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December 8, 2008

Ambiguous Conditions Warrant Moderation

John P. Hussman, Ph.D.
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The condition of the stock market here is ambiguous. Valuations are generally favorable, market action is generally unfavorable but with tenuous signs of improvement, the economy is deteriorating, and it is difficult to estimate how much further it will weaken, yet the outlook for further economic weakness is common knowledge, so it may already be reflected in prices.

The ability to be comfortable with uncertainty is one of the qualities that allow good investors to function – to pursue a disciplined investment approach even when the likely direction of the market is ambiguous.

The desire to create certainty out of ambiguity; to boldly take one side or another in defiance of all contrary evidence; is both tempting and foolish. Ambiguous conditions warrant moderate investment positions because the prospect for expected returns has to be tempered by the prospect for risk. Investors who accept a moderate investment exposure here should not do so in hopes of “picking a bottom” or “catching a falling knife.” They should do so in order to properly align their investment exposure with the moderate return/risk profile that characterizes market conditions here.

Investors should allow, and even hope, for the market to decline further over the next several months; both to provide better valuations, and to provide additional clarity (though not certainty) about the evolution of the economy. There are some conditions that have historically warranted entirely unhedged and even modestly leveraged investment exposures despite unfavorable economic conditions. We don't have that situation at present.

At best, present market conditions warrant a generally constructive “local” investment position, but with something of a “safety net” (for us, in the form of index put options against about 70% of our holdings) in the event that the market declines more than several percent. These options will help little in defending against moderate losses in the market, but are in place to defend against major deterioration toward fresh market lows.

We continue to hear remarks that the current economic downturn is the worst since the Great Depression. While the prices of stocks and other financial assets have certainly suffered a great deal, by any reasonable measure of output and employment, this isn't even close to being the worst economic downturn since the Depression. Even after November's awful job report, and including all of the downward revisions, the U.S. economy would have to lose twice as many jobs as it has already lost even to be on par with the 1981-82 recession (measuring job losses as a percentage of the labor force).

While we do expect fourth-quarter GDP to come in at a loss of -4% to -6%, it is important to recognize that this is a quarterly change at an annual rate. The overall contraction in U.S. output will be somewhere about 1-1.5% in the fourth quarter. In the Great Depression, actual GDP dropped by 30%. Ben Bernanke was correct in remarks he made last week that there is “an order of magnitude” (10 fold) difference between the current downturn and the Great Depression. For the record, the worst overall drawdowns in GDP since the Depression – not just bad quarterly growth rates – were in 1954 (-2.65%), 1958 (-3.75%), 1975 (-3.10%), and 1982 (-2.87%).

This is not to minimize the prospects for a further economic downturn, but to say that this is “the worst economy since the Great Depression” is like blowing up a crate of dynamite on the Nevada Proving Grounds and saying it is the worst explosion since the detonation of the atomic bomb there. Even if the statement is accurate, the comparison is absurd.

The point of all this is to discourage investors from abandoning reasonable investment positions with the market already down by nearly 50%. If your asset allocation is well diversified and not aggressive, you are not likely to do yourself a favor by cutting your risk to well-below average levels in response to market losses that have already occurred. Had an investor bought stocks during the Great Depression when they were already 50% off their highs (late 1931), that investor would have suffered a great deal of loss into the 1932 low, but would still have had a gain two years later.

There are times to take drastically defensive positions, but extreme avoidance of risk is no longer appropriate. In October 2007 (which turned out in hindsight to be the market peak) I noted in Warning - Examine All Risk Exposures that “investors should consider prevailing conditions as a warning about assuming substantial risk. This includes foreign and developing markets, because correlations between U.S. and foreign markets suddenly become stronger during periods of market weakness than they are in periods of general stability. That doesn't mean investors need to make major changes in their investment exposures. There is nothing wrong with buy-and-hold investing, provided that investors recognize at market highs how strong the impulse is to sell at market lows. Whatever market exposure investors accept today ought to be the same market exposure that investors are committed to maintain for the duration of a bear market, without abandoning their investment plan. Investors with no plan to own stocks through a market decline, holding them only in the hope of selling at market highs, may discover in hindsight that these were them.”

