Time to Be Cautious

The Daily Reckoning PRESENTS: Dr. John Hussman is one of the great fund managers alive today. His Strategic Growth Fund has averaged a 13.39% annual gain since it was started in July 2000. James Boric explains the key to Dr. Hussman’s success, below…


In today’s era of overhyped profit expectations, a 13% annual return may not turn most novice investors on. But to the seasoned professional, this is an accomplishment worthy of great praise.

Since July 24, 2000, the S&P 500 has averaged a negative 0.75% compounded annual return, the NASDAQ has shed 11% a year and the red-hot Russell 2000 has averaged a 7.32% gain. Hussman beat all of these indexes handily. He also soundly pummeled his peers over the same time frame.

According to Morningstar, Hussman’s Strategic Growth Fund was the best in its category over the last five years. No.1 out of 99 competing funds.

The key to Hussman’s success is threefold. He invests in companies with strong cash flows and attractive valuations. He takes an acceptable amount of risk based on the overall market climate. And he insists on long-term perspective. As he said in his latest annual report (which was just made public this past month):

“The investment objectives of the Hussman Funds are distinctly long-term and ‘full cycle’ in nature, placing very little weight on tracking the market over short periods of time.”

Hussman admits that in the short term, anything can happen. He isn’t out to beat the market in a given quarter, or even an entire year. In fact, his flagship Strategic Growth Fund underperformed the S&P 500 by 50% in 2004. While investors are quick to get up in arms about such a tragedy, Hussman was just fine with the results.

The good doctor judges his performance over a full market cycle – meaning from bull to bear market runs. After all, it is easy to make money in a bull market. Everything rises (a la 2003). But it’s much tougher to survive an ugly bear market and walk away with both your wallet and dignity intact. That’s where Hussman, and his shareholders, thrive.

When valuations are rich, Hussman hedges against the possibility of a falling market. He buys long-dated put options against the major market indexes in combination with buying great businesses on the cheap. As a result of that powerful combination, the biggest drop his fund has ever experienced was a 6.98% fallout during the bear market of 2000-02. \

Meanwhile, the S&P 500 fell as much as 47.41% during that same time. And the Russell 2000 fell as much as 37.94%.

Think back to 2000 for a second. How much money did you lose? Was it less than 7%? Or was it closer to the 47% fallout we saw on the S&P 500?

If you started with $10,000 in July 2000 and put that money with Hussman, you would be sitting on $21,074 today. You would have more than doubled your money. Meanwhile, that same $10,000 invested in the S&P 500 would be worth $9,564. Or said another way, even after four years of rising stock prices, you would still be down from the last bear market.

That, my friends, is the difference between losing only 7% versus 47%. So what does Hussman think about the current market environment?

In his latest annual report, he makes it very clear that the market is not an attractive place to be right now. Despite strong earnings growth and fat profit margins over the last four years, valuations suggest the coming years will be tough — especially in the small-cap sector. Hussman says:

“During the past fiscal year, speculative interest became increasingly concentrated in small stocks with low quality as measured by stability of fundamentals such as earnings and revenues and other financial characteristics. While such companies typically experience very high volatility over the full market cycle, they have become appealing to investors speculating on a continued advance in the small-capitalization sector of the market. As a result, smaller, low-quality stocks may be particularly vulnerable, especially if profit margins contract. I have intentionally avoided such stocks, despite their periodic short-term momentum.”

In fact, Hussman goes on to declare that if you look at price-book, price-dividend and price-revenue ratios, “Valuations are at levels rarely seen in history, except during the late 1990s market bubble.” When such conditions have existed in the past, the average returns have lagged those of low-yielding Treasury bills.

Of course, the mainstream is quick to point out that corporate earnings (for S&P 500 companies) have grown double digits for the past 16 consecutive quarters. And as long as profits continue to grow, we are in no danger of a downturn — no matter what valuations are.

Maybe the mainstream is right. Maybe we should all be bullish about the future. Or maybe not…

The latest Conference Board’s CEO Confidence Survey, a quarterly survey asking corporate leaders whether they are bullish or bearish on the economy, fell to its lowest level since 2000. In other words, despite the incredible profits their companies have been cranking out for the last four years, the men and women running those companies aren’t so sure the future will be as bright:

This chart (created by William Hester — a CFA who works with John Hussman) shows corporate CEOs’ expectations of the economy in the future (in blue) and the change in corporate profits (in red).

