For the fiscal year ended June 30, 2010, Hussman Strategic Growth Fund achieved a total return of 3.68%, compared with a total return of 14.43% for the Standard & Poor’s 500 Index. Meanwhile, Hussman Strategic Total Return Fund achieved a total return of 7.44%, compared with a gain of 9.50% for the Barclays Capital U.S. Aggregate Bond Index. The relatively modest returns of the Hussman Funds primarily reflected the maintenance of a defensive investment posture during 2009, based on what I viewed as overvalued, overbought, overbullish conditions in stocks, combined with significant potential for further credit strains and economic contraction.

 

I continue to be concerned about credit conditions and the underlying fundamentals of the U.S. economy. In recent months, fresh deterioration in leading economic measures, narrowing compensation for credit risk, and rich stock market valuations have increased the vulnerability of equities and corporate bonds to price weakness. These concerns are reflected in the restrained exposure to risk that the Hussman Funds presently accept.

 

While the potential for further credit and economic strains remains evident, I clearly underestimated the extent to which Wall Street would respond to a modest economic rebound in 2009, driving stocks to the point where they were not only overvalued again, but strikingly dependent on a sustained economic recovery and the achievement and maintenance of record profit margins in the years ahead. Meanwhile, near-zero yields on default-free Treasury bills and bank deposit instruments provoked investors to accept a great deal of credit risk as 2009 progressed, to the point where credit spreads (the difference in yields between risky debt and Treasury securities) narrowed to the lows seen just prior to the recent crisis.

 

Given that GDP growth over the past year has amounted to $563 billion, while Federal government debt has increased by $1.6 trillion, there appears to be little evidence that the positive economic growth of recent quarters was driven by much else but the deficit spending of government and to a lesser extent, the aggressive purchase of mortgage securities by the Federal Reserve. Private sector demand, income less government transfer payments, employment growth, housing activity and other measures of “intrinsic” economic activity remain remarkably weak. With the impact of stimulus spending trailing off, and little evidence that debt has been restructured in proportion to the cash flows available to service that debt, expectations for economic expansion appear to be based more on hope than on a careful reading of economic history. Except for a recent burst of inventory rebuilding that appears complete, the big-ticket, credit-financed expenditures that have historically driven cyclical expansions are still dormant.

 

I continue to believe that at present valuations, exposure to market risk and credit risk is not likely to be well compensated over the long-term, and may be associated with substantial losses in the intermediate term. Currently, we remain unable to rule out the likelihood that the recent advance is simply a fragile post-crisis bounce, similar to those following other historical credit crises in the U.S. and abroad.

 

Looking forward, even without depressed valuations, the Funds will have greater room for exposure to market fluctuations after we move through the quarters immediately ahead, which is, in our view, where the greatest risk of fresh credit strains and economic risk appears concentrated. The absence of further, crisis-level credit strains during this period, coupled with an improvement in leading measures of economic activity, would allow us to approach the financial markets from something closer to a “typical” post-war perspective.

 

Performance Review

 

Both the Strategic Growth Fund and the Strategic Total Return Fund have substantially outperformed their respective benchmarks in the most recent 3-year and 5-year periods, and since inception. Strategic Growth Fund has achieved an average annual total return of 8.33% from its inception on July 24, 2000 through June 30, 2010, compared with an average annual loss of -1.67% 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 $22,131, compared with $8,460 for the same investment in the S&P 500 index.

 

Strategic Total Return Fund has achieved an average annual total return of 7.60% from its inception on September 12, 2002 through June 30, 2010, compared with an average annual total return of 5.29% for the Barclays Capital U.S. Aggregate Bond Index. An initial $10,000 investment in the Fund on September 12, 2002 would have grown to $17,698, compared with $14,952 for the same investment in the Barclays Capital U.S. Aggregate Bond Index.

 

Since the inception of the Strategic Growth Fund in 2000, the Fund has outperformed the S&P 500 Index by 10.00% (1,000 basis points) annually, on average. Since the inception of the Strategic Total Return Fund in 2002, the Fund has outperformed the Barclays Capital U.S. Aggregate Bond Index by 2.31% (231 basis points) annually, on average. Both Funds are intended to outperform their respective benchmarks over the complete market cycle, with smaller periodic losses than a passive investment strategy. Thus, relative to their respective benchmarks, the performance of both the Strategic Growth Fund and the Strategic Total Return Fund since their inception has been as intended.

