Hussman: Very little of my work is concerned with trying to identify "bull markets" and "bear markets" in real time, since those aren’t operational concepts – you can’t know which one you’re in except in hindsight. Instead, I try to focus on market conditions that can be defined and identified objectively. That said, on a longer term basis, I would view stocks as having entered a secular bear market back in 2000 in the sense that you could reasonably expect a series of market cycles that would gradually take stock prices back to more normal levels of valuation over an extended period of time. When you look historically at how valuations revert to normal, you usually don’t get it in just one small cycle. You usually see successive bear market lows spaced several years apart where valuations gradually normalize toward the norms, and typically well below them. I’m not convinced that we have to end up at a price to peak earnings multiple of 7 or something like we saw in 1974 or 1982, but I think it’s perfectly reasonable to anticipate that at some time, within five to 10 years, we would at least touch the average of about 14 times peak earnings. Unfortunately, even if you make that pedestrian assumption that the market just touches the historical average multiple even five or 10 years out, the annualized return on stocks between this point and that would be close to zero. You’ve got a situation where stocks are certainly not priced to deliver a long-term return of much consequence in terms of durable long-term returns. The durable portion of returns that you get over history comes from points where the market is either undervalued or reasonably valued and you are able to capture the bulk of earnings growth without giving it up in P/E multiple contraction. The parts of the cycle where multiples are very stretched give you situations where earnings continue to grow but multiple contraction takes all of that away, or enough of that away, that you end up with low single-digit returns. I think, in terms of valuations, that is where we’re at right now.

Valuations, by themselves, only say something about long-term returns. Short-term returns are much more dependent on the willingness of investors to accept risk, which is reflected in the quality of market action, or the lack of it. The issue really is, even if stocks hold up over the short-term, how much of what we get from here is likely to be durable. I think the answer is very little to none. Controlling risk doesn’t have a lot of potential costs in terms of missed long-term returns. It does have some potential costs in terms of missed short-term returns. For an investor who is interested in full cycle, long-term and certainly risk-adjusted returns, I don’t think there’s much cost at all to having a reasonably defensive position even here.

Hussman: There are a number of things. Certainly, there is a general cycle of investor psychology – I don’t mean cycle in terms of things that have specific durations - but in general, you have periods of optimism and pessimism, of risk-seeking and of risk-aversion. Some of that gets correlated with the economic cycle. Some of it gets correlated with various themes that emerge from time to time. When you get to the point where risk premiums are very thin - and you look at corporate yields versus Treasury yields, you already see that - then you have a situation where a lot of favorable expectations are already built in. So small shortfalls from perfection become catalysts for greater risk-aversion and you get stocks changing hands from stronger holders to weaker holders. I think we’re seeing that here. I think there are enough people who are cognizant that stocks are richly valued that, over the past several months, we’ve started seeing patterns of distribution toward smaller investors and investors who really don’t have much of a value orientation. You see that in the small-caps and mid-caps which are pushing new highs here. That kind of pattern doesn’t last, and you often see initial signs of trouble as a gradual deterioration of market internals – breadth, leadership, industry group, risk spreads and so forth. Of course, actual events can trigger multiple contraction too. Interest rates rise so that competing returns look better, you get disappointments in earnings, and events like that. Part of it is just the normal cycle of optimism and pessimism.

Hussman: If you look at a typical earnings cycle, especially one that includes a recession, what you find is that earnings collapse predictably during recessions. That induces a very uninformative spike in price earnings multiples. In fact, the highest price earnings multiples tend to be recession multiples where the actual valuation of stocks can often be very good, but because earnings are so depressed, a raw price earnings ratio wouldn’t provide you that information. A good example of that is 1992, when you had the price earnings multiple on a raw basis surging to the high 20s and 30s because earnings were still depressed, but on a reasonably normalized basis, stocks were actually fairly attractive. If we look at S&P earnings, one of the things that we find very strongly throughout history is that on a peak-to-peak basis across economic cycles, S&P earnings just haven’t grown faster than 6% annually. Those collapses in earnings that we see during recessions tend to be short-lived, especially for an index where you have a broad range of companies. You can’t have that same amount of confidence for an individual stock. But for an index like the S&P, you can pretty much infer that a level of earnings once attained is going to probably be attainable again, and you probably get something along the lines of 6% growth from market cycle peaks to market cycle peaks over time. On that basis, you ask, well, what is the highest level of earnings that we’ve obtained to-date, and calculate the price earnings ratio off that. What you get from that is a price earnings ratio that’s much better behaved, because it doesn’t include these uninformative swings in earnings, and you also have more predictability in the denominator. The analytical machinery that you have with that is much more useful because you’ve stripped away a lot of the noise components.

