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April 5, 2010

Unpleasant Skew

John P. Hussman, Ph.D.
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With stock market conditions characterized by strenuous overbought conditions, strenuous overvaluation, overbullish sentiment and hostile yield trends, a few features of the present market environment are worth noting. Some of this will be familiar to regular readers of these comments, as they reflect observations that I made the final months of the advance to the 2007 market peak, and over recent months (and for those of you who have been with me that long, during the advance to the 2000 bubble peak).

The first crucial observation is that high risk market conditions like we observe at present come with an "unpleasant skew." If you look at overvalued, overbought, overbullish, hostile yield conditions of the past, you'll find that the most likely market outcome, in terms of raw probability, is a continued tendency for the market to achieve successive but slight marginal new highs. While this movement tends to be fairly muted in terms of overall progress, it can be somewhat excruciating for investors in a defensive position, because the market tends to pull back by a only a few percent, followed by bursts that recover that lost ground and achieve minor but widely celebrated new highs. That is the "unpleasant" part.

The "skew" part is that although the raw probability tends to favor slight successive new highs, the remaining probability tends to feature nearly vertical drops, typically well over 10% over a period of weeks. Frankly, I thought we had begun that process in the decline from the January highs, but much like we observed in early 2007, that initial decline was quickly recovered and followed by a restoration of overvalued, overbought, overbullish, hostile yield conditions. Eventually, of course, the outcome for investors was very bad, but that in no way rescued us from discomfort as the market approached its final peak in 2007. I suspect something similar is at work at present, but we will take our evidence as it comes.

Here and now, it does not matter which "data set" we live in - whether we are presently in a temporary lull prior to a second wave of credit difficulties, or whether we are in a typical post-war recovery, the present set of conditions would hold us to a defensive investment stance.

On the subject of credit conditions, the Federal Reserve was forced last week to reveal the assets that it acquired during the Bear Stearns and AIG bailouts (the "Maiden Lane" portfolios - remember, the ones that Bernanke and Geithner assured Congress were made up of extremely high quality assets on which it would most likely turn a profit?) As Bloomberg reports, it turns out that the assets that can be valued are currently worth between 39-44 cents on the dollar.

My concern is that this is something of a microcosm of the gap between reported and actual assets in the U.S. banking system as a whole. Clearly, investors have been willing to close their ears and hum as long as the reported numbers are encouraging, but bear in mind that all of these assets are still allowed to be valued with "significant judgment." In terms of overall dollars, the amount of "discretion" being exercised here could end up making Bernie Madoff look like a petty thief.

Asset values have been written up over the past year, but the underlying cash flows clearly continue to deteriorate. Delinquency rates remain at record highs, while foreclosure rates have lagged, creating a massive shadow inventory of bad but unforeclosed mortgages in the U.S. financial system. This may eventually get interesting, but again, even if we have somehow cured the underlying credit problems of the economy through Maiden Lane and other examples of Your Bureaucracy At Work, we would be defensive on the basis of other market-centric evidence.

From a valuation standpoint, I should note that while I originated the "price-to-peak earnings" metric in the late 1990's, we have increasingly avoided this measure since 2007 because the 2007 peak earnings figures reflected profit margins that were about 50% above the historical norm and are not sustainable in our view. For that reason, I have increasingly quoted direct calculations of the implied 10-year total return in stocks, which applies a range of terminal valuation multiples to projected mid-channel (i.e. normalized) earnings a decade into the future. The history of this particular metric is plotted below. At present, the implied total return for the S&P 500 over the coming decade is just 5.7% annually, the lowest level observed in any period prior to the late 1990's bubble (which has predictably been associated with dismal returns).

Notably, even at the March 2009 lows, the implied total return barely crossed 10%, suggesting that stocks were modestly undervalued at that point, but nowhere near the level of valuation observed at major long-term buying opportunities such as 1950, 1974 and 1982. This is not intended to excuse what in hindsight has been my awful underestimation of the extent to which investors would abandon their aversion to risk - in hope that credit difficulties have been solved and that record profit margins will be recovered and sustained into the indefinite future. It's just that current market levels now rely on those hopes to be validated.

Using a somewhat different metric (Shiller P/E ratios), Prieur du Plessis recently published an excellent analysis of present valuations and the prospect for long-term market returns.

Market Climate

As of last week, the Market Climate for stocks remained characterized by strenuously overbought conditions, strenuous overvaluation, overbullish sentiment, and hostile yield trends. If one was making a bet, and the payoff to the bet was simply whether the market will be up or down in the coming few weeks, it turns out that the raw probability of an advance in these conditions is greater than the raw probability of a decline. However, this does not reflect magnitudes. The probable gains are characterized by the likelihood of minor but successive marginal new highs. The potential downside risk is smaller in probability, but considerably larger in terms of magnitude.

In bonds, the Market Climate continued to be characterized last week by relatively neutral yield levels and hostile yield pressures. I expect that we would require a push beyond about 4% on the 10-year bond to prompt us to increase our overall portfolio duration (currently just under 4 years, mostly in straight Treasury notes). While fresh credit difficulties would tend to be favorable for long-term Treasury bonds (reflecting a likely flight to default-free securities), the countervailing pressures from brobdingnagian fiscal deficits and, at least for now, perceptions of economic recovery, suggest that we should move slowly with our duration shifts. On the employment front, we take no joy in anything but strong labor markets, but as I noted several weeks ago, the size of month-to-month seasonal adjustments is enormous (on the order of hundreds of thousands of jobs in one direction or another). Census hiring and weather-related impacts notwithstanding, sustained positive job creation will be much more likely once we get the weekly claims numbers (reported on Thursdays) below about 400,000 on the 4-week average.

Overall, our Treasury duration remains modest, and I continue to expect more significant shifts toward TIPS, precious metals shares and other inflation-hedges on material price weakness. My impression is that with unemployment still very much a problem, and a large contingent of unemployed workers out of the job market for more than 6 months, deflationary concerns will be easily revived if we have any credit hiccups in the months ahead. Given our longer-term inflation views, I would expect such an event to provide a reasonable opportunity to shift our investment mix in the Strategic Total Return Fund.

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