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June 16, 2008

Fed to Markets: "We Ain't Got To Show You No Stinking Credibility"

John P. Hussman, Ph.D.
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“WASHINGTON (Thomson Financial) - The number of foreclosures filed by US homeowners increased for the third consecutive month in May, California-based RealtyTrac reported today. Foreclosures totaled 261,255 in May, up 7 pct from April and 48 pct since May 2007. Approximately one in every 483 US households received a foreclosure filing during the month. Bank repossessions continued to surge in May -- posting a double-digit percentage increase from the previous month and more than twice the number reported in May 2007. Nevada continued to document the nation's highest state foreclosure rate, with one in every 118 households receiving a foreclosure filing in May. That is up 24 pct over April. California posted the second highest rate, with one in every 183 households receiving a filing.”

And the Fed is talking about raising rates to slow inflation and support the dollar? The Fed is on the fast track to destroying its own credibility. In my view, no sooner will all of this “tough love” leave the lips of Fed governors than the Fed will be forced to announce some novel emergency “liquidity facility” to address a fresh round of credit concerns. We may even observe an emergency easing on some morning in the next few months when the markets appear likely to open up particularly weak. The simple fact is that inflation outside of food and energy is not particularly high. Moreover, Fed tightening can do nothing to ease the food and energy pressures short of intentionally throwing the U.S. into a deeper recession (by making adjustable-rate mortgage resets more onerous than they already are). Mortgage failures remain the predominant risk to the economy, and that risk will not go away soon.

Most likely, the surge in food and energy prices will diminish by the end of the summer as the result of two factors. First, it is typical for commodity prices to “hang on” early into a recession and then dive as employment losses build. Whether or not we have seen the peak of the recent vertical push, the evidence of an early recession is already in from the standpoint of anything that has provided useful warning. The final highs in commodities will be difficult to identify simply because small changes in the end-point of a vertical ascent make for large differences in the terminal price. Still, commodities typically don't perform well during recessions once real interest rates trough (as they appear to have done). Those analysts who want to wait for two quarters of negative GDP before calling a recession are perfectly welcome to do so, provided they recognize that by the time such “proof” was available in prior recessions, the damage to stocks was often complete.

Second, as mortgage foreclosures and writeoffs predictably increase in the coming quarters, we are likely to observe a fresh demand for Treasury bonds as a safe-haven because of their lack of default risk. That is likely to place downward pressure on monetary velocity, which will act as a major brake on inflation. Recall that the brief period of deflation concerns during the 2001-2002 period emerged for exactly that reason.

As a side note, even during the deflation of the Great Depression, the monetary base grew at a very rapid rate, but demand for currency grew even faster (i.e. monetary velocity plunged). Deflation is always first and foremost a symptom of plunging velocity resulting from credit fears. We may not see deflation in the current cycle, but it's probable that inflation concerns will subside very quickly as we move further into the current recession.

We can't really blame the Fed for its confusing signals about tightening on one hand and easing on the other. Unfortunately, fiscal policy has put the FOMC between a rock and a hard place. If the government insists on creating huge volumes of debt, it must either be held by the public in the form of Treasury securities (putting a demand on funds that would otherwise be available for domestic investment), or else the Fed has to buy the Treasuries and create base money. That doesn't leave much room for finesse.

The large and continuing U.S. fiscal deficit forces us to finance our domestic investment with foreign savings inflows, and continues to pressure the U.S. dollar in the process. The Fed might like to tighten to support the dollar, but having sat idle during the housing bubble, higher rates now would simply accelerate the pace of mortgage defaults. The Fed can certainly talk about raising rates, and might even trot out an initial hike, but every time credit trouble threatens the markets, the Fed will predictably shift to frantic attempts to calm the market with easy money.

That fallout from the housing bubble is just beginning to hit its stride in terms of mortgage delinquencies and foreclosures. As I noted in my April 14 comment (Which “Inning” of the Mortgage Crisis Are We In?), since the progression of foreclosures has mirrored the pattern of adjustable mortgage rate resets, mid-2008 will most likely represent the highest rate of change in cumulative foreclosures, after which they will continue to rise but at a moderating rate.

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In short, mortgage foreclosures and defaults are just now hitting their stride, and we are likely to observe a second round of credit fears as those losses mount. The U.S. dollar has enjoyed a brief rebound on tightening talk from the Fed, which is likely to quickly dissipate as soon as those credit concerns revive. Meanwhile, commodity price pressure is likely to diminish by the end of summer as the result of a continuing economic downturn coupled with a flight-to-safety which will reduce monetary velocity.

Market Climate

As of last week, the Market Climate for stocks was characterized by unfavorable valuations and unfavorable market action.

While I'm generally comfortable making projections about about recession risk, credit conditions, foreclosures, Fed policy, inflation, and other factors that are grounded in economic fundamentals, I generally avoid projections about near-term market direction unless stocks are overbought in an unfavorable Market Climate or oversold in a favorable one. It's far more difficult to “forecast” specific stock and bond price movements than it is to project economic variables. This is because the risk-aversion and risk-tolerance of investors is essentially psychological, can change quickly, is not grounded in “fundamentals,” and has to constantly be gauged through the analysis of market internals. As a result, we align our investment positions with prevailing conditions of valuation and market action, and shift our stance when the evidence shifts. We concern ourselves with the average return/risk profile that has historically been associated with a given Market Climate, not with a specific "call" on about market direction in this particular instance. No short-term forecasts are required.

Presently, deteriorating stock market internals suggest fresh skittishness among investors, which coupled with still-rich valuations (on the basis of normalized earnings) often results in particularly negative outcomes for stocks. The dollar value of our shorts never materially exceeds our long holdings, but the Strategic Growth Fund remains fully hedged because the return/risk profile of this particular Climate hasn't been favorable on average.

In bonds, yields surged last week to levels that prompted us to modestly extend our average duration in the Strategic Total Return Fund. Still, at present the Fund's duration is still only about 2 years, because the overall level of yields is still relatively depressed. From an investment standpoint, the prospect of earning 4.25% total returns in Treasuries over the next decade is not what one would call a rich investment opportunity, so the primary attraction of Treasuries at present is on the basis of fresh downward yield pressure in a continuing recession. There is increasing reason to expect that, but we will tend to scale our exposure to longer-term Treasuries only gradually, as yields increase and investment merit improves. Meanwhile, we added a small amount to our foreign currency holdings in the Strategic Total Return Fund, bringing the Fund's exposure to foreign currencies to about 17% of assets. Given the relatively low volatility of currencies as compared with say, precious metals shares, this is still a conservative exposure, but it will provide at least a modest participation in any strength against the dollar.

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