If you think of the total capital gain that you are going to get on stocks over time as being the combination of earnings growth and multiple changes, then having cleaner measures of both the fundamental and the multiple is going to significantly improve your understanding of what’s going on. We know that peak earnings only grow at 6%, so the price-to-peak earnings multiple is much more amenable to simple closed form calculations of what the likely long-term return on stocks will be. Those calculations are also reasonably accurate. If you look at my February 22^nd weekly market commentary at hussmanfunds.com, there are some charts that address not only the earnings record and the price to peak multiple, but put those together in terms of the 10-year return one could project at any given point, given a range of potential future price-earnings multiples. That analysis does a reasonably good job of containing the entire history of stock price movement, with one notable exception being the run-up to the 2000 peak, but then, that was given back and here we are with the S&P still lower than it was six years ago.

Hussman: The most active content is the weekly market commentaries I write. Occasionally they are written simply to update shareholders on what I’m looking at, various changes I’ve made in the funds and why. Often there are longer pieces that involve deeper economic analysis, whether it’s regarding trade deficits and current account issues, clarifying the link between imports and this so-called productivity miracle, breaking down GDP growth, giving some context to the latest employment figures, or analyzing monetary policy. So part is ongoing market commentary and analysis of what’s going on, and part is a way to continue my teaching career without standing in front of a class. There’s a good amount of economic content. I have former students who still come and study some of that stuff.

Hussman: I think he’s right. The dollar is an interesting beast, though. If you look at a currency both as an asset and as a means of payment, you can ask the question, "Is the dollar reasonably valued in terms of both price levels and interest rates?" If you are familiar with the way currencies are modeled, from a long-term perspective, one expects that currency movements will reasonably reflect relative inflation rates in tradable goods across countries. This is something that’s called purchasing power parity. It doesn’t hold very well at all over the short term and is certainly not useful as a trading tool in and of itself, because you also have interest rate differentials. The idea is basically this: suppose two countries have the same level of inflation - the simplest thing is to temporarily assume that both levels of inflation are zero, then you don’t have to worry about trends and the long-term currency exchange rate. If one country has, for instance, 7% interest rates, and another country has 4% interest rates, one would expect that, once you’ve corrected for any long-term currency trend that might be inherent in different inflation rates, the country with 7% interest rates would draw capital better than the 4% country. What would happen is that the country’s currency would appreciate to the point where it was, in some sense, overvalued relative to the long-term purchasing power parity value, by something along the lines of 3% annually over whatever period you would expect those interest rate differentials to persist. For instance, if you expected one country to have interest rates 3% higher than the other country for somewhere around 10 years, then that country’s currency would be about 30% over what you might expect from looking at price levels alone. If you look at the currency markets, that’s essentially how currencies are priced. They’re not just priced to reflect this long-term purchasing power parity situation, where over the long-term goods prices and currency exchange rates have a relationship to each other. They’re also priced to reflect differentials in real interest rates between countries, so countries with higher real interest rates end up having stronger currencies than price levels alone would suggest.

The reason I’m bringing all that up is, if you look at the U.S. dollar, on the basis of simply prices and interest rates, it looks about fairly valued against most currencies, with the notable exception being the yen. The U.S. dollar looks about reasonably valued relative to the Euro, the Canadian dollar, the British pound and a number of other currencies. From that standpoint, you might not expect a huge amount of dollar weakness. The dollar has rallied some lately and in fact you have a little more potential there on the basis of valuation alone.

