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June 14, 2010

Born on Third Base

John P. Hussman, Ph.D.
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Barry Switzer, the former head coach at the University of Oklahoma, once said "Some people are born on third base, and go through life thinking they've hit a triple." Among the fascinating aspects of the recent economic "recovery," probably the greatest is the failure of analysts to understand that this growth is none of the private sector's doing.

Wall Street seems to have no concept at all that every bit of growth we've observed over the past year can be traced to government deficit spending, with zero private sector expansion when those deficits are factored out. As I noted last week, if one removes the impact of deficit spending, "the economy has recovered to the point where the year-over-year growth rate since early 2009 now matches the worst performance of any of the 50 years preceding the recent downturn." In effect, Wall Street's is seeing "legs" where the economy is in fact walking on nothing but crutches.

Similarly, it is apalling that Ben Bernanke can say with a straight face that many of the "investments" made by the Fed have been repaid "and some have even made a profit," without immediately noting that the two primary sources of these repayments have been, directly or indirectly, the U.S. Treasury, and savers who are receiving near-zero interest on bank deposit instruments.

If we fail to recognize that the "good news" reported over the past year is due not to a recovery in intrinsic economic activity, but instead to massive government intervention, we risk being blindsided as those synthetic effects gradually erode.

On that point, it is notable that the Economic Cycle Research Institute (ECRI) reported Friday that its Weekly Leading Index has slumped to the lowest level in 44 weeks, and has now gone to a negative reading.

Chart thanks to Mike "Mish" Shedlock

ECRI head Lakshman Achuthan is quick to point out that the downtrend in the WLI is not (yet) sustained enough to indicate an oncoming double dip. Then again, it's important to recognize how quickly the ECRI is likely to shift its position if we observe further deterioration. The WLI also moved to negative readings in 2007, but the ECRI cautiously avoided interpreting it as a recession warning until a few weeks later when the deterioration was sufficiently persistent.

John Markman, writing for MarketWatch, reports " Looking out over the horizon using his longer-term leading indexes, Achuthan sees a 'strong chance' of more frequent recessions in the coming decade than at any time since the 1970s. If that occurs, then he points out there will be major constraints on politicians' counter-cyclical response that did not exist in 2008. That's because the next recession will begin with unemployment not at 4.5%, as the last one did, but in the high 8% range. Also policy makers won't be able to cut rates as they are likely to still be near zero, and fiscal spending will be a problem due to all of the borrowed stimulus already fired off.

"A lot of people are going to wonder, Achuthan says, how this could happen again so soon after the last crisis. And he points out that the 'great moderation' in economic growth from 1985 to 2007 -- when recessions seem to have been ironed out of the system -- is over. That was an anomaly. The new reality will be a return to sharp cyclicality with a vengeance"

From my perspective, the evidence isn't yet sufficient, from a probability standpoint, to firmly anticipate a double dip. But it is notable how close the evidence is to locking in on that conclusion.

The following is our refined set of "Aunt Minnie" criteria for identifying oncoming recessions. See the November 12, 2007 comment Expecting a Recession for details. In every instance we've observed these conditions, the U.S. economy has either already been in a recession, or has been within a few weeks of what turned out in hindsight to be the official beginning of a recession. There have been no false signals.

1: Widening credit spreads: An increase over the past 6 months in either the spread between commercial paper and 3-month Treasury yields, or between the Dow Corporate Bond Index yield and 10-year Treasury yields. This criterion is currently in place.

2: Moderate or flat yield curve: A yield spread between the 10-year Treasury yield and the 3-month Treasury yield of anything less than 3.1%. As of last week, the 10-year Treasury yield was 3.22%. The 3-month Treasury bill yield was 0.08%. So virtually any decline in the 10-year yield from here will put this criterion in place.

3: Falling stock prices: S&P 500 below its level of 6 months earlier. This is not terribly unusual by itself, which is why people say that market declines have called 11 of the past 6 recessions, but falling stock prices are very important as part of the broader syndrome. This criterion is currently in place.

4: Moderating ISM and employment growth: Manufacturing PMI (at or) below 54, coupled with either total nonfarm employment growth below 1.3% over the preceding year (this is a figure that Marty Zweig noted in a Barron's piece years ago), or an unemployment rate up 0.4% or more from its 12-month low. At present, both of the employment measures are in place. Last month, the ISM PMI dropped from 60.4 to 59.7.

