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May 25, 2009

Market Internals Suggest Heightened Concern

John P. Hussman, Ph.D.
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Straight to the chase – our measures of market internals have somewhat unexpectedly broken down in recent sessions, partly as a result of hostile interest rate action, as well as reversals in a number of sensitive measures of "distribution" (largely driven by price-volume behavior) in an environment where overall price-volume behavior was already tepid. Breadth as measured by advances versus declines is still the clear bright spot in the market's action.

Importantly, the market still has the ability to establish a more constructive tone if it can advance past the recent resistance area. On the basis of constructive breadth and the potential that a better-sponsored advance might improve the tone of internals, we do continue to hold 1-2% of assets in the Strategic Growth Fund in call options, but overall, I am most concerned about abrupt downside risk, and apart from that “anti-hedge” in index calls, the Fund remains well hedged against the impact of market fluctuations here.

One of the concerns that seems to be developing here is that the stock market has gone a significant distance on what is now an article of faith (and a largely discounted one) that an economic recovery is close at hand. To some extent, that puts us in a situation where instead of requiring only that the news is “less bad than expected,” the maintenance and extension of recent gains will require actual improvement in economic reports. As continuing unemployment claims, retail sales and other data are suggesting, those improvements may not come as easily as expected.

So we have a combination of relatively neutral valuations (overvalued on measures that don't assume a quick return to 2007 record profit margins) and modest (but enough to be of concern) deterioration in measures of market action that were already tepid. The overall picture does still allow for the possibility of a further extension to the recent advance, and we hold a modest “anti-hedge” in index calls on that contingency. But general conditions are not compelling reasons to accept much market risk, particularly with the recent push higher in interest rates, so the Fund's primary stance remains defensive.

For personal reasons (very positive), next week's comment will likely be brief, but I'll extend it if market events warrant a more expanded discussion (thanks!)

Market Climate

As noted above, the Market Climate in stocks last week was characterized by relatively neutral valuations and a deterioration in market internals that were already somewhat borderline. The Strategic Growth Fund remains invested in a diversified portfolio of individual stocks, well hedged with offsetting short positions in the S&P 500, Russell 2000 and Nasdaq 100, with a modest “anti-hedge” of about 1-2% of assets in call options to soften our hedge in response to a substantial resumption of the recent advance – but without compromising important defense against significant market losses. Suffice it to say that my primary concern is on defending against downside risk here, but that we can't rule out, and are accordingly allowing for, the contingency of resumed strength.

In bonds, the Market Climate last week was characterized by modestly favorable yield levels, and unfavorable yield pressures. Bond yields have shot up lately, partly on disappointment that the Fed is not more aggressively buying long-dated Treasuries. The difficulty here is that such Fed buying is always a swap of one government liability for another, and the resulting impact on interest rates and inflation pressures are rarely durable from that sort of a swap. The Fed is not in a position here of being able to buy Treasuries while divesting itself of commercial mortgage backed securities, so any Treasury buying it does is effectively monetizing the Federal debt anyway, which the bond markets will eventually recognize as inflationary anyway. That said, it's important to emphasize that my views on inflation do not amount to an expectation of “hyperinflation” but rather a near-doubling of the U.S. price level over the next decade, most of the pressure coming after 3 years or beyond – most likely not in the near years. In the interim, there is always an “ebb and flow” of data that makes inflation seem more or less likely from time to time, so bonds will advance and decline in a wide trading range in the meantime.

To the extent that we are likely to observe fresh credit defaults (and are already seeing accelerating foreclosure activity again), there is likely to be another wave of “flight to safety” at some point. As usual, our response to bond yield fluctuations is generally to moderately increase durations as yields become attractive, particularly when yield pressures begin to abate. In the current circumstance we are watching credit spreads carefully, because upward pressure on spreads (measured based on corporate-Treasury and corporate-corporate yields) may cause the upward pressure on Treasury yields to reverse.

For now, the Strategic Total Return Fund continues to carry a duration of about 2 years, mostly in TIPS. I should note that TIPS are not particularly sensitive to interest rate fluctuations generally, since the strongest component of interest rate fluctuations is variation in the inflation component, not the real component. So we are comfortable with that TIPS position here. The Fund also holds about 25% of assets in foreign currencies, precious metals shares, and utility shares.

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