The Hussman Report

"No Margin of Safety, No Room for Error"

"Over the past 10 years, the S&P 500 has achieved a total return, including dividends, averaging -0.03% annually. Over the past 13 years, the total return for the S&P 500 has averaged just 3.23%. Why have stocks performed so poorly? One word. Valuation. If investors take nothing else from these commentaries, there are two primary lessons that should be clear. First, the poor market returns that investors have achieved for more than a decade were entirely predictable during the late 1990's, based on the historical relationship between valuations and subsequent returns. Second, from current valuations, the similarly poor returns that investors are likely to achieve over the coming 5-7 year period are also predictable based on the same evidence."

I remain concerned about the likelihood of a second economic downturn, and find little in the recent economic evidence (including last week's employment report and the negligible shift in the ECRI Weekly Leading Index to -7%) to reverse that view. That said, we do not rule out the potential for an improvement in economic tone, and will respond to that evidence if and when it emerges.

More importantly, however, investors should recognize that the presence or absence of immediate economic pressures does nothing to change the likelihood that stocks, from their current valuations, will achieve negligible returns in the coming 5-7 years. To understand this, investors need to ground themselves in exactly how reliable valuations - based on smooth, low-variability fundamentals - have been in explaining subsequent market returns throughout history.


...Economic notes

Citing "imminent funding pressures" in the global banking system, the IMF released a report last week suggesting the potential for a fresh round of bank stress. The primary focus of concern was the European banking system, due to "relatively greater pressure in European banking systems from both sovereign risks and wholesale funding strains," but the IMF indicated that U.S. banks may also need to raise additional capital "to reverse recent deleveraging trends, and possibly to comply with U.S. regulatory reforms." The IMF warned that "Conditions in the global financial system now have the potential of jumping from benign to crisis mode very rapidly."

It will come as no surprise that we agree, but at least for now, investors evidently could not care less. Had investors been correct in ignoring the ultimately disastrous risks of the dot-com bubble, the tech bubble, the housing bubble, and the overleveraging of U.S. financial institutions that preceded the recent credit crisis, we would concede that the market's wisdom on these issues should take precedence over our own concerns. But in our view, those disasters were predictable. Likewise, as noted above, the persistent willingness of investors to misprice stocks is exactly why they have gone nowhere for over a decade. We'd love to be bulls, scampering happily about. But that would be helped if stocks were priced appropriately and if there was not a large anvil suspended on a fraying string overhead.

...Market Climate

As of last week, the Market Climate in stocks was characterized by strenuous overvaluation, overbought, overbullish conditions, and unfavorable economic pressures. This is a combination that has historically been associated with poor returns, on average. As always, our interest is on the average return/risk tradeoff associated with the conditions we observe. For now, we remain defensive. In the Strategic Growth Fund, we remain fully hedged, with a "staggered strike" position where we have raised our put option strikes closer to market levels to defend as strongly as possible against potential market losses. In the Strategic International Equity Fund, the majority of our stock holdings are also hedged with a combination of global indices that are well-correlated with our holdings, including the Dow Jones EuroStoxx Index, the FTSE 100 and the S&P 500. To the extent that we use international stock indices to hedge, those indices hedge both the equity risk and the currency fluctuations. Meanwhile, using the S&P 500 as a hedge covers broad equity risk while leaving some of our currency exposure unhedged, which is intentional.

Last week was a bit uncomfortable for Strategic Growth, as the "risk trade" on hopes about quantitative easing strongly favored aggressive stocks over conservative ones, so our holdings did not participate well in the advance. This happens from time to time. We just stick to our stock selection discipline, which has served us well over the years.

While the S&P 500 has essentially gone nowhere since early January, the present overvalued, overbought and overbullish conditions, coupled with still negative economic pressures, suggests the potential for a familiar pattern of market behavior that I refer to as "unpleasant skew." The short-term tendency in such conditions tends toward small advances to repeated marginal new highs, often followed abruptly by a steep "air pocket" that wipes out weeks or months of progress in the span of a few days. During the interim, however, it's typical for 2-3 day pullbacks to to be followed by spike advances that do little but recover the lost ground, but that make the advance appear relentless. The average of numerous modest gains and a smaller number of steep losses may be negative, and yet, from a frequency perspective, there can be more up-days than down-days. Suffice it to say that we view the prospective return/risk profile of the market here as poor, but that assessment is based on average behavior.

In bonds, the Market Climate last week was characterized by moderately unfavorable yield levels and favorable yield pressures. The Strategic Total Return Fund continues to carry a duration of slightly over 4 years. On significant strength in precious metals and foreign currencies (neatly following the "exchange rate overshooting" argument that I discussed a couple of months ago), we did clip our holdings back, now with about 6% of assets in precious metals shares, about 2% of assets in foreign currencies, and about 2% in utility shares. My impression is not that the weakness in the dollar has fully run its course, but quantitative easing was elevated last week to a near certainty in the minds of investors. My impression is that it is not as certain as investors appear to believe, nor would it have the straightforward benefits that investors seem to assume. More on that next week. For our part, last week's strength was a good enough opportunity to take a bird in the hand on part of our holdings.

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