Notice that when corporate sentiment is strong and the blue line rises above the 50 line (which separates bullishness from bearishness), corporate profits tend to follow suit. It happened in 1980, 1990 and 2002. Likewise, when executives are worried about the economy and their respective industries, corporate profits tend to plunge in the following years. Again, you can see this play out in 1977, 1987 and 2000.

Now take a close look at the data for 2006. Notice the massive divergence between profits and expectations? Corporate profits are at an all-time high, yet the CEOs running these companies are bearish right now. How is this possible?

It’s possible because profits can’t rise at a double-digit clip forever. And with four years of ridiculous growth behind us, combined with rising interest rates and a falling U.S. dollar, corporate executives aren’t certain they can maintain this bullish trend. They are nervous.

As Hester points out, “Since 1976, when CEO optimism has risen above 55, the subsequent 12-month growth in profits has averaged 12%. When the index was below 45, indicating pessimism, profits grew at just 1.1%.”

What would your portfolio look like if all of your stocks grew only 1.1% for the next 12 months? Would you still want to hold those stocks? Something to think about…

Now, I admit, this is just one survey. It may not be entirely predictive of what’s to come for the entire stock market. But before you dismiss it altogether, check this out…

This is a chart that shows the ratio of insider purchases to sells (in blue) relative to the market’s performance (as measured by the S&P 500, in red).

Notice that insider buying and the market move in opposite directions. As the market plummets and becomes cheap, insiders (the people that run the companies you invest in) buy large positions in their stock. But as the market rises (and becomes expensive), insider buying all but dries up.

It is no coincidence that insider buying is at a six-year low right now — despite corporate profits being at a six-year high and despite the overall market rising to near-2000 highs. Quite simply, the managers running the companies we invest in know this recent earnings trend is not sustainable.

So what are you to make of all this?

As I have been preaching to my readers for months, now is the time to be careful. Now is the time to weed out the speculative stocks in your portfolio that are rising only because of short-term momentum. And now is the time to buy fundamentally sound companies that throw off lots of cash and are cheap relative to their peers.


James Boric
for The Daily Reckoning
September 26, 2006

P.S. As I said in the last issue of Small-Cap Strategy Report, there are hundreds of small-cap stocks worth owning — despite the overall extended market conditions. The key is to stick to your guns and invest in cash-generating, inexpensive and fundamentally sound companies with simple businesses.

I recently recommended a fantastic small-cap stock to my readers. John Hussman owns 1.4 million shares for his Strategic Growth Fund. And it’s no surprise why: The last time it was this cheap it rose 284% in less than two years.

Like spectators gawking at a speeding drunk, we have been watching the housing bubble closely…we’re wondering what he’ll run into.

In this, we are different from most viewers. Most people seem to think he’ll run every red light in town and then just coast to a stop out by the dump. Then, he’ll have a chance to sober up without hurting anyone.

Maybe so. But we doubt it.

This drunk is driving a Hummer a mile wide.

Here’s the hot news:

For the first time in 11 years, no longer is the rate of growth in housing prices merely flattening…now house prices are actually going down!

Here’s the Reuters’ report:

“The pace of existing home sales in the United States fell for a fifth straight month in August and prices dropped from year-ago levels for the first time in more than 10 years, a realtors group said on Monday.

“While the report offered a fresh sign of cooling in the U.S. housing market, the sales drop was not as steep as expected on Wall Street, where economists had looked for the pace to slow to 6.18 million units.

“The report, however, did show prices have begun to drop when compared to the lofty levels of last year. The median price dropped to $225,000, off 1.7 percent from August 2005 and the first annual fall since April 1995.

“In addition, the stock of unsold homes on the market rose 1.5 percent to 3.92 million units. At August’s sales pace that represented a 7.5 months’ supply, the highest since April 1993.”

Tech stocks could go down without doing much damage to the broader economy. You win some; you lose some; that’s just the way it goes. But housing is too important to lose. Too many people count their blessings in housing. Too many people depend on it. Too many people have too much of their wealth tied up in the roofs over their heads. And too much of the nation’s GDP is linked to the bubbly housing market.

