For the year ended December 31, 2011, Strategic Growth Fund achieved a total return of 1.64%, Strategic Total Return Fund achieved a total return of 4.00%, and Strategic International Fund lost -3.93%.
Strategic Growth Fund has achieved an average annual total return of 6.52% from its inception on July 24, 2000 through December 31, 2011, compared with an average annual return of 0.55% for the S&P 500 Index over the same period. An initial $10,000 investment in the Fund on July 24, 2000 would have grown to $20,601, compared with $10,649 for the same investment in the S&P 500 Index. The deepest loss experienced by the Fund since inception was -21.45%, compared with a maximum loss of -55.25% for the S&P 500 Index.
Strategic Total Return Fund has achieved an average annual total return of 7.08% from its inception on September 12, 2002 through December 31, 2011, compared with an average annual total return of 5.40% for the Barclays Capital U.S. Aggregate Bond Index for that period. An initial $10,000 investment in the Fund on September 12, 2002 would have grown to $18,902, compared with $16,310 for the same investment in the Barclays Capital U.S. Aggregate Bond Index. The deepest loss experienced by the Fund since inception was -11.52%, compared with a maximum loss of -5.08% for the Barclays Capital U.S. Aggregate Bond Index.
Strategic International Fund has achieved an average annual total return of 0.27% from its inception December 31, 2009 through December 31, 2011, compared with an average annual total return of -2.70% for the MSCI EAFE Index for that period. An initial $10,000 investment in the Fund on December 31, 2009 would have grown to $10,054, compared with $9,467 for the same investment in the MSCI EAFE Index. The deepest loss experienced by the Fund since inception was -7.92%, compared with a maximum loss of -26.93% for the MSCI EAFE Index.
Performance Drivers Credit concerns remained a significant focus of the financial markets in 2011, with the modest 2.11% total return of the S&P 500 Index masking a great deal of volatility during the year. Meanwhile, the yield on 30-year U.S. Treasury securities plunged from 4.33% to 2.89% during the year, driven by strong “safe haven” demand for Treasury securities in the face of government debt strains affecting a number of European countries. As credit concerns mounted, the European Central Bank (ECB) introduced changes in the quality of collateral it would accept in return for 3-year loans. Notably, the list of acceptable collateral was revised to include new, unlisted debt issued by European banks - essentially allowing distressed banks to issue bonds to themselves and then pledge those bonds to the ECB as collateral for newly created Euros. While I believe that these actions are hostile to the long-term stability of the global financial system, they provided short-term relief for the distressed European banking system, and the global stock markets enjoyed a year-end advance from their mid-year lows.
Meanwhile, as leading economic measures broadly deteriorated, the retreat in credit concerns supported a burst of economic activity late in the year. This created a divergence between numerous historically reliable leading indicators, which remained unfavorable at the end of 2011, and widely followed coincident indicators (such as employment and various regional surveys), which enjoyed a rebound. It remains unclear whether the late-year increase in activity represented a temporary release of pent-up demand, or whether it reflects a more durable improvement in economic activity.
Over the past few quarters, Strategic Growth Fund has enjoyed muted volatility and positive returns during market declines, but also a moderately inverse relationship versus the S&P 500 Index 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 in large part for stock selection. While our stock selection has significantly outperformed the S&P 500 Index over time, our continued avoidance of financials does introduce some inverse behavior in our hedged investment position during periods of “risk on” speculation.
The other related factor is that the past several quarters have been a constant cycle of “hot potato” between recession risk and what we identify as an “overvalued, overbought, overbullish” syndrome where market valuations, recent price trends, and investor sentiment are overextended at the same time. The result is that one or the other has generally kept us in a tightly hedged investment position. In our most defensive stance, 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 speculative periods.
