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June 21, 2010

Cliffhanger

John P. Hussman, Ph.D.
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As we survey the current state of evidence from market and economic data, my greatest concern remains that we may be nearing a point that mathematicians call a "discontinuity." With respect to the stock market, valuations remain uncomfortably rich, and market action is tenuous. As I noted last week, "Keep in mind that after a clear break of major support levels, markets often recover back to that previous support, which can create a feeling of 'all clear' complacency. Be careful."

Having largely cleared the recent oversold condition of the market, we are at an important inflection point. A further recovery in market action would most likely create modest further demand from already well-invested speculators and trend followers, and modest offsetting supply from already defensive value-oriented investors, allowing a dull but moderate continuation of upside progress. On the other hand, a deterioration in market action would likely trigger a substantial amount of liquidation by speculators, into a market where fundamentally-oriented investors would require large price adjustments in order to absorb it. That outcome could result in a price discontinuity.

As I've noted before, if something induces one trader to sell, the market must move in a way that either removes that impulse, or induces another trader to buy. In equilibrium, there is no other possibility. When an overvalued market loses support from market internals, it frequently produces discontinuous outcomes ranging from brief "air pockets" to "panics" to "crashes." Emphatically, I am not forecasting or predicting a discontinuity as the only possible outcome, but it is important to recognize that the risk is elevated.

If one thinks of the data as telling a story, the picture here would most decidedly be a cliffhanger - where our hero dangles from a steep precipice, clutching a rock of uncertain strength, and where the evidence is not clear about what outcome will prevail. One outcome is a continuity, and the other is an abrupt discontinuity. It's possible that things will resolve sufficiently well, but we have to consider the possibility that they will not. I am not suggesting that readers and shareholders deviate from careful discipline or well-diversified investment plans. Instead, I am urging them to make sure that a significant market decline would not derail their financial security or future plans, or cause them to abandon their discipline after the fact - something that I've seen investors do far too frequently over the past decade. These considerations are particularly important for investors who will need to satisfy specific expenses (tuition, medical bills, home downpayments) within a short number of years.

A similar cliffhanger can be seen in regard to economic data. I noted last week that we are closing in on a syndrome of indications that has always and only appeared during or immediately prior to recessions. At present, however, we still do not have that evidence in hand. A recession forecast would be jumping the gun.

The latest data from the Economic Cycle Research Institute (ECRI) draws the same conclusion. The ECRI weekly leading index deteriorated last week to a -5.7% annual growth rate. ECRI head Lakshman Achuthan noted "We're definitely rolling over, let's not sugar coat it," but properly reluctant to take that evidence to a recession forecast, he noted, "Unfortunately, it's not that simple. We're not brushing this off, but it's premature. It has not persisted long enough." From my perspective, that's exactly the right interpretation of the data - of notable concern, but not yet conclusive. Interestingly, the main indication required to trigger our own recession warning composite would be a deterioration in the Purchasing Managers Index to 54 or less, and fluctuations in the PMI have been well correlated with the ECRI's Weekly Leading Index. Still, we'll wait for the evidence to emerge in its own right.

Achuthan also added the following comment, which is consistent with our views - "We expect this decade to provide more recessions than anyone is used to."

While it would undoubtedly be more satisfying for the data to provide a specific point forecast of where the market is headed and when, the fact is that we deal with probability distributions, not specific forecasts. The prevailing evidence suggests that the outcome from similar conditions has historically been unfavorable on average, and also suggests that there is a "fat left tail" to the bell curve (that is, a small but larger-than-normal probability of a significantly negative outcome). Still, we can also find instances where similar conditions of valuation and market action were followed by positive returns, so it is impossible to rule out a more benign resolution to our situation.

Given that the primary source of economic growth over the past year can be traced to massive fiscal deficits, and given that credit strains are emerging at the same time this fiscal stimulus is trailing off, it's tempting to decide in advance which way this situation will play out. We'll leave that to speculators. We don't take bearish net positions - but we are fully hedged. For us, that stance adequately reflects the elevated risks we observe here.

Market Climate

As of last week, the Market Climate for stocks was characterized by unfavorable valuations and unfavorable market action. As is typical (though not entirely dependable) after a breakdown in market internals, we've seen the stock market recover back to its prior area of support near the 1100-1125 range on the S&P 500. While technicians appear likely to await a move to the 1150 area to define a nice "right shoulder" on the charts, we don't really believe in such patterns, and have observed that putative "right shoulders" are truncated in extent and duration more often than not.

For our part, the most important indication from market action is that we've observed broad, simultaneous and high-volume deterioration in market action, followed by an advance to prior support that has largely cleared the initial oversold condition. As I noted last week, once internals have deteriorated, "the steepest losses in a market downturn typically follow the 'fast, furious, prone-to-failure' rallies that clear an oversold condition." As usual, that's not a forecast, but it's a tendency we've observed too often to rule out.

In bonds, the Market Climate remained characterized last week by modestly unfavorable yield levels and favorable yield pressures. The decline in the Consumer Price Index last month took some of the edge off of inflation concerns, but I continue to expect that further credit strains and possible economic weakness are likely to be the main factor provoking near/intermediate-term deflation concerns. Again, while I expect substantial inflation pressure over the long term, particularly in the second half of this decade, I am also inclined to believe that investors will not maintain inflationary concerns in an environment of fresh economic weakness. Accordingly, I expect that investing in commodity-related assets and inflation hedges will benefit from a patient habit of accumulating on periodic price weakness rather than assuming that the present enthusiasm for commodities will persist unabated.

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