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September 6, 2010

The Recognition Window

John P. Hussman, Ph.D.
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Last week's stock market advance clearly reflected relief over an uptick in the ISM manufacturing Purchasing Managers Index (which advanced slightly to 56.3) and fewer employment losses than expected in the August report. Still, the market's reaction was selective from the standpoint of economic data, reflecting the tendency to seize on any piece of comforting news. Objectively, last week's data was mixed at best, as the broader-based ISM services PMI dropped from 54.3 to 51.5, paced by less growth in new orders, and a shift to contraction in the employment component. The U6 unemployment rate, which includes discouraged workers, moved up to 16.7%. Total hours worked were stagnant. New unemployment claims also remained high, at 472,000, though down slightly from the upwardly revised 478,000 claims the previous week (initially reported at 473,000).

The elevated focus of investors on small bits of news is palpable, and can be observed in the recent series of days where more than 90% of stocks have been either up in unison or down in unison. These strong responses to day-to-day news are somewhat understandable, because a further economic downturn is not well-priced into the market, and would most likely prompt a whole host of policy dilemmas. News that appears to reduce that risk is met with relief and short-covering, while news that validates economic concerns causes a spike in risk aversion.

Over the course of the market cycle, one of the primary areas of risk for stocks (and conversely, one of the best periods for Treasury bonds) is typically the "recognition window" where economic activity begins to deviate from the upward trend that is priced into the market, and investors begin to recognize that an economic downturn is, in fact, likely. In my view, the instant relief provoked by the manufacturing PMI and the employment report was an overreaction to data that is still very early in that window. The typical lead times between deterioration in reliable measures such as the ECRI weekly leading index (and several of our own measures) and deterioration in "coincident" economic activity tend to be on the order of 13-26 weeks. For most economic indicators, we are not there yet. This is why I emphasized two weeks ago that "the much earlier deterioration in economic measures is not encouraging, but it also opens up the possibility that we may see some misleading 'improvement' in the data in the next few weeks before we get into the more typical window of deterioration."

Given that comment, I was a bit dismayed last week by a flurry of inquiries we received just after the ISM data was released, asking whether the slight uptick in the manufacturing index was a "game changer" that removed any concern about further economic risks. The same happened in response to the August employment report. If investors who read these comments weekly - and knew that we could observe misleading "improvement" in the data - were still prone to interpret last week's data as some sort of "all clear" signal, it's no surprise that investors may have done the same on a much broader scale.

Unfortunately, this "all clear" impression is based on a lack of appreciation for lead-lag relationships, and the misconception that economic evidence and market movements come in on an exquisitely perfect timeline. The tone of economic data does not turn all at once. There are leading indicators, "coincident" indicators, and lagging indicators. Once leading indicators have clearly deteriorated, it takes a while for coincident indicators to follow. During the interim, small positive surprises in coincident indicators are unreliable. There is also some amount of variability in the timeline. From this perspective, my sense is that investors have abandoned the concern about further economic weakness prematurely.

To clarify the picture that I suspect we may see within the next few months, the chart below presents the historical relationship between the ECRI Weekly Leading Index (growth rate), the Philadelphia Fed Index (2 month smoothing), and the ISM Purchasing Managers Index (manufacturing). As I've noted before, movements in the ECRI leading index tend to precede movements in the PMI by about 13 weeks. Similarly, the Philly Fed index tends to lead the PMI, but only by a month, on average. The red line on the chart below presents the weighted average of the WLI and the Philly Fed Index, shifted ahead by those typical lead times, while the blue line depicts the Purchasing Managers Index.

Note that the latest reading on the PMI was fairly flat, but from the standpoint of the typical profile, was certainly not an outlier. Based on the ECRI and Philadelphia Fed data, however, the prospect of continuing strength in the PMI is not good.

Look closely at the graph above, however, and you'll note that it would be wrong to assume the PMI will follow the ECRI and Philly Fed data with exact precision. Observe, for example, that in 1974, the ECRI and Philly Fed index broke down sharply, but it took 7 months (beyond the normal window) until the Purchasing Managers Index abruptly plunged below 50. By then, the S&P 500 had cratered to one of the worst bear market lows of the post-war period. Likewise, if you look at the downturn in early 2008, the ECRI and Philly Fed index gave a timely warning, but the ISM data held near the 50 level for several months longer than usual before finally plunging. In the intervening period, the S&P 500 lost 20%.

