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March 26, 2007

Clear Statements and Rose Colored Glasses

John P. Hussman, Ph.D.
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Reprint Policy

Friedrich Hayek once said “socialism can only be put into practice by means of which most socialists disapprove.”

The same can probably be said about any prospect for Federal Reserve rate cuts here.

Given continuing inflation pressures and an otherwise unambiguous tightening bias, whatever room the Fed left open for policy change was clearly to allow flexibility in the event that the housing market deteriorates profoundly. A Fed cut is likely to be put into practice only under conditions that nobody would wish on this economy.

Let's revisit the changes in the statement from January's wording to March. First, its comments relating to the housing market:

January: “Recent indicators have suggested somewhat firmer economic growth, and some tentative signs of stabilization have appeared in the housing markets.”

March: “Recent indicators have been mixed and the adjustment in the housing sector is ongoing.”

Some observers were relieved that the FOMC didn't utter words like “sub-prime,” “delinquencies” or “foreclosures.” Far be it from the Fed to fuel that fire. An “ongoing adjustment” sounds better – sort of healthy, like massage therapy.

If the clarity of the Fed's continuing tightening bias is muddled by the rose-coloring of Wall Street's glasses, consider the following:

January: “Readings on core inflation have improved modestly in recent months”

March: “Recent readings on core inflation have been somewhat elevated.”

Both statements then attempt to maintain the Fed's credibility by asserting that those pressures “seem likely to moderate over time,” but also indicate that “the high level of resource utilization has the potential to sustain those pressures.”

Next, the Fed actually takes pains to re-affirm its tightening bias:

January: “The Committee judges that some inflation risks remain.”

March: “In these circumstances, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected.”

“Predominant policy concern” - that's not a bias? From January to March, the Fed's language indicated more concern about inflation, not less.

The difficulty is that the Fed can't act on these concerns because the economic situation has started to decay as well. As I noted last week, the economy has its head in the freezer and its feet in the oven, and Wall Street wants to call the temperature “just right.”

Essentially, the Fed now has to allow for bad things to happen in both directions – continuing risks on the inflation side, and an “ongoing adjustment” in housing and the mortgage market. Remember, the most recent problems have focused on adjustable-rate mortgages (though all classes of mortgages are showing increased delinquencies and foreclosures). Despite its inflation concerns, the last thing the Fed wants to do is talk about “additional firming” in the interest rates to which those ARMs are tied. It also has to allow some flexibility to become a “lender of the last resort” in case the foreclosures start to accelerate.

January: “The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook…”

March: “Future policy adjustments will depend on the evolution of the outlook…”

This is not a Fed that's “signaling prospects for a rate cut later this year” as Wall Street evidently concluded, but rather a Fed that's caught between a rock and a hard place, and knows it.

In short, despite persistent inflation pressures, the Fed can't easily raise rates further because that might add to the instability in the housing sector. So it has to manage inflation expectations verbally, while also backing away from its preferred inflation targets and accepting higher ones instead.

And that's exactly what Fed Governor Frederic Mishkin did on Friday night at a speech in San Francisco. He noted that getting inflation into the “comfort zone” of 1-2% could involve higher interest rates and “considerable output and employment losses.” So instead, the Fed is relying on the public's expectation that inflation will remain “anchored” around 2%. Mishkin noted “I am less optimistic about the prospects for core PCE inflation to move much below 2% in the absence of a determined effort by monetary policy,” adding that “a substantial further decline in inflation would require a shift in expectations, and such a shift could be difficult and time-consuming to bring about.”

Do those sound like remarks from a Fed that's eager to ease monetary policy?

Though my view remains that Fed actions are largely irrelevant to the volume of lending activity, there's no question that they have a psychological effect. Currently, my impression is that Wall Street has largely misinterpreted the Fed's language, and that its interpretation will be subject to an “ongoing adjustment” in the weeks ahead.

In any event, our investment position is driven not by expectations of future Fed actions, but by the prevailing condition of valuations and market action.

Market Climate

As of last week, the Market Climate in stocks was characterized by unfavorable valuations, and still constructive market action on the basis of the major indices. However, the recent advance has now re-established a combination of overvalued, overbought, overbullish conditions that has historically been associated with stock returns below Treasury bill yields, on average. Though these conditions aren't as extreme as the rare “ovoboby” combination I've described in other recent comments, the market has generally underperformed Treasury bills under a broader and much less restrictive definition of “overvalued, overbought, overbullish” conditions. That is where we are today.

The Strategic Growth Fund moved to another all-time high (including reinvested distributions) last week, and also moved back to a fully-hedged investment position. A small portion of our hedge reflects staggered strikes (which provide a slight increase in defense at the cost of a slight reduction in “implied interest”) but the broad behavior of the Fund is unlikely to be affected much by general market direction.

Of course, some of the strongest returns for the Fund have been achieved while the Fund has been fully hedged – so our present investment stance only means that the Fund's returns are not likely to be significantly affected by market fluctuations. When the Fund is fully hedged, its returns are driven by the extent to which our stocks outperform or underperform the indices we use to hedge, plus the implied interest (generally close to short-term Treasury bill yields) on those hedges.

For example, if the performance of the Fund's stock holdings were to exactly match the performance of the indices we use to hedge (after expenses), the return on a fully-hedged position would currently be about 5% annually. If our stock holdings outperform the major indices (whether by gaining more or declining less), we would expect to achieve performance above Treasury bill yields. If our stock holdings lag the major indices (whether by gaining less or declining more), we would expect to achieve performance below Treasury bill yields. Though past performance does not ensure future returns, the Fund's stock selections have strongly outperformed the major indices since inception, and my objective and expectation is to achieve that result, on average, in the future.

In bonds, the Market Climate was characterized last week by unfavorable valuations and relatively neutral market action. The Strategic Total Return Fund continues to carry an average duration of about 2 years, mostly in Treasury Inflation Protected securities, and a position of just over 20% of assets in precious metals shares, for which the Market Climate continues to be favorable on the measures we use.

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