During 2011, Strategic Growth Fund and Strategic International Fund remained largely hedged against the impact of market fluctuations. Strategic Total Return Fund generally held a conservative duration (a measure of interest-rate sensitivity and effective bond maturity) between 2-4 years during 2011, primarily in U.S. Treasury securities. The Fund also benefited from investments in precious metals and utility shares, which ranged from less than 2% of net assets early in the year, to slightly more than 20% of net assets by mid-year, followed by a gradual reduction in these holdings late in 2011.
Risk Management and Stress Testing 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, measures of market action, investor sentiment, economic factors, and so forth. In order to make the analysis less dependent on any particular historical period (e.g., post-war 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” of modeling which has several benefits, the two most important being on measures of “accuracy” and “robustness.” It is not difficult 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, ensembles tend to be 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 set of economic conditions.
Though I wrote numerous commentaries anticipating much of what actually occurred during the credit crisis, I certainly did not anticipate what I still consider to be terrible policy mistakes - particularly the absolute unwillingness to restructure bad debt, in preference for kicking the can down the road with public funds. It was a far cry from how U.S. regulators had responded to the S&L crisis, and how other international banking crises had been successfully addressed. (For example, in the early 1990’s, the Swedish banking crisis was durably resolved by the government taking receivership of a large portion of the banking industry, wiping out existing shareholders, writing down bad assets, and then taking the banks public to recapitalize them under new owners.)
In response to the 2008-2009 crisis, I believed that it was the responsibility of portfolio managers to stress-test each aspect of their investment approach, though I am still not convinced that much of Wall Street has stress-tested anything at all. For us, stress-testing meant taking our models to Depression-era data, because it was clear that events of the time were largely “out of sample” from the standpoint of post-war data. At the time, we were basing our estimates of market risk and return on data since about 1950, which I had expected was sufficient to capture “modern” market behavior. Prior to 2008, it seemed unlikely that the U.S. would face Depression-like credit strains again.
While our existing hedging approach performed well in Depression-era data overall, the occasional losses were far deeper than I was willing to risk for our shareholders. The result was what I called a “two-data sets” problem, which demanded that our hedging methods perform well, out-of-sample, and with tolerable risk, in data drawn from both post-war and Depression-era periods. We reached a satisfactory solution in late 2010 with the introduction of our ensemble approach. For the full period, we avoided a significant portion of the market’s 2007-2009 downturn, but in hindsight, the need to alter our hedging methods in response to the credit crisis led us to miss a rebound in 2009 that we should not have missed, had our present approach been already in hand.
As always, the hedging strategies used by the Hussman Funds are intended to be applied over a complete market cycle - generally several years, but in any event comprising a complete bull and bear market. Our approach to managing risk may result in lagging performance during the overvalued, overextended portions of a given cycle, but it has repeatedly demonstrated value over complete bull-bear market cycles, both adding returns and defending against severe market losses (exceeding 50% on two separate occasions in the last decade alone).
Portfolio Composition As of December 31, 2011, Strategic Growth Fund had net assets of $5,772,828,014, and held approximately 150 stocks in a wide variety of industries. The largest sector holdings as a percent of net assets were health care (33.5%), consumer discretionary (23.9%), information technology (22.0%), and consumer staples (12.4%). The smallest sector weights relative to the S&P 500 Index were in energy (2.8%), telecommunications (2.3%), financials (2.3%), materials (1.2%), and industrials (less than 0.1%).
The Fund’s holdings of individual stocks as of December 31, 2011 accounted for $5,792,612,946, or 100% of net assets. Against these stock positions, the Fund also held 37,000 option combinations (long put option/short call option) on the S&P 500 Index, 8,000 option combinations on the Russell 2000 Index and 2,000 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 December 31, 2011, the S&P 500 Index closed at 1,257.60, while the Russell 2000 Index and the Nasdaq 100 Index closed at 740.92 and 2,277.83, respectively. The Fund’s total hedge therefore represented a short position of $5,701,422,000, thereby hedging 98.4% 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 semi-annual period ended December 31, 2011: Panera Bread, Apple, Synaptics, AutoZone, Dollar Tree Stores, Humana, Ross Stores, Starbucks, MasterCard, Cisco Systems, and Amazon.com. Holdings with losses in excess of $25 million during this same period were First Solar, Illumina, SunPower, BMC Software, and Life Technologies.