For all intents and purposes, unless the credit spreads, the S&P 500, or the yield curve reverse, a further decline in the Purchasing Managers Index to 54 or below would be sufficient to confirm a "double-dip recession." Note that by itself, such a level might not be particularly troublesome. But in concert with the other evidence we observe, it would be sufficient to complete the syndrome of risk factors.

The historical recession signals based on the foregoing criteria are depicted in blue in the chart below. Actual recessions are depicted in red. The chart reflects the widely held assumption that the recent recession ended in June 2009, though it is not clear that this assumption is appropriate. Given that the economy has not recovered to anywhere near its previous peak, a second downturn would most probably be viewed by the NBER as a continuation of the recent recession rather than a separate event.

In short, it is small relief that neither the ECRI Weekly Leading Index nor our recession risk Aunt Minnie have provided confirming evidence of a double dip, because both would require rather minimal extensions of their recent deterioration to go to a hard warning.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully hedged investment stance. In this position (provided that our long-put/short-call index option combinations have identical strike prices and expirations), the primary source of day-to-day fluctuations in the Fund is the difference in performance between the stocks held by the Fund and the indices we use to hedge (the S&P 500, Russell 2000 and Nasdaq 100).

The somewhat oversold condition of the market on a short-term basis may soften the impression that there is any urgency to risk management here. I think that could be a mistake. It's worth repeating that if you are following a disciplined investment program and your asset allocation is constructed to weather a wide range of potential risks, I would prefer that you ignore my views and do nothing. But if your investment security or future plans would be unacceptably affected by a further, possibly substantial market loss, and particularly if you'll need the funds in a short number of years, I would suggest getting your risk exposure to the point where you can tolerate negative market outcomes.

Randall Forsyth offered the following nugget in Barron's last week, with which I can't disagree: According to Bespoke Investment Group, there have been 58 "corrections" of 10% or more in the Standard & Poor's 500 since 1927. In 33 cases, the corrections stopped short of the 20% bear market threshold and the market went on to higher highs, while 25 times they grew into a full-grown grizzly. But in the 32 instances when the market has dropped as much as this one has -- 14.4% from the April 23 peak through Monday -- the outcome has been heavily weighted to the losing side. Only seven times drops of that size stopped short of the 20% bear mark. In the 25 other times the decline extended to 20%, the average bear market decline was 35.5%.

As with our own work, we've observed fairly benign market outcomes from similar conditions about 20% of the time. The remaining 80% of the time has been characterized by more pointed losses. The probability mix is not good, particularly because that 80% group has several "fat tail" events featuring deep market plunges. 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 - as I've noted many times over the years, the steepest losses in a market downturn typically follow the "fast, furious, prone-to-failure" rallies that clear an oversold condition.

In bonds, the Market Climate remained characterized last week by moderately unfavorable yield levels and favorable yield pressures. Credit spreads continue to reflect concern about default risk that tends to benefit default-free securities, particularly U.S. Treasuries. Yield levels are not compelling on the basis of holding to maturity, so Treasuries are not long-term values. We have to recognize that the merit of U.S. Treasuries is essentially based on "speculative" factors relating to further credit strains. For that reason, I expect that we will clip our duration in Treasuries (now less than 4 years, mostly in intermediate term notes), in response to a significant further retreat in yields.

My views relating to inflation hedges such as TIPS and precious metals shares still hold - while I strongly expect inflation pressures in the second half of this decade, it is very difficult for investors to maintain that sort of thesis in the face of contradictory short-term evidence. As further credit strains are likely to prompt fears of deflation, I expect that our heaviest positioning in investments like TIPS and precious metals shares will be in response to price weakness on those fears. We've got enough exposure in Strategic Total Return that we would be comfortable with a sustained advance in these investment classes, but again, my expectation is that we'll see opportunities in the quarters ahead to establish larger positions on weakness rather than strength.


The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

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Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 reflect our standard valuation methodology, focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle (see for example Investment, Speculation, Valuation, and Tinker Bell, The Likely Range of Market Returns in the Coming Decade and Valuing the S&P 500 Using Forward Operating Earnings ).

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