NEW YORK (MONEY Magazine) - Call John Hussman a cautious optimist. The manager of the $1 billion Hussman Strategic Growth fund has plenty of money riding on some of America's biggest companies, including Merck, Eastman Kodak and Home Depot.

But Hussman also worries that the stock market as a whole is grossly overvalued. So to protect against any sudden drops, he's using a complex hedging strategy to short -- that is, bet against -- major market indexes.

At the ripe old age of 41, Hussman is a former economics professor with a Ph.D. from Stanford. His four-year-old fund has been a solid performer, especially (no surprise) during the last bear market, gaining 15 percent in 2001 and 14 percent in 2002.

But unlike some funds that bet on the short side -- notably David Tice's Prudent Bear -- Hussman also managed to make some money in the 2003 upturn. MONEY's Jonah Freedman asked Hussman to explain his take on the market and which stocks he thinks are still worth holding.

Q. You think the market is the most overvalued it's been since 2000. What are the telltale signs?

Hussman Strategic Growth (HSGFX)     Manager tenure:  Four years  Assets:  $1 billion  Annual expenses:  1.31%  Load:  None  Minimum:  $1,000  Minimum IRA:  $500   Contact:  800-487-7626; hussmanfunds.com   Note: As of March 18.  Source: Hussman Funds.

A. Right now Standard & Poor's 500-stock index is trading at 21 times prior peak earnings. With the exception of the late 1990s bubble, that's an unprecedented valuation. The 1929, 1972 and 1987 market peaks all occurred at no higher than 20 times prior peak earnings.

Q. What do you mean by prior peak earnings? Why not just look at the market's P/E ratio?

A. I'm comparing current prices to the highest level of earnings attained on the S&P 500 to date -- the peak was the third quarter of 2000. It's a useful measure of valuation because it's not influenced so much by short-term fluctuation in earnings.

Here's how you know when things are getting dangerous: You begin to observe breakdowns in the favorable picture. There are a few initial breakdowns that I'm watching closely. Despite the recent new highs in the Dow and the S&P 500, the Russell 2000 failed to establish a new high. Transportation stocks also failed to establish a new high, and the number of stocks hitting new highs trailed off despite the new highs in the indices.

Q. And now the market has been performing poorly for the past few weeks.

A. Unfortunately, the overvaluation I'm referring to is substantially greater than could be worked off through a minor decline like we've seen. Hands down, the worst periods for stocks occur when valuations are elevated and investors become skittish toward risk. So far we've got one, but not quite the other.

Q. Explain how you are trying to protect the fund.

A. The fund is fully invested in nearly 200 individual stocks across a wide range of industries, so it's highly diversified. But because of valuations and some of these initial deteriorations we see, about half of that value is hedged against the impact of market fluctuations with an offsetting short-sale option in a major index.

I use the Russell 2000, which hedges some of our smaller-cap stocks, and the S&P 100 for our larger-cap stocks. This is not a bearish call. It's simply to reduce the impact of market fluctuations on the fund. We still get to hold stocks that we think are great values, but without the corresponding exposure to volatility.

Q. Some of the fund's largest holdings really have been beaten up recently. Why are you sticking with them?

Hiding in the hedges A bet on short options protected Hussman Strategic Growth from the 2000-2002 bear market. Even so, the fund stayed in the black in 2003. NAME (TICKER)  % OF PORTFOLIO  Merck (MRK)  2.4  American Power Conversion (APCC)  2.2  Home Depot (HD)  2.1  PacifiCare Health Systems (PHS)  2.0  Eastman Kodak (EK)  2.0  Gap (GPS)  2.0  Guidant (GDT)  2.0  Macromedia (MACR)  1.8  Linens 'n Things (LIN)  1.8  King Pharmaceuticals (KG)  1.7   Note: As of March 18.  Source:  Hussman Funds.

A. There have been some clear disappointments with our biggest holding, Merck (MRK: Research, Estimates), in the recent pipeline of potential drugs. But investors have to remember that stocks are a claim on a very long-term stream of cash flows. This is a company that has a long history and a long future, so the extent to which investors discounted the stock exceeds the probable impact of that disappointment.

Q. What about Eastman Kodak (EK: Research, Estimates), another of your biggest holdings?

A. I was more fond of Kodak when it was at $21. [It was $25 in mid-March.] But I think Kodak got overly depressed on the basis of investors' love of all things digital and disdain for all things Old Economy.

The fact is that Kodak has a widely diversified product line, and of course once the company restructured its business strategy, the stock suddenly went up 30 to 40 percent. This is why a guy like Warren Buffett doesn't buy Krispy Kreme; he buys Coca-Cola. He understands the difference between a durable revenue stream and a fad.

It's the same with Home Depot (HD: Research, Estimates), another stock we own. Like Kodak, it had short-term marginal problems, but I believe the stock is attractively valued and was hurt far more than I thought was reasonable given some short-term margin disappointments.

Q. How do you respond to criticism that the fund lags in bull markets?

A. This bull market started at higher valuations than any historical bull market ever started at. Last year, we did lag -- the fund was up 21 percent while the S&P 500 was up 29 percent. But I really try to put together a fund that satisfies particular needs of investors: long-term growth and capital appreciation, but also some level of risk management.

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There are a lot of funds that try to track the market and beat it incrementally or try to exploit various areas with a lot of momentum, like technology. But there aren't a lot that do a good job of managing risk.

I think investors are sometimes encouraged in a rising market to focus on unrepresentative measures of performance. They want to know which funds have done best since the market low. If you ask that question, the answer will always be the funds that took the most risk.

What funds have done the best? They're hands down the most volatile, typically low-quality funds. I think our shareholders understand that we aren't willing to gamble their capital in order to track the market if conditions aren't favorable enough.