Investment

» Normxxx - ... a contrary indicator

By John P. Hussman, Ph.D. | 6 August 2007
All rights reserved and actively enforced.

"The way to wealth in a bull market is debt. The way to oblivion in a bear market is also debt, and nobody rings a bell. Easy access to credit facilitates the marginal transaction. It enlarges the gross national product, expands the debt industry, and creates the rationale for a future relaxation of lending standards. It hefts up prosperity by its bootstraps and makes it something more than it would otherwise be. It produces stupendous fees and underwriting commissions for investment bankers. Good ideas become bad ideas through a competitive process of "Can you top this?" But when the cycle turns, the process must swing into reverse. Marginal transactions, financed by debt, must be unwound through foreclosure or bankruptcy. Asset values, propped up by debt, must fall, and thereby reduce other asset values in a chain reaction."


-- James Grant ("Michael Milken, Meet Sewell Avery" 1989)

As usual, I have no forecast of what the market will do in the coming weeks. Suffice it to say that both valuations and market internals are unfavorable, which demands a largely hedged position at present, but that short-term conditions are oversold, which invites the potential for a "fast, furious, prone-to-failure" advance to partially correct the recent market weakness. These "clearing rallies" are more vulnerable when they are on lighter trading volume (which we only observe as they unfold), and are typically more exploitable when interest rates and credit spreads are trending lower (which is unfortunately not the case at the moment). Again, we remain largely hedged at present.

As a market decline becomes more severe, the potential "clearing rallies" can be more powerful and extensive. As a refresher, even the brutal 2000-2002 bear market decline included three separate advances in the S&P 500 in excess of 20% from intra-day low to intra-day high (March 2001--May 2001, September 2001--January 2002, and July 2002--August 2002). This is something that investors are apt to forget, because they were brief and ended miserably. Longer-term shareholders will recall that we were occasionally able to exploit those by removing a modest portion of our hedges (though the Fund remained mostly hedged until early 2003). Still, in hindsight we would have done just fine had we completely missed those three separate 20% advances and simply stayed fully hedged throughout that period.

Our hedging strategy is to accept market risk in conditions where the average return/risk profile of the market has been strong historically, and to avoid it in conditions where the average return/risk profile has been unsatisfactory. One need not "catch" overvalued, overbought rallies for fear of missing out forever on long-term returns. Indeed, part of my motivation for presenting various simplistic allocation models in recent weeks (e.g., 'Interest Rate Intuition') was to demonstrate how tolerant long-term returns are to avoiding market risk, even for long periods of time, when valuations are unfavorable, interest rates are rising, or other conditions are hostile. It's certainly true that avoiding market risk for a long period of time will periodically result in missed market advances. The issue is whether those advances are retained over the full cycle.

It's notable that between the point that our measures of market internals turned positive last October to the point where they turned negative last week, a fully invested position in the S&P 500 and Russell 2000 (weighted 75% / 25%, which is about our mix of hedges) would have outperformed Treasury bills by only about 3.5%. That would have been the net additional return we might have achieved by taking a fully unhedged position during this entire period.

Not that there was an ice cube's chance that we would have done so, given other market conditions. Moreover, such a position would have left us fully exposed during both the February-March decline and the recent plunge, until last week. Overbought markets usually need to traverse a lot of downside in order to finally "pull the plug" on trend-sensitive indicators. It's very easy to find methods that would have allowed a greater capture of returns over the past year, and even over the past three years [[as he demonstrated in past letters: normxxx]]. The question is how those methods perform in extensive historical data and complete market cycles, as well as the amount of volatility and drawdown they produce over time.

Overvalued, overbought, overbullish periods have historically left nothing on the table for speculative investors, on average, so I certainly don't believe the attempt to capture returns in such conditions is worth the risk. In any event, my impression is that little of the market's gain over-and-above Treasury bill yields since 2003 will make it through the next bear market, whenever it occurs.

Performance notes

The Strategic Growth Fund set a fresh high on Friday. Including reinvested distributions, the Fund has achieved a total return of over 120% since its inception in July 2000, while the S&P 500 has achieved a total return of less than 11%. The deepest pullback in the Strategic Growth Fund during this period has been -6.98%. The deepest pullback in the S&P 500 during this period has been -47.41%.

