July 6, 2009
Brief Holiday Update
As of last week, the Market Climate for stocks remained characterized by modestly unfavorable valuations and mixed market action, a combination that suppresses the likely return/risk profile of stocks enough to hold the Strategic Growth Fund to a fully hedged investment stance. On a long-term investment basis, the S&P 500 remains priced to deliver probable returns in the area of 7.8% annually over the coming decade, which suggests modest but not compelling investment merit. Short-term weakness has cleared the recent overbought condition of the market, but stocks are not oversold to any meaningful extent, so the overall set of investment conditions here has no compelling speculative merit either.
Thursday's employment report was not terrible in the context of what we observed earlier this year, but as I've noted frequently in recent weeks, the market's second-quarter advance creates a situation where investors now require favorable economic developments (not just “less bad” results). It's possible that we could see such improvements, but the risk, as we observed last week, is that investors will express significant disappointment if those improvements don't materialize. Price-volume action continues to be “heavy” in the sense that trading volume has been persistently waning, and advances are increasingly short-lived. Now that stocks have largely priced in a measurable economic turnaround, that "heavy" price-volume action suggests increasing impatience among investors for real proof of economic progress.
Given current household leverage from mortgage and consumer debt, coupled with the inability to access mortgage equity withdrawals (that largely fed spending increases during the most recent economic expansion), my concern continues to be that unemployment will behave as a leading indicator rather than a lagging one. During typical economic downturns, there is always some feedback from employment losses to credit losses, but that effect has been more contained because debt burdens have not been nearly as high, and homeowners have not been saddled with negative home equity. The dynamic of this downturn is different, so investors should be slow to accept the “employment is a lagging indicator” argument under present conditions.
On the inflation front, I continue to believe that any persistent inflation pressure is most probably several years out. The primary inflation risk is not simply that the Treasury and Federal Reserve have dramatically expanded the volume of government liabilities. To the extent that these agencies have taken assets in – commercial mortgage securities or preferred stock of banks – these transactions could theoretically be reversed without leaving a persistent increase of government liabilities in their wake. The real problem is that avoiding inflation here requires that these transactions can be undone, and that will prove impossible if mortgage defaults do not actually stop. There is no reason to believe that they will, particularly given the enormous overhang of second-wave mortgage resets that will begin later this year. So the real problem is not just that we've issued more government liabilities, but that the assets that we've taken in return will turn out to be worth less than the liabilities we created. The difference, of course, will represent pure money creation, and that's what will feed inflationary pressures over time.
Very short-term, to the extent that we observe periodic upward pressures on interest rates, we will also tend to see a pickup in monetary velocity that may lead to month-to-month upward surprises in inflation. But again, the longer-term impact is most likely several years away. Unless we see a major abatement in foreclosures and mortgage losses, neither which I believe is likely here, I expect that the government liabilities we've created will ultimately represent monetization. That doesn't imply hyperinflation by any means, but it does suggest a near-doubling of the U.S. CPI over the coming decade, with most of the pressure coming several years from now.
That's enough time that it will be hard for investors to sustain a durable sense of doom about inflation risk – particularly in an economy that's unlikely to gain a great deal of traction – so it's not at all clear to me that investors should be rushing for inflation hedges and “reflation trades” here and now. It will be a process of ebb and flow, just like we're seeing in stocks (and will likely continue to see). So while I would expect that a general bias toward defending against inflation and U.S. dollar weakness will be a useful strategy over the coming decade, I don't think that investors should pursue an approach like that in the expectation that it will be immediately or persistently profitable. As a side note, from my standpoint, I'd be careful of oil here – it is priced for a resumption of global demand and inflation that I think will be very difficult to pull off as perfectly as the market seems to require.
In bonds, the Market Climate last week was characterized by slightly unfavorable yield levels and relatively neutral yield pressures. In the Strategic Total Return Fund, we continue to carry an average duration of about 3-years, largely but not entirely in TIPS, with just under 20% of assets allocated to foreign currencies, precious metals shares, and utility shares.
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