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December 22, 2003

Bait & Tackle

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

The quickest way to hook a fish is to give it some idea that it has an easy target. That's why fishermen use artificial minnows. You give them a little tug with the tip of the fishing rod as you reel them in, so it looks like the poor little fellas are injured and struggling against the current. That's what a trout wants. An easy, free lunch.

Many investors, unfortunately, are no different. As Richard Russell of Dow Theory Letters has often said, every bear market has a hook - some notion, often patently false, that keeps investors holding on despite their mounting losses.

During much of the excruciating 2000-2002 decline, the hook was Fed easings "in the pipeline." To that point there was a significant amount of market history suggesting that two easings by the Fed were quickly followed by stellar market returns. As I argued at the time, that pattern was not likely to hold in an economic downturn driven by overcapacity and a broad plunge in capital spending. This was particularly true given that banks were tightening their credit standards. Unlike most economic downturns, the recent one was a situation where companies were not particularly willing to borrow, and banks were not particularly willing to lend.

Even the recovery that has taken place has been driven not so much by new bank lending, but by "helicopter money" dropped onto consumers via tax rebates and mortgage refinancings. (In contrast, other economic downturns in recent decades were associated with relatively mild shifts in the mix of goods demanded, resulting in large inventory disinvestment in a narrow range of industries, but continued demand for loans elsewhere in the economy).

Despite evidence that there was no reliable mechanism to link monetary easing with increased lending, analysts adopted a common mantra about Fed easing being "in the pipeline." The more that phrase "in the pipeline" caught on, the more it became clear that those easings were already priced into the market, and the more it became clear that this was the "hook."

Spinners and Minnows

Well, in our relentless quest for ideas that are already priced into the market, we've found two new hooks: the "sweet spot" and the "synchronous global expansion." My guess is that you'll soon be hearing these phrases a lot.

The clear appeal of these hooks is that they make investing look easy. What investor doesn't want economic growth without inflation, especially when it is firing on all cylinders internationally? What could be easier than that?

Then again, what could be easier than eating that injured little minnow struggling against the current? If investors don't look for the hooks, they're likely to be reeled in like trout.

The basic idea of a "sweet spot" is that the economy is growing, but not by enough to produce inflationary pressures. It's actually a notion that briefly surfaced early in the 2000-2002 market plunge, but quickly went into hiding. The phrase has resurfaced, and once you're attentive to it, you'll suddenly notice how many analysts are parroting the idea as an argument to buy stocks.

As a fund manager, the whole concept of a “sweet spot” is disturbing. It suggests that stocks are simply a thermometer of short-term conditions and can be purchased without regard to the long-term stream of cash flows they represent. To promote stocks on the basis of a sweet spot – without discussing or accounting for valuations – reveals a short-sighted understanding of finance and a reckless tendency to jump on the bandwagon.

The idea of a "synchronous global expansion" is that since the recent economic downturn was global in nature, the ensuing recovery will also be broad, leading to much more rapid and sustainable growth than otherwise.

Examining the recent economic expansion, it is clear that is anything but normal. While an overlay of recent economic behavior over "typical" recoveries makes this expansion look fairly standard, that kind of analysis overlooks the enormity of deficit spending and mortgage refinancing required to attain it. These sources of growth were one-shot, lump-sum jolts to the economy.

There's no question that economic growth will propagate for a couple of quarters, largely due to inventory rebuilding. There's also little question that we'll see some growth in capital spending, offset by a downturn in housing investment. Employment will also probably improve as well, with the unemployment rate dropping perhaps a half-percent in coming quarters. But overall, the underpinnings of the economy - massive corporate and consumer indebtedness, huge fiscal deficits, and a record current account deficit - underscore the likelihood of further deleveraging of the U.S. economy in the next several years. As a rule, deleveraging (gradual reduction of debt - requiring slower growth in consumption and investment) doesn't lend itself to economic booms.

In my November 10th market comment, I argued that one of the key sources of the apparent "productivity boom" in the U.S. has actually been import growth. Growth in imports, coupled with strength in the dollar, was one of the main factors that kept U.S. inflation firmly in control during the late 1990's. The flipside is that as the U.S. dollar weakens and import growth slows, we're likely to see both higher inflation and lower productivity growth figures. We would already be seeing this, were it not for the continued appetite of China and Japan for U.S. dollar assets, which has prevented the current account deficit from narrowing despite significant weakness in the dollar. If that demand begins to weaken, and there is every reason to expect that it ultimately will, U.S short-term interest rates will be quickly pressured higher, Fed tightening or no Fed tightening, accompanied by further dollar weakness and inflation pressures. (As for the argument that rising short-term rates in the U.S. would help the dollar, the interest rate that matters is the long-term, real interest rate on dollar assets, and it's not at all clear that this would rise even if short-rates do).