Additional performance information:
Performance Chart: Hussman Strategic Growth Fund (HSGFX)

As always, the Fund is intended for long-term investors, and our investment horizon is the complete market cycle. The Fund is expressly not appropriate for investors with a strong desire to track general market fluctuations. Still, I recognize that the investment industry has a strong focus on shorter-term "scoreboards," even when the performance horizons represent bull-market-only periods. On that note, there remains a gap between the Fund and the S&P 500, which would need to close by 8.22% (1.1384/1.2403-1) to put the Fund even with the S&P 500 since 2004, and 12.95% (1.1971/1.3752-1) to put the Fund even with the S&P 500 since 2003. While both the Fund and the market will fluctuate over time, these are the amounts by which the S&P 500 would have to decline, holding the Fund constant, in order to eliminate the performance differential of recent years.

The S&P 500 has now lagged Treasury bills for more than 8.5 years, so I'm not sure that evaluating relative performance only over the rebounding portion of that time span is really appropriate, but in any case, we would not require catastrophic market losses in order to close that gap since 2003.

Strong economic optimism (... is a contrary indicator)

Despite credit concerns, Wall Street remains exuberant about economic prospects. Last week brought a 6-year high in consumer confidence, evidently supporting the idea that the consumer remains strong and the economic expansion remains intact. Unfortunately, if you examine the data, you'll quickly discover that consumer confidence is a lagging indicator, well explained by past movements in GDP, employment, and capacity utilization. Worse, for the stock market, it's a contrary indicator (especially when it is well above the "future expectations" component of the same survey). This is a fact that I've noted at both extremes, not only in early 2000 when new highs in consumer confidence supported a defensive position, but conversely in the early 1990's, when new lows in consumer confidence supported a leveraged position in stocks (prompting that "lonely raging bull" comment in the L.A. Times).

High levels of economic optimism are regularly observed at the peaks of both U.S. and foreign economic expansions. This includes the general consensus of individuals, businesses, politicians, central bank officials and notoriously-- economists. That shouldn't be suprising. It's the very nature of a peak that it can't be produced except by unusual optimism. Here's a phrase you don't hear a lot-- "global recession." It's interesting how immediately and reflexively Wall Street rules it out. A great deal of the world's present stock market capitalization relies on ruling it out for years and years to come.

The uncertainty in the economic outlook is not only that the U.S. economy appears increasingly vulnerable, but also that tensions with China are markedly increasing. Last week, the House Banking Committee-- frustrated with the massive current account deficit and the depressed value of the Chinese yuan-- passed a measure that would provide for countervailing duties on imports from countries that manipulate their currencies. The Senate Finance Committee passed a separate measure. The increasing concerns over the toxicity of imported consumer products-- tootpaste, children's toys, fish, tires, pet food-- are almost certain to lower the political barriers to more stringent trade legislation as well.

Maybe it's just anectodal, but I've increasingly heard the media using the phrase "Communist China" in recent weeks, rather than simply "China." Unfortunately, as a result of accumulated deficits from military spending and irresponsible U.S. fiscal policy, China owns a substantial portion of the float in U.S. Treasury securities. Indeed, nearly all of the growth in U.S. gross domestic investment since 1998 has been financed with foreign capital inflows. Combining these ingredients is a lot like watching a small child play with a chemistry set and a pack of matches-- you don't know exactly what's going to happen, but you can bet you're headed to the emergency room.

Another useful contrary indicator is the mutual fund cash/assets ratio, which just hit a fresh low of 3.5%. Since cash levels tend to fluctuate with Treasury bill yields, Norm Fosback of the Institute for Econometric Research noted that the relationship to subsequent market returns is significantly improved by factoring out the effect of interest rates, which I've done in the chart below. Adjusted for interest rates, mutual fund cash levels are the lowest level, relative to assets, on record. This is another sign of extreme bullishness about the prospects for the stock market and the economy. Unfortunately, such extreme bullishness has historically been well correlated with subsequent weakness.

http://www.hussmanfunds.com/wmc/wmc07080...

Still, I continue to believe that it's too early to form any strong expectation of an oncoming recession. The evidence is certainly increasing, given that credit spreads have now blown wider, and the growth rate of employment is edging closer to the levels that typically indicate imminent recession risk (1% year-over-year or 0.5% over a 6-month period). The ISM Purchasing Managers Index also shifted lower, though still above the 50 level. While readings below 50 on the PMI are not sufficient indicators of recession risk in themselves, their usefulness is substantially magnified when they occur in the context of slow employment growth, a flat yield curve, rising credit spreads and flat or declining stock prices.