Current market conditions do not offer the strength of evidence that would be required to encourage aggressive investment positions here, or to offer confidence that the final lows have been registered. Still, regardless of how the market performs over the next few quarters, it is already true that investors will probably do themselves long-term harm by making major allocations out of stocks on market declines from this point forward.

As a final note, it is important for investors to remember that stock prices trade on expectations. It is often said that the market bottoms before the economy does because investors begin to look ahead to a recovery several months before it occurs. I'm not entirely sure this is a good way to think about market dynamics. Rather, I believe it is more useful to think in terms of what actually creates the bottom itself. Almost by definition, bottoms require an overwhelming negativity about the future. That negativity itself; the common acceptance of the premise that more economic losses are yet to come (which may very well be true) is what creates the market trough. The tendency for stocks to rise afterward isn't necessarily forward-looking wisdom about a recovery. It may be almost a side-effect of investors moving away from such an overwhelming negative consensus.

The common knowledge among investors that “things are bad and will only get worse” is precisely what forms the basis of every durable market bottom. The consensus of investors tends to be wrong at peaks and troughs in the market, not because the market is diabolical and secretly wishes to frustrate the greatest number of investors, but because the consensus of optimism or fear is exactly what creates the peak or trough in the first place. For that reason, investors who are defensive at tops and constructive at bottoms will be out-of-step with what nearly everyone considers to be “obvious” fact.

Remember this. Just as there are a thousand reasons to buy stocks when the market is at its peak, there are a thousand reasons to avoid them at the trough. It feels dangerous, risky, foolish, and against all common sense to buy stocks low and to sell them high. This is why investors have a difficult time doing it, despite the apparent simplicity and logic of the advice.

I wish we could offer unequivocal evidence to buy or sell here, but we don't have it. Fortunately, there is really no need for it. Ambiguous evidence is perfectly good evidence – it simply argues for a moderate investment position in response.

Market Climate

As of last week, the Market Climate for stocks was characterized by favorable valuations, while market action showed early evidence of improvement, particularly on measures of risk aversion, despite being unfavorable on the basis of broader measures that are slower to change. The Strategic Growth Fund has a constructive “local” exposure in the sense that it will tend to participate in market fluctuations on the order of several percent. The Fund does, however, continue to hold a hedge against about 70% of its stock holdings (primarily index put options with strike prices several percent out-of-the-money), which serves as something of a “safety net” against major unexpected weakness toward the prior market lows.

In bonds, the Market Climate last week was characterized by unusually unfavorable yield levels and generally favorable yield pressures. As I have frequently noted, yield levels are much more important than market action in driving subsequent total returns in bonds. This is because bonds are less susceptible to “bubbles” as a result of their payment stream being known, so favorable market action can't be taken as evidence of favorable surprises in those payments. The problem with Treasury yields here is that while there are good economic reasons for the downward yield pressures, the levels are low enough to invite explosive spikes that can easily wipe out a year or more of yield-to-maturity in a few days.

Corporate yields have increased significantly, but default rates tend to pick up in the later stages of recessions, and there isn't much historical evidence to suggest that corporate bonds reach their lows any earlier than stocks do. For that reason, corporate bonds are essentially equity-equivalents here, and the same considerations about quality apply as well here as they do for stocks. Generally speaking, corporate bonds are currently priced to deliver both lower long-term returns than stocks, but as a group, will probably have lower volatility than stocks as well. Our inclination to invest in corporates for the Total Return Fund will likely increase at about the same time as our willingness to hold stocks on an unhedged basis for Strategic Growth (which is not yet). For now, the Strategic Total Return Fund continues to hold primarily TIPS (generally yielding 3-5% in real terms), with about 30% of assets allocated to precious metals shares, utilities, and foreign currencies.

NEW FROM BILL HESTER: Low Quality's Round Trip

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