Cautiously Pessimistic

John P. Hussman, Ph.D.
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Three weeks ago, I noted that market conditions were "characterized by overvaluation, overbought conditions, overbullish sentiment, and upward pressures on yields - a situation that has historically been associated with a moderate continuation of upward stock market progress and a tendency to make successive but very marginal new highs, typically followed by abrupt and often severe market losses within a time window of about 10-12 weeks. As usual, that's not a forecast - just a regularity. But it's a harsh enough regularity to turn our knuckles white here, given the depressed and complacent level of the CBOE volatility index (VIX) and the little-observed upward pop in credit default spreads last week."

While the intervening three weeks have seen the market retrace most of its upside progress since last August, the decline is still somewhat shallow relative to previous instances when that "overvalued, overbought, overbullish, yields rising" conformation was cleared.

I'll also reiterate that blaming such a clearing event on a particular piece of news is not particularly useful. Once market conditions become as overstretched and complacent as they have become in recent weeks, a thousand events can act as triggers for abrupt weakness. Indeed, our main concern here - that of significant "second wave" credit losses - is not presently a significant part of the current focus of analyst conversation (where attention is centered on Greece and a few regulatory concerns). That's interesting, in the sense that we continue to expect those credit risks to become more salient as we move through the first quarter, and if that occurs, there may be a perception that the market is being hit by one thing after another. Credit spreads widened again last week, and we're keeping a keen eye on those, as well as indications of delinquencies and foreclosures, which may become a renewed source of concern.

The January employment report Friday was interesting. A month ago, the December employment report indicated total non-farm employment of 130,910,000 jobs. Following revisions, the January employment report indicated total non-farm employment of 129,527,000 jobs, a net loss of nearly 1.4 million jobs - over and above what had previously been reported. Essentially, job creation was vastly overestimated during 2009. While these revisions were spread over the year, particularly March, the extent of the previous overestimation is notable given the large conclusions that market participants lend to monthly "surprises" of even 10,000-20,000 jobs. The labor force participation rate has declined sharply since 2007 as discouraged workers have dropped out. Accordingly, the unemployment rate strongly understates the level that we would observe if the labor force had remained constant.

While we are certainly hopeful that payrolls have been cut enough that further job cuts will be unnecessary, the situation continues to be fragile. If we get perhaps a month with about 400,000 or fewer weekly new claims for unemployment, that is about the point where we would expect positive prints for monthly job growth, on average. Even then, however, the difficulty will be speed of recovery.

Importantly, any influx of discouraged workers back into the labor pool will tend to keep the unemployment rate elevated even in the face of new job growth. Typically, with normal influx into the labor force, the economy needs about 150,000 new monthly jobs just to keep the unemployment rate steady. It will take much more to hold that rate constant if we see recently discouraged workers return. Suffice it to say that I am hopeful for a stabilization of the job market, but that I suspect that last month's dip in the unemployment rate was an anomaly. Given what remains a difficult credit outlook, I suspect that we have observed a lull rather than a reversal, and that we'll most likely see an 11-12% unemployment peak before a sustained downturn is observed.

I suppose one could refer to that outlook as cautiously pessimistic.

Market Climate

As of last week, the Market Climate was characterized by unfavorable valuations and unfavorable market action. Coupled with rising yield pressures, widening credit default spreads, and only a moderate clearing of the recent overvalued, overbought, overbullish, rising yields conformation, the Strategic Growth Fund is fully hedged.

Recent weakness is much less a reflection of new developments as it is a natural (though unpredictable in timing) clearing of the previously overextended market condition. It's not impossible that this clearing phase is complete, but it would be uncharacteristic, particularly since we've seen a lot of technical breakdowns, and our broad measures of market internals are negative. We'll certainly allow for the possibility of a "whipsaw," which would prompt us to establish some market exposure on a firming of market internals, but presently we are holding on tightly.

In bonds, the Market Climate last week remained characterized by relatively neutral yield levels and moderately negative yield pressures. I continue to expect periodic credit concerns to be reflected in bursts of safe-haven demand for default-free U.S. Treasuries, fresh - if temporary - strength in the U.S. dollar, and downward pressure on commodity prices. Having a longer-term inflation concern but little reason to expect those pressures in the first few years of this decade, our tendency is likely to be gradual accumulation of commodity and inflation hedges over time, as well as inflation protected TIPS to the extent that we observe a widening in real yields. The weakness we've observed to-date has been relatively muted, so we continue to have small 2-4% exposures in precious metals shares and foreign currencies in the Strategic Total Return Fund. In the event of fresh credit deterioration, low nominal yields and wider real yields on TIPS (reflective of deflation concerns), I would expect our investment position to flip considerably toward inflation-sensitive holdings. For now, we continue to hold a moderate 4-year duration, primarily in intermediate term Treasury securities.