My impression is that we will have a much better sense of economic risks by September or October. Meanwhile, it is essential not to carry investment positions that heavily rely on market strength or market weakness. The potential for weakness is evident in the state of normalized valuations, internal market action, widening credit spreads, and other measures. But it's also important to recognize that oversold markets also contain the potential for powerful-- if often short-lived-- clearing rallies.

Finally, while bullish sentiment on Wall Street has been extremely high for months, I doubt that this cycle will end with the same "public" frenzy for stocks as we saw in the late 1990's. The speculation of the public in this cycle has been largely tapped out on real estate-- including heavy mortgage equity withdrawals. While we can't rule out the possiblity that investors will add further to their risk levels, households are already overleveraged with mortgage debt [[see also the longish article by 'Contrary Investor': normxxx]], and have long spent out their mortgage equity withdrawals of recent years. It strikes me that the extremely low mutual fund cash levels, as well as the enormous flows into speculative (and dangerously illiquid) emerging market funds, is evidence that the public is already in to the greatest extent that household balance sheets are likely to allow. Again, we can't rule out more public participation, but given the already high risk levels inherent in the elevated level of household debt to income, I'm not at all convinced that it's a promising strategy to speculate until the pizza guy starts offering stock tips.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action. The Strategic Growth Fund remains fully invested in a broadly diversified portfolio of individual stocks, largely hedged with an offsetting short position in the S&P 500 and Russell 2000 indices. Suffice it to say that little would prevent the market from moving substantially lower, but we are not relying on this, and can allow for the potential for a rebound and even the (somewhat unlikely) possibility that investors will recover their willingness to accept increasing levels of risk. I should emphasize that I am in no hurry to remove a major portion of our hedges. At the margin, however, we'll respond to the evidence as it emerges, and adjust the extent of our hedging based on prevailing market conditions and the average return/risk profiles that they have historically generated.

In bonds, the Market Climate is characterized by unfavorable valuations (yield levels) and unfavorable market action. While we've observed some improvement in interest rate trends, the historical evidence is very strong that yield levels are a more important determinant of bond market returns. That's another way of saying that chasing trends is not very useful in bonds once the level of yields is relatively depressed. There's certainly some potential for a further "flight to safety," but we don't have sufficiently high yields or evidence from other factors to increase our portfolio durations here. The Strategic Total Return Fund continues to carry an average duration of about 2 years, mostly in TIPS, with close to 15% of assets in precious metals shares.

As for Federal Reserve action, Fed officials have already noted that there is no significant evidence at present that the mortgage problems have spilled over to the overall economy, which is Fed-speak for "don't get your hopes up." The Fed Funds futures are clearly indicating market expectations for a rate cut later this year, but I continue to view that as somewhat problematic, given that the headline CPI number will almost undoubtedly be above 4% year-over-year by November (even if inflation figures between now and then only average 2% annually). That fact is likely to create some concerns within the FOMC about its own credibility should it cut rates at that point. As I noted last week, the prospect of a rate cut will be significantly better if measures of "resource utilization"-- primarily employment and capacity use-- fall out of bed.

  M O R E. . .

Normxxx    
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

-- posted by Normxxx

» Normxxx - Hardly a Bailout

By | 12 August 2007
All rights reserved and actively enforced.

The Federal Reserve did exactly what it was supposed to do on Friday.

As I've noted before, under most conditions, the Federal Reserve is irrelevant in the sense that (since the early 1990's when reserve requirements were removed on all but demand deposits [[and thanks to the 'sweeps' policy of banks, effectively even from there: normxxx]]) there is no longer a link between bank reserves and the volume of lending in the banking system. However, the Fed certainly has a role to play during bank runs and other crises where the demand for the monetary base [[real money, not credit: normxxx]] soars.

That's exactly what the Fed did on Friday. Contrary to the apparent belief of investors, the Fed did not shift its policy, nor did it "bail out" the mortgage-backed securities market by "buying" them from banks.

What actually happened is that the Federal Funds rate shot to about 6% on Friday morning, and the FOMC brought it down to its target rate by entering into 3-day repurchase agreements . The banks sold securities [[(repos): normxxx]] to the Fed on Friday, and are obligated to buy them back from the Fed on Monday at the sale price, plus interest. Such open market operations are designed to ease the immediate demand for liquidity, and to give the banks and dealers more time to find buyers in the open market for the securities they are trying to liquidate.

