John Hussman: Gradually Expanding Market Exposure, Avoiding Duration Bonds in Favor of TIPS

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Excerpt from the Hussman Funds' Weekly Market Comment (1/26/09):

As of last week, the Market Climate for stocks remained characterized by favorable valuations and unfavorable market action. The appropriate investment policy in this climate is to gradually, and I emphasize gradually, expand market exposure on significant price weakness.

Unfortunately, the failure to address the foreclosure aspect of this financial crisis has revealed itself in a fresh widening in credit default spreads, which suggests that the add-on effects to the economy will be worse than they would otherwise have been. That suggests that we allow for the possibility of 'revulsion' against stocks, at least until we observe market action that suggests better tolerance of risk.

There are numerous stocks that I believe will be seen in hindsight as fantastic bargains a few years from now, and investors are only beginning to separate the wheat from the chaff. Hopefully, we'll observe that process continue even if the general behavior of the market is uncertain. The Strategic Growth Fund is predominantly hedged here, with only a small exposure to market fluctuations, so most of our returns at present are likely to be driven by differences in performance between the stocks we own and the indices we use to hedge (primarily the S&P 500 and Russell 2000).

There will probably be enough ebb-and-flow in the economic data to allow for significant strength in the financial markets at various points this year, but we will respond to economic developments, stock valuations and market action as that evidence unfolds. Meanwhile, it may be helpful to reiterate some comments I made in December (Recognition, Fear and Revulsion):

  • Strong intermittent advances are typical during bear markets, and can often achieve gains of 20% as we've seen in recent weeks, and sometimes substantially more. But the very existence of bear market rallies can be a problem for investors, because they clear the way for fresh weakness. The scariest declines in bear markets are typically the ones when investors think they are making progress and recovering their losses, only to see stocks go into a new free-fall.
  • That cycle of decline, followed by hope, followed by fresh losses, is really what ultimately puts a final low in place. The final decline of a bear market tends to be based on 'revulsion' - a growing impatience among investors who conclude that stocks are simply bad investments, that the economy will continue to languish, and that nothing will work to help it recover. Revulsion is not based so much on fear or panic, but instead on despair and disillusionment. In a very real sense, investors abandon stocks at the end of a bear market because stocks have repeatedly proved themselves to be unreliable and disappointing.
  • My impression is that regardless of near-term prospects, we will observe a tone of 'revulsion' at some point next year, which we should certainly allow for especially during the first half of 2009. At that point, we should not rule out a low that would compete with the November lows and perhaps break them, but we should also expect that the market will be more selective at that point, so there will be many stocks that hold above the lows that have already been set.

In bonds, the Market Climate remains characterized by unusually unfavorable yield levels and moderately favorable yield pressures. We continue to observe compressed yields as a result of an investor flight to safety, but would avoid intermediate- and long-term Treasury bonds because of the potential for brief upward yield spikes that may wipe out weeks (and eventually years) of total return in a very short time span. The Strategic Total Return Fund remains invested primarily in moderate duration Treasury Inflation Protected Securities. There is a wide variance in yields even at similar maturities because of coupon levels and accrued inflation compensation premiums over par value, but these securities continue to be priced for low or negative inflation levels not only over the next few years, but for a decade or more, and will still achieve good real returns if that occurs.

The Fund also continues to hold about 10% of assets in precious metals, about 10% in foreign currencies, and about 5% of assets in utility shares.