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November 12, 2007

Expecting A Recession

John P. Hussman, Ph.D.
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Fund News: On Friday, November 9, 2007, the Hussman Funds paid annual distributions of short-term and long-term capital gains. The Strategic Growth Fund paid a distribution of $0.63 per share, classified entirely as long-term gains. The Strategic Total Return Fund paid a distribution of $0.5375 per share, classified as $0.26 per share in long-term gains, and $0.2775 per share in short-term gains. As usual, the NAV of each fund declines by the amount of the distribution, which is paid in cash or reinvested in new shares (based on the choice of the shareholder). For shareholders reinvesting these distributions, the reinvestment will result in an increase of approximately 4.018% in the number of shares of HSGFX you own, and approximately 4.694% in the number of shares of HSTRX you own.

Expecting a recession

In recent months, I've repeatedly noted that while recession risks were gradually increasing, there was not sufficient evidence to expect an imminent economic downturn. Most economists still believe this. 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.

This conclusion is based on the combined weight of several classes of indicators, including asset prices, reliable survey measures, and measures of labor market activity. One way to understand this change in outlook is to examine our 4-indicator “rule of thumb” – a simple composite of readily obtainable indicators that have been observed in every U.S. recession. It is a syndrome of conditions that are logically and historically related to economic weakness, none particularly informative when observed individually, but important when they occur together.

They are: widening credit spreads, a moderate or flat yield curve, falling stock prices, and a weak ISM Purchasing Managers Index. Notice that we are not interested in the behavior of any single indicator, but rather in a group of indicators that collectively indicate deteriorating growth expectations and rising credit risks. The 4-indicator composite I defined several years ago used the following definitions:

1: Widening credit spreads: An increase over the past 6 months in either the spread between commercial paper and 3-month Treasury yields, or between the Dow Corporate Bond Index yield and 10-year Treasury yields.

2: Moderate or flat yield curve: 10-year Treasury yield no more than 2.5% above 3-month Treasury yields (this doesn't create a strong risk of recession in and of itself).

3: Falling stock prices: S&P 500 below its level of 6 months earlier. Again, this is not terribly unusual by itself, which is why people say that market declines have called 11 of the past 6 recessions, but falling stock prices are very important as part of the broader syndrome.

4: Weak ISM Purchasing Managers Index: PMI below 50.

At present, the S&P 500 is lower than it was 6 months ago, so the last holdout would seem to be the PMI, which fell to just 50.9 in the last report. To a large extent, this is a distinction without a difference, since any PMI in the low 50's performs as well. Also, 30-year Treasury yields are as effective as 10-year yields and so forth, so there is nothing particularly magical about specific numbers or measures used here (though alternate choices will typically produce an outlier or two within a few months either way of an actual recession). The reason I create indicator sets like this recession composite and A Who's Who of Awful Times To Invest, is to capture a broad set of reasonable symptoms that produce a collective picture or “gestalt.” From that standpoint, the evidence of recession risk is already apparent.

We can further improve the accuracy and immediacy of the recession signal by allowing any PMI in the low 50's, and requiring moderating employment as additional confirmation:

4 (alternate): Moderating ISM and employment growth: PMI below 54, coupled with either total nonfarm employment growth below 1.3% over the preceding year (this is a figure that Marty Zweig noted in a Barron's piece years ago), or an unemployment rate up 0.4% or more from its 12-month low.

[Note - Applying this alternate criteria also relaxes the yield curve criterion (2) so that any difference of less than 3.1% between the 10-year Treasury yield and the 3-month Treasury bill yield is sufficient].

In diagnostic terms, this composite is what physicians would refer to as an “Aunt Minnie” (certain features might mean little by themselves, but you observe them together, you can draw only one conclusion - it's Aunt Minnie). The recession signals based on the foregoing criteria are depicted in blue in the chart below. Actual recessions are depicted in red – yes, those two instances in 1980 and 1982 were separate recessions. In every instance we've observed these conditions, the U.S. economy has either already been in a recession, or has been within a few weeks of what turned out in hindsight to be the official beginning of a recession. There have been no false signals. Few things in investing or economics are certain, but my impression is that current evidence moves recession risk from "possible" to "probable."

As usual, we never rely on a single indicator, but instead on the weight of a broad set of confirming evidence. On that note, the RBC Consumer Confidence index plunged in the latest report, from 80.6 to 64. The Conference Board figures will be important to monitor late this month. The growth rate of the ECRI Weekly Leading Index has also turned negative, suggesting economic softness in the current quarter. This indication is consistent with what we're observing from other measures of imminent risk.

