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February 6, 2006

Flying Wallendas

John P. Hussman, Ph.D.
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“ When I was seven years old, my grandfather, Karl Wallenda, put me on a wire two feet off the ground. He taught me all the elementary skills: how to hold my body so that I remained stiff and rigid; how to place my feet on the wire with my big toe on the wire and my heel to the inside; how to hold the pole with my elbows close to my body. But the most important thing that my grandfather taught me was that I needed to focus my attention on a point at the other end of the wire. I need a point to concentrate on to keep me balanced.”

- Tino Wallenda (He Found Me)

One of the most difficult requirements of long-term investing is to keep an eye on a reliable “fixed point.” It's fairly easy to get caught up in the day-to-day earnings news and political developments, in a way that makes investors ignore reliable benchmarks of value and probable long-term returns. I've noted before that while valuations have relatively little to do with short-term investment returns, they are a very strong and reliable determinant of long-term returns. So valuations are that “fixed point” at the other end of the wire. Now, you can't ignore the short-term pressures that sway the wire one way or the other, but you'll lose balance if you focus only on those. In the end, the objective is to take account of both the “fixed point” – valuations – and the short-term sway of the wire – market action – and then align each step in a way that's consistent with the condition of those factors at each moment.

It is a mark of this concern with the “fixed point” of valuations that the Strategic Growth Fund is well-hedged here. Valuations are untenably high from a long-term standpoint. Suppose that price/peak earnings multiple remained at current levels forever, that we also observe further earnings growth along the very top of the 6% long-term trend that connects S&P 500 earnings peaks from economic cycle to cycle across history (earnings have now recovered right to that trendline) and that dividends continue to grow with earnings (resulting in a constant 1.85% dividend yield, provided that P/E multiples are also constant). In that event, the S&P 500 would provide a long-term total return of 7.85% indefinitely. Any contraction in the currently elevated level of valuations is likely to result in substantially lower returns between now and some future point where valuations establish a trough.

So to a large degree, we already know that stock market risk is likely to be poorly rewarded over a period of several years – a period that starts today and ends at some point where stocks establish lower valuations. That description might seem unsatisfactory, since we don't know where that endpoint is, and it's unlikely that we'll be able to identify the precise bottom of valuations. Regardless, it will almost certainly be possible to gradually increase our exposure to market risk as valuations normalize. That's really all a long-term investor needs – to take greater amounts of risk when the likely return/risk profile of the market is relatively strong, and to limit risk taking when the likely return/risk profile is poor. Though I think that the quality of market action is a useful additional consideration, even the simple approach of basing risk exposure on prevailing valuations is enough (well, simple in concept, but excruciatingly difficult in practice). That's essentially what Warren Buffett has done over his professional lifetime, and it's why he has carried large cash positions in recent years.

One might argue that, fine, valuations are rich and long-term returns will suffer, but market action looks OK, and it doesn't seem like we're going into a recession yet, so why not take some extra risk here and get out when the dangers start to become more obvious?

The answer is that stocks tend to decline abruptly and steeply in the days and weeks before clear recession indications emerge. The other short-term consideration is that when stocks are richly valued, increases in risk taking are best taken after declines or the development of oversold conditions. Presently, market action is mixed, with breadth (advances versus declines) and leadership (new highs versus new lows) appearing reasonably good. But we've also got a rich level of valuations, where inflation pressures persist, wage pressures are emerging, profit margins are unusually wide, the yield curve is flat, and investors are unusually bullish. With that combination of factors, the case for accepting short-term market risk is more tenuous.

The issue again comes down to being a Flying Wallenda. If we were on a trapeze, would we be wise to let go of one in order to fly through the air and catch the trapeze on the other side of the tent? The answer depends on how easy the other trapeze is to catch. Once we let go of this trapeze, we'd better have confidence that we can reliably catch the other one and get back to safety before falling to the ground below. You don't have such concerns when you're two feet off the ground, but when you're swinging at high elevations, your ability to catch the other trapeze is something you've got to take seriously.

In short, if we accept market risk by closing down our hedges, it's not enough for the market to advance from here. Given the strong likelihood for disappointing returns over a more extended period of time, we've got to have reasonable confidence that we'll be able to close out our market risk out at even higher levels before conditions deteriorate. In my view, that's a very tall order. Last week, with the ISM figures below expectations but the prices-paid figures above, the employment figures below expectations but the wage inflation figures above, the productivity figures below expectations but the Fed Funds trajectory (as indicated by futures prices) above, and so on, I took the Strategic Growth Fund back to a 95% hedged stance. We've still got a slight amount of uncovered risk, and could very well trade between a full hedge and a 70-80% hedge depending on the quality and character of market action, but overall, the Fund is defensive at present.

In bonds, the Market Climate remained characterized by unfavorable valuations and unfavorable market action. Though I do believe that economic growth is likely to be disappointing in the coming quarters, we still don't observe enough pressure on credit spreads (the difference in yields between corporate yields and default-free Treasuries) to indicate imminent recession risk. More importantly, I continue to believe that bond yields will continue to be pressured by further inflation stemming from the rapid increase in government liabilities that we've observed in recent years (not to mention higher velocity resulting from recent increases in short-term interest rates). For that reason, the Strategic Total Return Fund continues to carry a relatively muted 2.3 year duration, mostly in Treasury Inflation Protected Securities, with a modest precious metals position of less than 10% of assets.

As I've noted before, the most likely development that would argue for an increased duration in the Total Return Fund would be an abrupt widening of credit spreads. That sort of widening would not only indicate recession risks, but importantly, it would also signal reasonably high credit risks. Since credit defaults are almost synonymous with falling monetary velocity, inflation risks would ease substantially (essentially, people stuff money under their mattresses when they're concerned about bankruptcies, and this allows the government to create more of the stuff without inflationary consequences). Suffice it to say that I'm monitoring credit spreads closely here, because they are among the primary factors that would argue for a portfolio shift toward longer bond durations.

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