From my favorite Fund Manager...



January 19, 2004
Spinning Muons

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

Last week physicists at the Brookhaven National Laboratory sent four billion spinning muons down a particle racetrack at nearly the speed of light, in hopes of confirming the existence of new matter. Muons, in case you missed that day in grade school, are tiny spinning particles – heavier cousins of electrons – that emerge from the spray of fragments created by shooting protons at high speed from an Alternating Gradient Synchrotron into a nickel plate.

The elusive new matter is predicted by an unconfirmed theory called supersymmetry. The New York Times offered this report: “According to the theory, every known particle in the universe from the electron to the neutrino has a counterpart that has eluded detection. Seemingly empty space is populated by a kind of fizz of particles that flit into and out of existence. If not for the background fizz of other particles, the frequency with which the muons zip around the track would be the same as their wobble frequency. But a set of 24 detectors found that they were different. The findings seem to agree with the group's earlier examination of positive muons, suggesting to some scientists that the shadow universe of supersymmetry may have been dimly sighted.”

There are a lot of reasons this story is important. From the standpoint of physics, the idea of supersymmetry is really a notion of everything having been created from nothing; taking zero and splitting it apart into one and negative one; and yet that if we were to take everything in the universe and crush it back together, it would all add up to nothing again. From the standpoint of philosophy, there is a Buddhist teaching that everything we call self is composed of non-self elements, just like a sheet of paper is made of the sun and the rain and the earth; that there is no truth to the belief that we are entities separate from others, even from our enemies; that the essence of compassion is to understand that “this is because that is, and this is not because that is not.”

Information is in the divergences

From the standpoint of finance, the best part of the article was a sentence explaining why this experiment was the path to new information. Essentially, the muons seemed to be bumping into that “fizz” of particles, which slightly changed their wobble. The Times wrote “Only through differences between the expected and observed behavior of the muons could the existence of new matter be inferred.”

Long-time readers of these comments should recognize that concept, because it is exactly the approach we use to learn information from the markets. Information is never in the news itself, but rather in the deviation between the actual news and the news that would be expected given the surrounding context. The information is always in the divergences – the surprises – that we see in market action. A market that produces uniformly good performance across a wide range of securities, indices, and industries is a market where investors are comfortable taking risk. A market that produces unusual or subtle breakdowns in its internal action is a market where investors are quietly becoming skittish. As a highly ranked U.S. chess champion recently told me, “when your opponent makes a very peculiar move, there's something wrong.”

Market Climate

Which brings us to the current Market Climate for stocks. There is faintly an end to the criticisms that we could heap on the current status of the stock market: it is steeply overvalued on the measures that we've found most reliable; sentiment is extreme, with just 10.1% of individual investors bearish (AAII) and 18.8% of investment advisors bearish (Investors Intelligence), while corporate insiders are selling stock at nearly the highest rates on record; the CBOE volatility index has plunged to just 15%, exhibiting a sleepy complacency about risk; and the major indices are clearly stretched, with 1027 issues on the NYSE hitting new highs last week and over 90% of industry groups technically overbought. Over the long-term, it is difficult to see how the poor fundamentals of the market and the economy will end well for investors.

Yet despite these conditions, we still do not observe the sort of internal divergences that would lead us to take anything but moderate precautions here. There is currently very little in market action that suggests the sort of investor skittishness that typically emerges prior to or early into major market declines, or that has been associated with a poor return/risk profile for stocks. In the Strategic Growth Fund, we've hedged about 50% of our exposure to market fluctuations, with a small contingent put option position (a fraction of 1% of assets) sufficient to hedge another 25% of the portfolio in the event of a decline of more than 4% or so.

In short, we still don't observe the creeping aversion to risk that would move us to a fully defensive position. The current Market Climate is sufficient to hold us to a moderately hedged position, but we would expect to benefit from further market advances if they occur.

In the bond market, the Market Climate remains characterized by modestly unfavorable valuations and modestly unfavorable market action. The Strategic Total Return Fund continues to maintain an overall portfolio duration of about 2 years (meaning that a 100 basis point move in interest rates would be expected to impact the Fund by about 2% on the basis of bond price fluctuations). As I noted last week, there was some potential for strength in the U.S. dollar, which we in fact observed. That sent gold stock prices down sharply; much more than the metal in fact, and that created a very small opportunity to place a few percent of the Fund's assets into precious metals shares.

Where might the returns come from?

Despite the still-benign Market Climate in stocks, the over-broad consensus that stocks will advance until at least election day is slightly unnerving. We don't take positions based on scenarios, but I would not be at all surprised to see the market clear the current overbought condition with a potentially sharp pullback, but one that is met with fresh speculative interest. Advancing markets seldom shift gears to outright plunges (though we don't rule out the possibility). Instead, they tend to roll over gradually. And it's during that extended period of rolling over – declines met by fresh advances and marginal new highs, followed by declines met by fresh advances and marginal new highs – that cracks often begin to appear in the foundation of market action.

My opinion, which we don't trade on and neither should you, is that we probably won't see the market adhering to the very popular pre-election rally theme. Instead, I wouldn't be surprised to see a wide sideways path in the months ahead, with marginal new highs sufficient to maintain bullish hopes, but not much for buy-and-hold investors to show in the end.

In a wide sideways market, stock selection and convexity (a property of options that allows the capture of returns when market volatility exceeds the volatility implied by the options) would likely be the primary sources of potential return, while market risk would not be worth much at all. Again, we aren't positioned on the basis of scenarios like this, but we would easily welcome this sort of outcome.

In a bond market that is not priced to deliver strong long-term returns, the sources of potential return must be something other than passive holding. This is precisely why we designed Strategic Total Return Fund to allow flexibility in the overall portfolio duration taken by the Fund depending on market conditions, as well the ability to invest limited amounts of Fund assets in alternatives such as Treasury Inflation Protected Securities, precious metals shares, utility stocks, foreign currencies, and foreign government bonds. While there is no assurance that this approach will outperform a passive investment in bonds, it is difficult to see how bond market strategies lacking this flexibility will maneuver through a low yielding environment with very thin credit spreads and an extraordinary overhang of debt. That's probably why at least one famous bond fund manager has liquidated his personal investments the fund he manages … and is certainly why I haven't had any such impulse.