For quick accessibility, here is a review of useful confirming indicators of oncoming recession (from my Brief Economics Primer ), aside from the indicators noted above. These will be important to monitor in the months ahead, but some have significant reporting lags, so are more useful for confirmation than for advance warning.

A sudden widening in the “consumer confidence spread,” with the “future expectations” index falling more sharply than the “present situation” index (currently in place). In general, a drop in consumer confidence by more than 20 points below its 12-month average has accompanied the beginning of recessions. The latest report from the Conference Board will be released on November 27, though the Consumer Sentiment report on November 21 will also be informative;

Low or negative real interest rates , measured by the difference between the 3-month Treasury bill yield and the year-over-year rate of CPI inflation. Real short term rates have now declined to negative levels on this basis;

Falling factory capacity utilization from above 80% to below 80% has generally accompanied the beginning of recessions. September capacity utilization stood at 82.1. The October statistic will be released on Friday, November 16. My impression is that the November or December statistics are the figures at risk to fall below 80%.

Slowing growth in employment and hours worked. The unemployment rate itself rarely turns sharply higher until well into recessions (and rarely turns down until well into economic recoveries). So while the unemployment rate is an indicator of economic health, it is not useful to wait for major increases in unemployment as the primary indicator of oncoming economic changes. As for employment-related data, slowing growth in employment and hours worked tend to accompany the beginning of recessions. Specifically, when non-farm payrolls have grown by less than 1% over a 12 month period, or less than 0.5% over a 6 month period, the economy has always been at the start of a recession. Similarly, the beginning of a recession is generally marked by a quarterly decline in aggregate hours worked.

Notably, the 6-month growth in non-farm payrolls declined to the 0.5% threshold in the latest report, while 12-month employment growth stands at 1.23%. Quarter-over-quarter growth in aggregate hours has slowed markedly, but was still marginally positive as of the October report.

As for Federal Reserve actions, as I noted last week, the Fed has injected no liquidity into the banking system in recent months. What investors keep believing to be "new injections of liquidity" are just rollovers of a relatively constant $40-$45 billion in repos that finance the stagnant pool of bank reserves. This Thursday, we'll probably get an $8 billion rollover of the 14-day repo from November 1, plus a $20 billion rollover of the 7-day repo from November 8. A $3.25 billion repo comes due on Wednesday. There's also a $9 billion repo that will be rolled over the day before Thanksgiving. In all, the Fed currently has $40.25 billion in repos outstanding, which is a billion less than it had outstanding a week ago, and about the same as it has had outstanding for months. Total bank reserves dropped by another $41 million in October, after dropping by $2.4 billion in September. Meanwhile, the total amount of money lent by the Fed to banks through the discount window dropped by $38 million last week.

People seem to believe that the Fed is doing a "stealth easing" because the actual Fed Funds rate has been hovering slightly below the target. The truth is that the banks are doing this all by themselves and the Fed is passive. The FOMC could bring the Fed Funds rate back up slightly to match the 4.5% target, but that would require the Fed to drain even more reserves than it is already draining. As I've noted before, lending activity is likely to continue at banks because the commercial paper and securitized debt markets are frozen. As paper comes due, savers are depositing the proceeds at banks, while companies who are now unable to refinance commercial paper in the securities markets are borrowing through the banks. In other words, the banks are acting as a substitute source of refinancing. The banks don't need liquidity from the Fed, and they won't unless credit conditions become so bad that savers begin to pull their deposits out. As Nouriel Roubini has argued, liquidity isn't the issue, it's solvency. The problem is mounting loan losses, bad mortgages, and the collapsing value of securitized debt. Unfortunately, the Fed can't help any of that. The only thing that can is a Federal bailout of bad lenders and weak borrowers, but taxpayers are going to be hard pressed to bail out somebody else's bad mortgage when they've got their own to pay.

This whole belief that the Fed is adding liquidity, and that this imaginary liquidity will be useful, is pure, unmitigated superstition. No need to take my word for it - just look at the data.

Fed Open Market Operations: http://www.ny.frb.org/markets/openmarket.html
Total Discount Window Borrowings: http://research.stlouisfed.org/fred2/data/TOTBORR.txt
Total Bank Reserves: http://research.stlouisfed.org/fred2/data/TRARR.txt

Investment planning

Given the common interpretation of the ISM indices (above 50 = expanding, below 50 = contracting), it might seem that a conservative approach would be to wait for the PMI to drop from its current reading of 50.9 to a reading below 50 before forming expectations about an oncoming recession. However, I should note that the 1973 signal was somewhat late exactly because the PMI held up despite a recession that was already in progress. More importantly, waiting for overwhelming evidence is only conservative if the costs of acting on an incorrect signal outweigh the costs of not acting on a correct signal .