While a rising housing market pumped money into the economy…a falling housing market will suck it out. In the last two years, about $1.3 trillion was “taken out” of housing by way of refinancings and equity withdrawals, and shoved into the U.S. economy. But now there is no more equity to take out. And even in a flat market, the Institutional Strategist estimates that the owners of 8 million houses will have their mortgage payments increased by as much as 50% over the next 16 months.

Imagine what happens with prices falling. Suddenly, the equity disappears. Sellers – if they can get a bid – have to put the money back into housing. That is, one way or another, they have to make up the difference between what they borrowed against and what the house is really worth. In many cases, that will mean owners will walk away from their houses – putting more and more properties on the market at distressed prices.

“The home-equity line has supported American consumer spending,” wrote Lon Witter in Barron’s last month, “but at a steep price: Families that tapped into their home equity with creative loans are now in the same trap as those who bought homes they couldn’t afford at the top of the market.”

Buyers have been strapped for cash from the get-go – even in the midst of the biggest bulge of liquidity the world has ever seen. As many as 70% of the people who took out ARMs (adjustable rate mortgages) ended up making the lowest permissible payment.

As the bubble grew, mortgage lenders became more reckless…as if Avis or Hertz were to give young drivers a bottle of whiskey along with the car keys. Loans made with ‘reduced documentation’ – wherein the borrower was allowed to state his own level of compensation, no questions asked – rose to 40% of the entire mortgage pool. Eventually, the Mortgage Asset Research Institute wondered how much lying borrowers were doing. They did a survey and found that 90% of borrowers inflated their income by at least 5%…and nearly 60% of them falsified the figure by more than 50%.

What are credits of that kind worth? Borrowers pretended to earn more than they actually did, so they could buy houses they couldn’t afford…and lenders pretended the credits were good so they could sell them on to hedge funds, which pretended to know what they were doing. Now that prices are going down, we’re about to find out what all that pretense will cost. We don’t know the answer, but we guess it will be more than most people expect.

More news:


Mike Shedlock, reporting for Whiskey & Gunpowder…

“…I proposed copper was about to break down. Technically, that near-perfect symmetrical triangle is a continuation pattern, which in this case would be a bullish formation…”


And more views:

*** Although the gas price has been steadily declining in recent weeks, people are still looking for a fuel-efficient, environmentally friendly option for transportation.

The big automakers are falling over themselves to develop what has been coined “the car of the future”…we’ve got the Toyota Prius…GM is claiming to have “reinvented the automobile” with their Chevy Sequel, a fuel cell powered car…and now Honda reports yesterday that they have developed a new and simple diesel powertrain that is as clean as gasoline-fueled cars.

“Its new diesel drivetrain features a unique method that generates and stores ammonia within a two-layer catalytic converter to turn nitrogen oxide into harmless nitrogen,” reported the Japanese manufacturer.

Although some fine-tuning and technical hurdles remain, Honda hopes to roll out this diesel engine with in three years.

“Just as we paved the way for cleaner gasoline engines, we will take leadership in the progress of diesel engines,” Honda Chief Executive Takeo Fukui told a news conference at the automakers R&D center north of Tokyo.

*** Here is something interesting: for the first time in 90 years, the United States is paying more to foreign creditors than it receives from its overseas investors. The Wall Street Journal says this development may presage a drop in U.S. living standards. More tomorrow…

*** We are grateful to the hedge funds. While the lumpen watch reality TV for laughs, we have the comic unreality of hedge fund industry.

Says the Economist:

“Finance has been convulsed by a computer-enhanced frenzy of creativity. In today’s caffeine-fuelled dealing rooms, a barely regulated private equity group could very well borrow money from syndicates of private lenders, including hedge funds, to spend on taking public companies private. At each step, risks can be converted into securities [like mortgage-backed securities], sliced up…re-packaged, sold on and sliced up again. The endless opportunities to write contracts on underlying debt instruments explains why the outstanding value of credit-derivatives contracts has rocked to $265 trillion – $9 trillion more than six months ago, and seven times as much as in 2003.”

More and more, risk is divorced from consequences. A mortgage company lends money to a guy who misstates his income. When the crunch comes, the guy cannot pay. The house goes into foreclosure. But who loses money? The lender sold the mortgage contract on…where it was sliced and diced in many different ways. Who takes the hit?

It is as if one man got drunk…and another had the hangover.