I think the bigger issue for the dollar is what’s coming across in terms of financial imbalances. We have this monster current account deficit, and that is really the way that the U.S. economy is financing its current level of domestic investment. Normally, you don’t get investment booms from deep current account deficits. Historically, every major expansion in the U.S. economy has started with a current account surplus. What you get to do then is have an investment boom that relies on not only growth and domestic savings, but also huge imports of foreign savings, so by the time you get to the peak of an economic cycle, that’s the only time you’re running a big current account deficit. The fact that we’re running a big current account deficit right now suggests that we probably don’t have a lot of upside available for U.S. gross domestic investment. We might get some increase in capital spending by having a little bit less housing investment and so forth. However, you’ve got this situation where you have this mammoth current account deficit which has the likelihood of putting pressure on the dollar above and beyond what you would expect simply from price and interest rate relationships. I even think it’s reasonable to envision a situation where we could have price and interest rate fundamentals changing in a way that justifies a lower dollar. The main way we could get that would be to experience higher levels of inflation without nominal interest rates keeping up. In other words, a move to negative real interest rates. I think we have more potential for that than people are necessarily aware of. We could get exactly that sort of behavior from continued commodity price inflation, combined with a weakening economy. So I don’t rule out the possibility that we could get dollar weakness being justified by real interest rate differentials going negative here at home. But I don’t think you need that argument. The massive deficit that we have on current account is itself enough to induce at least a modest further depreciation of the U.S. dollar, somewhere around 10% or 15%. I think to go beyond that, you’re going to have to see though some combination of higher inflation without nominal interest rates keeping pace. That would normally require a softer U.S. economy or a recession, which I wouldn’t rule out either, although we’re not quite at that point yet.

Hussman: Sure. The Strategic Growth Fund actually has two components, as you know. The fund is always close to fully invested in a diversified portfolio of individual stocks, but I will hedge the market risk of those stocks from time to time depending on market conditions. One of the things I’m not sure shareholders realize is how much stock selection has been a benefit for the fund since inception. Since the fund started in 2000 through late-March of this year, the stock selection of the fund alone has contributed about 58 percentage points to its overall return. To give you some basis for comparison, the Russell 2000 gained only 27% over that time and the S&P 500 has earned zero total return since the fund’s inception. So part of the fund’s performance has resulted from consistently strong stock selection. Even last year our stocks outperformed the S&P 500. The second component is that I hedge the market risk of the stocks we hold from time to time, depending on the level of valuations and the condition of market internals. That hedging has contributed further returns for the fund since inception and is also responsible for really muting our volatility. We haven’t experienced any decline of over 7% since the fund started, from peak to trough, while the fund’s annualized return has been close to 16% annually. The real objective is to achieve strong long-term total returns, and long-term risk-adjusted returns without taking deep drawdowns. Of course, the standard considerations apply – past performance doesn’t ensure future returns, and there’s no guarantee of achieving our objectives, and the fund does take risk. Specifically, one of the risks I try to emphasize for shareholders is that the fund won’t necessarily track the market over the short-term. Certainly, in the post-election rally last year, because the fund was a little over 50% hedged, we only captured about half of the return that, say, a buy and hold strategy did during those weeks. We ended up last year a few percentage points behind the S&P. That kind of event is something that I hope I’m fairly clear about, not only in the prospectus but also in the annual reports and weekly comments. I really don’t have any intention of tracking short-term movements, especially in the richly valued portion of a bull market where market internals are starting to convey evidence of distribution. I think that’s where we’re at right now.

Currently, we’ve got about 70% of the fund’s exposure hedged with matching long-put short-call positions, which is another way of saying, interest-bearing short sales on the Russell and the S&P 100. The remaining 30% of our stock exposure is hedged with put options only. One of the reasons why I’m doing that is, number one, volatility is very low in the options market, so we have a lot of ability to offset the modest time decay of those put options by even a small amount of gamma scalping. Gamma scalping basically involves raising your strike prices up after rallies, and lowering them after declines, and so you take advantage of the curvature inherent in the options. When the market rallies, you lose less because the delta of the put option declines, and if the market declines through your strike price, you gain an accelerating rate because the delta of your option is getting larger. Gamma scalping mitigates the some of the time decay from hedging with put options, and the puts provide a little more certainty as far as not having to worry about the impact of an abrupt decline from these levels of valuation. I hope I’m fairly clear in the weekly comments that I am not under any illusion at all that current stock valuations are appropriate. I very strongly think that investors will be badly served by accumulating a lot of stock market risk at these levels. We very well could get a little bit further upside, but I think whatever upside that we get here is likely to be transitory and I’m not confident enough about my or anybody else’s ability to perfectly time a shift in market conditions that we can necessarily capture upside and get out at a higher level than we’re at right now. I’m content to have the fund right now be driven mainly by any tendency that our stocks have to outperform the indices. Since the inception of the fund, that’s been a pretty strong tendency and it has contributed a significant amount to the total return of the fund.