Given that the steepest market plunges generally occur before a recession is widely recognized, my impression is that investors should at least be certain that they can tolerate the impact of a downturn without substantially deviating from their investment discipline. As I frequently note, there is nothing wrong with a long-term buy-and-hold approach to stock market investing, provided investors recognize that the impulse to abandon that strategy can be extremely strong when the market has declined steeply and it seems that there is no end in sight. If you examine the historical record, the norm for bear markets is a loss of about 30%, with a typical frequency of one every 4-6 years.

My intent here is not to encourage disciplined investors to deviate from carefully considered investment plans. But if a recession or a bear market would produce unacceptable losses or would force you to abandon your investment plan, it is best to begin altering your investment position immediately (even if not entirely at once) toward a position that you can maintain regardless of market outcomes. If your position is inappropriate, do not wait for an “ideal” opportunity to change it. Begin changing it immediately, and continue to change it in steps – larger steps when you can get favorable prices, smaller steps when you have to do it at adverse prices. The important thing is to start immediately and decide in advance to move step-by-step over a reasonably limited period of time, until your position is appropriate.

Anytime you discover you are taking too much risk, realize in advance that you will experience some level of regret as you correct it – if you sell your first portion and the market advances, you'll regret having sold anything. If you sell your first portion and the market continues to decline, you'll regret that you didn't sell everything. The way to keep from being “paralyzed” in the financial markets is to realize in advance that gradually changing an investment position will always involve regret. It is better to “lock in” an acceptable level of regret than to risk an unacceptable loss.

I should also emphasize that I have no intention of encouraging short-selling or bearish speculation about potential market weakness. Our investment position is fully hedged, but it is not net short. The dollar value of our shorts never materially exceeds our long holdings. It can be very costly to bet on market declines because the “tracking risk” is intolerable – it's one thing to gain only moderately when the market gains, but it's entirely another thing to lose predictably and continuously as the market advances. You simply can't maintain the discipline if the market makes a sustained move against you.

In short, my intent is to prod investors to carefully think about their risk exposures, and to make any needed changes in a step-wise fashion. Make larger changes when prices are advantageous, and smaller changes when prices are adverse, but start immediately and keep moving step-by-step until your position is correct. The inability of investors to extract themselves from speculative positions destroyed the financial security of many investors in 2000-2002. At the same time, I don't recommend “bearish” investment positions except as a hedge against long exposure that would otherwise be inappropriate.

Valuations and long-term returns – an update

The S&P 500 has now underperformed Treasury bills for nearly 9 years. This is a reminder that while valuations may not have much impact on short-term returns, even for several years at a time, they are a powerful and reliable determinant of long-term investment returns.

This disappointing long-term total return since the late 1990's is no surprise, and is within a few percentage points of the low return that valuations indicated as probable at the time. As shown below (using methods that I've detailed frequently over the years) there have been few instances outside of the 1973-74 collapse and late 1990's bubble that 7-year total returns have departed by more than a few percent from what valuations would have dictated. Indeed, the only reason that total returns since 2000 have been positive at all is because valuations are back to historically rich levels (though not as extreme as in 2000). Even today, stocks are most probably priced to deliver only about 5% over the coming 7-year period.

Industry groups: rotating disappointments

It's interesting that investors have not yet put the rotating disappointments among various industry groups into a “gestalt.” Rather, investors seem to be looking at various industries as if their problems are each somehow unique and unrelated. Investors recognized early that the housing sector is profoundly vulnerable. More recently, they have recognized that financials face growing loan loss risk. With Caterpillar's disappointing guidance, they suddenly realized that cyclicals and machinery face significant challenges. With Exxon's refining difficulties, they realize that profit growth in the oil sector is unlikely to produce major upside surprises. And last week, technology stocks were clipped when Cisco produced strong earnings but didn't raise guidance. Yet somehow, investors haven't put all of these together to see the larger picture, which is that the market has lost leadership from every important group. This isn't a stock-selection or an industry-selection issue. It is a pervasive indication of oncoming economic risk.

In day-to-day action, we continue to see individual stocks being “taken out and shot” in a similar rotating fashion. My impression is that all groups will experience this to some degree or another, but depending on whether the particular sector being hit is overweighted or underweighted in the Fund, we will experience short-term gains and losses accordingly. When financials are particularly hard hit, the Fund will tend to benefit. When consumer, health and technology stocks are hard hit, but financials perform well, the Fund will tend to pull back. Unless our stock holdings exactly mirror the S&P 500 and Russell 2000, this is simply unavoidable. Regardless of these day-to-day effects, the primary source of returns in the Strategic Growth Fund since inception has been a positive difference in performance between the stocks we own and the indices we use to hedge. But again, when we are fully hedged, as we are now, that differential is also our primary source of day-to-day risk.

