Dear Shareholder,
The Hussman Funds continue to pursue a historically-informed, value-conscious, risk-managed investment discipline focused on the complete market cycle. From the standpoint of a full-cycle discipline, it is essential to understand the current position of the market within that cycle.
Only a handful of instances in history – 1929, 1972, 1987, 2000 and 2007 – match the syndrome of overvaluation, lopsided bullish sentiment, and overbought multi-year equity market speculation as extreme as we observe today. Every instance was somewhat different, of course. For example, on measures that we find most strongly related with actual subsequent total returns, large-capitalization stocks were more extremely overvalued in 2000 than today (primarily because of breathtaking valuations in the technology sector), whereas the median stock is overvalued to a greater degree today than in 2000, making present concerns much more broad-based. The main difference between the recent market advance and those other instances is that severely overvalued, overbought, overbullish conditions have been sustained for a longer period without a material market retreat. In our view, investors should be more concerned about market risk, not less, the longer this delay continues.
By the end of a market cycle, the illusions within it are laid bare. That repeated narrative runs through more than a century of market history. Investors might recall the lessons more readily, except that as the legendary value investor Benjamin Graham once observed, “the memory of the financial community is proverbially and distressingly short.”
Investors do not kindly remember 1929, 1972, 1987, 2000 and 2007 for the optimism that brought the stock market to those peaks. Instead, we remember them for the damage that was inflicted when the illusions beneath them were shattered. The unraveling of the late-1990s technology bubble took only two years, but wiped out the entire total return of the S&P 500 – in excess of the return on risk-free Treasury bills – all the way back to May 1996 while the technology-heavy Nasdaq Composite lost more than three-quarters of its value. Likewise, the unraveling of the mid-2000s housing bubble took less than two years, but wiped out the entire total return of the S&P 500 – in excess of the return on risk-free Treasury bills – all the way back to June 1995.
Investment results over the full course of the market cycle are determined not only by what happens during a bull market period, but also what happens as the cycle is completed by a bear market. While past performance does not ensure future results, it is instructive that, on a total return basis, the S&P 500 lost -47.41% from the bull market peak of the S&P 500 on September 1, 2000 to the bear market low on October 9, 2002, while Strategic Growth Fund gained 47.83%. Assuming equal initial investments in the S&P 500 and Strategic Growth Fund at the bull market peak, the investment in Strategic Growth Fund, by the end of the bear market, would have been worth 2.81 times the value of the investment in the S&P 500. Similarly, the S&P 500 lost -55.25% from the bull market peak of the S&P 500 on October 9, 2007 to the bear market low on March 9, 2009, while Strategic Growth Fund lost only -6.47%. Assuming equal initial investments in the S&P 500 and Strategic Growth Fund at the bull market peak, the investment in Strategic Growth Fund, by the end of the bear market, would have been worth 2.09 times the value of the investment in the S&P 500.
We fully expect that the phrase “QE bubble” will soon enough join the list of phrases like “housing bubble,” “tech bubble,” “dot-com bubble,” “New Economy,” “go-go years,” and “roaring '20s.” The delusions associated with each period seem self-evident now. It is easy to forget that overvalued, overbought, overbullish extremes are the same today as they were at those points, and investors then believed precisely the same thing: this time is different.
Understanding the half-cycle since 2009 from a full-cycle perspective
Despite the tendency of the financial markets to experience repeated bouts of speculative delusion and collapse, our job remains to achieve strong long-term returns for our shareholders without exposing them to the steep losses that often characterize a passive investment approach. The recent half-cycle since 2009 has been challenging in this regard, and it is important to understand why. This understanding not only helps to place our recent performance in perspective, but also helps to clarify what investors should expect from our discipline over the completion of the present market cycle and beyond.
Consider the Hussman Strategic Growth Fund over the complete market cycle from the 2000 bull market peak to the 2007 bull market peak. From the inception of the Fund on July 24, 2000 through October 9, 2007, Strategic Growth Fund achieved a cumulative total return of 119.79% (11.54% annually) compared with a cumulative total return of 20.70% (2.64% annually) for the Standard and Poor’s 500 Index. The deepest peak-to-trough loss experienced by Strategic Growth Fund in that period was -6.98%, compared with a -47.41% loss in the S&P 500 Index.
