January 11, 2010
Green Shoots, Weak Roots
On Friday, the Labor Department reported a loss of 85,000 in nonfarm payrolls, coupled with a net downward revision of 1000 jobs over the preceding two months. While that job loss was considered a negative surprise, the only real surprise is that the consensus expectation was for positive growth in nonfarm payrolls in the first place. As I noted last month, a sustained move to fewer than 400,000 new weekly unemployment claims over more than 4 weeks or so is probably where we would expect to observe predictable job growth.
The focus of analyst commentary on Friday was that "although the layoffs have stopped, we're not yet seeing job creation." It seems strange to say that layoffs have stopped on a day where 85,000 payroll losses are reported, and reflects the likelihood that investors are still trading on the green-shoots theme that things are not getting worse, rather than looking at the full economic picture and the very different challenges that we face today compared with typical post-war economic recoveries.
Invariably, the strongest engine of growth at the outset of economic recoveries is rapid expansion in debt-financed classes of expenditure such as housing, autos and other forms of durable investment - something that is unlikely here outside of a brief burst of inventory rebuilding. Moreover, there is a widespread tendency here to extrapolate the trend of recent improvement into 2010, without considering that the improvement is almost exclusively a reflection of government spending (see, for example, the dull performance of personal income once transfer payments are excluded), and that the strains in the employment market coupled with high loan to value ratios and heavy mortgage resets nearly ensure fresh credit deterioration.
Once again, the figures from the household survey (which are affected much more by smaller businesses and tend to lead at economic turns) were abysmal. The household survey indicates a loss of 589,000 jobs in December (not a typo), while 843,000 workers left the labor force. Even in the establishment survey, which is commonly used to calculate the unemployment rate, 661,000 workers were reported to have left the labor force in December. Since only workers actively seeking employment are counted among the unemployed, the exodus of discouraged workers helped to keep the unemployment rate unchanged at 10% despite the new job losses (the U6 unemployment rate, which includes discouraged workers, increased to 17.3%).
To provide a more complete picture of the economic situtation, Bill Hester provides a nice view this week of where the U.S. economy stands on the basis of indicators used by the business cycle dating committee of the National Bureau of Economic Research (the official arbiter of recessions and expansions): A View from the NBER Recession Indicators (additional link at the end of this comment). On Friday, Bill remarked "this isn't a jobless recovery - it's a job-loss recovery."
There's no denying that the beliefs of investors have been far more important, in the intermediate term, than economic realities, which are revealed more slowly and sporadically. Yet despite the high level of bullishness here, the market has gained only a few percent beyond its September highs. Most of what we are seeing now is a tendency to make marginal new highs, back off slightly, and then recover that ground enough to register another marginal new high. As I've noted frequently, when market conditions are characterized by unfavorable valuations, overbought conditions, overbullish sentiment, and upward yield pressures, the market's tendency is exactly that - to make continued marginal new highs for some period of time, followed by abrupt and often steep losses virtually out of nowhere. Being defensive in that situation can make each slight new high feel excruciating, even if the market is not making much net progress. I remember that my own patience with this process was tested in mid-2007, when I quoted Wallace Stevens - "Does ripe fruit never fall? Or do the boughs hang always heavy in that perfect sky?"
Given this context, the next few months are likely to be extremely important. The present overvalued, overbought, overbullish, yields-rising conformation holds us back from accepting market risk here in any case. But the market is quite likely to clear this condition in one way or another over the next few months, most likely with an abrupt decline. Meanwhile, the next few months will also afford us better clarity with respect to the actual condition of the delinquency/foreclosure situation, as well as a look at the off-balance sheet entities that, per FASB rules, must now be disclosed on the balance sheet of financial institutions (where Freddie Mac has already warned the accounting change will significantly impair its solvency).
The combination of greater clarity, and hopefully, better valuation, should offer us much more flexibility to accept market risk, without the "two data sets" issue that has plagued us in recent quarters. My concern is still very much that the outcome of this clarity will not be favorable for the financial markets or the economy. But once you know the environment you are in, it is much easier to work with the details, good or bad.
So we begin the year with the expectation of at least somewhat better valuation, and significantly better clarity, in the coming months. Whether we clear the current overvalued, overbought, overbullish, yields-rising condition with a major decline or a minor one, the flexibility we obtain from improved economic clarity should allow us more flexibility to accept market risk as opportunities arise. Here, however, we remain defensive on the basis of observable conditions.
As of last week, the Market Climate for stocks was characterized by unfavorable valuations, overbought conditions, overbullish sentiment and rising yield pressures. Market internals were mixed, with yield-sensitive sectors having some trouble, but breadth reasonably intact.
With the Strategic Growth Fund well-hedged here, most of the day-to-day fluctuation in the Fund is due not to our hedges but to the difference in performance between the stocks that the Fund holds and the indices we use to hedge. Last week, we observed a modest pullback in the relative performance of some of our best performing stocks, relative to the S&P 500 itself. That variation in the "basis" between our stocks and the S&P 500 created some day-to-day fluctuation in Fund value that was largely unrelated to market direction. Though the performance of our stocks, relative to the indices we hedge, has driven a significant portion of our long-term returns relative to the S&P 500 since the inception of the Fund, we do get periods where a handful of our stocks back off a bit. To have that occur on days when the market itself is hitting marginal highs is doubly frustrating, but these are short-term considerations. Our primary objective remains to outperform the S&P 500 over the complete market cycle, with smaller periodic losses than a passive investment strategy.
In bonds, the Market Climate last week was characterized by modestly favorable yield levels and moderately unfavorable yield pressures. The upward pressure on yields, however, appears largely dependent on the absence of fresh credit concerns, and Treasuries are likely to enjoy fresh price strength if those concerns resurface. Likewise, with Treasury yields rising and inflation figures still fairly subdued, we've got some upward pressure on real interest rates, which tends to be helpful to the U.S. dollar while creating a headwind for precious metals.
The upshot of this situation is that near-term factors are likely to be somewhat favorable to Treasury securities and the U.S. dollar, while presenting challenges for gold and other commodities. The situation is precisely reversed, however, from a longer-term perspective, where the relentless issuance of government liabilities is likely to result in a significant deterioration in their value on a 7-10 year horizon.
Overall then, near-term defensiveness is warranted in stocks, at least until we clear the present overvalued, overbought, overbullish, rising yield conformation, while it is reasonable to nibble on Treasury bonds in response to weakness, but only to a limited extent because the merit of bonds is likely to be limited to the window in which fresh credit concerns are likely. My impression is that this window encompasses the next quarter or two. Accordingly, the Strategic Total Return Fund currently carries a still-conservative duration of about 4 years. Beyond that, both in the Strategic Total Return Fund and the Strategic Growth Fund, I expect that our tendency will be to establish some amount of commodity-related exposure on price weakness as we move through this year and next, since the longer-term inflation outlook is troubling. As usual, we'll respond to market conditions as they develop.
New from Bill Hester: A View from the NBER Recession Indicators
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