 

However, the rich valuation and uninspiring overall returns in stocks and bonds over the past decade has provided fewer opportunities to accept market risk than I would expect over the long-term. I believe that a gradual return toward historical valuation norms in stocks and bonds would allow us to pursue higher absolute returns by enabling us to accept greater average levels of market exposure. This was regularly possible prior to the valuation bubble that began in the late 1990’s. From that standpoint, I view the persistent defensiveness of the Strategic Growth Fund since its inception in 2000 as an anomaly born of historically unfavorable valuations during this period, and should not be viewed as a standard feature of the Fund’s investment approach.

 

In assessing market conditions over the past year, I have frequently noted that subsequent to credit crises, the reliability of uniform market action as an indicator of the market’s return prospects has been inconsistent until valuation levels become quite depressed (about 12 times normalized earnings or less). While we did observe several weeks of valuations in that range in early 2009, this was also a period where market action measures were still negative. Since then, our primary challenge has been responding to the implications of two very different data sets; one reflecting market history subsequent to major credit crisis, and the other reflecting standard post-war data. The most important effect of credit risk is that it forces a greater reliance on valuation criteria in setting investment positions. Since applying a reasonable range of weights to these two data sets invariably produced poor average return expectations, the Strategic Growth Fund retained a significant hedge during 2009.

 

Based on prospects for additional mortgage strains, coupled with the fading impact of large “stimulus” outlays in 2009, I view the current quarter and those immediately following to be the primary window of risk for renewed credit strains and economic deterioration. I expect that the primary risk to the market would be in the period of “recognition,” where economic realities may diverge from the “V-shaped” recovery that the markets have priced into securities. As we move through 2010, we are gradually applying increasing weight to standard, “post-war” criteria in evaluating market conditions. We would respond to fresh, crisis-level credit strains by modestly slowing this transition, but in any event, I expect that once we pass through the major risk window of the next several months, our standard criteria of valuation and market action will be able to manage any residual risks.

 

Strategic Growth Fund

 

For the fiscal year ended June 30, 2010, the Strategic Growth Fund achieved a total return of 3.68%. The S&P 500 gained 14.43% during this period. The Fund’s relative underperformance during the year can be primarily attributed to the Fund’s hedging activities.

 

From a stock-selection perspective, the Strategic Growth Fund continues to emphasize companies and industries reflecting strong stable revenue growth and profit margins, balance sheets generally having low levels of debt, and valuations that we view as favorable based on the long-term stream of cash flows that investors can expect to receive over time. The Fund’s primary sector holdings remain in health care, consumer related goods, and technology, with a continued avoidance of sectors that rely on credit expansion, particularly financials.

 

The table below presents the total returns for the Strategic Growth Fund and S&P 500 Index since the inception of the Fund. In order to assist in attributing the effects of stock selection and hedging on the Fund, the table separately presents the returns of the stock positions and cash equivalents held by the Fund (after expenses), without the impact of hedging transactions.

 

The performance of the stocks held by the Fund has generally been a significant contributor to overall investment performance. Since inception, the average annualized return of the stocks held by the Fund has been 6.05% after expenses, accounting for much of the Fund’s 8.33% average annual total return. The Fund’s hedging has also enhanced long-term returns while significantly reducing volatility and drawdown risk.

 

Strategic Total Return Fund

 

For the fiscal year ended June 30, 2010, the Strategic Total Return Fund achieved a total return of 7.44%, compared with a total return of 9.50% in the Barclays Capital U.S. Aggregate Bond Index.

 

During the most recent fiscal year, the Strategic Total Return Fund has held an allocation to precious metals shares generally ranging between 1% and 10% of assets. The Fund’s modest and variable exposure to precious metals shares has been an important contributor to the performance of the Strategic Total Return Fund, but is also responsible for much of the Fund’s day-to-day volatility when the Fund is invested in this sector.

 

The table below presents the total returns for the Strategic Total Return Fund since inception.

 

 

 

Portfolio Composition and Performance Drivers

 

As of June 30, 2010, the Strategic Growth Fund had net assets of $6,185,341,895, and held 103 stocks in a wide variety of industries. The largest sector holdings as a percent of net assets were Health Care (30.8%), Consumer Discretionary (22.8%), Information Technology (16.0%), and Consumer Staples (16.0%). The smallest sector weights relative to the S&P 500 Index were Energy (2.2%), Industrials (2.0%), Financials (0.5%) and Materials (0.1%).

