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December 10, 2007

Overbought in an Unfavorable Market Climate

John P. Hussman, Ph.D.
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With the November employment report, the 6-month change in total non-farm payrolls has declined to just 0.41%, while the year-over-year change has also slowed further, to just 1.11%. Far from being a sign of fresh economic health, the deterioration in job growth is now in the range where prior recessions have typically emerged.

Now, if the belief in “Fed liquidity injections” was not so clearly misguided, I could launch into detailed speculation about how much “stimulus” the Fed might provide, and how long that liquidity will take to “work itself through the pipeline.” But as I detailed last week, the Fed has only “injected” about $16 billion into the banking system since March, all of which has been drawn out of the banking system as currency. Suffice it to say that I see speculation about the Fed's "stimulative" impact as useless because it is based on the demonstrably false premise that the Fed is actually injecting meaningful “liquidity” in the first place. Despite investors' flight to the safety of Treasury securities, commercial lending rates are not responding either (though economic softness is providing downward pressure that moderates the competing upward pressure from rising default risk).

Also, as I've frequently emphasized, monetary policy is not, and cannot be independent of fiscal policy. All the Fed does is to determine whether government liabilities take the form of Treasury bonds sold to the public, or currency and reserves held by the public directly or indirectly through the banking system. Monetary policy determines the mix of government liabilities held by the public (and even then only at the margin). Fiscal policy determines the total quantity of those government liabilities, most which are absorbed these days not by the Fed but by foreigners (in an amount many, many times what the Fed absorbs). If you want to worry about some entity that could have enormous impact on U.S. economic activity, ignore the Fed and focus on the real “maestros:” foreign purchasers of U.S. Treasuries, particularly China and Japan.

In the continuing saga of repo rollovers masquerading as “liquidity injections,” the total amount of Fed repos outstanding declined to $45 billion last week, which may be somewhat thin given the holiday shopping season. Most of this predictably comes due again this week, so the FOMC will initiate at least $33 billion in new repos by Thursday (a $12 billion repo matures on Monday, with $13 billion to roll over on Wednesday, and $8 billion on Thursday) – more if it refinances the rolls on Monday and Wednesday with 1-3 day repos. This fairly stable $45 billion pool of “liquidity” provided by FOMC actions is useful in maintaining the similar quantity of “required reserves” in the U.S. banking system. It is helpful in accommodating the day-to-day demand for currency and reserves (monetary base), but has no material impact on the volume of bank lending, nor the solvency of the $12.7 trillion banking system or the mortgage market in general.

Again, the Federal Open Market Committee (FOMC) has “injected” only about $16 billion of “liquidity” into the U.S. banking system since March – all via short-term repos that are continually rolled over. Meanwhile, foreign investors (particularly China's central bank) have provided about $2 billion in fresh “liquidity” per day, mostly by purchasing U.S. securities (primarily Treasuries).

Liquidity and real investment

What has happened to this dough? This is the money that the U.S. uses to finance its own gross domestic investment (“real” investment such as factories, equipment, housing, etc). Indeed, all of the growth in U.S. gross domestic investment over the past decade has been financed by foreign capital inflows, since our government appears incapable of existing without spending away the domestic savings that would otherwise allow America to self-finance its growth*.

In the coming year or so, we'll probably see a narrowing of the massive trade and current account deficits that have accumulated in recent years. As I've noted before, every dollar of “improvement” we observe in the U.S. current account deficit is typically matched by a dollar of deterioration in gross domestic investment. That regularly happens during recessions, and it's likely to happen in this one (nothing in recent reports or market action materially changes the prospects of an oncoming U.S. economic downturn).

Recessions are generally due to a growing mismatch between what the economy produces and what is demanded. During those recessions, overinvestment stops, losses are taken, adjustments are made, and resources are reallocated, all of which help to eventually turn the economy around. It is these adjustments that require a long and variable lag. They are not primarily the result of “Fed liquidity.”

In any event, the overinvestment and excess inventory during this economic cycle has clearly been in the areas of housing, finance, and debt origination, so those are the areas that will bear the primary burden of adjustment. Capital spending and consumption may also soften, but the bulk of the economic decline in any recession is always related to the industry or set of industries that experienced overinvestment during the prior boom. Again, those would be housing, finance and debt origination here. Meanwhile, consumer stocks, health care, and even many technology stocks (particularly in wireless and broadband communications) appear situated to perform reasonably well relative to the broad market, though we wouldn't own them without a hedge against general market weakness.