Suffice it to say that it is premature to interpret last week's somewhat benign data as an "all clear" signal for the economy. Yes, this time may be different, and we may somehow skirt evidence that has historically been reliable, but we don't have a clear logical justification based in other data to support a rosy view. Even when statistical relationships are quite strong, the fact is that "coincident" evidence of economic weakness does not follow the leading indicators with flawless precision. We work with probability distributions - not forecasts - and distributions (picture a bell curve) have variation. There is no way to remove this uncertainty, and it is dangerous to assume that last week's data have done so. From my perspective, economic risks continue to be quite serious.

Bearishness without nervousness

An important part of last week's advance appeared to be a simple "clearing" of the a short-term oversold condition in prices and bearish sentiment. While the recent increase in bearish sentiment might have deserved something of a "clearing rally," it is notable that we're observing what might be called bearishness without nervousness. The chart below presents the Investors Intelligence bearish percentage versus the CBOE volatility index (VIX), which is often viewed as a "fear gauge" for the stock market. Historically, increases in the level of bearishness early in a market downturn are often both accurate and persistent, as we observed all through 2008 and in many past market cycles. It's difficult to look at the evidence and conclude that investors are excessively bearish, much less terrified here.

A note on quantitative easing

One of the things I'm increasingly dismayed to learn is that no matter how much detail, data, and qualification I might include in these commentaries, my conclusions will often be summed up by writers or bloggers in a single sentence that often bears no relation to my point. For instance, my view that quantitative easing will trigger a "jump depreciation" in the dollar has evidently placed me among analysts warning of hyperinflation and Treasury default (a club whose card is nowhere in my wallet).

To clarify once again - I emphatically do not anticipate inflationary pressures until the second half of this decade. As I've repeatedly emphasized, the primary driver of inflation - historically and across countries - has been growth in government spending for purposes that do not expand the productive capacity of the economy. It does not matter what form the government liabilities take, because default-free government liabilities and central bank notes are nearly perfect portfolio substitutes (though extreme deficits do tend to be monetized eventually). That said, the seeds of inflation can often remain dormant for years before emerging.

The price level is nothing more than a ratio: the "marginal utility" of goods and services divided by the "marginal utility" of government liabilities. Heavy demand for goods and services in the presence of production constraints is inflationary because it increases the numerator, while credit fears and precautionary cash balances reduce inflation pressures because they increase the denominator. Presently, there is no reason to anticipate inflation until we observe some combination of robust demand for goods and services, production constraints, or reduced demand for cash balances and other government liabilities.

Quantitative easing does not pressure the dollar by fueling inflation. It has a much more subtle effect (but one that can be expected to be amplified if fiscal policy is long-run inflationary as it is at present). Normally, equilibrium in capital flows between countries is achieved through changes in interest rates. As a result, countries with greater capital needs or higher long-run inflation tendencies also have higher interest rates. If interest rates can adjust, exchange rates don't have to. But notice what quantitative easing does: by sitting on long-term bond yields (and creating a negative real interest rate differential versus other countries), quantitative easing prevents bond prices from acting as an adjustment factor, and forces the burden of adjustment on the exchange rate.

While some observers have noted that the value of the Japanese yen did not deteriorate dramatically over the full course of quantitative easing by the Bank of Japan - from its beginning until it was finally wound down - this argument misses the point. The exchange rate depreciation occurs as a jump adjustment in order to set up a subsequent appreciation over time. That gradual appreciation is needed to offset the lost interest difference caused by the policy of zero interest rates.

If you look carefully at Japan's experience over the past decade, that's just what happened. After a period when most market participants expected the Bank of Japan to move to a more neutral policy stance - the market had priced in a modest rate hike in July 2000 - the collapse of Sogo bank that month moved the BOJ back to a zero-interest rate policy, which was followed by explicit quantitative easing several months later. In the 18 months following Sogo's collapse, the yen depreciated by more than 20% (the number of yen purchased by one U.S. dollar increased from 105 to 135). That initial depreciation then set up a subsequent yen appreciation to make up the lost interest rate differential. The chart below traces the path of the yen versus the level implied by purchasing power parity (PPP).

In short, quantitative easing is not a story about inflation. It is a story about capital market equilibrium and the need for exchange rates to act as the adjustment variable when the central bank lays its weight on the bond market. The likely outcome of quantitative easing is not hyperinflation. Rather QE is likely to provoke a relatively quick plunge in the exchange value of the U.S. dollar.

With respect to gold and precious metals, as I noted years ago in Going for the Gold, factors that influence real interest rates and the value of the U.S. dollar are the primary drivers of gold price fluctuations. Moreover, the level of gold stock prices relative to the price of the metal provides useful information that is well-correlated with subsequent long-term returns in those shares. While I consider our present holdings of gold shares in Strategic Total Return as moderate, and we would prefer some amount of share price weakness before establishing a more aggressive stance, the high gold/XAU ratio, weak leading economic indicators, and renewed real-interest rate pressures all appear supportive.

