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February 2, 2009

The GDP Deflator Takes a Hit

John P. Hussman, Ph.D.
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Last week, the Commerce Department released preliminary estimates for fourth-quarter GDP, which contracted at an initial estimate of -3.8% at an annualized rate. That was better than the -5.5% figure estimated by economists, but as noted last week, these are actually quarterly figures quoted at annual rates. In that context, the actual contraction in real GDP in the fourth quarter was -0.96%, compared with an estimated contraction of -1.40%. While it was widely reported that this was the worst contraction since 1982, it was far less noted that the GDP price deflator posted its first quarterly decline since 1954.

Keep in mind that nominal GDP growth is (to a close approximation) the sum of real GDP growth and the change in the GDP deflator. The overall contraction in nominal GDP last quarter was actually the most severe since 1958, but to the extent that the deflator took the hit, real GDP was less affected. In other words, part of the reason that GDP evidently held up better than expected in the fourth quarter was that businesses attempted to preserve sales by offering price concessions. That practice was clearly evident in the retail sector, but was also at work in the broad economy, and was one of the main reasons for the fierce contraction in profit margins we've seen recently.

This Friday features the January employment report, which is likely to be very poor judging from the weekly jobless claims figures (and continuing claims data). I have no particular view on whether it will be better or worse than expectations, but at present, we continue to grade the quality of market action as unfavorable, which generally prepares us for negative surprises. With the market essentially waiting on additional data here, we'll respond to changes in valuations and market action as they emerge.

Market Climate

As of last week, the Market Climate for stocks remained characterized by favorable valuations and unfavorable market action. While in this particular Climate, the general investment strategy is to gradually expand our exposure to market fluctuations in response to price declines, but to retain a generally hedged position. The only other point that we would expect to make a discrete change in our market exposure would be if we observed a clear improvement in the quality of market action, but that evidence is not in hand here, particularly with credit default spreads still hovering near their highs.

At present, the Strategic Growth Fund is well-hedged against market fluctuations. Though we do retain a moderate position in what are currently out-of-the-money index call options, I would expect most of the day-to-day fluctuations in the Fund to be driven not by general market fluctuations, but by the difference in performance between the stocks that we hold in the Fund, and the indices we use to hedge (primarily the S&P 500 and Russell 2000).

In bonds, the Market Climate last week was characterized by unfavorable yield levels and relatively neutral yield pressures. We've observed a spike in Treasury yields in recent weeks, not so much because of a measurable abatement in risk-aversion (which would show up as an easing in credit spreads and other metrics), but simply because bond investors evidently took a moment to think about whether long-term yields-to-maturity of 2% were really reasonable, and they apparently concluded that they were not. While I don't expect much in the way of inflation pressures for several quarters, it still appears unreasonable to expect inflation to average about zero for nearly a decade, which is how Treasury Inflation Protected Securities have been priced in recent weeks. They've certainly advanced in price from their lows, but I remain comfortable with the Strategic Total Return Fund predominantly invested in moderate-duration TIPS. The Fund also holds about 10% of assets in precious metals shares, about 10% in foreign currencies, and about 5% of assets in utility shares. Again, those positions will change as we observe shifts in yield levels, yield pressures and other factors, as we try to be opportunistic about the price and yield levels at which we establish or remove investment exposure in these areas.

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