The 2007 peak was followed by a market plunge and credit crisis that we fully anticipated. By October 2008, our valuation methods indicated that the equity market had moved to undervaluation, and based on improvements in measures of market action that had previously been reliable during the post-war period, Strategic Growth Fund shifted to a constructive stance, resulting in a peak-to-trough loss of -21.45% for Strategic Growth Fund before largely recovering. From the October 9, 2007 market peak to the March 9, 2009 trough in the S&P 500 Index, Strategic Growth Fund lost -6.47%, compared with a loss of -55.25% in the Index.
Thus, measured from the inception of Strategic Growth Fund on July 24, 2000 to the March 9, 2009 market trough, Strategic Growth Fund experienced a cumulative total return of 105.57% (8.71% annually) compared with a cumulative loss of -45.99% (-6.89% annually) for the S&P 500 Index. Excluding the impact of hedging, the stock portfolio held by the Fund would still have achieved a positive cumulative total return of 12.81% (1.41% annually).
We frequently observed in our annual reports prior to 2009 that this margin of outperformance, relative to the major stock market indices, was “as intended” in our view – neither extraordinary nor disappointing in the context of the historical research that guides our work. Our stock selection approach significantly outperformed the S&P 500, and our hedging approach contributed additional returns over the complete market cycle while significantly reducing our exposure to severe market losses. However, we believed that the absolute returns of our hedged strategy, our unhedged stock selections and the S&P 500 Index itself during this period were significantly lower than our expectations for each over the longer term.
The Fund’s stock selections have gone on to achieve a cumulative total return of 264.88% (9.73% annually) from the inception of the Fund on July 24, 2000 through June 30, 2014. During the same period, the S&P 500 Index has recovered to achieve a cumulative total return of 75.21% (4.11% annually). Though hedging challenges since 2009 have hidden this stock selection success from full view, we believe we’ve addressed those challenges in a way that we expect to allow us to fire on both cylinders – stock selection and hedging strategy – over the completion of the present cycle and in future cycles.
We also maintain strong expectations for the hedging strategy that we use to vary our exposure to general market fluctuations over the course of the market cycle. On this aspect of our discipline, it may be useful to detail the challenges that we have addressed in the half-cycle since 2009. The combination of missed returns and loss of index option premium resulted in a -19.47% loss in Fund value from March 9, 2009 to June 30, 2014. As a result, the cumulative gain of the Fund from its inception on July 24, 2000 to June 30, 2014 has retreated to 65.55% (3.68% annually). Though our investment discipline often benefits from varying its exposure to market fluctuations (as it did in the 2000-2008 period), the Fund’s loss during the sustained market advance since 2009 has been particularly uncomfortable.
Two factors are most responsible for our disappointment in recent years:
1) As the credit crisis intensified in 2008, economic and financial losses worsened beyond anything observed in post-WWII data on which our pre-2009 methods were based. As risk-conscious, evidence-driven investors, we looked to historical parallels and only found similar conditions in Depression-era data. Measures of market action that were reliable in post-war data were far less useful in Depression-era data. Knowing that in the Depression the same valuations seen in early-2009 were followed by losses of another two-thirds of the market’s value, we insisted that our methods should be robust to the uncertainty of that “two data sets problem.” I still view this as a proper fiduciary decision, but the timing of that decision was unfortunate. By the time we developed methods that performed well across post-war, Depression-era, and “holdout” validation data, we had missed a substantial rebound in the stock market.
2) Historically, we have found that the proper way to allow for speculative “animal spirits” in overvalued markets is to place a significant weight on market action and the quality of market internals until – but not beyond – the point that a complete syndrome of overvalued, overbought, and overbullish conditions develops. Historically, the emergence of overvalued, overbought, overbullish features was predictably followed by market retreats to clear those conditions. But in recent years, the repeated expansion of “quantitative easing” by the Federal Reserve has encouraged speculation for a much longer period. This forced us to find ways to limit our defensive response to overvalued, overbought, overbullish conditions to the smallest possible set, while still seeking the historical benefit of avoiding (and ideally gaining from) the market losses that we would expect typically to follow.
These two factors resulted in a frustrating and awkward transition from our pre-2009 methods to our present methods of classifying market return/risk profiles.
The solution to our “two data sets problem” of 2009 and early-2010 was a set of ensemble methods, named because they combine dozens of different methods to arrive at a single classification of the prevailing market return/risk profile. Our evaluation of the performance of these methods in post-war data, Depression-era data and validation data exceeded any prior method we had evaluated.