Fast, furious, and prone to failure

As I noted last week, “The market has now cleared the oversold condition that it established a week ago. Stocks aren't overbought here, but overbought conditions in unfavorable Market Climates tend to be rare. The steepest bear market losses tend to follow immediately on the heels of such overbought conditions.”

Presently, the market has established just that profile. This is one of the very few situations in which I ever have a pointed view about likely market direction. Although the likely Fed rate cut (no opinion on 25 vs. 50) this week adds some uncertainty, and the market would most likely celebrate a 50-basis point cut, there is currently not much evidence that suggests that even such a rally would be sustained for long. In my view, the probable risks are skewed to the downside. I don't believe there is such a thing as the Fed getting “ahead of the curve.” LIBOR continues to be “sticky” in the face of multiple cuts in the Federal Funds rate, credit spreads continue to push toward new highs, and there is no reason to believe that minuscule volumes of Fed repos will have any effect in ameliorating credit risks.

Meanwhile, the Treasury plan to bail out homeowners (without bailing them out) is likely to be both very little and very late. Think of it as the equivalent of the FEMA response after hurricane Katrina. Barring an almost immediate freeze on foreclosures and interest rate resets, we are likely to observe a rash of delinquencies and the need for soaring loan loss reserves even over the next few months. All of this talk of Federal help feels good, but it will be next to impossible to coordinate Federal assistance quickly and equitably. On the other hand, freezing lenders ability to collect on bad loans will simply allow balance sheets to deteriorate without any actual financial solution to the problem.

The problem is simple: people bought houses during a boom, at bubble prices that they couldn't actually afford. The money that was lent has already been dissipated to the sellers – the owners of the houses don't have it, and neither do the lenders. The excess money that homeowners can't actually afford to pay back will have to be written off institution by institution, lender by lender. Major loan losses are inevitable. To believe they are something less than inevitable is to stay at the party even as flames climb up the building, in hopes that water is on the way. The U.S. financial system is going to have a bad time with this – there will be large losses and major adjustments. Eventually we will work through it, but it is delusional to look for a bottom when the real losses haven't even started to emerge.

Again, with regard to the stock market, my having any view at all relating to short-term market direction is very unusual, but I am particularly concerned because we now have overbought conditions in a negative Market Climate. The Fed may very well give the market an extra psychological boost this week with a 50 basis point cut, but a disappointing move or statement could prompt a steep decline. As for market action, despite the standard “fast, furious” rebound from oversold conditions, there is no indication from the quality of market action that investors have adopted a robust willingness to speculate.

On the subject of multiple Fed rate cuts being bullish for stocks, it may be helpful to note that in those events that multiple Fed cuts helped the market, stocks had generally already experienced a bear market decline of 20-40% prior to the second rate cut, and the average P/E on the S&P 500 was typically below 14 and (generally less than 11). Stocks were generally poised to perform well by virtue of being sold off to depressed valuations. Even in the 1998 instance (which occurred at much richer valuations than other instances), the S&P 500 had plunged about 20% prior to the second cut.

Investors let mottos like “Don't Fight the Fed™” and “It's a New Economy.com” do their thinking for them in 2000-2002, while the S&P 500 lost half its value and the Nasdaq lost three-quarters. There's good reason to expect “motto-based investing” to be disappointing again. Keynes may have been right in saying “the market can remain irrational longer than you can remain solvent,” but provided you don't do things that endanger your solvency (like taking large net short positions), there's nothing wrong with avoiding risk in periods of market irrationality - particularly once market internals deteriorate measurably as they have now. Provably incorrect ideas are eventually proven incorrect. The beliefs that the Fed is “injecting massive liquidity” and that profit margins hold up despite economic softness are provably incorrect ideas.

