Fund Managers Bracing for a Sell-Off

Bear tactics: How a handful of gloomy fund managers are preparing for a sell-off

By Ben Levisohn

Investors have a right to feel sunny. The recession has most likely ended, analysts are raising predictions for third-quarter earnings, and the Standard & Poor's 500-stock index is up 56.8% since its March low. So why are some prominent fund managers feeling gloomy?

All of the managers featured in this story bumped up equity exposure in their portfolios earlier in the year—they are not permabears. But some look at the economy and still see troubling signs of stress. Others have analyzed the stock market's rally and determined that it may have come too far, too fast, and are preparing their portfolios for a market sell-off.

The Hedger
JOHN HUSSMAN
President, Hussman Investment Trust
During the first quarter of 2009, when the S&P 500 fell 12.7%, John Hussman watched the $5.2 billion Hussman Strategic Growth Fund (HSGFX) gain 7%. That wasn't the result of brilliant stock picks, although his selections did outperform the market. Rather, it had to do with a strategy Hussman uses to hedge his portfolio with option contracts. He has employed it since opening his Ellicott City (Md.) fund shop nine years ago.

Hussman sells calls (options betting that the stock market will climb) and buys puts (options betting the market will fall) on the S&P 500, Russell 2000, and Nasdaq 100. When he hedges the entire dollar value of his portfolio, as he did at the start of 2009, he's betting that his stocks will gain more (or lose less) than the general market. As a result, he should make (or lose) the difference between the return on his stocks and the overall gain or loss from his hedges. So while his stocks rose just 1.45% from January to March, his fund was up 7% because the market dropped 11% and his hedges paid off.

As the market turned in March, Hussman stuck with his portfolio of companies with stable sales and operating margins, including AstraZeneca (AZN), which is 3.5% of the fund, and Johnson & Johnson (JNJ), at 3.19%, rather than follow the crowd into beaten down financials and cyclical stocks. He also bought call options, a bet that the stock market would rise. That gave him exposure to the overall market without having to buy companies he didn't want to own for the long run.

As the market climbed, so did the value of the options, reducing some of the fund's losses from hedging. (It was down 0.8% in the second quarter, compared with 23.8% for the S&P 500.) But in late September, he sold the call options, judging the market "strenuously overbought." Translation: Stocks are not cheap. He calculated that at current prices, stocks would return just 6.6% annually, well below their historical levels of about 10%. Market volume, too, has been underwhelming, an indication that many investors prefer to sit on the sidelines. Add in tough economic conditions, and the rally could be coming to an end. "I'm extremely concerned we've put a Band-Aid over an infection," Hussman says.

The Technician
BARRY JAMES
President, James Investment Research
Back in February, Barry James, president of Xenia (Ohio)-based James Investment Research (GLRBX), started adding stocks to the $545 million James Balanced Fund. His timing was off—it usually is, he says, since the technical indicators he follows tell him what's going to happen but not when. Nevertheless, he continued buying equities through the market's low and into April and May, bringing the fund's equity position from under 35% to 55% at its peak. (In a "normal" market, James usually has a 50/50 split between stocks and bonds). But like Hussman, James thinks the market has overreached.

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