While these methods captured much of the impact of valuations and market action, they also captured the historical regularity that severe market losses have predictably followed syndromes of overvalued, overbought, overbullish conditions. Because our discipline is to align our investment stance in proportion to the expected return/risk profile of the market, we established “staggered-strike” hedge positions at these points (raising the strike price of the index put option side of our hedges), and experienced loss of put option premium as a result. So a further challenge of the period since 2009 was to adapt to the reality that Fed-induced speculation was amplifying overvalued, overbought, overbullish conditions much more persistently than in prior market cycles, without exposing our shareholders to the severe losses that have typically followed such conditions.
We believe that the challenges of the recent half-cycle have been addressed, and we have validated the resulting methods across a century of market cycles as well as the most recent cycle. Understandably, it is little consolation that our present methods of classifying market return/risk profiles could have better navigated the period since 2009. Still, it is incorrect to view the performance of our discipline in recent years as if it were simply the result of the inflexible execution of some fixed “perma-bearish” strategy. To the contrary, in market cycles across history, our present methods would encourage an unhedged or leveraged investment position in about 52% of historical conditions (generally adding leverage by holding a few percent of portfolio value in index call options). They would encourage a partially-hedged stance about 12% of the time, a fully-hedged stance about 31% of the time and a “staggered strike” position (raising the strike prices of index put options closer to market levels than the corresponding short index call options) only about 5% of the time.
We cannot take a time machine back and apply our present methods through the half-cycle since 2009. Still, we can confidently execute our discipline over the completion of this cycle, and through the course of future ones. There is no assurance that present speculative extremes will not be driven further in the months or quarters ahead. We know that similarly extreme overvalued, overbought, overbullish conditions in recent decades were limited to the very late portions of prior market cycles, but if anything makes the present cycle unique, it has been the prolonged and uncorrected escalation of these conditions without consequence. My impression is that the completion of the present market cycle will be worse as a result, but we have adapted considerably to the potential for similar speculative episodes in the future.
Research is an essential aspect of our discipline, and we continue to look for ways to improve our methods in a way that also maintains or augments their estimated performance in market cycles across history. Despite an unfortunate and admittedly awkward stress-testing transition since 2009, we are focused on the disciplined execution of the methods that have emerged from it. They have a stronger record across history and also in data from the most recent cycle than any alternative approach we have examined in decades of research. We are confident that our historically-informed, value-conscious, risk-managed investment discipline is well-suited to navigate the completion of the present cycle and the cycles ahead and to seek performance that is “as intended” on the basis of that record.
Performance summary
For the year ended June 30, 2014, Strategic Growth Fund lost -6.11%, largely attributable to the cumulative decay in the time-value of index put options held by the Fund. Strategic Total Return Fund achieved a total return of 6.19%, attributable to positive returns both in precious metals shares and U.S. Treasury securities. Strategic International Fund achieved a total return of 2.36%, reflecting a generally hedged investment stance in the international equity market. Strategic Dividend Value Fund achieved a total return of 2.96%, reflecting partial hedging of the Fund’s portfolio of dividend paying stocks.
From the inception of Strategic Growth Fund on July 24, 2000 through June 30, 2014, the Fund achieved an average annual total return of 3.68%, compared with an average annual total return of 4.11% for the S&P 500 Index. An initial $10,000 investment in the Fund on July 24, 2000 would have grown to $16,555, compared with $17,521 for the same investment in the S&P 500 Index. The deepest loss experienced by the Fund since inception was -30.25%, compared with a maximum loss of -55.25% for the S&P 500 Index.
It is instructive that in order to lose -55.25% (as the S&P 500 Index did following steep overvaluation in 2007 much like the present), one must first lose -30.25%, and then lose an additional -35.84%. So even at its lowest point, Strategic Growth Fund had experienced far less volatility and drawdown than the S&P 500 Index. The focus of our risk management is not the avoidance of small or moderate losses, which we view as a necessary aspect of long-term investing, but rather the avoidance of deep market losses requiring heroic recovery. I expect opportunities over the completion of the present market cycle and future cycles to pursue strong investment returns without abandoning our attention to the risk of deep market losses.