This was not a major policy shift. Again, it was an effort to keep the Federal Funds rate at the current target of 5.25%, in the face of demand for base money that was pushing the Fed Funds rate to 6%.

These repurchase (RP) agreements fall into three increasingly broad "tranches:" 1) Treasury securities, then 2) federal agency debt, and finally 3) mortgage backed securities issued or fully guaranteed by federal agencies. "Today's RPs were of this type," noted The Federal Reserve Bank of New York, which conducts the Fed's open market operations. So the Fed was not taking in the toxic, leveraged, exotic stuff.

Economist Steven Cecchetti concurs, "A quick look at the history of these temporary open market operations shows that they have been taking mortgage-backed securities as collateral for repo for some time. The quantities have normally been small (between $100 mil and $2 bil) but they have been doing it. So this is not what I would call an 'intervention in the mortgage-backed securities market.' And it is not unusual."

Now, the size of the operation ($38 billion) was unusual, as was the scale with which the Fed allowed dealers to submit mortgage-backed securities as collateral, rather than simply Treasury and agency securities. My impression is that in doing so, the Fed had no intent of "bailing out" the mortgage backed market, or of creating a huge "moral hazard" by absorbing losses for the irresponsible behavior of lenders. Rather, the Fed had to allow submission of mortgage-backed securities because that's what the banks actually own, and it's precisely the collateral for which the banks can't find a buyer [[even though this stuff is good-- its just been tarred by the same brush as the 'toxic waste': normxxx]].

Look at Treasury bill yields-- they're dropping sharply again because investors are scrambling for default-free securities as a safe haven. Banks and dealers have no problem selling those puppies on the open market, so there's no reason to enter a Fed repo to do it. But banks have drawers full of the mortgage-backed stuff that they can't get rid of, so the Fed bought them more time by allowing them to post those securities as collateral for 3 days. Most likely, the Fed will have to do it again on Monday, but in any event, these are not securities that are going into the "investments" column of the Fed's balance sheet. They are simply collateral taken for short-term credit extended. The Fed does not assume a risk of loss unless the bank defaults on the repurchase agreement with the Fed (whether the mortgages underlying the collateral go belly up is of secondary importance, because it is relevant only if the bank is already in default, and at that point, believe me, we've got bigger problems).

A few interesting details-- in the midst of Friday morning's panic, banks would have liked to have done more. At the 8:25 AM operation, $31 billion of securities were submitted by the banks for repo, and $19 billion were accepted by the Fed. At 10:55 AM, $41 billion were submitted, and just $16 billion were accepted. But by 1:50 PM, the scramble for funds had eased somewhat-- $11 billion were submitted, and $3 billion were accepted.

Given that about $1.4 trillion of interest-only adjustable-rate mortgages were issued in 2005 and 2006, and hundreds of billions in sub-prime mortgages are already delinquent, a $38 billion repurchase operation by the Fed, where the securities posted as collateral have to be bought back by the banks unless the banks default, is hardly a "rescue operation."

The Fed has an interest in stabilizing the banking system and the real economy. It has no interest in taking the private sector's loss for the irresponsible lending practices of recent years, nor in saving overly aggressive hedge funds from the losses on their leveraged bets. Again, the Fed did exactly what it was supposed to do on Friday. There will inevitably be enormous losses taken as a result of mortgage defaults-- but don't assume it will be the Fed that takes them.

Hedge Funds, Basis Risk, And Dispersion

Given the intensified focus on hedge fund losses in recent days, it's important to understand what causes a "hedge fund blowup," and what distinguishes various approaches.

I used to tell my students at the University of Michigan that there are three factors at work in most financial debacles.

1) Mismatch: The investment position typically involves either a position that relies on a market moving only in one direction, or it involves a combination of long and short positions where there is no natural "offsetting" relationship, or that relationship is purely statistical and susceptible to breaking down under market stress.

2) Leverage: It's hard to really blow yourself up unless you're doing it big, usually with borrowed money.

