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November 19, 2007

Critical Point

John P. Hussman, Ph.D.
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“The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.”

- Rudiger Dornbusch, MIT Economist

Financial and economic conditions are becoming increasingly strained. The litany of concerns include

•  Rich valuations, particularly on normalized earnings – if profit margins were anywhere near the highs of prior economic cycles, the S&P 500 P/E ratio would still be above 20 (the 1929, 1972 and 1987 peaks occurred at similar multiples, while other historical bear market declines began at lower multiples, often with interest rates no higher than at present)

•  Emerging pressure on profit margins, with wage pressures, materials prices, rising import costs, loan losses, and unit labor costs all threatening to normalize the record profit margins of recent years

•  Enormous current account deficits, and the likelihood that improvement in the current account will be matched by deterioration in gross domestic investment (as has historically been the case)

•  Mountains of dodgy debt securitized into “investment-grade tranches” representing the claims on the initial set of payments, and lower tranches representing claims on more distant payments, all of which are increasingly being downgraded to junk status. As economist Jan Hatzius of Goldman Sachs recently noted, if a large part of this loss (he estimates a likely $400 billion) is borne by leveraged institutions, the loss to capital will lead to a reduction in lending. “There's a great deal of academic research that indicates that financial institutions tend to resist declines in their capital ratios in a difficult environment. It's going to mean another restraint on economic activity.” The Problem with Financials details my views on this.

•  Rising delinquency and foreclosure rates, which are very predictably in the early stages because the spike in mortgage resets only started in October of this year, suggesting that the real surge of delinquencies won't be seen until the first quarter of 2008, with foreclosures surging even later.

•  Despite hopes that the Fed can reverse these pressures, the fact is that the entire amount of "liquidity” added to the banking system by the Fed in the past four months amounts to about $15 billion (in a banking system with a thousand times that in loans and assets). On Thursday, several news stories reported that the Fed “pumped $47.25 billion of liquidity into the banking system,” the highest total since September 2001 - but you'll find once again that $40.5 billion of that was pure rollovers of existing repos (which Thomson Financial noted in a news story the day before as my ballpark expectation). The rest is pre-holiday liquidity to accommodate demand for cash. Investors are deluding themselves when they count each rollover of a 3-day, 7-day or 14-day repo as new money. It's the same stuff, rolled over to retire the maturing stuff. The amount of outstanding repos is currently only about $15 billion more than its lowest 30-day average over the past year.

•  As Jim Stack of Investech recently noted, a market drop of even the recent -7.1% following a third discount rate cut has happened only 3 times in the past 80 years: February 1930, July 1982, and March 2001. In each case, the economy was already in recession (or worse). “Those are not the kind of odds that make one feel comfortable in today's uncharted waters.” I should add that while the 1982 instance was different than the others (in that it was followed by very strong market returns), this is because the S&P 500 price/peak earnings multiple in July 1982 was already less than 7. These periods are also interesting for another reason: if you look at what happened to S&P 500 earnings over the following year, you'll find that earnings plunged in each instance. 1930: -39.4%, 1982: -15.9%, 2001: -49.8%.

The level of my concern should (and is intended to) strike long-time readers of these comments as unusually high. Over the years, I've consistently emphasized that my discussion of the market's return/risk profile generally does not imply any “forecast.” Historically, every Market Climate we identify includes both positive and negative returns – it's just that the mean and variance (the average return and risk) are different enough to justify varying exposures to market fluctuations. When we adhere to those various exposures over the complete market cycle, our expectation is that we will achieve higher overall returns and smaller periodic drawdowns than a passive buy-and-hold approach. Since we focus on the average return and risk associated with each Market Climate, individual short-term forecasts aren't required, so I usually avoid them.

Still, there are occasionally situations where the set of conditions becomes so extreme that we observe them only before significant shocks. In the past few months, I've emphasized two such “Aunt Minnies;” one related to stock market risk, and one related to recession risk. Accordingly, I've used the term “warning” in recent weeks, which I don't take lightly.

A Who's Who of Awful Times to Invest:
http://www.hussmanfunds.com/wmc/wmc070716.htm

Expecting A Recession:
http://www.hussmanfunds.com/wmc/wmc071112.htm

In short, the financial markets are at a critical point. It's possible that investors will somehow adopt a fresh willingness to speculate, but my impression is that in the weeks ahead, investors will be forced to recognize that recession risk has tipped. That's not to say that this realization will produce one-way market movements. Seasonal factors tend to buoy the market a few trading days before holidays and a few days around the turn of each month, and as I noted last week, oversold conditions lend themselves to “periodic short squeezes and spectacular but short-lived rebounds” (which we observed on Wednesday before quickly eroding). So we will almost certainly observe advances driven by investors frantic to “buy the dip” and “catch the rebound.” Overall, however, the return/risk profile on both stocks and the economy as a whole appear increasingly lopsided toward bad outcomes.