From the inception of Strategic Total Return Fund on September 12, 2002 through June 30, 2014, the Fund achieved an average annual total return of 5.45%, compared with an average annual total return of 4.76% for the Barclays U.S. Aggregate Bond Index. An initial $10,000 investment in the Fund on September 12, 2002 would have grown to $18,700, compared with $17,308 for the same investment in the Barclays U.S. Aggregate Bond Index. The deepest loss experience by the Fund since inception was -11.52%, compared with a maximum loss of -5.08% for the Barclays U.S. Aggregate Bond Index.
From the inception of Strategic International Fund on December 31, 2009 through June 30, 2014, the Fund achieved an average annual total return of 0.69%, compared with an average annual total return of 8.25% for the MSCI EAFE Index. An initial $10,000 investment in the Fund on December 31, 2009 would have grown to $10,312, compared with $14,287 for the same investment in the MSCI EAFE Index. The maximum decline of the EAFE Index since the inception of Strategic International Fund was -26.48%, compared with a maximum decline of -10.45% for the Fund.
From the inception of Strategic Dividend Value Fund on February 6, 2012 through June 30, 2014, the Fund achieved an average annual total return of 3.30%, compared with an average annual total return of 19.63% for the S&P 500 Index. An initial $10,000 investment in the Fund on February 6, 2012 would have grown to $10,809, compared with $15,367 for the same investment in the S&P 500 Index. The deepest loss experienced by the Fund since inception was -3.91%, compared with a maximum loss of -9.58% for the S&P 500 Index.
Performance drivers
Strategic growth fund
The stock selection approach of the Fund has outperformed the S&P 500 Index by 5.63% (563 basis points) annually since the inception of the Fund. In the most recent fiscal year ended June 30, 2014, the stock selection approach outperformed the S&P 500 Index by 6.05% (605 basis points). However, market conditions during the past year generally matched those that have historically been associated with strikingly negative return/risk profiles. In the face of rich valuations and strenuously extended market conditions, the Fund was fully hedged during this period, and index put options held by the Fund experienced a loss of time value. The hedging strategy of the Fund (which often offsets periodic losses in the Fund’s holdings and can contribute strongly to investment returns in unfavorable market conditions) accounted for the Fund’s -6.11% one year loss. In my view, the fact that negative market outcomes did not emerge during this period is more a reflection of uncertain timing and temporary monetary distortion than of any durable change in market structure.
Historically, the simultaneous emergence of overextended valuations, price trends and exuberant sentiment (which we generally refer to as an “overvalued, overbought, overbullish” syndrome) has created significant risk for the stock market. In the past year, this risk was not realized and the stock market instead moved to further extremes. It is tempting to imagine that we could safely pursue our stock selection approach without hedging, but we view that temptation as an artifact of an overvalued market temporarily at record highs. The S&P 500 lost -55.25% during the 2007-2009 bear market, and although our stock selection approach fared better, it would still have lost as much as -49.83% on an unhedged basis at its lowest point during that period. We expect that the most reasonable opportunity to reduce hedges and establish a more constructive investment stance will emerge at the point that a material retreat in valuations is coupled with a firming of market action after such a retreat.
Strategic Total Return Fund
During the fiscal year ended June 30, 2014, Strategic Total Return Fund gained 6.19%. The Fund held a relatively conservative position in bonds during this time, with a duration typically ranging between 2-6 years (meaning that a 100 basis point move in interest rates would be expected to affect Fund value by about 2-6% on the basis of bond price fluctuations).
Prior to 2013, neither the fixed income component nor the equity component (primarily mining stocks) of Strategic Total Return Fund ever posted a calendar-year loss. In 2013 both were down: losses in the fixed income component (approximately -3.2%) and equity component (approximately -5.3%) contributed to a -8.37% loss for the Fund in calendar-year 2013.
For the equity component, there was a sharp contrast between the first half of the year and the second half. During the first half of 2013, the Philadelphia Gold Stock Index (XAU) plunged by -45.6% which caused the equity component of the Fund to lose approximately -6.3% with a maximum drawdown of -7.1%. This was the equity component’s second-worst drawdown (in 2008, there was a -10.7% drawdown for this component). A significant portion of the loss occurred in the second quarter of 2013 – with the equity component down -4.9% and the XAU down -33.6%. During the beginning of the second quarter, the Fund increased its allocation to precious metals shares as nominal and real yields were declining, consumer inflation was increasing, the Gold/XAU ratio was rising and economic data was softening. We associate these and other factors with strong historical returns, on average, for precious metals shares.
