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August 24, 2009

Bernanke Sees A Recovery - How Would He Know?

John P. Hussman, Ph.D.
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Reprint Policy

Just a note - the Hussman Funds Annual Report (fiscal year ended June 30, 2009) - is now available. There is an additional link at the end of this weekly comment.

The printed report is currently in press, and will be mailed shortly (as with corporate earnings releases, audited financial statements for mutual funds tend to lag the closing date of the fiscal period by several weeks). Since some of our shareholders are not regular readers of these comments, those of you who are will see a few themes repeated in my letter to shareholders. I suspect that my continued skepticism about blue skies ahead is self-evident, but as usual, we'll take our evidence as it comes, and even here we have a position in index call options (as something of an "anti-hedge" in the Strategic Growth Fund) that is now slightly in-the-money. Don't miss the Note on Risk and Return in the letter to shareholders, which shares some thoughts I believe are essential to good investing.


"Our forecast is for moderate but positive growth going into next year. We think that by the spring, early next year, that as these credit problems resolve and, as we hope, the housing market begins to find a bottom, that the broader resiliency of the economy, which we are seeing in other areas outside of housing, will take control and will help the economy recover to a more reasonable growth pace."

Ben Bernanke, Federal Reserve Chairman

On Friday, investors took great cheer in an optimistic statement by Ben Bernanke suggesting good prospects for economic growth ahead. We might be inclined to place a sliver of credibility in Chairman Bernanke's assessment - if not for the fact that the quote above wasn't from last week at all, but rather, hails back to November 8, 2007, just before the recent recession began. You might recall that the S&P 500 was pushing 1500 at the time. The implosion of the global credit markets was still just a slight rumble.

As it happens, that was also the week our recession warning composite shifted clearly into negative territory, prompting the weekly comment Expecting A Recession, where I wrote "On Saturday, the consensus of economists surveyed by Blue Chip Economic Indicators indicated expectations that growth will be sluggish into next year, but that there will be no recession. Unfortunately, the economic consensus has never accurately anticipated a recession. For my part, the outlook has changed. I expect that a U.S. economic recession is immediately ahead." That was followed the next week with Critical Point, which opened with a saying of Rudiger Dornbusch: "The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought."

A good economist thoughtfully recognizes "general equilibrium" - resources moved to one place must be taken from somewhere else. Securities or monetary liabilities, once issued, must be held by someone in the economy until they are retired (the failure to recognize this is the basis for the "cash on the sidelines" fallacy). Instead, Bernanke's economic research is a minefield of partial equilibrium analysis. Helicopter Ben is a lot like John Maynard Keynes, who wrote in his General Theory "If the Treasury were to fill old bottles with banknotes, bury them at suitable depths, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again, there need be no more unemployment."

Solving economic problems, to our Fed Chairman, is as easy as throwing money out of helicopters. Not surprisingly, throwing money out of helicopters has been the basic core of his strategy during this crisis. This does not involve complex thought about debt restructuring, moral hazard, incentives, equitable distribution of resources, or other factors. All it requires is the three second tape playing in Bernanke's head - "We let the banks fail in the Great Depression, and look what happened." And then the tape repeats. Never mind that the cause of the upheaval was not the failure of banks per se, but the disorganized Lehman-style failure of banks. The tape isn't long enough to encompass such nuances.

Ben Bernanke (like Tim Geithner and his predecessor Hank Paulson), shows no hesitation in diverting the real resources of the American public to defend and compensate the bondholders of mismanaged financial companies who made reckless loans and who should have (and equally important, could have) been expected to write down principal or swap debt for equity as an alternative to receivership. This is not decisiveness. It is timidity and poor stewardship. Worse, the underlying problems are not healed - only band-aided temporarily by a flood of public money.

Unfortunately, the resources used in the recent bailout were not just free money tossed out of a helicopter. Only a partial-equilibrium economist thinks that way. No, this was an allocation of trillions of dollars of real resources that could be spent improving access of poor families to health care, finding cures for life-changing diseases, providing better education, and reversing the crowding-out of productive private investment. A public servant willing to act this carelessly with the resources entrusted to him, and so strongly in defense of fellow bankers, frankly does not deserve the job. Most likely, we will face the same credit issues a few quarters from now, given that the lull in the adjustable-rate reset schedule is near its end. We continue to expect a fresh acceleration of credit losses as we enter 2010. It would be best if we faced these challenges with more thoughtful leadership.

Meanwhile, Harvard economist Martin Feldstein (who was the likely alternative for Fed Chairman when Bernanke was appointed) noted last week "I think we'll see a positive number in the third quarter, but what will it be driven by? Fiscal stimulus, Cash for Clunkers, and some inventory building. But the question is what happens next - in the fourth quarter and into next year - and I think there's a real danger of a double dip." Elsewhere, Alan Greenspan concurred, saying "We're OK for the next six months. We are getting a recovery… but the process doesn't have legs to it."

A second part of Friday's enthusiasm, of course, was the sharp jump in the rate at which lenders are realizing losses on failing mortgages. That, as it happens, is what was behind the sharp jump in the rate of existing home sales. As John Mauldin recently pointed out, a June survey of 1500 real-estate agents by Mortgage Finance found that only 36% of all existing home sales involved "non-distressed" properties, and of those, only 31% were described as unforced or optional, the remainder being sales prompted by personal financial difficulty such as unemployment or changes in family circumstances, but without a delinquent or foreclosed mortgage. As John wrote, "Think about that for a minute. Two-thirds of home sales are either foreclosures or banks taking a loss on the mortgage. And only a third of the remaining one-third - roughly 10% of overall sales - comes from something we could call a normal selling process."

Rest easy though. Bernanke sees a recovery.

Market Climate

As of last week, the Market Climate for stocks was characterized by unfavorable valuations and mixed market action, with strong breadth and major indices generally trending higher, but still tepid sponsorship evident in trading volume and strenuously overbought conditions. Currently, we estimate that the S&P 500 is priced to deliver average total returns over the coming decade of only about 6.8% annually.

Presently, about 40% of our defensive hedge in the Strategic Growth Fund is covered with what are now in-the-money index call options, so we will allow the market to put us in a more constructive position - without removing our existing downside protection - if investors are inclined to carry the market higher on the winds of questionable economic enthusiasm. The overall "delta" of the Fund is still relatively flat, but will pick up more positive exposure to market fluctuations if the market advances further. This does mean that we will stand to lose whatever we gain on a decline back down toward current levels, so the call exposure will be profitable only if the market sustains an advance. Our exposure to index calls is currently just over 1% of assets, and we are otherwise well-hedged against any serious downside that might emerge.

In bonds, the Market Climate continues to be characterized by relatively neutral yield levels and moderately unfavorable yield pressures. Yields are generally in the middle portion of what I view as a wide trading range, so we are maintaining our current positions, with an eye toward adding some additional duration exposure on yield spikes above, say, 4% on the 10-year Treasury, and clipping off some duration on significant declines in yields. The Strategic Total Return Fund also holds somewhat less than 20% of assets in bond alternatives such as foreign currencies, precious metals shares, and utility shares.

Just released: Hussman Funds Annual Report (fiscal year ended June 30, 2009)


The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

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

Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 reflect our standard valuation methodology, focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle (see for example Investment, Speculation, Valuation, and Tinker Bell, The Likely Range of Market Returns in the Coming Decade and Valuing the S&P 500 Using Forward Operating Earnings ).

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