John Hussman: Profiting from the Tooth Fairy

Excerpt from the Hussman Funds' Weekly Market Comment (8/3/09):

Although the stock market's advance since March is taken as evidence that the economy is on the mend, the extent of that advance represents just over one-third of the prior bear market loss, which is somewhat standard (if not reliable or predictable) for bear market rallies. Interestingly, the advance since March has almost exactly matched the size and duration of the rally that followed the initial market plunge in 1929, just before the stocks and the economy suffered fresh deterioration.

That's not to say that we are assuming that stocks are still in a bear market. Nor do we assume that they are in a bull market. I don't think we can rule out a further advance, nor should we rule out a fresh loss from these levels of over 40%, extending well into next year, before this adjustment is durably behind us. We aren't investing on either as an expectation. As I've noted before, the bull/bear distinction is not a useful concept except in hindsight. The prevailing status is not observable in real time, so we rely instead on variables that are continuously measurable, focusing on full-cycle performance, and accepting that hindsight will only sometimes be kind to our assessment, and will sometimes be utterly cruel.

The recent rally never recruited the sort of price-volume sponsorship that has usually occurred very early on in prior bull markets, and we have been defensive in recent months (other than a periodic but helpful allocation to index call options). The evolution of the market's advance to recover a full one-third of the market's prior losses has been frustrating given that position.

...

That said, we can't ignore the potential for investors to continue to speculate for a while, despite tepid price-volume sponsorship and deep-rooted economic challenges. The Strategic Growth Fund has just under 1% of assets in index call options as something of an “anti-hedge” to soften our position and make it somewhat more constructive in the event of a further advance. We don't intend to stand in front of a train, if investors are intent on playing a recovery theme, but the way we would participate in that case would be to let the market “take us out” of our hedge by advancing further and allowing our index call options to go “in the money” (at the risk of losing those gains if the market subsequently sells off). In any event, we don't have evidence that would provoke us to remove our downside protection against significant losses, so at present, our “constructive” exposure amounts to just under 1% of assets allocated to index calls, and a fully hedged investment stance otherwise.

Comments

[Robert Mart...:]

Kudos on using index call options as a hedge. That is the best strategy for a market like this, which is rallying on liquidity without fundamental support.

Aug 04 10:32 AM

[Larry House:]

Sound advice. We are in no-man's land right now. A case can be made for higher or lower. Hedging makes sense.

Aug 04 10:39 AM

[Robert Mart...:]

Larry,

I can see a fundamental case for lower (no organic demand, rising inflation, weak dollar). The only case I see for higher is pure momentum, based on Fed liquidity.

Is this what you mean when you say that you can see it both ways?
Thanks,
Rob


On Aug 04 10:39 AM Larry House wrote:

> Sound advice. We are in no-man's land right now. A case can be made
> for higher or lower. Hedging makes sense.

Aug 04 11:00 AM

[CautiousInv...:]

I'm of the mind that the recent rally reflects (1) unabated efforts between the Fed and its various agents to support the market, (2) that we have stepped away from the precipice of finanacial Armageddon and (3) a belief that there will be V shaped reovery and a corresponding rebound in corporate profits.

Once belief in the latter (3) is shattered, it will be increasingly diffcult to make a case for today's valuations and the markets will drift down to more realistic valuations and trade within a channel that better reflects long-term prospects for earnings. If, in fact, we do face a new normal and interest rates increase, things could get ugly very quickly.

Aug 04 11:23 AM

[John Galt:]

Dr. Hussman,

Do you believe in the Austrian Theory of the Credit Bubble? That Government set price and quantity of money distorted producers & consumers view of the market and created the boom ( and following bust) as similar what happened to USA 1929 and Japan more recently?

I believe that in general the Austrians believe in " A W shapred" recovery, a "new normal", slow growth and a mess even when things are "better", while more of the Keynsians and Neo Moneterists are more bullish on the future.

It seems like most people either talk like "investors" or "economists". I'd be curious to hear your thoughts. You strike me more of a fan of Von Mises.

$

Aug 04 11:24 AM

[Zmartmoney:]

Great WSJ story - "Teeing Up The Middle Class." Obama will be seen in retrospect as the man who lied his way into the White House, in a way that only a Chicago lawyer could. And, the goons of the country who didn't pay attention in Civics class put him there, with the hope that all their troubles would go away and world peace would break out in adoration of their saviour. Brother... Our short rally in celebration of not going over the cliff is just about over.

Aug 04 11:34 AM

[Thomas J. G...:]

The highest places in hell are reserved for those with no opinion in time of moral crisis. As far as I'm concerned this article has no opinion.

Aug 04 12:00 PM

[Swashbuckler:]

Show me someone who is convinced they know where the market is going short term, an I'll show you an idiot. (GS and JPM traders excepted). So, unless you have an excellent relationship with your sister, and she's sleeping with one of the HFT traders at Goldman, it is unknowable where the market goes over the next few months. And if you are a trader and trade these "hijacked" markets, I've got some rough news for you. If you get in a pi$$ing match with Goldman Sachs, you're going to come in second.

Aug 04 01:55 PM

[jse17:]

Your next 7.5 years will be long, painful, and futile. Empty, mindless rhetoric appeals currently to only 21% of the population!


On Aug 04 11:34 AM Zmartmoney wrote:

> Great WSJ story - "Teeing Up The Middle Class." Obama will be seen
> in retrospect as the man who lied his way into the White House, in
> a way that only a Chicago lawyer could. And, the goons of the country
> who didn't pay attention in Civics class put him there, with the
> hope that all their troubles would go away and world peace would
> break out in adoration of their saviour. Brother... Our short rally
> in celebration of not going over the cliff is just about over.

Aug 05 04:27 PM