During the second half of 2013, the equity component of Strategic Total Return Fund gained 1.1% while the XAU was down -6.7%. Because the Fund has the ability to vary its investment exposure in response to market conditions, it has not been unusual for the equity component of the Fund to enjoy modest gains even in periods that the XAU is down. The same pattern occurred in 2012 (equity component up 0.6%, XAU down -8.3%), 2011 (equity component up 0.7%, XAU down -20.3%) and 2008 (equity component up 2.5%, XAU down -28.5%).
With regard to the fixed income component of Strategic Total Return Fund, 2013 was a difficult year for the bond market, particularly if one was not willing to assume credit risk at very low yields. Much of the volatility in the bond market followed the “taper tantrum” in the Treasury market, as bond market investors became more risk averse in response to indications that the Federal Reserve would reduce, and eventually eliminate, new bond purchases under its policy experiment of quantitative easing. We are generally comfortable with rising yields, provided that they do not advance in a straight line. The intervening volatility can provide opportunities to strategically adjust the Fund’s exposure to bond market fluctuations. Despite a relatively conservative exposure to long-maturity Treasury bonds, the challenging combination of a very low-starting yield (below 2%), and the near-doubling of 10-year Treasury yields – rising from 1.6% to 3.0% between May and September of 2013 – caused the fixed income component of the Fund to lose about -3.2%. Both components have achieved positive returns to-date in 2014, with Strategic Total Return Fund achieving a total return of 6.76% through June 30, 2014.
Strategic International Fund
In the fiscal year ended June 30, 2014, Strategic International Fund gained 2.36%. The Fund remained fully hedged against the impact of general market fluctuations during this period. Because of high correlations that occur between international equity markets during steep declines in U.S. markets, we expect the Fund to maintain a relatively defensive stance until our assessment of U.S. market risk becomes less extreme. In the absence of such extreme risks, the Fund will have substantially greater opportunity to establish a constructive investment stance based on valuation, market action and other investment considerations specific to the equity markets of individual countries.
Strategic Dividend Value Fund
In the fiscal year ended June 30, 2014, Strategic Dividend Value Fund gained 2.96%. In the context of market conditions that have historically been hostile for equities, we have been patient in expanding the Fund’s exposure to equities during this period. Because of this, the Fund initially held a larger cash position than would be expected over the long term. From the Fund’s inception through October of 2013, the Fund held close 50% of its assets in cash, expanding its equity exposure gradually and opportunistically on a stock-by-stock basis. As of June 30, 2014, the Fund had close to 80% of its assets invested in stocks. Half of the value of the Fund’s exposure to equities was offset with short positions in the S&P 500 - the Fund’s most defensive posture.
As is also true of Strategic Growth Fund and Strategic International Fund, the defensive position and corresponding hedge of Strategic Dividend Value Fund has – at least temporarily – hidden the Fund’s generally strong stock selection performance from view. The stock selection performance of the Fund is particularly notable in light of how challenging recent years have been for dividend strategies to keep pace with the S&P 500 Index (which has a higher weighting in younger, faster-growing companies that investors often prefer during the later stages of a stock market cycle). Consider the relative performance of five exchange-traded funds based on well-known dividend strategies – S&P Dividend (SDY), iShares Select Dividend (DVY), Vanguard High Dividend Yield (VYM), Vanguard Dividend Appreciation (VIG) and PowerShares Dividend Achievers Portfolio (PFM). All five of the strategies have underperformed the S&P 500 Index since the inception of Strategic Dividend Value Fund.
The largest peak-to-trough drawdown in Strategic Dividend Value to date has been -3.9%, compared with a loss of -9.6% in the S&P 500 Index. The volatility of Fund returns (based on daily standard deviation) has been 3.3% versus 11.7% for that benchmark. Much of this lower drawdown and volatility can be attributed to the hedge held by the Fund against the impact of market fluctuations. The companies in the Fund’s portfolio also tend to have lower variability in sales, earnings, and profit margins, combined with an emphasis on balance sheet stability, dividend coverage, and favorable estimated valuations relative to the general market. In our view, these characteristics have contributed to lower volatility in the Fund’s stock holdings relative to the S&P 500 Index.
