Hussman Funds - Weekly Market Comment Page 1 of 6

October 3, 2010

Economic Measures Continue to Slow

Weekly Market Comment John P. Hussman, Ph.D.

Archive All rights reserved and actively enforced.
Reprint Policy
Investment Research &
Insight Page The latest evidence from a variety of economic measures continues to suggest deterioration
in U.S. economic activity. Probably the best way to characterize the latest round of data from
the ISM and other surveys is that the data is coming in a bit less negative than we've
anticipated, but continues to deteriorate in a manner that is consistent with stagnant
economic activity.

To obtain a broad indication of economic performance, we averaged eight different

measures reported by the ISM and the Federal Reserve. These included the ISM National,
Chicago, Cincinnati and Milwaukee surveys, as well as the Federal Reserve's Empire
Manufacturing, Philadelphia, Richmond and Dallas surveys. The chart below shows the
average standardized value of the overall indices, as well as the new orders and backlogs
components (a standardized value subtracts the mean and divides by the standard deviation
of a given series, so all of the variables are essentially Z scores).

Closer inspection shows that all of these measures dropped below zero last month. That
said, these measures are not as negative as what we observe from the ECRI Weekly
Leading Index, for example, so at this point we can only conclude the likelihood of tepid
economic growth, not outright contraction.

http://www.hussmanfunds.com/wmc/wmc101004.htm 04/10/2010
Hussman Funds - Weekly Market Comment Page 2 of 6

Still, with the S&P 500 at a Shiller P/E over 21, and our own measures indicating an
estimated 10-year total return for the S&P 500 in the low 5% area, it is clear that investors
have priced in a much more robust recovery than we are likely to observe. Our long-term
total return estimates are consistent with what we observed based on Shiller P/E's here -
since 1940, Shiller P/E values above 21 have been associated with annual total returns for
the S&P 500 averaging 5.3% over the following 7 years and 4.9% annually over the
following decade.

The activity indices presented above are closely correlated with GDP growth. On that note,
second quarter GDP growth was revised last week to 1.7% annualized, which was up
slightly from the first revision of 1.6% growth, but down from the initial estimate of 2.4%.
Based on what we observe in other data, third quarter GDP is likely to reflect continued tepid
growth, though the overall activity indices did not decline enough to suggest that the
economy contracted in the third quarter.

http://www.hussmanfunds.com/wmc/wmc101004.htm 04/10/2010
Hussman Funds - Weekly Market Comment Page 3 of 6

As a side note on valuation, a number of observers have suggested that the low level of
dividend payouts as a fraction of operating earnings is indicative of strong prospects for
reinvestment, which is then extrapolated into assumptions for high rates of future earnings
growth. Unfortunately, this argument is problematic on two counts.

First, forward operating earnings are not realized cash flows. As I've noted frequently over
the years, forward operating earnings represent analyst estimates of the next year's
earnings excluding a whole range of chargeoffs and "extraordinary expenses" as if they do
not exist. While operating earnings provide a smoother measure of business performance,
they don't provide a good measure of the cash flows that are actually deliverable to
shareholders.

Losses that are booked as "extraordinary" are still losses, and represent the results of bad
investments and a consumption of amounts that were previously reported as earnings.
Similarly, the portion of earnings used for share buybacks is often expended simply to offset
dilution from grants of stock to employees and corporate insiders, and again do to reflect
cash that is deliverable to shareholders. In recent years, based on the widening gap
between reported operating earnings on one hand, and the sum of dividends and increments
to book value on the other, a great deal of what is reported as earnings ends up evaporating
as extraordinary losses and share compensation.

The second problem with the low level of dividend payouts, relative to forward operating
earnings, is that there is no historical evidence whatsoever that low payouts are
accompanied by higher growth in future operating earnings. To the contrary, when dividends
are low relative to forward operating earnings, it is a signal that operating earnings are
temporarily elevated - typically because of transitory profit margins. As a result, subsequent
growth in forward earnings is actually slower than normal over the following decade.

Dividend policy is set in a very forward-looking manner. Since dividend cuts generally result
in very negative events for corporations, dividend payments are set to a level that
management believes it can sustain. Relative to current forward operating earnings,
indicated dividend payments are near the lowest level on record. If anything, investors
should take this as a signal that managements do not expect present levels of earnings to
be sustained at a level that is sufficient to justify higher payouts.

In contrast, high dividend payouts (as a ratio of forward operating earnings) typically reflect

http://www.hussmanfunds.com/wmc/wmc101004.htm 04/10/2010
Hussman Funds - Weekly Market Comment Page 4 of 6

temporarily depressed operating earnings, and short-term margin compression. Accordingly,

elevated payouts tend to be followed by above average growth in operating earnings over
the following decade. The tendency for dividend payouts to lead operating earnings growth
is depicted below (see Long Term Evidence on the Fed Model and Forward Operating P/E Ratios for
details on forward operating earnings prior to 1979). Suffice it to say that the low level of
payouts today most likely reflects elevated and unsustainable operating margins.

On the latitude for a constructive investment stance

Based on the data that we've observed in recent months, my view remains that a fresh
downturn in the economy remains a not only a possibility but a likelihood. Little of the
economic improvement we've observed since 2009 appears intrinsic, but instead appears
driven by enormous government interventions that are now trailing off. Still, while I believe
that there is a second shoe that has not dropped, I recognize that the full force of
government policy is to obscure, stimulate, intervene and borrow in every effort to kick that
can down the road. I believe that the unaddressed and unresolved problems relating to debt
service, employment conditions and housing are too large for this to be successful, but as
we move through the remainder of this year - as I've said throughout 2010 - we are gradually
assigning greater probability to the "post-1940" dataset. Accordingly, there are
developments that could potentially move us to a more constructive position. We don't
observe those at present, but an improvement in economic evidence and a clearing of
overbought conditions, leaving market internals intact, would be one configuration that might
warrant less defensiveness.

