John Hussman: Holiday Update

Excerpt from the Hussman Funds' Weekly Market Comment (12/29/08):

To the extent that investors may have lightened up on risk near the lows, a further rally could serve to make investors concerned that they “missed the bottom,” which I still believe could fuel a short-squeeze given the relatively light volume conditions at present. Still, we don't trade on that sort of expectation. Rather, we are aligned with the positive but moderate expected return/risk profile suggested by current valuations and market action.

It's difficult to give a “percent hedged” figure here, since our “delta” changes considerably as the market moves, given that the Strategic Growth Fund is essentially fully hedged with at-the-money and slightly in-the-money puts. As usual, we regularly shift our strike prices and expirations in order to reduce the impact of time decay wherever possible, so we certainly aren't just holding a static hedge. On a major decline, the puts would go gradually in-the-money so the Fund would look increasingly as if it were 70-80% hedged. On a major advance, the puts would go gradually out-of-the money so the Fund would look as if it were 70-80% unhedged. Locally, our delta looks about 40-50% here, but again, that will change as the market fluctuates. We don't have any strong views on whether or not we will recruit enough favorable market action to remove some of our put defenses altogether. I expect that if a strong advance fails to recruit very good internals and expanding trading volume, it would prompt us to tighten our hedges considerably to defend against a fresh market decline. So our willingness to accept market risk here will depend a lot on the quality of market action we observe. For now, we're comfortable with a moderate exposure to market fluctuations.

As of last week, the Market Climate for stocks was characterized by favorable valuations, moderately unfavorable market action on the basis of broad internals, but continued improvement in “early” measures of market action. In bonds, the Market Climate was characterized by extremely unfavorable yield levels and moderately favorable yield trends, however, the depressed level of yields holds sway since bond yields at this point are vulnerable to very sharp reversals. Given the level of extension in yields, it would not be difficult for the bond market to generate losses of say 10% in the 10-year Treasury bond, and as much as 20-25% in the 30-year Treasury bond over a very short period of time. Straight Treasuries may have safety from default risk, but the price risk is becoming downright dangerous. Corporate yields are much more reasonable, but there will be more fallout in this sector, and as I've noted before, taking a significant position in corporate would be essentially like a “bottom call” in stocks, since corporate bonds tend to trade much like stocks during periods of elevated default risk.

Comments

[Richard H. ...:]

Professor Hussman,

I had you for an MBA international finance class at the University of Michigan in 1996. For the readers, Professor Hussman is an outstanding teacher, and very passionate about teaching.

I have a question, if I may ask, about your April 30, 2007 article, Double Counting. You wrote:

<blockquote><... first problem is that in order to produce 2% real annual growth in earnings per share, companies have historically devoted about 50% or more of their earnings to reinvestment and repurchases - over 300 basis points of that earnings yield to get 200 basis points of real growth. That's a tip-off that historically, competitive pressures have prevented earnings from simply growing at the rate of inflation without new investment. You had to invest new money to get your earnings growth up to the inflation rate.</i></bl...

So the issue is essentially, will just paying depreciation be enough to keep the firm's assets producing the same real income? Certainly the firm's competition moves ahead, and so the firm's capital must too. If you never modernize your computers, software, and other machines, your competitors will steal your business.

But the issue I have here is, while your competitors move ahead, so do your suppliers. Competitive advances appear to be symmetric within the system of corporations. More concretely, depreciation is enough to pay for more than replacement of the company's worn assets, it's enough to pay for improvement of those assets. The old PC cost $2,000, and so did the new one three years later, but the new one was 4 times as fast.

Of course your empirical claim, "that in order to produce 2% real annual growth in earnings per share, companies have historically devoted about 50% or more of their earnings to reinvestment and repurchases - over 300 basis points of that earnings yield to get 200 basis points of real growth.", supports the view that accounting earnings are understating "true firmwide depreciation costs", but the years you measure the data over matter. Jeremy Siegel, using a data series going back to 1802, you quoted in your article as saying, "In the US, the long-term average p/e ratio has been 14.4 times, which corresponds to a 6.9 per cent earnings yield. This is extremely close to the historical average real return on equities." So, he found a good fit in his long empirical data between the standard earnings yield and real returns, indicating that depreciation is enough to both replace capital and improve it enough to keep up with the competition.

What do you think about the counter that depreciation is enough to pay for not just replacement, but improvement of capital, and it therefore may be enough on average to keep competitors from eating away the firm's current profit level? Also, I would be very grateful for any article recommendations to learn more about this, PhD level and non. I'm ABD in finance.

2008 Dec 31 09:31 PM

[adan:]

interesting read, as usual, thanks!

if you could do a follow up re long rates danger etc, that'd be great

it seems the writes i respect re rates seem split between deflation keeping rates down, and fiscal irresponsibility forcing rates up

maybe a little of one first, then the other?

thanks again

Jan 04 11:26 AM