Though it doesn't necessarily follow that a coordinated downturn in the world economy must be accompanied by a coordinated upturn, there actually is some evidence that a pickup in economic activity is occurring globally. Unfortunately, the main impact of this is not on U.S. economic growth but on commodity prices. The debt burden of the U.S. already ensures that future growth in U.S. consumption and investment will fall short of overall GDP growth, which is another way of saying that exports are likely to grow faster than the economy, and imports slower.

So there is a certain benefit that exporters will experience if indeed we get global economic growth, but particularly in the financial markets, this benefit is likely to be offset by upside surprises in inflation and interest rates.

Prices already reflect the economic outlook

Needless to say, many of the most overvalued stocks in the market are elevated exactly because they already price in the economic outlook. These include cyclicals like Caterpillar, Ingersoll Rand, United Technologies, MMM, and Deere, industrial metals stocks like Alcoa and Inco, and tech companies situated to benefit from additional capital spending such as IBM, EMC, KLA Tencor, Symantec, Adobe, Dell, Texas Instruments, Xilinx, and National Semiconductor. A handful of other stocks round out our list of most overvalued large stocks, including financials like American Express, Unionbankcal, Bank of New York, M&T Bank, and oddities like Allergan (maker of a diversified line of eye care products and Botox).

In summary, then, we can expect a number of developments in the quarters ahead:

1) A moderate continuation of economic growth, paced by inventory rebuilding;

2) A pickup in capital spending at the expense of housing investment;

3) A pickup in export growth at the expense of the U.S. dollar, and;

4) A modest period of stability in short-term interest rates, followed by an abrupt and larger-than-expected increase (particularly if foreign governments slow their accumulation of U.S. Treasuries), with an equally abrupt increase in inflation pressures.

Meanwhile, it's clear that stocks are unusually overvalued, and that while increases in short-term interest rates are already priced into the yield curve, bond investors may not be fully prepared for the speed and extent to which short-term rates will actually rise (an increase in Treasury bill yields toward 4% during the next 12-16 months appears likely in our work).

As usual, we don't base our investment positions on forecasts, but on the prevailing Market Climate that we identify at any given time. At present, stocks remain unusually overvalued, but they still display moderately favorable market action, which suggests that for now, investor's still have a willingness to take risk. That doesn't ensure further market gains, but we can't rule them out. In any event, however, further gains would be based on purely speculative merit, not on investment merit arising from “sweet spots” and “synchronous expansions.” Despite the temptation to make a free lunch out of those minnows, investors might want to think carefully before swallowing the lines that Wall Street analysts are tossing out here.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and still moderately favorable market action. The Strategic Growth Fund remained fully invested in stocks that appear to have some combination of favorable valuation and market action, with just over half of that portfolio hedged against the impact of market fluctuations. We're also holding a modest “contingent” position in out-of-the-money put options. Though this position represents only a fraction of 1% of assets, our measures of market action are becoming increasingly “hot” – it would no longer take a great deal of deterioration to shift the Market Climate to a fully defensive stance, and there is at least some potential for this to occur abruptly.

Recently increasing investor attention toward blue chips is actually something of a negative in that investors seem to be taking a more selective approach toward stock investments. As usual, this is not a forecast, and we're perfectly willing to allow our small put option position to decay if the market turns out to have more wind behind it. But again, at these valuations and with a modest increase in the selectivity of investors toward risk, we can no longer be confident that investors' risk preferences are robust. We remain positioned to gain primarily from market advances (and the dollar value of our shorts never materially exceeds our long holdings), but it's fair to say that we've modestly ratcheted up our level of caution.

In bonds, the Market Climate remains characterized by modestly unfavorable valuations and modestly unfavorable market action, holding us to a short-duration portfolio of less than 2 years (i.e. a 1% move in interest rates would be expected to affect the Strategic Total Return Fund by less than 2% on account of bond price fluctuations).

Precious metals stocks corrected last week, but the metal did not correct as significantly. As a result, the ratio of the gold price to the XAU is again above 4.0, which has historically been a reasonable level of valuation. The ideal conditions for gold stocks occur when, in addition to reasonable valuations, there is pressure on the U.S. dollar as a result of upward inflation pressures, early weakness in the economy, and falling nominal interest rates. This combination typically happens very early into economic downturns. We don't see that yet, so it is not appropriate to take a significant exposure to precious metals shares here. But valuations, combined with increasing pressure for revaluation in Asian currencies is enough to make us willing to buy very lightly into weakness in gold stocks. We did a bit of that late last week in a handful of issues. Again, however, overall conditions for precious metals are not compelling enough for us to take positions of significant size yet.

It's a Boy!

“Where your treasure is, there will your heart be also.”

Merry Christmas.

Wishing you also a Happy Hanukkah, a promising New Year, and most importantly, a joyful heart. I am grateful for the trust that you've placed in me, and I hope that I've served that trust well.

Best wishes,

- John


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