 

The Fund’s holdings of individual stocks as of June 30, 2010 accounted for $5,591,444,103, or 90.4% of net assets. Against these stock positions, the Fund also held 44,000 option combinations (long put option, short call option) on the S&P 500 Index, 8,000 option combinations on the Russell 2000 Index and 3,000 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 June 30, 2010, the S&P 500 Index closed at 1,030.71, while the Russell 2000 Index and the Nasdaq 100 Index closed at 609.49 and 1,739.14, respectively. The Fund’s total hedge therefore represented a short position of $5,544,458,000, thereby hedging 99.16% of the total value of the Fund’s long investment positions in individual stocks.

 

The overall returns on a hedged investment position can be expected to be driven by several factors. First, a hedged position earns the difference in performance between the stocks it holds long (after expenses) and the indices it uses to hedge. In addition, because of the way that options are priced, the combination of a put option and a short call option acts as an interest-bearing short position on the underlying index and delivers implied interest at a rate close to short-term Treasury yields.

 

Though the performance of the Strategic Growth Fund’s diversified portfolio cannot be attributed to any narrow group of stocks, the following holdings each appreciated in excess of $50 million in value during the fiscal year ended June 30, 2010: Netflix, NetApp, Panera Bread and Starbucks. Holdings that depreciated in excess of $15 million in value during this same period were Transocean, WellPoint, Diamond Offshore Drilling, Sunpower, Synaptics and Microsoft.

 

The Strategic Growth Fund continues to be very manageable, with substantial flexibility to respond to changing market conditions, low market impact of trading, commission costs well below estimated industry averages, and continued reductions in the Fund’s expense ratio. The Fund’s positions in individual stocks generally represent less than a single day’s average trading volume in those securities. Even during the volatile and often low-volume trading of the past year, the Fund’s average market impact of trading (the difference between the last sale at the time of order placement and the actual price at which the Fund’s stock transactions are executed) has been a fraction of 1%, and the Fund’s average commission was 1.4 cents per share, compared with industry averages estimated to be several times that amount. Finally, the Fund’s expense ratio during its fiscal year ended June 30, 2010 was 1.05%, and has since declined further due to a reduction in management fees and economies of scale. According to recent statistics, the average expense ratio among the limited group of mutual funds pursuing similar strategies and classified as “long-short” by Morningstar is 2.03%.

 

As of June 30, 2010, the Strategic Total Return Fund had net assets of $1,884,985,240. Short-term Treasury bills accounted for 13.3% of the Fund’s net assets, with Treasury notes, Treasury bonds, Treasury Inflation Protected Securities (TIPS) and shares of money market funds representing an additional 73.5% of the Fund’s net assets. Exchange-traded funds, precious metals shares and utility shares accounted for 2.5%, 7.7% and 2.3% of net assets, respectively. The Fund carried a duration of approximately 3 years (meaning that a 1% change in interest rates would be expected to impact the Fund’s asset value by about 3% on the basis of bond price fluctuations).

 

In the Strategic Total Return Fund, during the fiscal year ended June 30, 2010, portfolio gains in excess of $5 million were achieved in U.S. Treasury Note (3.375%, due 11/15/2019), Newmont Mining, U.S. Treasury Note (3.625%, due 8/15/2019) and Barrick Gold . Only U.S. Treasury Note (2.625%, due 5/31/2010) experienced a loss in excess of $500,000 during this same period.

 

Present Conditions

 

A year ago, I noted “investors have become hopeful about ‘green shoots’ of economic recovery. However, nearly all of the improvement has reflected enormous doses of debt-financed government spending, and it is questionable that any of this will translate into sustained private activity. >From my perspective, much of the enthusiasm about these green shoots overlooks the extent to which economic recoveries have historically relied on the expansion of private lending and debt creation. Economic expansions are paced not by major growth in consumption (which tends to be fairly smooth even during economic downturns), but instead by gross investment in capital goods, technology and housing, as well as debt-financed durables such as autos. We are in the midst of – and will continue to require – perhaps the largest adjustment in U.S. personal, corporate and government balance sheets that we will see in our lifetimes. This will be a very long process. Most likely the economic outlook is not up, but very widely sideways.”

 

While debt-financed government spending helped the U.S. economy to achieve three quarters of moderate economic growth, it is notable that growth has been slightly negative when the impact of federal deficit spending is removed. This is the worst performance in the private economy in any of the 50 years preceding the recent crisis. Meanwhile, the volume of outstanding bank credit has continued to collapse. In recent months, a variety of leading indicators of economic activity, such as the ECRI leading index, have moved to negative readings, suggesting that economic growth may have already peaked. At the time of this report, a number of our own measures of recession risk have deteriorated to the point that very modest declines in stock prices and the ISM Purchasing Managers Index would be sufficient to complete a set of criteria that has always and only been present during or immediately prior to recessions.