3) Lack of disclosure and transparency: Generally speaking, blowups are more likely in situations where there is no regular reporting of investment positions, or where very arcane and complex instruments are being used. [[This enables everyone to assume the worst, and really panic.: normxxx]]

A few examples. When Long-Term Capital Management blew up, they had a huge book of long and short positions in international debt securities that were "statistically" related in terms of how they typically behaved. LTCM then took that position and leveraged it up 40-to-1. In other words, for every $1 of capital, they were controlling $40 of securities. Finally, their position (as is typically the case with hedge funds) was a 'black box,' so the hedge fund investors [[and even their creditor banks: normxxx]] were operating completely on the basis of returns information, with little idea of what was driving those returns. Unfortunately, the fine-tuned "correlation matrix" between their long and short positions blew up in a global debt crisis. At 40-to-1 leverage, it only takes a 2.5% movement between your long positions and your short positions to wipe out 100% of your equity.

When Nick Leeson took down Barings Bank of England , he did it by taking a heavily bullish position in Nikkei futures. As his losses grew, he continued to add to his position, and built up massive leverage. But in order to conceal those losses, he disabled the normal reporting channels by which Barings would have been able to oversee his trading. The combination of leverage, mismatch, and lack of transparency allowed one trader to bring down one of the oldest banks in England.

When Robert Citron drove Orange County into the red, he did it by taking a large position in highly leveraged and difficult to understand "inverse floaters." These exotic securities essentially wrapped up the three ingredients for debacle-- mismatch, leverage and lack of transparency-- into a single package. A lot of the more toxic CDO mortgage securities today are of this variety.

In short, when you observe the really big wipeouts, you'll notice that they tend to be in vehicles that take leveraged, mismatched positions and don't provide much disclosure.

A Mixed Bag Of "Long-Short" Strategies

It's notable that in recent weeks, a significant number of funds in Morningstar's "long-short" category [[these are the theoretically 'market neutral,' 'Alpha' funds: normxxx]] have experienced abrupt losses. As Warren Buffett famously said, "it's only when the tide goes out that you learn who's been swimming naked."

Hedged strategies in the mutual fund area differ from standard "hedge funds" primarily because they use less leverage, or none at all, because they have regular disclosure and reporting requirements, because the mutual fund industry is highly regulated, and because hedged mutual funds don't charge 2% plus 20% of profits (though even the mutuals in this category generally sport much higher expense ratios than HSGFX).

Still, various strategies differ in the amount of "mismatch" they can produce, and the amount of leverage they can take (and I don't know any that do quite as much disclosure as I do in these weekly comments).

There are a number of funds that follow a "130/30" strategy, meaning that they are 130% invested in a portfolio of long securities, and simultaneously short 30% in stocks they view as unattractive. While this structure has greater flexibility, it also runs the risk that the short positions may have no "overlap" with the longs, and may be in entirely different industries. Without that overlap, the worst-case risk is the sum of the absolute exposures, in which case a fund might find itself behaving as if it is 60% leveraged. The risk is much more controlled if the long and short positions represent "pairs" in the same industry, for example, being long GM and short Ford. There are also a few "statistical arbitrage" funds can take significant "basis risk" by having long and short positions. A few of these have had tremendous difficulty lately-- I would suspect because there may not be a tight enough overlap of characteristics between the long positions and the short positions.

Of course, what is most relevant to shareholders is how the Strategic Growth Fund is positioned. It's important to note that I wrote controls into the prospectus specifically to limit the ability of the Fund to take leverage or mismatched positions.

While there is no regulatory reason the Fund could not use outright leverage to buy stocks, the prospectus allows leverage only through the use of a small percentage of funds in call options. The reason is that I don't think it's appropriate for a mutual fund to take a position that invests more capital than it has, and relies on the market moving in one direction or another, at the risk of unacceptable losses otherwise. With call options, the most you stand to lose is the premium paid for the option. So while the Fund can allocate a few percent to calls, that few percent is the only potential difference from a fully invested position. There is no potential for a major loss on account of leverage.

Similarly, there is no regulatory reason that the Fund could not take net short positions-- there are certainly "bear funds" that take 100% or even "ultra-bear" 200% short positions in the market. But again, I wrote the restriction against net short positions into the prospectus so that we would not be in a situation of predictably and continuously losing money during unexpected market advances. The Fund does have the ability to stagger its strike prices somewhat, which may produce modest gains on market declines, and give back part of those gains if the market rebounds quickly before we have a good opportunity to reset our strike prices. But the Fund doesn't establish positions where the "notional value" of our long put/short call combinations materially exceeds the value of our long positions.

