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August 11, 2008

Nervous Bunny

John P. Hussman, Ph.D.
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With bonds and utilities deteriorating, stock market internals are becoming unusually hostile. This sort of joint deterioration in interest sensitive securities has often provided important warning of steep subsequent losses, as we observed for example in 1966, 1987, and 1990. While the market is still sustaining something of a relief rally from the lows of a few weeks ago, I've noted that hostile yield trends have a tendency to cut such advances short, even when bearish sentiment and oversold conditions would otherwise invite more sustained bear market rallies.

Given the unusually low level of option volatilities (“cheap gamma” from the perspective of option strategies), the best way to accept any exposure at all to market risk has been to trade like a nervous bunny: hopping into small exposures on selloffs sufficient to produce oversold evidence, and quickly jumping out and shutting those positions down as soon as that evidence clears on the fast, furious but prone-to-failure rebounds that ensue. Until we observe more favorable valuations, declining yield pressures, or more robust internals, it's unlikely that we'll have much evidence to accept much but a passing and limited exposure to market risk, and even then, I would expect to use small call option positions while leaving our downside put defenses in place.

Currently, we are in an unusually defensive stance. Given that the market has cleared its oversold condition, yield trends are not favorable, and stocks are now overbought in an unfavorable Market Climate (among the only times we ever have an opinion about near-term direction), the Strategic Growth Fund is positioned with a “staggered strike” position to boost our protection against deep or abrupt losses. I've discussed staggered hedges in detail in prior commentaries. Essentially, the Fund can be considered to be fully hedged, with a fraction of 1% of assets allocated to boosting our put option strike prices closer to being at-the-money. The low level of option premiums makes this "insurance" particularly inexpensive here.

Among the factors that should make investors nervous is that despite the low level of volatility implied by options premiums, the actual intra-day volatility of the market is increasing sharply at short intervals. I discussed the same sort of behavior last year in my July 30, 2007 comment (Market Internals Go Negative), noting the market's tendency to experience increasing volatility at 5-10 minute intervals prior to major declines.

On the news front, last week was largely a continuation of ongoing trends, with the jobless claims numbers remaining near the 450,000 level, continued reports of loan losses from Fannie Mae and Freddie Mac, and cracks in the commodity boom (though it appears likely that we'll observe a clearing rally in the commodities between now and the point where further evidence of economic deterioration sets in).

With regard to Fannie Mae's report, the most interesting figure wasn't the reported $2.3 billion loss, but rather the much larger deterioration in the reported fair value of Fannie's balance sheet. We can observe what's going on by comparing Table 32 of Fannie Mae's Q2 2008 10Q filing with the same table in Fannie Mae's Q1 2008 10Q filing.

As of June 30, 2008, the fair value of Fannie Mae's common equity (that is, the book value available to common shareholders) was -$5.39 billion, compared with a March 31 fair value of -$2.07 billion. What's notable here is that this deterioration (-$3.32 billion) was even larger than the -$2.30 billion loss that Fannie reported to investors, which was itself about four times higher than the loss analysts had estimated. Note that balance sheet losses are excluded from earnings. Financial stocks tend to be reasonably valued when they trade at tangible book value, but simply put, Fannie Mae has no tangible book value. The common stock is now a call option.

Even if we include the fair value of preferred equity, we find that on a fair value basis, Fannie Mae is operating at a gross leverage multiple of 72.7 (total assets comprised primarily of mortgage loans, divided by shareholder equity). In other words, a slight 1.4% deterioration in the value of Fannie's book of assets will wipe out all of the remaining shareholder equity. This makes Long Term Capital Management look like a conservative strategy.

Finally, just a note about the recent “economic stimulus package.” As I noted in the January 28 market comment, “Several years ago, Joel Slemrod and Matt Shapiro (former colleagues at the University of Michigan) estimated that only about 22% of the tax rebates provided during the last recession were directed to consumption, with the bulk going to savings and debt service. Given the much higher debt burdens today, I don't expect this instance to be much different. In the end, the U.S. economy will carry a larger amount of U.S. Treasury debt, and a somewhat smaller amount of mortgage and credit card debt than it would have in the absence of the fiscal stimulus.”

Last week, Martin Feldstein, the head of the National Bureau of Economic Research (which officially dates U.S. recessions), confirmed this expectation: “The evidence is now in and that optimism was unwarranted. Recent government statistics show that only between 10% and 20% of the rebate dollars were spent. The rebates added nearly $80 billion to the permanent national debt but less than $20 billion to consumer spending. This experience confirms earlier studies showing that one-time tax rebates are not a cost-effective way to increase economic activity.”

Market Climate

As of last week, the Market Climate in stocks was characterized by unfavorable valuations and unfavorable market action. In addition, stocks are again overbought in an unfavorable Market Climate, which tends to produce unusually poor subsequent returns, on average. Combined with hostile yield trends in interest-sensitive securities, current market conditions warrant unusually strong concern. Though I have a longstanding aversion to forecasts, the outcomes from prevailing conditions have historically been so negatively skewed that the distinction between “average outcomes” and “forecasts” is not meaningful.

We have a strongly defensive position here, but since the main element of defense (versus a standard full hedge) is only a fraction of 1% in option premium dedicated to a staggered strike position, we can maintain this stance without much concern in the event that the market advances instead.

In bonds, the Market Climate last week was characterized by relatively neutral yield levels and generally hostile yield trends, holding the Strategic Total Return Fund to a modest 2.5 year duration. The U.S. dollar has advanced recently, with traders paying attention to the reluctance of the Fed to cut further and to emerging recession in Europe, with less attention to the risk of deepening recession here in the States. Fresh dollar weakness will most probably come on the heels of further negative economic news and interest rate weakness, which will probably be coincident with U.S. stock market weakness. The Strategic Total Return Fund continues to maintain about 15% of assets in foreign currencies. In addition, the steep drop in precious metals shares last week was enough to finally bump our exposure to this market back to about 8% of assets – not an aggressive exposure by any means, but in line with the improved valuations and steeply oversold condition of those shares.

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