As of December 31, 2011, Strategic Total Return Fund had net assets of $2,728,550,834. Treasury notes, Treasury bonds, Treasury Inflation-Protected Securities (TIPS) and shares of money market funds represented 83.9% of the Fund’s net assets. Precious metals shares, utility and energy shares, and exchange-traded funds (ETFs) accounted for 13.2%, 1.4% and 1.3% of net assets, respectively. The Fund carried a duration of less than 4 years (meaning that a 1% change in interest rates would be expected to impact the Fund’s asset value by less than 4% on the basis of bond price fluctuations).
In Strategic Total Return Fund, during the semi-annual period ended December 31, 2011, portfolio gains in excess of $5 million were achieved in Newmont Mining, U.S. Treasury Note (1.75%, due 5/31/2016), U.S. Treasury Note (2.125%, due 8/15/2021), Randgold Resources-ADR, U.S. Treasury Bond (3.75%, due 8/15/2041), U.S. Treasury Note (2.25%, due 3/31/2016), U.S. Treasury Inflation-Protected Note (2.50%, due 1/15/2029), and U.S. Treasury Note (2.00%, due 4/30/2016). Holdings with losses in excess of $1 million during this same period were NuStar Energy, Freeport-McMoRan Copper & Gold, Harmony Gold Mining-ADR, Goldcorp, and Agnico-Eagle Mines.
As of December 31, 2011, Strategic International Fund had net assets of $79,052,209 and held approximately 125 stocks in a wide variety of industries. The largest sectors as a percent of net assets were in health care (11.7%), consumer discretionary (11.2%), telecommunications (10.5%), consumer staples (9.4%), information technology (8.4%), and industrials (8.0%). The smallest sector weights were in utilities (5.5%), energy (3.0%), and materials (1.0%). Shares of exchangetraded funds and money market funds accounted for 7.8% and 13.6% of net assets, respectively. The total value of equities and ETF shares held by the Fund was $60,497,717.
In order to hedge the impact of general market fluctuations, as of December 31, 2011, Strategic International Fund held 185 option combinations (long put option/ short call option) on the S&P 500 Index, and was short 750 futures on the Euro STOXX 50 Index and 150 futures on the FTSE 100 Index. The combined notional value of these hedges was $58,731,037, hedging 97.1% 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 December 31, 2011. Individual equity holdings having portfolio gains in excess of $75,000 during the semi-annual period ended December 31, 2011 included Bunzl, Royal Dutch Shell–ADR, William Morrison Supermarkets, and Next. Holdings with portfolio losses in excess of $200,000 during this same period included Norbert Dentressangle, Enel, H. Lundbeck, iShares MSCI Germany Index Fund, DeNA, Recordati, Telecom Argentina-ADR, and CENTROTEC Sustainable.
Supplementary information including quarterly returns and equity-only performance is available on the Hussman Funds website at www.hussmanfunds.com.
Present Conditions Recent quarters have been largely characterized by a fragile underlying global economy coupled with a persistently overvalued stock market (though to varying degrees). We have seen little during this period but the effect of a hot potato being repeatedly passed from speculative “overvalued, overbought, overbullish” market conditions fueled by massive central bank interventions, to renewed credit strains and emerging economic pressures that appear nearly the instant those interventions are even temporarily suspended. By turns, we’ve seen the repeated emergence of the same speculative conditions that have historically accompanied major and intermediate market peaks, followed by credit strains and economic pressures that reflect an unresolved overhang of global debt. The alternation is certainly not typical of market history. Nor is it typical of a complete market cycle or business cycle. As unsatisfactory as it may be, the market is presently in an extended game of “hot potato” which will be resolved by the market’s eventual departure from both environments.