Second, I generally maintain a significant overlap between our long positions and our hedges. Now, that's not a perfect overlap-- if the Fund was to hold, for example, every stock in the S&P 500 with the same weights as in the index, and was to fully hedge that portfolio with an offsetting position in futures or option combinations, the position would have no risk at all, and (because of the way that futures and options are priced) would earn an interest rate of roughly the 3-month Treasury bill yield. This makes sense-- a risk-free position should earn the risk-free rate.

In our actual investment positions, the Fund holds a diversified portfolio typically of 100 or more individual stocks in a wide range of industries, and hedges the market risk of those stocks with offsetting short positions in the S&P 500 and Russell 2000 indices. Note that we don't take our long positions in one set of industries and our short positions entirely in another-- rather the short positions are in broad indices that contain the same industries and range of capitalizations, if not exactly the same stocks.

Our largest sources of "mismatch" or what is commonly called "basis risk" is in those industries where we have a much different weighting than the major indices. Currently, for example, our largest weighting difference is in financials, where the Fund has virtually no weight, and the S&P 500 has about 25% weight. Meanwhile, the Fund has about 25% more weight than the S&P 500 allocated to consumer, health care, and technology stocks. We also have a more subtle source of basis risk in the fact that we prefer companies with greater stability and lower debt, so there's a "quality" bias in our portfolio here.

All of this means that the Fund will tend to perform best on days when financials and low-quality speculative stocks are weak, while health care, technology and consumer stocks are holding up relatively better. In contrast, the Fund can be expected to experience a pullback on days when financials and low-quality speculative stocks are strong, while health care, technology and consumer stocks are lagging those sectors.

As always, the basis risk that we accept in the Fund is very intentional-- our various weightings in individual stocks and industries is based on specific characteristics of the stocks we hold-- valuations, balance sheet stability, price/volume behavior, sponsorship, earnings expectations, and other factors.

The Fund is currently positioned in a way that I expect to achieve gains regardless of the direction of any sustained market movement. We may achieve higher returns to the extent that our stocks perform better than the indices we use to hedge, and may experience losses to the extent that our stocks significantly underperform those indices. Our long-term experience is that the performance increment of our stocks over the major indices has been quite positive, on average. On smaller market movements, the "staggered strike" position of our current hedge is likely to produce a small positive bias on down days and a small negative bias on up days, but that behavior is "local"-- over time, the cost of the additional protection from higher-strike put options is essentially financed by the implied interest earned on the hedge.

Needless to say, I don't think it's useful to parse day-to-day fluctuations too finely. It's absolutely reasonable to expect my investment decisions to achieve strong total returns in the Fund over the full market cycle, with less downside risk than the S&P 500-- that is my job, and I readily submit to being evaluated on that basis. The most recent full market cycle runs from the peak of the 2000 bull market to the most recent market peak. Of course, we can also measure a market cycle from one bear market trough to the next. Measured from the 2002 lows, it appears that the trough-to-trough market cycle may have completed its bull phase, but as always, there is no need to forecast-- we'll take our evidence as it arrives.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action. While we had lifted a portion of our short calls in the prior week as the market declined into the low 1400's, last week's mid-week market advance was accompanied by tepid market internals. Despite the moderate net gains in the major indices for the week as a whole, declining stocks led advancing stocks. The Fund reestablished a fully hedged stance during Wednesday's market strength, as the conditions we require to identify a more sustained "clearing rally" failed to emerge. As of last week, the Strategic Growth Fund was fully hedged.

Following Wednesday's unusual market action, I posted the following note on the Fund's home page, to help in interpreting that day's returns: "A note regarding HSGFX performance drivers for 8/8/07-- the Fund's 0.25 decline today was attributable to an unusually wide spread between the performance of the stocks held by the Fund and the indices used to hedge. The Fund's stock holdings appreciated by approximately 0.4%, versus a gain of 1.4% in the S&P 500 (led by homebuilders, cyclicals and financials in which the Fund has little exposure), and a gain of 2.7% in the Russell 2000. No individual stock in the Fund was a primary driver. The largest gain in any individual stock holding was approximately $3.5 million, the largest individual loss was-- $2.3 million (each representing about 1-2 cents of NAV). The most unusual features of the day were the dispersion of returns between various groups of stocks and the intense focus of investors on battered sectors."