So we remain defensive here, both with regard to the stock market, and with regard to the economy as a whole. Possible enthusiasm about the Fed notwithstanding, an overbought condition in a negative Market Climate is rarely a prescription for strong returns at acceptable risk.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action. The Strategic Growth Fund remains fully hedged, with a “staggered strike” position that provides somewhat stronger defense against market weakness, largely financed from the “implied interest” we would otherwise earn on the hedge. Though the hedge configuration can cause a pattern of day-to-day returns that is sometimes slightly counter to market fluctuations, the Fund is not “net short” and it is not positioned in a way that would be expected to lose value as a result of a sustained market advance. The Fund is also not positioned in a way that is intended to “make a killing” on a steep market decline. The dollar value of our shorts never materially exceeds our long holdings. Rather, as was the case in 2000-2002, I would expect the majority of Fund returns to be driven by the gradual (if uneven from day-to-day) “accrual” of a performance difference between the stocks we hold long and the indices we use to hedge. This difference can be both positive or negative, but since the inception of the Fund it has been the primary driver of our returns (for informational purposes, the stock selection record of the Fund is broken out separately in our performance chart).

In bonds, Treasury yields experienced a “spike” higher last week, reversing about 3 weeks of downward progress. I continue to believe that Treasury prices have something of a “speculative” component to them, since it's not clear that investors really intend to “lock in” a yield of just over 4% for a 10-year commitment of capital. To the extent that yields normalize at some point even several years from now, purchasers at today's Treasury prices are likely to achieve a total return of even less than 4% between today and that future point. So it's clear that whatever demand there is for Treasury bonds is driven by the speculative expectation of selling them to someone else at even lower yields. Given oncoming recession risk, that may very well be a reasonable expectation, but it's still important to recognize that the basis for Treasury exposure here is largely speculative, not “investment” driven.

Our own inclination is to respond to periodic yield spikes by increasing our portfolio duration in the Strategic Total Return Fund, while clipping our exposure at points where yields become depressed. The latest spike may provide some amount of opportunity if it can extend a bit further, but I don't expect taking a substantial exposure to duration risk unless yields rise considerably more. My impression is that oncoming recession risk will prevent too much upward pressure on yields, so we're likely to be adding and clipping duration exposure in something of a trading range for a while.

In precious metals, the Market Climate remains favorable, and the Strategic Total Return Fund currently has about 15% of assets invested in this area. The U.S. dollar remains fairly depressed, so it's possible that a 25 basis-point move by the Fed rather than 50 would be an opportunity for the dollar to clear its oversold condition with a sharp (if not sustained) advance. That said, the larger macroeconomic picture continues to lean toward further depreciation risk for the U.S. dollar.

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* You might be asking, what happens to those foreign capital inflows after they get spent on investment goods like factories, capital equipment and housing? The answer is that however you trace the money, you can prove that the total amount of saving: private saving, plus government saving, plus "imported" foreign saving, is exactly equal to the total amount of domestic investment. To the extent that the people who did the saving are different than the people who did the investing, you can also prove that securities will have been issued to effect the transfer between saver and spender.

Suppose that the U.S. grows 2 tons of corn, and China grows 2 tons of rice. U.S. consumers eat half a ton of corn, invest half a ton by planting it, and import 1 ton of rice from China for $500. The Chinese people eat the other ton of rice. The U.S. government buys America's remaining ton of corn for $1000 and burns it. It gets the $1000 by issuing Treasury bonds.

In the end everything that was produced gets classified as consumption, or investment, or government spending. U.S. private savings were a half ton of corn ($500) plus $500 of income that was not spent, government savings were -$1000, and foreign savings were $500 from what China sold the U.S. So total world savings are $500, which got invested as seed. Real savings equal real investment. On the financial side, Americans must have $500 of financial savings ($1000 from selling corn to the government, less $500 spent in China). The Chinese must have $500 in financial savings as well. In the absence of any new money creation, equilibrium requires that Americans bought $500 worth of the Treasury bonds and the Chinese bought the other $500 worth. The issuance of financial assets ($1000) is exactly matched by the creation of financial liabilities (in this case government debt). These financial securities are simply a means of intermediating funds from savers to spenders. Alternatively, the Fed could have bought the $1000 of Treasuries, paying for them by printing currency, in which case Americans end up with $500 in currency, and the Chinese end up with the other $500.

In any event, the newly issued securities are evidence of production that was transferred for somebody else's use. The securities are evidence of past spending - simply IOUs. The current output is gone, and the financial securities are now a claim on future real output that can be commanded. That, by the way, is the problem with running up trillions of dollars in current account deficits with foreigners - they now have a claim to our future production. To the extent that we borrow from foreigners for consumption rather than for productive purposes, their claims will lower America's future living standards. A fiscally responsible federal government would be the best start toward correcting this problem.

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