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Hot Potato - John Hussman Weekly Market Commentary
Posted by: John Hussman, Ph.D. (IP Logged)
Date: February 14, 2012 01:12PM

Portfolio Notes - Particularly over the past few quarters, the Strategic Growth Fund has enjoyed muted volatility and positive returns during market declines, but also a moderately inverse relationship versus the S&P 500 during market advances. This behavior isn't a general feature of our hedging approach, but rather the reflection of two factors that are currently in place. One is our significant "underweight" in financials, materials, cyclicals and other "risk on" sectors that we view as speculative, and where we find few candidates that satisfy the discounted cash flow criteria that we rely on for stock selection. While our stock selection has significantly outperformed the S&P 500 over time, our continued avoidance of financials does introduce some inverse behavior in our hedged investment position during runs of "risk on" speculation. The other related factor is that the past several quarters have been a constant game of "hot potato" between recession risk and what we identify as an "overvalued, overbought, overbullish" syndrome. The result is that one or the other has generally kept us in a tightly hedged investment position. In our most defensive stance (conditions we identify as "hard negative"), we typically endure some decay in option value during market advances, because we raise the strike prices of our put options in order to defend against indiscriminate selling that often follows, as we saw during sharp market declines in 2010 and 2011. The overall result is that the Fund has typically enjoyed positive returns when the market plunges, but has experienced some erosion during periods of "risk on" speculation.

In order to eliminate this somewhat inverse pattern, we could take a new position in financial stocks and other "risk on" sectors here, and lower the strike prices on our defensive put options. My impression is that both of those would be hostile to our prospective returns, and of course, would also depart from our stock selection discipline in the process. One do-it-yourself method of closing down that pattern would be to take a position in financials, materials, and cyclicals, write call options on them in order to take in time premium, but accept all of the downside risk in those holdings. That would do it. For most of our shareholders, my guess is that that doesn't sound like a brilliant idea here. This may offer some appreciation for why we continue to pursue our discipline, despite the occasional pressure we experience - I expect temporarily. Even if we ignore economic risks entirely, we presently observe overvalued, overbought, overbullish conditions that have repeatedly been resolved by steep declines, even in the past few years.

Ensembles

We often receive questions relating to the ensemble method that guides our hedging strategy. Along with last week's comment (Notes on Risk Management ), the following section is intended to provide a broad overview.

One of the main approaches we use to estimate return and risk prospects is to group current market conditions among historical instances that are most similar. Each point in history is defined by various "features" based on a broad range of key factors, including valuations, trend-following indicators, market breadth, sentiment, credit spreads, economic factors, overbought/oversold measures, and so forth. In order to make the analysis less dependent on any particular historical period (e.g. postwar data, bubble-era data, Depression-era data), or any single set of indicators, we extend this analysis to a very large number of randomly selected sub-samples across history.

This sort of analysis is an example of an "ensemble method," which has several benefits, the two most important being on measures of "accuracy" and "robustness." It's easy to fit a model to past data, but those models often break down quickly in new data. So to evaluate accuracy, we estimate return and risk on data that the model has not "seen" previously, and find that the ensemble approach generally performs better than alternative methods. Equally important, the ensemble is robust to very large changes in the underlying economic environment, because randomizing over numerous sub-samples of history reduces the likelihood that the model is "over-fitted" to a particular economic environment.

Continue reading.




Guru Discussed: John Hussman: Current Portfolio, Stock Picks
Stocks Discussed: SPY, DJI, QQQ,
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Re Hot Potato - John Hussman Weekly Market Commentary
Posted by: AlbertaSunwapta (IP Logged)
Date: February 14, 2012 10:06AM

Good discussion of bear markets.



Guru Discussed: John Hussman: Current Portfolio, Stock Picks
Stocks Discussed: SPY, DJI, QQQ,
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