I noted a few weeks ago that increasing volatility at 5-10 minute intervals tends to be a precursor to significant market weakness. Indeed, a variety of systems, both in the physical world, and in networks, display a "signature" prior to chaotic instability, similar to how tremors precede earthquakes. These signatures are sometimes measured in terms of very arcane features, but in the stock market, you can observe it prior to other historical panics and crashes as a combination of surging trading volume coupled with rising volatility at increasingly short frequencies (so that the time dimension "collapses," and you begin to observe fluctuations in 10-minute, 1-hour and 1-day periods that would normally take several days, weeks, or even months).

It is of some concern that we are seeing this sort of behavior here, but this does not mean that a crash or further panic should be expected. There are certainly some positive factors, or at least factors that investors believe are positive. For example, Treasury yields are falling (albeit because Treasuries are being sought as safe havens), and stocks look cheap to investors who believe in misleading measures like forward operating earnings, and aren't aware that the historical norms they are applying are actually based on trailing net earnings and normal profit margins. While I believe that these perceived "positives" are largely empty arguments in terms of valuation, we have to allow for the fact that enough investors believe them to potentially act on them.

The bottom line is that at present, both valuations and market action remain unfavorable, and the Fund remains fully hedged. Still, if investors develop enough willingness to accept risk to produce an improvement in market internals, I would expect that we will remove some portion of our hedges. Presently, the case goes to the prevailing evidence, not to any speculation about how the evidence might change, so for now, the Strategic Growth Fund remains defensive.

In bonds, valuations deteriorated but market action, at least in Treasuries, improved. China remains a wild card, and there remains some risk that U.S. trade and currency sanctions (such as tariffs, etc) could provoke some liquidation of Treasuries by China as a countering move. In any event, historically, it has been best to focus first on yield levels and second on yield trends and other market action when setting the duration of a bond portfolio. For now, the Strategic Total Return Fund continues to carry a duration of about 2 years, mostly in TIPS, with about 15% of assets in precious metals shares.

Normxxx    
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

-- posted by Normxxx

» Normxxx - Adjusting P/E Ratios for the Profit Cycle

By William Hester, CFA, Hussman Funds | July 2007
All rights reserved and actively enforced.

"In former times analysts and investors paid considerable attention to the average earnings over a fairly long period in the past-- usually from seven to ten years. This average figure was useful for ironing out the frequent ups and downs of the business cycle, and it was thought to give a better idea of the company's earning power than the results of the latest year alone."
-- Ben Graham, The Intelligent Investor.

Even though Ben Graham was writing about the analysis of individual companies, it seems logical that the same process should be applied to an index of companies. Are the index profits earned over the most recent 12 months a true measure of the earnings power of the index? Or are the average earnings-- earned throughout the ups and downs of the business cycle-- a better measure? Arriving at the true measure of earnings power is important, Graham counsels, because that's the figure to use when calculating a proper P/E ratio.

The answers to these questions are more important today than at any time in at least 60 years. That's because the difference between the P/E ratio based on trailing earnings and the P/E ratio based on average earnings is wider than at any time during this period.

There are two other reasons that make the question timely. The first is that this earnings cycle is one of the longest on record. If we count a profit cycle from the point that year-over-year earnings growth turns positive to when it first turns negative, this is the third-longest cycle since 1950. The longest cycle took place during the mid to late 90's, lasting 5 ½ years. A cycle of 4 ¾ years ended in 1981. The current cycle is just 3 months shy of that record.

But that also makes the current cycle more than twice as long as the average cycle of just over 2 years. You can see the extent of this uninterrupted expansion in the chart below which graphs the S&P 500 earnings since 1950.

http://www.hussmanfunds.com/rsi/adjustin...

You can also see the steady rate at which earnings have grown at over the last few years. Following the rebound off the low, the variability in the growth rate has also moderated more recently. This trend has helped investors to forget an important characteristic of year-over-year earnings: they're volatile. Since 1950, year-over-year earnings growth has actually been more volatile than stock returns have been.

It's likely that this volatility will return. While data is available to argue that swings in the economy have become more muted, it's difficult to say the same about earnings. Although the economy experienced one of the mildest recessions on record earlier this decade, S&P 500 profits fell by nearly half.

Second, it's not only the length of this earnings cycle that stands out, but the total growth in earnings from trough to peak. The chart below shows the average growth in earnings during profit cycles lasting at least a year. Per share earnings have grown by a larger amount in this cycle than in any other during the period since 1950. This can be partially explained by the depth of the 2002 profits recession. Much of the gain in profits was a snap-back from that trough. Another part can be attributed to the role that record profit margins are playing in the level of current earnings, fueling faster earnings growth.

http://www.hussmanfunds.com/rsi/adjustin...