Portfolio Composition
As of June 30, 2014, Strategic Growth Fund had net assets of $1,137,305,301, and held 113 stocks in a wide variety of industries. The largest sector holdings as a percent of net assets were information technology (32.1%), health care (20.7%), consumer discretionary (11.5%), energy (10.5%), consumer staples (8.0%), industrials (5.9%), financials (4.8%) and materials (4.6%). The smallest sector weights were in utilities (1.5%) and telecommunication services (0.4%).
Strategic Growth Fund’s holdings of individual stocks as of June 30, 2014 were valued at $1,140,519,123. Against these stock positions, the Fund also held 4,500 option combinations (long put option/short call option) on the S&P 500 Index, 1,000 option combinations on the Russell 2000 Index and 325 option combinations on the Nasdaq 100 Index. Each option combination behaves as a short sale on the underlying index, with a notional value of $100 times the index value. On June 30, 2014, the S&P 500 Index closed at 1,960.23, while the Russell 2000 Index and the Nasdaq 100 Index closed at 1,192.96 and 3,849.479, respectively. The Fund’s total hedge therefore represented a short position of $1,126,507.568, thereby hedging 98.8% of the dollar value of the Fund’s long investment positions in individual stocks.
Though the performance of Strategic Growth Fund’s diversified portfolio cannot be attributed to any narrow group of stocks, the following holdings achieved gains in excess of $10 million during the year ended June 30, 2014: Synaptics (SYNA), Sunpower (SPWR), Safeway (SWY), Helmerich & Payne (HP), Deckers Outdoor (DECK), SunEdison (SUNE), First Solar (FSLR), and United Therapeutics (UTHR). Holdings with losses in excess of $2 million during this same period were ValueClick (CNVR), Cisco Systems (CSCO), Panera Bread (PNRA), Jabil Circuit (JBL), International Game Technology (IGT), and Cooper Tire & Rubber (CTB).
As of June 30, 2014, Strategic Total Return Fund had net assets of $622,494,156. Treasury bills, Treasury notes, Treasury Inflation-Protected Securities (TIPS) and money-market funds represented 78.7% of the Fund’s net assets. Exchange-traded funds, precious metals shares and utility shares accounted for 1.6%, 16.8% and 2.9% of net assets, respectively.
In Strategic Total Return Fund, during the year ended June 30, 2014, portfolio gains in excess of $3 million were achieved in Barrick Gold (ABX), Agnico-Eagle Mines (AEM), U.S. Treasury Note (2.50%, due 8/15/2023), Newmont Mining (NEM), and Randgold Resources ADR (GOLD). Holdings with losses in excess of $1 million during this same period were U.S. Treasury Bond (2.875%, due 5/15/2043), U.S. Treasury Inflation-Protected Note (2.00%, due 7/15/2014), and U.S. Treasury Note (1.75%, due 5/15/2023).
As of June 30, 2014, Strategic International Fund had net assets of $104,969,994 and held 95 stocks in a wide variety of industries. The largest sector holdings as a percent of net assets were in information technology (12.3%), utilities (10.0%), health care (9.7%), consumer staples (9.5%), consumer discretionary (7.7%), industrials (6.1%) and telecommunication services (5.2%). The smallest sector weights were in energy (3.2%), financials (1.7%) and materials (1.1%). Exchange-traded funds (ETFs) and money market funds accounted for 8.5% and 21.2% of net assets, respectively. The total value of equities and exchange-traded funds held by the Fund was $78,791,926.
In order to hedge the impact of general market fluctuations, as of June 30, 2014 Strategic International Fund held 85 option combinations (long put option/short call option) on the S&P 500 Index, and was short 975 futures on the Euro STOXX 50 Index and 150 futures on the FTSE 100 Index. The combined notional value of these hedges was $77,031,092, hedging 97.8% of the value of equity and ETF investments held by the Fund. When the Fund is in a hedged investment position, the primary driver of Fund returns is the difference in performance between the stocks owned by the Fund and the indices that are used to hedge.
While Strategic International Fund is widely diversified and its performance is affected by numerous investment positions, the hedging strategy of the Fund was primarily responsible for the reduced sensitivity of the Fund to market fluctuations from the Fund’s inception through June 30, 2014. Individual equity holdings having portfolio gains in excess of $500,000 during the year ended June 30, 2014 included Smith & Nephew PLC – ADR (SNN), Astrazeneca PLC – ADR (AZN), and Red Electrica Corp (XMCE:REE). The only holding with a portfolio loss in excess of $100,000 during this same period was Electricite De France (XPAR:EDF).
