S&P index to about half the level of the Nasdaq (blue line). While the markets advanced strongly over the following 4 years, the Nasdaq underperformed the S&P 500 by about 7% annually (red line). By the 1990 market lows, the Nasdaq had lagged for several years, setting up a period of extraordinary outperformance. The red "actual" performance line spikes in 2006, reflecting the tech bubble over the following 4 years, ending in 2000. By 2000, the ratio of the S&P 500 to the Nasdaq had plunged to the lowest level in history, putting the S&P 500 index at just a fraction of the Nasdaq index. This was the "setup." While both indices plunged during the subsequent bear market, the Nasdaq lagged the S&P 500 by nearly 15% annually over the 2000-2004 period - a fairly predictable "resolution."

Over the past four years, the Nasdaq has performed much more strongly than one would have expected (red line), resulting in a depressed S&P 500 / Nasdaq ratio. Given the relative standing of these indices, one would presently expect the Nasdaq to lag the S&P 500 over the coming 4-year period by close to 5% annually. Needless to say, if one divides the S&P 500 itself into high and low quality sectors, the expected performance gap is even wider.

The chart below presents the same analysis for the Russell 2000. Here, note that in 1995, the red "actual" performance shows that small cap stocks substantially lagged the performance that would otherwise have been expected over the next 4 years. This set up a huge dispersion in 1999, where the S&P 500 (despite underperforming the Nasdaq), was vastly elevated relative to the Russell 2000. This dispersion between the S&P 500 versus the Russell 2000 was followed over the next 4 years by stellar small-cap performance on a relative basis.

Presently, we see just the opposite. On the basis of the relative standing between indices, one would expect small cap stocks to underperform the S&P 500 by roughly 8% annually over the coming 4-year period. On this expectation, we're in pleasant company with Jeremy Grantham at GMO, who also expects large-cap, high quality to strongly outperform small-cap and low quality over the next several years.

The setup here has largely been fueled by Fed policy, and may very well be extended somewhat further. But as I noted above, we've noted more often than not that speculative setups in the financial markets tend to be followed by a striking degree of resolution in the opposite direction.

Market Climate

As of last week, the stock market remained characterized by an overvalued, overbought, overbullish, rising-yields condition that has historically produced poor average market returns, and consistently so across historical time frames. However, this condition is also associated with what I've called "unpleasant skew" - the most probable market movement is actually a small advance to marginal new highs, but the right tail is truncated and the left tail is fat, meaning that there is a lower than normal likelihood of large gains, and a much larger than normal potential for sharp and abrupt market losses. The Strategic Growth Fund and Strategic International Equity Fund are both fully hedged here. Strategic Growth also has a "staggered strike" position where our put option strikes are set a few percent below current market levels to better defend against the often indiscriminate selling that sometimes emerges from this set of conditions.

In bonds, the Market Climate remained characterized last week by relatively neutral yield levels but unfavorable yield pressures. The Strategic Total Return Fund presently carries a duration of less than 2 years. While our overall investment position tends to shift several times a year, the Fund is presently in flat position, largely in short-term Treasury instruments, with negligible exposure to precious metals, utilities and foreign currencies. Overall, our evaluation of the bond market conditions is modestly negative, and our evaluation of conditions in precious metals is neutral - not hostile, but no longer positive.

The upshot is that there is little historical basis at present to expect positive returns as compensation for accepting risk in stocks, bonds, or precious metals. This will change, possibly soon, but the result of the recent speculative run is that risk premiums have been compressed to levels that have historically been inadequate to compensate for risk. We will reestablish exposure to each of these markets as their expected return per unit of risk improves on the combined basis of valuations, market action, yield pressures, economic data, sentiment, and other factors.

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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 ).