How constructive is "constructive"? Without an improvement in valuation levels, a

constructive investment exposure for us here would likely be limited to a removal of perhaps
20% of our hedges, because the improvement in expected return and reduction in expected
risk will not be dramatic unless valuations retreat sharply. That said, we occasionally
observe conditions that warrant placing about 1-2% of assets into call options, which would
allow a subsequent market advance to soften our hedges without actually removing the put
option side of our defenses.

A better configuration would include a significant retreat in valuations and a massive, if

uncomfortable, amount of debt restructuring. Those two events would be the best way to put
the recent (and probably ongoing) debt crisis behind us, and could easily allow us to
completely lift our hedges for an extended period of time in anticipation of an unobstructed
recovery.

http://www.hussmanfunds.com/wmc/wmc101004.htm 04/10/2010
Hussman Funds - Weekly Market Comment Page 5 of 6

To some extent, I view current market conditions as something of a "Ponzi game" in that
valuations appear neither sustainable nor likely to produce acceptably high long-term
returns, and speculators increasingly rely on finding a greater fool. As the mathematician
John Allen Paulos has observed, "people generally worry only about what happens one or
two steps ahead and anticipate being able to get out before a collapse... In countless
situations people prepare exclusively for near-term outcomes and don't look very far ahead.
They myopically discount the future at an absurdly steep rate." Undoubtedly, we have
periodically missed returns due to our aversion to risks that rely on the ability to find a
"greater fool" in order to get out safely. But it is important to recognize that speculative risks
are not a source of durable long-term returns. At a Shiller P/E of 21 and a historical peak-to-
peak S&P 500 earnings growth rate of 6%, a simple reversion to the historical (non-bubble)
Shiller norm of 14 would require seven years of earnings growth and yet zero growth in
prices. Stocks are not cheap here.

Meanwhile, the U.S. financial system appears to be a nicely painted dam, behind which a
massive pool of delinquent debt is obscured. A significant correction in valuations and
resolution of the growing backlog of delinquent debt may finally restore strong "investment
merit" to the U.S. stock market, but only after a greater amount of pain and adjustment than
most investors seem to anticipate.

In general, we want to take risk in proportion to the improvement we observe in the return
that we expect per unit of that risk, primarily based on long-term historical evidence about
what has occurred in similar conditions. For now, we remain defensive.

Market Climate

As of last week, the Market Climate for stocks was characterized by rich valuations, elevated
(but not extreme) bullish sentiment, generally positive but overbought price trends, and
continued negative economic pressures. Overall, our measures suggest an overvalued,
overbought, overbullish condition, but with shorter term factors struggling between emerging
economic weakness and overbought conditions on the negative side, and speculative trend
following on the positive side. For our part, the current set of conditions is associated with an
unfavorable return/risk profile, so the Strategic Growth Fund and the Strategic International
Equity Fund remain well hedged.

In bonds, the Market Climate last week was characterized by moderately unfavorable yield
levels and positive yield pressures. The Strategic Total Return Fund continues to carry a
portfolio duration of just over 4 years, mostly in straight Treasury securities. We've clipped a
small portion of our precious metals holdings on strength in order to hold our exposure to
roughly 10% of assets, but the overall Market Climate remains favorable in that sector for
now. The Fund continues to hold about 5% of assets in foreign currencies and about 2% of
assets in utility shares.

NEW from Bill Hester: Do Past 10-Year Returns Forecast Future 10-Year Returns?

---

Prospectuses for the Hussman Strategic Growth Fund, the Hussman Strategic International
Equity Fund, and the Hussman Strategic Total Return Fund, as well as Fund reports and
other information, are available by clicking "The Funds" menu button from any page of this
website.

Home | The Funds | Open an Account | Account Access | Research & Insight | Site Map

[Open Disclosure in Separate Window] Past performance does not ensure future results, and there is no assurance that
the Hussman Funds will achieve their investment objectives. An investor's shares, when redeemed, may be worth more or
less than their original cost. Investors should consider the investment objectives, risks, and charges and expenses of the
Funds carefully before investing. For this and other information, please obtain a Prospectus and read it carefully.

The Hussman Funds have the ability to vary their exposure to market fluctuations depending on overall market conditions,
and they may not track movements in the overall stock and bond markets, particularly over the short-term. While the intent
of this strategy is long-term capital appreciation, total return, and protection of capital, the investment return and principal
value of each Fund may fluctuate or deviate from overall market returns to a greater degree than other funds that do not
employ these strategies. For example, if a Fund has taken a defensive posture and the market advances, the return to
investors will be lower than if the portfolio had not been defensive. Alternatively, if a Fund has taken an aggressive
posture, a market decline will magnify the Fund’s investment losses. The Distributor of the Hussman Funds is Ultimus
Fund Distributors, LLC., 225 Pictoria Drive, Suite 450, Cincinnati, OH, 45246.

http://www.hussmanfunds.com/wmc/wmc101004.htm 04/10/2010
Hussman Funds - Weekly Market Comment Page 6 of 6

For more information about investing in the Hussman Funds, please call us at
1-800-HUSSMAN (1-800-487-7626)
513-587-3440 outside the United States

Site and site contents © copyright 2003 Hussman Funds. Brief quotations including attribution and a direct link to this site (www.hussmanfunds.com) are
authorized. All other rights reserved and actively enforced. Extensive or unattributed reproduction of text or research findings are violations of copyright law.

Site design by 1WebsiteDesigners.

http://www.hussmanfunds.com/wmc/wmc101004.htm 04/10/2010