 

A larger concern relates to valuation and long-term return prospects that are likely from current market levels. Measured from peak-to-peak across economic cycles, S&P 500 earnings have rarely exceeded a 6% annual growth rate. While earnings experience a great deal of “cyclical” fluctuation beneath that long-term trend, they can be normalized in a variety of ways to better reflect their long-term dynamics. A decade ago, the valuation of the S&P 500 was well over twice the historical norm, relative to normalized earnings. Despite experiencing a loss over the past decade, the valuation of the S&P 500 is still not at a point, relative to the now higher level of normalized earnings, that has historically resulted in average or above-average long-term returns.

 

Over more than a century, the pattern displayed by stock market valuations has been broadly characterized by “cyclical” fluctuations typically about 4-5 years in length, each comprising what investors commonly identify as bull and bear markets. However, the larger historical pattern is that the stock market has periodically achieved major extremes of overvaluation and major extremes of undervaluation spaced closer to 17-18 years apart. The deep undervaluation of 1982, and the striking overvaluation of 2000, are examples of these extremes. The long intervening periods between these “secular” extremes generally contain a number of shorter cyclical bull and bear market phases. During periods from a secular trough such as 1982 to a secular peak such as 2000, each successive bull market tends to peak at a higher level of valuation. In contrast, during periods from a secular peak such as the mid-late 1960’s to a secular trough such as 1982, each successive bear market tends to bottom at a lower level of valuation (though not necessarily a lower absolute price level, if earnings and other fundamentals have grown in the interim).

 

This context is important, because while the market lows we observed in early 2009 appeared extreme relative to the market highs of 2007, the trough was not particularly deep from a long-term valuation perspective. Moreover, the subsequent market advance quickly restored valuations that are, on the metrics we use, among the highest 25% of historical observations. With little basis to expect strong long-term returns from the standpoint of valuations at present, and little basis to expect robust economic growth from the standpoint of credit expansion, it is important to allow for the possibility that investors will require a substantial revision in market valuations in order to accept sustained long-term exposure to market risk.

 

Without question, there are many Wall Street analysts who presently argue that stocks are cheap. Almost without exception, these assertions are based on 1) using a single year of projected “forward operating earnings” to value the stock market; 2) applying an improperly high “norm” for the price-to-earnings ratio; and 3) ignoring the variation in long-term earnings growth induced by changes in profit margins. To the extent that the usefulness of a valuation model can be judged by its ability to explain subsequent market returns, this valuation debate can be resolved by an examination of historical evidence (see in particular “Valuing the S&P 500 Using Forward Operating Earnings” in the weekly market commentaries of the Hussman Funds website). While the simplistic use of forward operating earnings fails to adequately explain subsequent long-term market returns, it is possible to produce historically accurate 10-year total return projections for the S&P 500 by properly correcting for earnings growth, profit margins and historical valuation norms. Unfortunately, these projections concur with other historically reliable measures in suggesting that the U.S. stock market is substantially overvalued at present.

 

Still, while valuations and economic considerations may create sufficient headwind to require periodic hedging of market risks, I do expect that we will continue to see a great number of opportunities in individual securities and industries that will provide a basis for investment returns on the basis of security selection. The same difficulties that have prompted what we view as reckless fiscal and monetary policy in recent years is likely, in our view, to provoke inflationary pressures in the second half of this decade, suggesting that securities with returns tied to real assets and commodity exposure may represent opportunity. As credit strains often produce concerns about deflation rather than inflation, my impression is that the next few years will provide adequate opportunities to establish holdings in these areas during occasional periods of price weakness.

 

Moreover, despite economic challenges, there is every reason for optimism about innovation and discovery in a wide range of areas including wireless communications, medical devices, consumer electronics, genomic medicine, alternative energy, and even creative niche companies within established industries such as apparel and food services. When a company has well-received products that are not easily replicated, has significant opportunity to reinvest earnings into its growing business (rather than repurchasing shares to offset stock-based compensation to insiders), appears capable of delivering a long-term stream of cash flows to its investors over time, and has a stock price that appears reasonable in relation to the present value of those expected cash flows, that company may be a useful component to a well-diversified portfolio. Over the years, the emphasis of the Hussman Funds on careful security selection has been an important factor in our investment returns. I expect that, regardless of overall market prospects, we will observe numerous investment opportunities in securities characterized by favorable valuation and market action.

 

As always, the investment positions held by the Funds at any particular time reflect prevailing market conditions, and those positions will shift as market conditions change. We continue to pursue disciplined security selection, while aligning the market exposure of the Funds in response to changing market conditions.

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