Valuation update

On the valuation front, we presently estimate that the S&P 500 is priced to achieve total returns over the coming decade of less than 6%. Though we use a variety of methods, the consensus estimate is at about 5.6% annually. I've detailed our estimation methodology in numerous weekly comments over the years. Below is a chart taking this analysis back to 1928. It would be nice, before quoting alternative valuation models, if Wall Street analysts would at least present similarly broad historical evidence that their methodology actually has a relationship with subsequent market returns. If a valuation opinion doesn't come with extensive historical evidence, it's noise.

That said, one thing that does concern me about the foregoing model is that our "real" inflation-adjusted version projects a 10-year real total return for the S&P 500 of just over 1% annually. That suggests that about 4% of the nominal return projection represents implied inflation, which would be consistent with post-war U.S. history, but may or may not be accurate in this instance. My guess is that, in fact, we will observe significant CPI inflation in the latter half of this decade. Still, it is worth noting that our projection for real 10-year returns is not compelling in any case. 10-year real returns for the S&P 500 have been predictably negative since 1998, but it is unfortunate that except for a few weeks in early 2009, we have not yet achieved a level of valuation from which we can expect a meaningfully different result.

It continues to fascinate me that Wall Street analysts choose to benchmark projected S&P 500 returns against the 10-year Treasury yield. A 10-year Treasury note has a duration of about 7 years (which also implies roughly 7% price fluctuation in response to a 100 basis point change in yield). The S&P 500 presently has a duration of nearly 50 years, which is the investment horizon one needs to have in order to be completely indifferent to the shorter-term path of stock prices. The models and comparisons made by Wall Street between operating earnings yields and interest rates are a complete absurdity, which can be easily demonstrated by looking at the historical record (which I've presented repeatedly).

To the extent that investors wish to compare our 5.6% estimate for 10-year S&P 500 total returns with the 2.7% yield on 10-year Treasuries, it is important to recognize that the higher 10-year expected return in the S&P 500 comes with a several-fold increase in risk, particularly over a shorter horizon. Moreover, the divergence between the two figures tends to expand, not contract, during economic downturns. Stocks are not cheap, and to the extent they may outperform bonds over the next 10 years, it will most likely be with extreme discomfort. My impression is that near-term risk in the stock market is very high, while the risk for bonds is more long-term in nature. As with economic data, expected outcomes should not be treated as if they are deliverable with exquisite precision. Long-term returns are not achieved in a straight line.

Observations on massive mortgage refinancing

One of the policy suggestions bouncing around recently involves refinancing all of the mortgages held by Fannie Mae and Freddie Mac. This policy would essentially repay Fannie and Freddie security holders at par (face value), and replace those mortgage pools with freshly issued securities. At present, longer term agency securities typically trade at prices higher than face value because the underlying mortgages were set at interest rates well above the interest rates available now, so a massive refinancing would involve immediate losses to existing holders of agency debt.

Unfortunately, the primary loser would be the Federal Reserve, whose holdings are predominantly long-term mortgage bonds, mostly at prices significantly higher than face (with the possible exception of any newly issued debt having below-market coupons). From my perspective, massive refinancings would have been a better idea before Bernanke and Geithner put us on the hook for losses on agency debt that never had an explicit government guarantee. In effect, the old holders of those agency securities have already walked away with the cash, so the Fed would take the loss in the event of refinancing. It would also undoubtedly be the buyer of the freshly issued refinancing bonds.

Existing borrowers in those mortgage pools would benefit from a reduced interest burden, but as a significant percentage of those homes are worth less than the mortgage principal, it would still leave a great deal of foreclosure risk in the system. In any event, a massive refinancing would entail a reduction in interest rates to homeowners at prevailing levels, with a major loss to the Federal Reserve, which already paid above-par to the previous owners of those Fannie and Freddie securities.

Of course, existing holders of above-par agency securities would also take a loss, and to the extent that they are holding hedged positions (long agency, short other long-duration instruments), it follows that they would have to reposition by absorbing the loss and buying newly issued agencies, or alternatively, cover their hedge by purchasing long-duration instruments (primarily long-term Treasury debt).

