The Timing Value of John Hussman’s Market Climate Assessments

John P. Hussman, Ph.D, president of Hussman Investment Trust, describes his market timing approach as follows: “The key elements in evaluating securities and market conditions are ‘valuations’ and ‘market action.’ Each unique combination of these conditions results in a distinct Market Climate, with its own profile of expected return and risk.” His investment approach, as applied to funds such as Hussman Strategic Growth (HSGFX), is to “align our investment position with the prevailing Market Climate and shift that position when sufficient evidence of a Climate shift emerges.” Does this fund demonstrate good market timing? Using weekly dividend-adjusted returns for HSGFX during 11/21/00 (the earliest available) through 9/30/11 (565 weekly returns), along with contemporaneous weekly returns for several benchmarks, we find that:

Each of the Hussman funds “varies its exposure to market fluctuations – from neutral to aggressive – based on the unique return/risk characteristics of each Market Climate”. Performance of a fund with respect to some index, such as the S&P 500 Index, therefore derives from some combination of:

1. Stock selection (including dividends).
2. General policy to hedge exposure of the selected portfolio to market fluctuations.
3. Hedging adjustments based on expected returns for variations in market climate (market timing).
4. Trading frictions and fund fees.

If the hedging adjustments are effective, the fund portfolio should be on average more (less) sensitive to fluctuations of the broad stock market when the market advances (declines).

As tests of the effectiveness of HSGFX hedging adjustments, the following two scatter plots relate the weekly returns of HSGFX to those of the S&P 500 Index (upper chart) and the Russell 2000 Index (lower chart) separately when the weekly index return is negative (red) and positive (green) over the entire sample period. Each chart shows both the equations for the best-fit lines and the the R-squared statistics for advancing and declining markets. Results show that the exposures of the HSGFX portfolio to market fluctuations are very similar when the broad market is advancing and declining.

Relative to the S&P 500 Index, HSGFX is a bit more sensitive to market fluctuations when the market is falling (slope or beta of 13.4% and R-squared of 5.6%) than when it is rising (slope or beta of 12.4% and R-squared of 3.7%). In other words, efforts to time the market by adjusting the level of hedging may be slightly harming the fund’s long-run performance.

Relative to the Russell 2000 Index, HSGFX is slightly less sensitive to market fluctuations when the market is falling (slope or beta of 12.5% and R-squared of 7.1%) than when it is rising (slope or beta of 13.9% and R-squared of 6.6%). In other words, efforts to time the market by adjusting the level of hedging may be slightly enhancing the fund’s long-run performance.

Note that for both charts the y-intercept or alpha is positive (slightly negative) when the broad market is falling (rising), indicating that benefit of stock selection derives mostly from intervals of broad market weakness (portfolio stock holdings are operationally defensive). Splitting the sample period into two equal subperiods indicates that the alpha of HSGFX comes predominantly from the first half of the sample period (before May 2006).

For comparison, we replicate this analysis for a conventional, unhedged mutual fund.

The next scatter plot relates the dividend-adjusted weekly returns of Fidelity Magellan (FMAGX) to those of the S&P 500 Index separately when the weekly index return is negative (red) and positive (green) over the entire sample period. Results show that the exposure of FMAGX to market fluctuations is about the same whether the broad market is rising or falling, and that it is far more sensitive to these fluctuations than is the HSGFX portfolio. The R-squared statistics indicate that broad market fluctuations explain nearly 90% of the variation in FMAGX returns. Note that the y-intercept or alpha is little different from zero when the market is falling or rising.

For another perspective on the HSGFX timing effectiveness, we look at correlations between HSGFX and S&P 500 Index weekly returns by range of the latter.

The next chart summarizes the correlations between HSGFX and S&P 500 Index weekly returns by decile of S&P 500 Index returns over the entire sample period. A steadily increasing progression of correlations across deciles would indicate systematically good timing, but no such progression is evident. In fact, HSGFX appears just as exposed to extremely negative market returns as it is to extremely positive market returns.

For another perspective on the role of hedging (not timing), we look at average weekly returns.

The final chart compares average weekly total returns for HSGFX, FMAGX, S&P Depository Receipts (SPY) and the iShares Russell 2000 Index (IWM) when the weekly S&P 500 Index return is negative (red), positive (green) and overall (black) for the entire sample period. The chart shows that, while FMAGX closely mimics SPY behavior, HSGFX on average avoids market weakness but also misses most of market strength. Cumulative returns over the entire sample period (ignoring tax implications) are 104%, -20%, 2% and 56%, respectively, for HSGFX, FMAGX, SPY and IWM.

In general, when the mix of up and down market intervals tilts substantially toward down (up) intervals, the average HSGFX weekly return tends to beat (lag) that of the broad market. HSGFX has done relatively well during the 565 weeks in the sample, encompassing 299 (52.9%) up weeks and 266 down weeks (47.1%). Since the beginning of 1950, the S&P 500 Index has 56.2% up weeks and 43.6% down weeks.

Note that the hedging approach suppresses portfolio volatility considerably. The standard deviations of weekly returns are 1.1%, 3.0%, 2.7% and 3.4%, respectively, for HSGFX, FMAGX, SPY and IWM over the entire sample period. Metrics that adjust returns for volatility risk (e.g., Sharpe ratio) therefore substantially favor HSGFX over unhedged funds.

The performance of HSGFX is much stronger during the first half of the sample period (average weekly total return 0.25%) than the second half (average weekly total return 0.02%).

HSGFX is arguably more like a market-neutral equity hedge fund than an equity mutual fund and its appropriate benchmark therefore the average performance of such hedge funds. However, hedge funds are inaccessible to many investors. See “Testing a Market Neutral Equity Mutual Fund” for comparison of HSGFX to an available market neutral mutual fund over a recent period.

In summary, while hedging has generally been advantageous for equity investing over the past 11 years, evidence from simple tests provides little support for a belief that John Hussman successfully times the stock market via hedging adjustments based on his assessments of market valuation and market action.

These findings are generally consistent with those described in “Outperformance of Hedge Funds: Timing or Asset Selection?”, “Hedge Fund Success: Timing or Stock Picking?” and “Mutual Fund Stock Selection vs. Market Timing” that funds generate alpha through stock picking and not market timing.

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