[ Normxxx Here:   It sure helps if you can keep labor costs unnaturally(?) low, partly through the globilization of labor. ]

Adjusted P/E Ratios

The length of the current earnings cycle and the extent to which earnings have grown above trend is now creating a major divergence between traditional P/E ratios and those that adjust for the profits cycle. These adjusted P/E ratios have also moved noticeably higher over the last few months, indicating additional risk over what the traditional P/E ratio already implies.

One method of adjusting the P/E ratio is to take the current index price over the 10-year average of earnings per share, a method Robert Shiller made popular. This method smooths out shorter-term variability in earnings, and seems particularly appropriate now. That 10-year average would include the strong earnings growth seen during the late 90's, the profits recession of 2002, and the recent extended rebound. Considering the rapid earnings growth in 1999 and the beginning of 2000, and of the last few years, this is no conservative reading. This method is plotted in the graph below along with the P/E Ratio based on trailing 12-month reported earnings.

http://www.hussmanfunds.com/rsi/adjustin...

The P/E ratio based on average earnings has mostly traded at a higher level than the traditional P/E ratio because 10-year average earnings are usually lower than the most recent level of 12-month earnings. The chart also shows the growing difference between the two ratios, which is now at its largest spread for the period shown.

The P/E ratio using average earnings has been rising steadily throughout the year. As the rate of earnings growth has slowed during the last couple of quarters, and as stock prices have moved higher, the ratio has become more extended. The current multiple is 31.5. Again, since 10-year average earnings are generally lower than trailing 12-month earnings, that P/E of 31.5 shouldn't be compared apples-to-apples with P/E ratios based on one-year trailing earnings. The P/E based on 10-year average earnings should instead be compared with its own history, and on that basis, it is at the highest level since the late 1990's market bubble.

Another way to adjust P/E ratios is to factor in the extent earnings are either above or below their long-term trend. This is one component of a model Steven Leeb has previously written about. Leeb takes the cumulative earnings growth over the previous 5 years and divides it by 50, to scale it more appropriately to the P/E ratio. So if earnings have doubled over the past 5 years, he adds two points to the P/E ratio. The idea is that if earnings have grown quickly in recent years, the elevated earnings make the observed P/E ratio appear more attractive than it really is, since the elevated earnings aren't usually sustained. Adding points to the P/E ratio corrects for that illusion.

Because these adjustments don't compensate enough for the uninformative spikes in the P/E ratio during profit recessions, we'll use Dr. Hussman's P/E ratio based on peak earnings prior to the adjustment. The calculation based on 5-year earnings growth then adjusts the P/E ratio during both the early part of the earnings cycle and its later portion. Points are subtracted from the P/E ratio during profits recessions, to correct for the fact that earnings are depressed relative to their trend, and the observed P/E is probably overstated. Points are added to the P/E ratio when earnings have grown substantially above trend-- since the observed P/E at that point is probably misleadingly low.

http://www.hussmanfunds.com/rsi/adjustin...

The P/E ratio [so] adjusted for 5-year earnings growth is currently 24.5, which is also at its highest level outside of the late 90's bubble. This adjusted P/E takes into account both the duration of this current earnings cycle and its above-trend growth. Both have played a role in the recent spike in the adjusted P/E ratio.

Of course, a model is of little use unless it has predictive power.

[ Normxxx Here:   Or, as Dr. Hussman would put it, unless it reflects the probability of various outcomes going forward. ]

As the chart below shows, this simple model has proved very effective. When the adjusted P/E ratio has been below 10, the total return on the S&P 500 has averaged 18.3% annually over the next five years. In contrast, ratios above 25 have led to negative 5-year returns.

http://www.hussmanfunds.com/rsi/adjustin...

The current profit cycle looks mature by two important standards, its age and its cumulative earnings growth. Both are at or near records. Both are causing important divergences between traditional P/E ratios and P/E ratios adjusted for the earnings cycle. It takes a number of aggressive assumptions to believe that current earnings represent true sustainable earnings, and that P/E multiples based on those earnings should be taken at face value.

The most important of those assumptions is that the profit cycle no longer exists.

  M O R E. . .

Normxxx    
______________
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The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

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