The Timing Value of John Hussman’s Market Climate Assessments
Posted in Individual Gurus
September 2, 2010
Over the past several years, we have tracked and evaluated qualitatively the commentary of John P. Hussman, Ph.D., president of Hussman Investment Trust, with respect to timing the U.S. stock market in the context of Guru Grades. He 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 is to “align our investment position with the prevailing Market Climate and shift that position when sufficient evidence of a Climate shift emerges.” Qualitative evaluation of this approach is difficult because of the fairly frequent and often fine adjustments he makes to his investment stance (degree of hedging) as referenced to the Hussman Strategic Growth (HSGFX). We therefore use a quantitative review to measure the market timing effectiveness demonstrated by HSGFX. Using weekly adjusted return data for HSGFX during 11/21/00 (the earliest available) through 8/27/10 (509 weeks), along with contemporaneous weekly return data for several benchmarks, we conclude 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:
- Stock selection (including dividends)
- General policy to hedge exposure of the selected portfolio to market fluctuations
- Hedging adjustments based on expected returns for varying market climates (market timing)
- 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 a test of the effectiveness of HSGFX hedging adjustments, the following scatter plot relates the adjusted weekly returns of HSGFX 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. The chart shows both the equation for the best-fit line and the the R-squared statistic for each of these two scatters. Results show that the exposures of the HSGFX portfolio to market fluctuations in aggregate are very similar when the broad market is falling and rising. In fact, the portfolio is a bit more sensitive to market fluctuations when the market is falling (slope or beta of 16.7% and R-squared of 8.6%) than when it is rising (slope or beta of 15.9% and R-squared of 6.4%). In other words, efforts to time the market by adjusting the level of hedging may be slightly harming rather than enhancing long-run performance.
Note that 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 approximately equal subperiods indicates that nearly all the alpha of HSGFX comes from the older half and that most of the beta comes from the newer half.
Results are a little different using the Russell 2000 Index as a benchmark, with HSGFX a little more sensitive to Russell 2000 Index fluctuations when the index is rising than when it is falling.
For comparison, we replicate this analysis for a conventional, unhedged mutual fund.
The next scatter plot relates the 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 the FMAGX portfolio to market fluctuations in aggregate 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 about 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 role of hedging, we look at average weekly returns.
The final chart compares average weekly adjusted returns for HSGFX, FMAGX, S&P Depository Receipts (SPY) and the iShares Russell 2000 Index (IWM) when the weekly 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. 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 508 weekly returns in the sample, encompassing 268 (52.8%) up weeks and 240 down weeks (47.2%). Note that the hedging approach suppresses portfolio volatility considerably. The standard deviations of weekly returns are 1.2%, 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 (e.g., Sharpe ratio) therefore substantially favor HSGFX over the index and unhedged mutual funds.
During the older (newer) half of the sample period, the average weekly return for HSGFX is 0.27% (0.03%).
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 decade, evidence from simple tests does not convincingly support 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 consistent with those described in “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.