With regard to financials in particular, investors continue to look for a bottom. Aside from periodic short squeezes and spectacular but short-lived rebounds, I don't think it is coming anytime soon. The recent concern about higher loan losses is no surprise (see The Problem with Financials), and this is likely to continue. This is not simply a problem that will go away if various financial companies “come clean” with what their CDOs and so forth are worth. The real problem is that the companies don't know what they're worth because the foreclosures that will determine their value haven't happened yet. The defaults are just starting. The heaviest round of mortgage resets only started in October, so it will probably be months before we observe mass delinquencies, and several more months until we observe significant foreclosures, loan losses, and writeoffs. This is a multi-year problem, not a multi-week problem that can be resolved by “just coming clean” with what's on the balance sheet.

According to the latest FDIC banking profile, FDIC insured institutions currently hold a notional value of $153.8 trillion in credit derivatives. That's not a typo – though GDP itself is only about $13 trillion, the high notional value emerges because for each derivative that connects two true “end users” (one long, one short), there is a whole chain of intermediaries who are long with one intermediary and short with another, hoping to earn a tiny profit on the spread. For example, I buy a derivative from Andy, who goes short to me, so he buys one from Barry who is short to Andy, hopefully for a tiny spread, and covers the risk by buying a derivative from Charlene, and so on, until someone finds a true “end user” who actually wants to carry a pure short position in that derivative. Unfortunately, this also exposes banks to as-yet-unknown “counterparty” risk. If one link in the chain snaps, the links surrounding that chain have to bridge the gap. This is not a material risk in exchange traded derivatives, but can be a problem in “over-the-counter” derivatives traded between banks, where “know thy counterparty” currently ought to be chiseled into every marble surface.

Elsewhere in the economy, we observed an “improvement” in the trade deficit in the most recent figures. As we saw in A Fragile Dependence on Foreign Capital, such “improvement” in the external deficit is generally matched dollar-for-dollar with deterioration in gross domestic investment. Far from being a favorable sign, the trade figures are a harbinger of weaker capital spending ahead. I continue to expect that housing will bear the brunt of this weakness, while we'll probably observe relative strength in capital spending, particularly in broadband telecommunications.

I'll reiterate my view that recessions emerge not because of a general decline in the willingness to consume, but rather because a mismatch emerges between the mix of goods and services demanded in the economy, and the mix of goods and services that the economy has been supplying. Many industries experience continued growth during recessions (even if their stocks trade somewhat lower), while other industries experience profound demand shifts. In the late 1990's, there was clear overinvestment in telecom and information technology, and these sectors suffered disproportionately during the recession that followed. In the current cycle, the overexpansion has been in housing, debt origination, and leveraged finance, so a much different group of stocks will probably be hung out to dry this time.

Market Climate

As of last week, the Market Climate for stocks was characterized by unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully hedged investment stance, with part of our hedge “staggered” to provide somewhat stronger defense (trading some of the “implied interest” we would normally earn on the hedge for that additional protection). As usual, we don't carry hedges where the notional value of the hedge materially exceeds the value of the stocks we own, so even this staggered-strike position should not be confused with the sort of net-short position that bear funds typically hold.

Presently, we've got an interesting combination of stocks being very oversold on a short-term basis, while bonds and precious metals are very overbought. Though all of these prevailing trends are reasonable given the current profile of economic risks, I would view all of them as vulnerable to "fast, furious" moves to clear the overextended trends, even if they continue over a more extended period. This isn't a strong enough impression to actually take trading positions on that basis, but it's important to recognize that the generally unfavorable Climate for stocks does not rule out a fast, furious clearing rally, nor does the outlook for recession rule out a brief spike in bond yields to clear the overextended short-term conditions in that market.

In bonds, the Market Climate was characterized by unfavorable yield levels and favorable yield trends. Bond prices have become extremely overbought, to the point where we clipped a moderate portion of our TIPS positions last week. At this point, the Treasury market has responded so strongly to credit fears that there are diminishing prospects that yields will decline further, even if recession concerns increase. Bond yields tend to “spike” from such compressed levels, even if only briefly. Since the timing of that is always uncertain, I continue to believe that the best approach is to respond to yield fluctuations rather than attempting to forecast them. I would expect to increase our exposures on material short-term weakness in the TIPS market.

As usual, we tend to trade around core positions in both the bond market and the precious metals market, adding exposure on short-term weakness and clipping it on overbought strength. In precious metals, I also clipped part of our exposure on further strength last week. Presently, the Strategic Total Return Fund carries about 10% of assets in precious metals shares, where the Market Climate continues to be generally favorable, but strenuously overbought.

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