As of June 30, 2014, Strategic Dividend Value Fund had net assets of $10,799,033, and held 50 stocks in a wide variety of industries. The largest sector holdings as a percent of net assets were information technology (24.9%), consumer staples (21.6%), consumer discretionary (12.5%), health care (12.1%) and energy (10.2%). The smallest sector weights were in materials (3.8%), telecommunication services (2.5%) and utilities (2.0%).
Strategic Dividend Value Fund’s holdings of individual stocks as of June 30, 2014 were valued at $9,678,209. Against these stock positions, the Fund also held 24 option combinations (long put option/short call option) on the S&P 500 Index. The notional value of this hedge was $4,704,552, hedging 48.6% of the value of equity investments held by the Fund.
In Strategic Dividend Value Fund, during the year ended June 30, 2014, portfolio gains in excess of $125,000 were achieved in Safeway and Astrazeneca PLC – ADR (AZN). Holdings with portfolio losses in excess of $100,000 during this same period included Leidos Holdings (LDOS) and Coach (COH).
Supplementary information including quarterly returns and equity-only performance is available on the Hussman Funds website: www.hussmanfunds.com.
Current outlook
We believe that the financial markets are presently in the latter stages of what will ultimately be remembered as the “QE bubble” – a period of reckless speculation and overvaluation in a broad range of risky securities, particularly equities, high-yield debt, and leveraged loans (loans to already highly indebted borrowers). We view this bubble as the result of the Federal Reserve’s policy of quantitative easing or “QE,” which has driven short-term interest rates to zero, depriving investors of any source of safe return. This policy has encouraged investors to drive the prices of risky assets higher in a speculative “reach for yield,” to the point that we presently estimate zero or negative total returns for the S&P 500 Index – from current price levels – on every horizon of 8 years or less.
After the 2000-2002 recession, the Federal Reserve remained fixed on holding down short-term interest rates in efforts to stimulate demand in interest-sensitive sectors of the economy. Deprived of a meaningful return on safe investments, investors looked for alternatives that might offer them a higher rate of return. They found that alternative in mortgage securities. Historically, home prices had never experienced a major and sustained decline, and mortgage securities were AAA credits. On that basis, investors chased mortgage securities in search of higher yield, and hedge funds sought to leverage the “spread” by purchasing massive volumes of higher yielding mortgage securities and financing those purchases using debt that was available at a lower interest rate.
The key observation is that, when the demand for securities of a particular type is high, Wall Street and the banking system have the incentive to create more “product” to be sold. So create it they did. In order to satisfy the yield-seeking demand for new mortgage debt that resulted from the Fed’s policy of suppressing the yield of safe alternatives, trillions of dollars of new mortgage securities were created. But how do you create a mortgage security? If you take the money of the investor, you actually have to lend it to someone to buy a home. In order to create enough supply, banks and Wall Street institutions began to lend to borrowers with poor credit and speculative motives, resulting in a housing bubble, an increasing volume of subprime debt and, ultimately, the greatest financial collapse since the Great Depression.
One would think the Federal Reserve would have learned from that catastrophe. Instead, the Fed has spent the past several years intentionally trying to revive the precise dynamic that produced it. As a consequence, speculative yield-seeking has encouraged the record issuance of “junk” bonds that couple high credit risk with historically low interest rates and has driven the most historically reliable measures of equity valuation to more than double their pre-bubble norms. Among those measures that are best correlated with actual subsequent market returns, the ratio of non-financial market capitalization to GDP is now within about 20% of its historic extreme in 2000 and is more than 2.4 times its long-term norm.
What quantitative easing has done is to exploit the discomfort that investors have with earning nothing on safe investments, making them feel forced to extend their risk profile in search of positive expected returns. The problem is that there is little arithmetic involved in that decision. For example, if a “normal” level of short-term interest rates is 4% and investors expect 3-4 more years of zero interest rate policy, it would be reasonable for stock prices to be valued today at levels that are about 12-16% above historically normal valuations (3-4 years x 4%). The higher prices would in turn be associated with equity returns also being about 4% lower than “normal” over that 3-4 year period. One can demonstrate the arithmetic quite simply using any discounted cash flow approach, and it holds for stocks, bonds and other long-term securities.
