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December 4, 2006

Goldilocks' Wake-Up Call

John P. Hussman, Ph.D.
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“Just then, Goldilocks awoke and saw the three bears. “Help!” She cried, and she jumped out of the bed, ran down the stairs, opened the door, and fled into the forest. "Get away! Away from that house!" she told herself as she ran, forgetful of all the trouble she had so unkindly caused...”

At present, there is a certain inconsistency – a sort of tension – between various market conditions, which suggests that the markets may be close to adopting a new “theme” to replace the “Goldilocks” one that it has been clinging to in recent months. Those conditions include rich stock valuations on record profit margins, an inverted yield curve, an abrupt break in the U.S. dollar, upward pressure on commodity prices, falling interest rates but at already depressed levels, persistent core inflation at a level that remains “uncomfortable” to the Federal Reserve, clear weakness in the housing sector, and a softening ISM purchasing managers index (even while the prices paid index increased).

The stock market has remained reasonably firm on the theme that, while the economy may be softening more than expected, this just makes it likely that the Fed will cut interest rates sooner rather than later.

My guess for a possible new theme: the economy is slowing, profit margins are in trouble, and the Fed can't ease without provoking a dollar crisis because China and Japan are diversifying their central bank holdings from the dollar to the Euro.

See, even if one believes in the effectiveness of the Federal Reserve, a look at the data quickly makes it clear that the Fed has its hands tied. It would be damaging enough to Bernanke's nascent credibility to loosen monetary policy while core inflation remains well above the Fed's target range, but to do so when the U.S. dollar is already weak and commodity prices are pushing higher would only add fuel to those pressures.

Yes, if the economy remains relatively soft, inflation figures come in very benign and the dollar recovers, the Fed will have the leeway to cut rates. The problem is that the markets have already taken all of that as a fait accompli. Stocks and bonds are now priced to rely on those outcomes.

As always, we set our investment positions based on prevailing, observable evidence, but in preparing psychologically for what might be ahead, the two most important questions, in my view, are: 1) why is the dollar weakening? and 2) how likely is a recession?

Dollar weakness

With regard to the sudden dollar weakness, it's not evident that there's been any particular surge in the supply of U.S. dollar liabilities, so it's reasonable to assume that foreign demand has shifted – at this point probably a reduction in the pace at which foreign central banks are purchasing U.S. Treasuries. My guess is that China and Japan are diversifying their central bank reserve assets into the Euro. If that's the case, we'll observe it in the next few months as a surprising “improvement” in the U.S. current account.

Now, if a reduction in foreign demand was the whole story, we would also probably be seeing weakness in the U.S. Treasury market, which hasn't been the case. So it stands to reason that at least for the time being, the eagerness of U.S. bond investors to accumulate bonds, based on evidence of a weakening economy, has been more than enough to offset the lost foreign demand. The question then becomes whether this is sustainable, and whether it is reasonable.

From the perspective of someone who doesn't place much faith in the Federal Reserve (see Superstition and the Fed), my impression is that the bond market has now allowed itself little room for error even if the economy slips into recession. At this point, the Fed could cut rates repeatedly with the only effect being a normalization of the front-end of the yield curve. The Fed's actions clearly determine the Federal Funds rate, but that's the only maturity on the yield curve where they do have effect. If you look at the yield curve, you'll see that it drops from 5.25% for overnight money and the very shortest-dated Treasury bills, down to about 5% for 3-month T-bills, and quickly down to about 4.5% for longer term bonds. The Fed Funds rate is now an outlier – market rates are, if anything, leading the Fed.

Now, one might argue that the reason the yield curve is inverted in the first place is only because the bond market believes that the Fed is going to cut interest rates in the future on the basis of a soft economy, but given the evidence that the Fed's open market operations (and total bank reserves themselves) are tiny – minuscule – relative to the Treasury market and foreign investment flows, why insert the middle man? Why assume a powerful cause-and-effect link from the Fed to the markets, where we can find no materially relevant mechanism other than words and the belief that the Emperor has clothes? Are we really so afraid to think that we, as investors, collectively drive the markets?

In any event, the bond market has priced in not only a weak economy but also an easing of inflationary pressures. It now matters enormously whether or not inflation slows – particularly core, PCI and wage inflation, where to this point we haven't observed much progress.

One might expect the weaker Purchasing Managers Index to be helpful to the cause of slower inflation, but you won't find it in the data (nor is there any discernable tendency, on average, for inflation to fall as the economy approaches recession). Indeed, core inflation has been higher, on average, when the PMI has been below 50 than when it has been above 50 (and it has been higher still when the yield curve has been inverted).

That said, despite stubborn core and wage inflation numbers, the headline CPI and PPI inflation numbers have been surprisingly good over the past two months. In the context of other economic data, those figures have been unusual, but unfortunately, those figures also have too much month-to-month noise to take much of an information signal from them. If those good headline numbers actually represent information, then the next numbers may indeed look as the bond market hopes (though one gets the impression it's already been priced in). On the other hand, if it has been noise, we could be in for some fairly sharp mean reversion.