As a result, the full impact of a massive refinancing would be a) a major loss to the Fed, since prior owners of that agency debt already received full value; b) a loss to agency debt-holders who still own securities above par; and c) a possible spike in the price of long-term Treasury bonds as private market participants respond to the abrupt shortening of the asset side of their portfolios. Of course, it's possible that the Fed could simultaneously sell Treasuries and buy even more agency debt, which would take the pressure off of the Treasury market and load the Fed's balance sheet with even more underwater mortgage debt. But in any event, it should be observed that the primary loser in the event of a massive refinancing would be the Fed, and by extension, the public. It would be a large transfer of wealth from the general public to specific mortgage borrowers. Again, this would not be monetary policy - it would be pure fiscal policy, and any such action should be subject to Congressional approval.

Market Climate

As of last week, the Market Climate for stocks was characterized by unfavorable valuations and mixed market action, coupled with still-negative economic pressures overall. From a technical standpoint, the market is displaying a specific set of trends and divergences that has often been associated with "whipsaw" reversals. Internal dispersion is increasing, which can be observed, for example in the relatively high number of stocks establishing both 52-week highs and 52-week lows. When this sort of dispersion is coupled with overvaluation and negative economic pressures (which we also observed, for example, in Nov 1973, June 1990, Nov 2000 and June 2008), the subsequent outcomes have often been quite awful. Once those conditions are all in place, one indication of immediate risk is a "leadership reversal" where the number of new lows predominates following a week where new highs predominate (though you sometimes see a couple of these events a few weeks apart near market peaks if prices are whipping around).

A leadership reversal here could be followed by a lot of damage, particularly if a break of the repeatedly-tested 1040 area on the S&P 500 was to prompt selling pressure by the technical crowd. Barring such a reversal, the market appears likely to whipsaw back and forth within the trading range the market has established in recent months. Again, the best description of market action here is "mixed." The Strategic Growth Fund remains fully hedged here.

In bonds, the Market Climate remained characterized last week by moderately unfavorable yield levels and favorable yield pressures. The Strategic Total Return Fund continues to carry a duration of slightly over 4 years, mostly in straight Treasury securities. As noted above, the Strategic Total Return Fund also holds a moderate position in precious metals shares, representing about 10% of assets, with about 5% of assets in foreign currencies. Approximately 2% of assets are invested in utility shares.

In my view, bonds are further into the "recognition window" than stocks are, as bond market action is increasingly contemplating downside risks to the economy as well as further policy actions by the Federal Reserve. To the extent that analysts and investors still doubt and debate economic risks, it appears unlikely that these risks are fully reflected in bond prices, and to that extent, it also appears unlikely that positive economic surprises will significantly shake the bond market. In contrast, at the point where worsening economic activity is well-recognized, there may be little prospective return and substantially greater risk in holding longer maturity Treasuries.

Last week, we opened the Hussman Strategic International Equity Fund (HSIEX) to new shareholder investments. We're confident that the new Fund will help to address the existing need for risk-managed mutual funds in the international markets. Probably the best description of Strategic International Equity is that it is intended to be a risk-managed international fund - essentially an international version of Strategic Growth, based on largely the same stock selection and hedging approach. The inception of the Fund was actually December 31, 2009. Over the past several months, we have established and tested brokerage, clearing, accounting, custody and other functions of the Fund. I will be managing the Strategic International Equity Fund with Bill Hester as the co-portfolio manager.

I should note that since we incurred all of the normal fixed costs of a Fund during the past several months with a small capital base, you'll see a somewhat out-of-whack 5% "gross" expense ratio and a 2% "net" expense ratio in the financial report covering the first 6 months of this year. In practice, the expense ratio is capped at 2% through 2012, but as with the other Hussman Funds our expectation is to reduce the expense ratio promptly in response to asset growth. See the Prospectus for more detail on risks and expenses.

The Hussman Funds don't run advertisements, we don't have sales reps, we don't charge 12-b(1) fees, and we don't launch our Funds with press releases and dog-and-pony shows. We don't want the Funds to be "sold" to anybody. Instead, what we prefer is that investors read each prospectus carefully (see The Funds page), read the financial reports, examine the portfolio holdings, track Fund performance, read the weekly commentaries, and understand our investment strategy before investing. As with Strategic Growth and Strategic Total Return, Strategic International Equity is intended to outperform its benchmark (the EAFE) over the complete market cycle (bull market plus bear market) with smaller periodic losses than a passive "buy and hold" approach. However, the Fund is inappropriate for investors who wish to closely track market fluctuations or have short-term (rather than full-cycle) investment horizons. On the subject of portfolio allocation, we don't advise any specific mix of Funds, because the situation of each investor is different. Still, just as a "standard" allocation for U.S. stocks, bonds and international equities is typically 50-60%, 20-30%, and 10-20%, respectively, our view is that the same range of allocations is probably reasonable as a "standard" portfolio mix for the risk-managed portion of investors' portfolios.

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