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July 27, 2009

Biting A Bullet

John P. Hussman, Ph.D.
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In recent weeks, the dominant view of investors and analysts has shifted clearly to the expectation that the U.S. economy is in recovery. Appearing to seal the deal for some analysts was the third consecutive increase in the index of leading economic indicators. For that index, interest rate spreads and the S&P 500 Index have been the strongest contributors in recent months, as 10-year yields have shot higher from near 2% at the beginning of the year to about 4% before retreating a bit, and stocks have similarly rebounded from deeply oversold levels. Unfortunately, as I've noted before, there is little information content in mean reversion following extreme moves, and that's what the LEI is picking up here – to a much greater extent than has typically been the case at the end of recessions. Put another way, the case for an economic recovery is based largely on mean reversion from the early 2009 extremes (not on improvements in jobless claims or other measures to a level that is on par with prior recoveries). The recovery argument also relies strongly on the idea that this is a run-of-the-mill post-war recession.

That said, I can only describe our investment stance here as “uncomfortably defensive.” That is, the measures that have guided the performance of the Strategic Growth Fund over time are still holding to a defensive stance, which is admittedly uncomfortable with the market pressing strenuous but persistent overbought levels. It's a lot like watching people scale across a tenuously secured rope bridge and get a nice meal at the center. You'd like to climb across and join them, but you know that too many things aren't right with the bridge, and it's not clear that the people who are eating will ultimately survive.

Our defensive stance here is driven by a combination of poor price-volume sponsorship, moderate overvaluation, strenuous overbought conditions, Treasury yield and commodity price pressures, as well as a variety of other factors that have historically combined to produce a weak overall return-to-risk tradeoff. Moreover, from a fundamental standpoint, the ebullience about an economic recovery is based on what I've frequently called the “ebb and flow” of short-term economic information that very well can turn hostile again – particularly given that there is no reason to assume that deleveraging pressures have seriously abated.

As John Mauldin notes, “this is going to feel like a very different recovery from what we normally think of as recovery. It will be more of a statistical recovery than a real one.” Essentially, we've observed a great deal of contraction in some sectors of the economy, such as housing, inventories and business investment, but at this point sheer stagnation would mean that they would no longer subtract from GDP growth, allowing us to observe flat or positive GDP figures. As John asks, “Does that mean recovery? No, it just means that things aren't getting worse.”

Still, knowing why we are defensive doesn't make holding a defensive stance in an advancing market any less uncomfortable. We can certainly look back on the past several years and observe many instances where we felt the same sort of short-term discomfort, and where our caution was clearly validated later. It would be nice to be able to take risk in a dangerous environment and get away with it. The fact is that you can get away with it, in hindsight, a good portion of the time. But on average, you'd get destroyed. Suffice it to say we're biting a bullet.

The extent of the recent rally is still smaller than the rally that stocks enjoyed following the 1929 crash (and was later followed by spectacular losses). That doesn't mean the same outcome will follow in this event, but I continue to believe that the path to recovery will be far harder, with much greater headwinds, than investors seem to assume at present. Taking the rally in stocks as an indicator of economic recovery (which the LEI largely does), and then taking the presumption of an economic recovery as a reason to buy stocks, all strikes me as circular reasoning.

In my view, investors have left themselves far too little room for error, not only in stocks, but also in corporate bonds. We'll take our evidence as it comes, and change our positions as the expected return-to-risk profile of the market changes. For now, we remain defensive.

Market Climate

As of last week, the Market Climate for stocks was characterized by moderate overvaluation and mixed market action. Presently, we estimate that the S&P 500 is priced to deliver average annual returns of 7.3% over the next decade (the probable range is 6% to 8.5%). Valuations are certainly not as poor as we saw at the 2000 or 2007 peaks (or during the “lost decade” between 1998 and 2008 where stocks returned nothing at all), but expected returns are clearly below historical norms. Frankly, projected 10-year returns here are at levels that typically characterized market tops, not bottoms, prior to about 1990. Stocks are emphatically not cheap here.

Breadth (advances versus declines) remains a standout, while price-volume behavior is still much more characteristic of a short-squeeze than of robust sponsorship by investors. The Strategic Growth Fund continues to be fully invested in a broadly diversified portfolio of individual stocks, with an equal offsetting short position in the S&P 500, Nasdaq 100 and Russell 2000 to mute the impact of overall market fluctuations on the Fund. The primary driver of Fund returns here is the difference in performance between the stocks we hold long and the indices we use to hedge.

In bonds, the Market Climate last week was characterized by slightly unfavorable yield levels and slightly unfavorable yield pressures. The Strategic Total Return Fund remains largely invested in Treasury Inflation Protected Securities, with an average Fund duration of about 3 years (meaning that a 100 basis point move in interest rate would be expected to induce about a 3% fluctuation in Fund value due to bond price changes). The Fund continues to hold less than 20% of assets in alternative classes including foreign currencies, precious metals shares and utility shares.

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