Having priced in favorable news, the bond market seems to present a fairly asymmetric return/risk tradeoff. If the favorable news arrives, there may not be much benefit because it's so heavily discounted already. In contrast, bonds could prove to be very vulnerable in the event of unfavorable inflation figures.

Recession risks

Last week, James Montier of Dresdner Kleinwort in London noted that based on the yield curve and the level of Fed Funds (a model developed by John Wright at the Fed), the probability of a recession within the next 12 months appears to be about 50%.

Of course, there are a number of additional indicators with good records of discerning recession risk, so I estimated a small but more extended “probit model” last week on a somewhat more demanding question: What is the probability of a recession beginning within the next 6 months?

Well, on the basis of a larger data set that includes interest rate differentials (yield curve, credit spreads), housing starts, and the ISM Purchasing Managers Index, the probability of a recession beginning within 6 months has spiked to about 79%, with the probability of a recession within 12 months now running about 92%. That's not certainty, however, and there have indeed been a few times when risk has shot up without an imminent economic downturn (the spike in 6-month risk to 83% in 1989 was not followed by a recession for a full year, and a couple of lesser spikes in the 1990's were uneventful). Suffice it to say that based on recent data, the odds of an oncoming recession have increased sharply and abruptly.

Also, to update an indicator that I've tracked in these comments from time to time, the following chart updates the indications from housing starts (the chart depicts the 12-month stochastic of 24-month exponential moving average, which has historically captured informative swings in this data). A collapse in the housing starts oscillator to zero, as we currently observe, doesn't ensure an oncoming recession, but it's clearly an important factor. Every prior recession has been preceded or accompanied by weakness on this measure.

Stocks, bonds, and gold

So we have before us an environment in which something seems likely to give. If the economy strengthens, against the likely evidence, bonds are probably in trouble. In the more likely event that the economy weakens, my impression is that bonds have already priced it in. In either case, if inflation surprises come in on the upside, bonds are again probably in trouble. The most bullish outcome for bonds would be a recession that generates enough credit defaults to induce a plunge in monetary velocity and an accompanying deflation, but at present, we don't observe a sharp widening of credit spreads that would support anything close to that expectation. We're left with a bond market that is most probably priced for as much perfection as the current economic climate is likely to deliver, and is very open to disappointments if slower inflation and friendly Fed-speak isn't delivered.

Meanwhile, the stock market is priced at rich multiples on record profit margins, which also force equity investors to rely on perfection – in this case a benign inflation picture, with slow enough wage inflation to sustain wide profit margins, but strong enough growth to sustain revenues. That again, seems like a tightrope. On the positive side, market action continues to be reasonably favorable, though the current overvalued, overbought, overbullish combination suggests shorter-term caution until that condition is cleared. Taking all of this together, stocks appear vulnerable longer-term, and while nothing in particular forces that vulnerability to be immediate, the growing risk of an approaching recession probably does not argue for an extended continuation of the bull market.

As for precious metals, we currently observe a combination of conditions that has historically been extremely favorable for precious metals shares (see Going for the Gold) – a gold/XAU ratio well above 4.0, the 10-year Treasury bond yield below its level of 6 months earlier, a Purchasing Managers Index below 50, and a year-over-year inflation rate higher than 6 months earlier (it is sufficient to grade inflation as favorable for gold if at least one of the year-over-year CPI and core-CPI inflation rates is above its level of 6 months earlier). The only factor that would further improve conditions for precious metals shares would be short-term weakness in price, on which we would anticipate adding to our existing positions in the Strategic Total Return Fund. Needless to say, one of the reasons that the combination of factors above is useful is that it also strongly defines conditions in which the U.S. dollar is vulnerable.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations, and moderately favorable market action. While the status of market action suggests that investors have not adopted any measurable skittishness toward market risk, the combination of overvalued, overbought and overbullish conditions has historically been associated, on average, with market returns short of Treasury bill yields.

In the Strategic Growth Fund, our diversified stock holdings remain well-hedged, but the Fund also holds just under 1% of assets in index call options that would provide an exposure to market fluctuations in the event of a continued advance. If the market clears its overbought condition without much deterioration in internals, we would be inclined to establish a more constructive call option position close to 2% of assets (which would effectively provide perhaps 50% exposure to market gains without sacrificing much in the event of an abrupt downturn). So while we would have some exposure to a further significant market advance, should it emerge, the evidence leans toward a correction or sideways trading range for now.

In bonds, the Market Climate was characterized last week by unfavorable valuations and modestly favorable market action. Since bonds are much less prone to “bubbles” than stocks are, valuations tend to trump market action. Given the current profile of the yield curve, credit spreads, inflation pressures, economic growth, and other factors, bond yields appear inappropriately low even if hopes of a Fed easing were achieved. For that reason, I shortened the duration of the Strategic Total Return Fund modestly last week, to about 1.5 years, mostly in TIPS. The Fund also holds just over 20% of assets in precious metals shares, for which the Market Climate remains favorable.

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