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February 28, 2005

Brief Market Climate Update

John P. Hussman, Ph.D.
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With a holiday-shortened week, there was little change in the Market Climates for stocks or bonds last week. Since last week included a large amount of important content (Semi-Annual Report, February 22nd Comment regarding probable long-term market returns), I'll hold this week's commentary to a brief update.

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and still modestly favorable market action. The kind of behavior we've seen from the market lately is both preferable and typical. Even as the major indices show resilience, market internals are gradually deteriorating. Breadth has flattened out, bond market action has deteriorated in recent sessions, and we're seeing more divergent action across industry groups. As I've frequently noted, market internals tend to deteriorate well before trouble is evident in the major indices. This sort of behavior is preferable, because to the extent that we may have to re-establish a full hedge in the coming weeks or months, it's always best to do so on market strength rather than obvious weakness.

Of course, there's absolutely no assurance that the next shift in the Market Climate won't take place during an abrupt market decline. We already have a sufficient combination of overvaluation and deteriorated market action to warrant put option coverage even on the portion of the Strategic Growth Fund that is not fully hedged. Having covered that risk, though, we remain willing to accept the impact of smaller market fluctuations on the portfolio.

Suffice it to say that about two-thirds of the stock holdings in the Strategic Growth Fund are hedged with offsetting short positions (matched long put/short call combinations) in the S&P 100 and Russell 2000 indices. The remaining exposure is hedged with put options only, which continues to give the Fund a modest but constructive investment posture. So I would expect the Fund to benefit from further advances in the market.

Looking at the larger picture, my sense is that stocks continue to go nowhere in an interesting way, with the major indices making very little peak-to-peak progress, despite the excitement of day-to-day fluctuations. With valuations still very elevated, its important to keep that big picture in mind.

In bonds, the Market Climate remained characterized by unfavorable valuations and modestly unfavorable market action. Despite the somewhat better than expected 4 th quarter GDP figures, growth in real liquidity (M2, consumer credit, monetary base, etc) remains weak, while inflation pressures are likely to be sustained. The main driver of inflation pressure here isn't money creation, but a) the increase in monetary velocity that accompanies rising interest rates and b) higher oil prices working their way through the supply chain. With the yield curve continuing its flattening trend, I continue to favor relatively modest durations even within inflation protected securities. The Strategic Total Return Fund continues to have a duration of about 2 years, mainly in TIPS, and a continued exposure to precious metals shares amounting to somewhat less than 20% of assets.

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