October 26, 2003
Theory of Relativity
By John P. Hussman, Ph.D.
The October 27 issue of Barron's includes a profile of your faithful portfolio manager in the Mutual Funds section. Christopher Williams did a good, thorough job of explaining our focus on risk-adjusted return. Unfortunately, an overzealous copy writer sent Christopher's rock-and-roll spin completely out of control, and apparently confused me with Jon Bon Jovi. The headline blurbs identify me as “Rocker” and “Musician” John Hussman… which I can assure you is an insult to rockers and musicians everywhere.
Investing – and often defending – shareholder's capital is a serious responsibility and a profound matter of trust, not just a “trademark riff.” Aside from a few percent in money market funds, all of my own liquid assets are invested in the Hussman Funds.
Anyway, if you can get past the frivolous headlines, it's a well-written article. Christopher Williams asked a lot of great questions and worked carefully to present our approach to readers, and it shows.
New expense ratio: 1.38%
I am pleased to note that the Hussman Strategic Growth Fund has again lowered its expense ratio, to an annual rate of 1.38%. This reduction is the result of economies of scale and the achievement of additional fee breakpoints, which we pass along to shareholders as lower operating costs. Morningstar has just updated their data to 1.45%, which was our expense ratio for the fiscal year ended June 30, 2003. We're happy to put Morningstar's information out-of-date once again by moving to 1.38% (no offense to the company, which provides a great service to investors). As always, the Fund's expense ratio is affected by a number of factors, including total net assets and fee breakpoints, and may increase or decrease over time.
Winning the competition by running in place
When I was a kid, we used to take our Super-8 movie camera and (safely) run in place on the platform at the Mt. Prospect train station, just as the Chicago-Northwestern express trains came speeding by from the southeast. If you caught it just right, you looked like the Road Runner on steroids.
You can do the same thing in the financial markets. Albert Einstein would have understood how to invest in a dangerously overvalued market. It's possible to win a competition by running in place, if everyone else is running backward. Indeed, that's how the Strategic Growth Fund managed much of its returns during the bear market. Our stock selections were reasonably stable, and we removed the impact of market fluctuations by being short an equal dollar amount in the major indices. What mattered was relative performance. As long as our stocks lost less than the market, the Fund's total return was higher than simply holding cash – even if our stocks lost value in absolute terms.
The concept of relativity is important here.
One of my daily actions involves sorting through stocks on the basis of valuation and market action. On any given day, there are generally a few new large or mid-cap candidates to analyze. In addition, there are usually a few fairly small stocks that I consider “low-hanging fruit” – stocks that appear perplexingly undervalued, with reasonably good businesses on further analysis, and yet with no unfavorable market action that might otherwise bring those fundamentals into question. We don't rely on these stocks, because they are usually far too small to take meaningful positions. But we do take small positions from time to time, and they can be useful indicators of broader market conditions.
In recent weeks, I haven't seen any low-hanging fruit at all. Among the larger stocks we own, the values we find are the result of excessive investor concerns about slower growth. Aside from these, there are simply very few stocks that appear undervalued on an “absolute” basis.
In my view, that's a dangerous sign, and one that we've seen before – not only at the market's peak in 2000, but near the peaks of various “bear market rallies” that occurred during 2001 and 2002.
In this week's issue of Barron's, Warren Buffett echoes this observation: “We've got more cash than ideas. The question is whether that will prevail for an unduly long time. But occasionally, successful investing requires inactivity.”
Our approach responds to this situation in a slightly different way. Rather than holding cash, we recognize that there are always stocks that are attractive on a relative basis. We still have a moderate exposure to market fluctuations here. But even if we lose the remnants of favorable market action, and even if we can't find many stocks that are absolutely undervalued, it is enough to hold fairly valued stocks in an overvalued market, and then remove the impact of market fluctuations.
A quick reminder – the intent of these market comments is to provide background and context, both about our investment positions and about the markets as a whole. However, I generally do not report changes in our investment positions as I am making them. If I ever say enough about our investment positions that they could be replicated by others, I've said far too much. So while these comments are intended to inform our shareholders, they should not be construed, or relied upon, as investment advice.
As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and modestly favorable market action. We continue to see additional deterioration in market action, including an increased tendency for trading volume to become dull on advances and active on declines. According to Vickers, corporate insiders are dumping stock at a frantic pace of 5.49 shares sold for every share purchased. Still, market action could stand further deterioration on our measures before we would conclude that investors had abandoned their preference toward market risk. The most dangerous action would be strength in the major indices such as the S&P 500 without similar strength in the broad market. In the meantime, about half of the value of our diversified stock portfolio is hedged against the impact of market risk.
We also have a few “contingent” positions established a couple of weeks ago, to hedge the risks of various outcomes, particularly the risk of an abrupt decline. Since those positions are very small and continuously subject to change, I don't think it's useful to comment on them in detail. Suffice it to say that the market appears increasingly vulnerable to a shift back to an unfavorable Market Climate. Until that Climate actually changes, however, we'll remain positioned to gain primarily from market advances .
In the bond market, the Market Climate as of last week remained characterized by modestly favorable valuations and modestly favorable market action. In the Strategic Total Return Fund, we continue to hold an overall portfolio duration of about 7.5 years, meaning that a 1% (100 basis point) change in interest rates would impact the value of the Fund by approximately 7.5%.
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