The more extended period since 2000 has been generally characterized by unusually rich valuations, which is duly reflected in the annual average total return of 0.21%, including dividends, that the S&P 500 achieved from its 2000 peak through the end of 2011. That is not an accident, but instead approximates the total return that we projected for the S&P 500 more than a decade ago, based on our standard valuation methodology. Given this outcome, it should be clear that the generally defensive stance of Strategic Growth Fund during this period is no fixed aspect of investment strategy or personal temperament, but instead owes far more to the repeatedly and predictably disastrous overvaluation of the stock market since the late 1990’s.
Such a richly overvalued period is unique in U.S. stock market history, and as a direct result, 12-year periods of virtually zero returns are also rare. Only two periods come close. The stock market suffered negative returns in the 12 years after the 1929 peak, which started with the S&P 500 at about 22 times cyclically-adjusted earnings (the 10-year average of prior inflation-adjusted earnings). Stocks also achieved an average annual total return of just 3.7% in the 12 years between 1963 and 1975, owing to the unfortunate combination of a high starting valuation, with a starting price-earnings multiple of about 21, and a low ending valuation, with a multiple below 9. That depressed valuation in 1975 then set the groundwork for over two decades of excellent market returns.
As of February 2012, the S&P 500 is again at a multiple of over 22 times cyclically adjusted earnings. Regardless of economic prospects, this is a strong headwind. As of February 2012, we estimate that the S&P 500 is likely to achieve an average annual total return of just 4.4% over the coming decade. However, this does not imply that strong investment opportunities will remain scarce for another decade. Projected long-term returns can rise quickly when the stock market declines significantly, which appears likely to occur within a far shorter period than a decade.
Unfortunately, it is both dangerous to speculate, and utterly frustrating to remain defensive, in richly overvalued markets coupled with significant economic risks or strenuously overbought conditions. This is the environment we are presented with, and it is in no way typical of “standard” market conditions, despite its repetition in recent years.
Even so, it is notable that less than half of a bull market gain is typically retained by the end of the subsequent bear market. There is very little chance, in my view, that market gains from present levels will be retained by investors over the remainder of the current cycle. There appears equally little chance that investors who are willing to accept significant risk now will be prompted to reduce their risk later, until they encounter a market decline that is - by then - nearly impossible to act upon. The value of avoiding major losses is clear from the arithmetic of compounding: a 20% loss wipes out a 25% gain; a 30% loss wipes out a 43% gain; a 40% loss wipes out a 67% gain; and a 50% loss wipes out a 100% gain. Investors should not overlook the fact that the market has lost more than 50% of its value twice in the past decade, and remains overvalued on our measures (which correctly anticipated those losses).
We will certainly have periods where we appear remarkably out-of-step with the prevailing trend of the market, particularly in overvalued, overbought, overbullish periods of speculation. But defending against losses in these periods is essential to risk management, despite the tendency of bulls to declare victory at halftime. One of the reasons we so strongly discourage short-term investments in the Hussman Funds is that I hope - and also manage the Funds on the expectation - that shareholders will be with us through the completion of each bull-bear market cycle. For example, shareholders who initially invest in Strategic Growth Fund near major lows in the stock market are encouraged to set their investment horizon at least through the completion of the subsequent market cycle.
This period of overextended conditions and high recession uncertainty will end, and we will have opportunities to accept moderate or even significant amounts of market risk, with proportionately high expected returns. Whether the present gap between leading and coincident economic evidence closes in favor of recession or recovery, that gap will close. As investor sentiment and short-term price movement experience a normal ebb-and-flow, I expect that at least some opportunity to accept market risk will emerge even within the next few quarters. A major positive shift in our investment stance would most probably accompany a significant improvement in valuations, confirmed by improving market internals (a sequence that is characteristic of early bull market advances). With the stock market characterized by an overvalued, overbought, overbullish syndrome of conditions, I do not believe that we are faced with such an opportunity here. This will change, and we will respond accordingly. Always, I remain grateful for your trust.
John P. Hussman, Ph.D.
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.
The 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 the 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.