However, if investors are so uncomfortable with zero interest rates on safe investments that they drive security prices far higher than 12-16% above historical valuation norms (and again, stocks are presently more than double those norms on what we identify as the most reliable measures), they are doing something beyond what is justified by interest rates. Instead, what happens is that the risk premium – the compensation for bearing uncertainty, volatility and risk of extreme loss – also becomes compressed. We can quantify the impact that zero interest rates should have on stock valuations, and it would take decades of zero interest rate policy to justify current stock valuations on the basis of low interest rates. In my view, what we presently observe is not a rational, justified, quantifiable response to lower interest rates, but rather a historic compression of risk premiums across every risky asset class, particularly equities, leveraged loans and junk bonds.
In our investment approach, the strongest expected market return/risk profile we estimate is associated with a material retreat in valuations that is then joined by an early improvement across a wide range of market internals. These opportunities occur in every market cycle, and we have no doubt that we will observe them over the completion of the present cycle and in those that follow. In contrast, when risk premiums are historically compressed and showing early signs of normalizing even moderately, a great deal of downside damage can follow. Some of this may be on virtually no news at all, because that normalization is baked in the cake and is independent of interest rates. All that is required is for investors to begin to remember that risky securities actually involve risk. In that environment, selling begets selling.
In our view, this outcome is inevitable because prices are already elevated and risk premiums are already compressed. Every episode of compressed risk premiums in history has been followed by a series of spikes that restore them to normal levels. It may be possible for monetary policy to drag the process out by helping to punctuate the selloffs with renewed speculation, but there is no way to defer this process permanently. Nor would the effort be constructive, because the only thing that compressed risk premiums do is to misallocate scarce savings to unproductive uses, allowing weak borrowers to harness strong demand. We do not believe that risk has been permanently removed from risky assets. The belief that it has been removed is itself the greatest risk that investors face here.
That said, there is no assurance that this speculation will not continue somewhat longer. Our assertion is not that the performance of our investment strategies will immediately accelerate, particularly in the event that extreme market conditions remain uncorrected for a longer period. Rather, we believe that our investment strategies are sufficiently robust to effectively navigate the full completion of the present cycle and the course of future ones.
Most importantly, we do not anticipate any future need for stress-testing of the nature that we encountered in the recent cycle, nor do we anticipate the need to substantially alter our methods to address the likelihood of future speculative episodes. Continuing research remains an important component of our investment discipline. Still, we believe that the unique challenges of the recent cycle have been addressed. Our objective remains to achieve strong full-cycle performance of our investment discipline, supported both by our security selection methods and our hedging approach. While future performance cannot be ensured, our expectations are supported by the evidence from a century of market history, as they are by our real-time record prior to the challenging and speculative half-cycle since 2009.
As always, I remain grateful for your trust.
Sincerely,
John P. Hussman, Ph.D.
From John Hussman (Trades, Portfolio)’s Hussman Funds Annual Report.
Past performance is not predictive of future performance. Investment results and principal value will fluctuate so that shares of the Funds, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than the performance data quoted.
Weekly updates regarding market conditions and investment strategy, as well as special reports, analysis, and performance data current to the most recent month end, are available at the Hussman Funds website www.hussmanfunds.com.
An investor should consider the investment objectives, risks, charges and expenses of the Funds carefully before investing. The Funds’ prospectuses contain this and other important information. To obtain a copy of the Hussman Funds’ prospectuses please visit our website at www.hussmanfunds.com or call 1-800-487-7626 and a copy will be sent to you free of charge. Please read the prospectus carefully before you invest. The Hussman Funds are distributed by Ultimus Fund Distributors, LLC.
Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based on the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 Index reflect valuation methods focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle.
This Letter to Shareholders seeks to describe some of the adviser’s current opinions and views of the financial markets. Although the adviser believes it has a reasonable basis for any opinions or views expressed, actual results may differ, sometimes significantly so, from those expected or expressed. The securities held by the Funds that are discussed in this Letter to Shareholders were held during the period covered by this Report. They do not comprise the entire investment portfolios of the Funds, may be sold at any time and may no longer be held by the Funds. The opinions of the Funds’ adviser with respect to those securities may change at any time.