As I emphasized last week, my intent here is not to encourage investors to depart from carefully considered investment strategies. The real issue is that investors tend to overestimate their ability to stick with large (often inappropriate) exposures to equities during significant market downturns. I hope to encourage investors to carefully consider their ability to withstand a standard, run-of-the-mill 30% bear market loss (which has historically occurred once every 5 years or so) without deviating from their investment plan. Investors who can't believe that that sort of decline is, in fact, standard and run-of-the-mill are probably already in trouble because they haven't bothered to look at the data. None of this requires that we forecast or necessarily expect such a decline. But investors emphatically should not rule out such a decline in considering their investment exposure.

As even Jack Bogle concurred in a Friday CNBC interview “I think the probability of a recession is about 75%.” When asked how investors should respond, he answered “I would say do nothing – ride it out, if your asset allocation is right. The bonds in your portfolio and the long-term growth of businesses will bail you out. Unfortunately 80% of the market is speculators now, not investors. What would I say to the speculator? I would say I'm nervous and I might even say get out.”

As for our own investment strategy, we may observe opportunities to cover some short call options or vary our investment exposure modestly, depending on the behavior of market action, but we are likely to remain predominantly hedged until we observe a clear improvement in market internals or valuations.

Meanwhile, shareholders can trust that I don't play in minefields with shareholder assets. We don't remove a significant portion of our hedges in overvalued markets with poor market action in an attempt to “play” purely technical bounces of unpredictable size and duration. The intent of the Strategic Growth Fund is to outperform the S&P 500 over the complete market cycle, with smaller drawdowns than a buy-and-hold approach. The Fund is intended for no other shorter-term objective.

I should also note that our various holdings in technology and small-cap are largely hedged with non-S&P 500 indices such as the Russell 2000 and Nasdaq 100. So while the difference in performance between our stocks and our hedges will continue to be our primary source of expected return, as well as day-to-day risk, I believe that our hedges are appropriately matched to our stock holdings.

Market Climate

As of last week, the Market Climate in stocks was characterized by unfavorable valuations and unfavorable market action. Internals continue to deteriorate, and with default spreads (corporate yields minus straight Treasury yields) widening to fresh highs and our own measures already anticipating a recession, this is not an environment in which we are likely to “buy the dip” except perhaps by covering a modest number of short call options, leaving put option defenses in place. As I've noted before, one of the best indicators of oncoming recession is a spike in the spread between 6-month commercial paper and 6-month Treasury bill yields. Now that we observe this and a broad mix of other warnings, whatever effectiveness “buy the dip” has had in prior instances is not likely to persist in the present case.

In bonds, the Market Climate remained characterized by unfavorable yield levels and favorable yield trends. Bond prices have extended their strenuously overbought run, which is a testament to increasing risk aversion, but presents risks of its own. It's difficult to believe that investors in say, 10-year Treasury bonds are really willing to accept annual total returns of just 4.15% for the next decade, and to the extent that they will probably demand somewhat higher returns over time, it implies that some part of the recent Treasury market rally is inherently speculative. To some extent, I think the speculation over the short-term will be correct, but we're much more comfortable with TIPS than straight Treasuries, and even there we've clipped our exposure a bit on the recent price strength.

Historically, the yield curve has tended to steepen during recessions, meaning that long-term rates either fall slower than short-term rates, or increase (which they have done, on average). While I don't place much faith in Fed actions (other than for psychological effect), Fed officials have attempted to discourage expectations for further cuts in the Fed Funds rate, most likely because of the weakness in the dollar, combined with the 4% year-over-year headline inflation rate that is virtually baked-in-the-cake for the November CPI. That may cause some re-adjustment in short-term rates, and in turn, a quick spike in long-term rates (not that I expect it would develop into a sustained uptrend). In any event, we'll continue to respond to such yield spikes, if they occur, to modestly boost our exposure in TIPS.

In precious metals, the Market Climate remains positive, and the recent pullback in precious metals shares gave us a good opportunity to slightly boost our exposure, to just over 12% of assets in the Strategic Total Return Fund.

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