Hussman: The Strategic Total Return Fund is essentially a Treasury fund at its core, but it also has the ability to invest about 30% of its assets in alternatives to the bond market. There are two main things that drive the return of that fund. One is the ability to vary the duration of the fund. In that way, it is similar to the Strategic Growth Fund in that on an historical basis, you can identify various climates in the fixed income markets on the dimensions of the level of yields and various elements of market action, including trends in yields, inflation, risk premiums and so forth. Clearly, the best returns in the bond market generally emerge when yields are relatively high. Relatively means not simply looking at nominal yields, but also looking at yields in relation to inflation rates, the growth rate of the economy, looking at yields in terms of the yield curve relationships. There are a number of factors that go into an assessment that yields are relatively high. The other thing that goes into a favorable climate for bonds is market action that’s generally pressing downward on yields, so, disinflation, downward trends in yields themselves, and even widening credit spreads are very good for the bond market because they signal recession risk. Normally, if you see Treasury yields going down without corporate yields going down as quickly, or even with corporate yields rising, that’s a good sign for Treasuries, because it suggests economic risks that often play themselves out.

Right now, we’ve got upward pressures on inflation, thin risk spreads, sustained Fed tightening, a certain amount of economic growth that’s still proceeding, and we’ve got a fairly flat yield curve, so you’re not getting much yield premium for taking duration risk. That’s a set of conditions where bond market risk has generally not been very well compensated and that’s why we have a relatively limited duration for the fund. The fund takes a long-term total return view, accepting more duration risk during conditions where bond market risk has historically been well compensated, limiting duration risk in conditions where bond market risk hasn’t been well compensated.

As with the Strategic Growth Fund, the basic idea is fairly simple. If you want to achieve a high Sharpe Ratio, as it were, over the full cycle, it makes sense to take greater amounts of risk in conditions that have historically generated high Sharpe Ratios and to take much more limited amounts of risk during conditions that have historically generated poor Sharpe Ratios. In short, both funds are intended to achieve a high, exposure-weighted, average Sharpe Ratio over the full market cycle. In conditions that are very favorable or if the expected Sharpe Ratio for taking market risk is very high, that’s where we, in the Strategic Growth Fund, would look to use fully invested positions or even leverage through these call options. It’s where the Strategic Total Return Fund would generally establish higher durations, longer maturities, and lower coupons. The second part to the Strategic Total Return Fund is the ability to invest in alternative assets. We can use a variety of assets that also have their own profiles of return to risk. I mentioned, for instance, currencies. Clearly the best condition for the U.S. dollar is where not only the dollar would be viewed as undervalued on a fundamental basis, but also where you have a tendency for U.S. real interest rates to be rising. For instance, you could have disinflation going on without a lot of economic softness, so nominal interest rates might remain strong. A good situation for foreign currencies is the reverse, where you have foreign currencies nicely undervalued and you have a situation where U.S. real interest rates are being pressed lower. We’ve seen that since 2000. There’s a piece on our web site, hussmanfunds.com, called "Valuing Foreign Currencies" that’s somewhere in the lower part of the Research and Insight page. I originally wrote that article at a point where the Euro was at about $0.84 versus the dollar and talked about the probability of the Euro being more appropriately valued at about $1.15. It has since gone beyond that, partially because of inflation and interest rates have improved the fundamentals for the Euro, and partially because the Euro has become much more fully valued. The Strategic Total Return Fund focuses mostly on the Treasury market, but can also allocate a limited amount of capital in a few other areas that are related to income and/or and related to the preservation of purchasing power - foreign currencies, precious metals, real estate investment trusts (REITs), convertible bonds and so forth. That gives us a number of imperfectly correlated asset classes where we can look for good risk-adjusted returns. We can take greater amounts of risk in certain areas when conditions advise it and then mute our exposure when appropriate in other asset classes. Our potential position in all of those alternatives is only about 30% of assets. So the Total Return Fund acts primarily as a Treasury fund, but we also have the ability to use these alternative assets even in conditions where the bond market risks just aren’t that attractive. That ability to invest a certain amount in precious metals and utility stocks, for example, is part of the reason the fund has achieved strong returns relative to the Lehman Aggregate Bond Index.

Hussman: My pleasure. I’ve enjoyed talking with you.