This Is, Because That Is

John P. Hussman, Ph.D.
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The market action of the past two weeks contrasts with the generally uncorrected advance of recent months. The chart below places this pullback in perspective, relative to the "big picture" for the S&P 500, showing monthly bars since 1996. I suppose it's possible for investors to characterize the recent decline as a "panic" if they press their noses directly against their monitors, but in that case, they really do have a short memory. The pullback has been negligible even relative to the action of the past several months, and is indiscernible in the big picture. As of Friday, the market remained in an overvalued, overbought, overbullish, rising-yields syndrome that has typically been cleared much more sharply than anything we saw last week.

We still expect to establish a moderate positive exposure to market fluctuations if we can clear some component of this syndrome, provided that market internals (breadth, leadership, sector uniformity, etc) don't also deteriorate substantially enough to signal a shift to risk aversion among investors. We've already seen meaningful breakdowns in international markets, both within and outside of Asia. Thus far, market internals in the U.S. have maintained intact, though still burdened with a negative syndrome of conditions over the short-to-intermediate term. Even with a more constructive position, we would still expect to maintain a strong line of put option protection in the event of abrupt weakness, but suffice it to say that we don't require a major change in valuation in order to be willing to accept greater market exposure - just enough to clear this syndome without strongly damaging market internals.

In order to clear this syndrome, last week's decline would have required either a meaningful retreat of investor bullishness, or a deeper price decline on the week. That said, the pullback did clear very short term overbought conditions, and we covered some short calls and lowered some put strikes as the market briefly challenged the 1250 level. This maintains a defensive line of index put options for the entire portfolio of Strategic Growth, but leaves us with short calls against only 60% of the portfolio. The change wasn't very observable on Thursday and Friday, because the sharp drop in implied volatilities (to a VIX of 23) created some short-term drag. But even here, any sustained upmove in the market should be far more comfortable than what we've experienced since QE2 triggered the recent speculative run.

It's important to recognize that various indicators used by investors often have implications contrary to what is commonly assumed. For example, the strong ISM Purchasing Managers Index reading above 60 is widely seen as a favorable indication for stocks, yet historically, readings above about 59 have been followed by negative average returns for the S&P 500 over the short- and intermediate-term, and flat returns over a 12-month horizon. Weaker PMI readings are actually preferable, so long as they don't occur within a syndrome of pre-recession signals (rising credit spreads, flattening yield curve, weak employment growth and tepid stock returns).

Meanwhile, a "This time is different" perspective may very well apply to the increasingly extreme policy moves that have been required to produce a surface layer of economic growth, but while this has affected short-term market dynamics to a surprising degree, it doesn't materially change the long-term stream of cash flows that stocks are likely to deliver. So positive short-term returns come at the cost of progressively thinner long-term return prospects.

Our investment orientation is emphatically long-term and full-cycle. Even so, short- and intermediate-term returns do matter, particularly those that have some hope of being retained. Even in richly valued markets, there are often conditions that have been associated with positive average return/risk profiles when you look across numerous subsets of historical data. Those favorable conditions reasonably warrant a moderate exposure to market fluctuations, and we would certainly prefer to observe and respond to those opportunities. Until we do observe them, however, we have aligned ourselves with the expected return/risk profile associated with the current set of market conditions. For now, that profile remains negative.

The events in Japan have had a tragic effect on individual lives, and they are undoubtedly in all of our prayers. With respect to the global economy, there will likely be supply disruptions, and reallocations of trade, but we would expect these to be mainly of a short-term nature. Given that the most strongly affected areas were not heavily urbanized or industrialized, the increased demand for raw materials is also unlikely to be enormous. Instead, it is likely to be modest and spread over a large number of years. Witness the slow pace of reconstruction in the wake of Katrina, and in other places that have been hit by natural disasters in the past. Invariably, such disasters result in rapid destruction but very slow and long-term reconstruction.

The larger economic problem is that this disruption is occurring when there are other economic pressures elsewhere, particularly in Europe. The U.S. has quite a bit of slack capacity, so the prospects for economic growth over a multi-year period seem reasonably good, but the frequency of weak patches is also likely to be higher in the next several years, and it is worth keeping in mind that much of the recovery we've observed - particularly in the credit markets - is a veneer over continuing credit issues.

Nobel economist Joseph Stiglitz tied the issues together nicely in an interview that appeared in Barron's over the weekend. Speaking about Japan, he observed "The sad thing is that they've never fully recovered from the bubble of 1989 bursting. In that sense it should remind the U.S. of what happens if you allow a bubble to get outsized. It's water under the bridge, but Bernanke and Greenspan have to bear some responsibility for that ideology that bubbles don't really exist, and they clearly do. When we went into this financial crisis, the administration said, 'We won't make the mistake of Japan and delay restructuring.' That's exactly what we did. It's mind-boggling that we haven't learned any of the lessons of Japan."

My only disagreement might be that any of this is actually "water under the bridge," because the same basic policies that produced the bubble are still very active. These policies have driven financial assets to rich valuations and low prospective returns, which compete sufficiently well with zero interest rates, but offer little for long-term investors. Meanwhile, the financial sector has a continuing overhang of delinquent and unforeclosed homes, which the FASB still allows banks to carry on their books at amortized cost. When the main source of "prosperity" is the policy-induced elevation of asset prices - rather than the allocation of savings into productive investment - it helps to remember that present gratification often equates to future unpleasantness.

When we look around the world, we see difficult social tensions, particularly in North Africa and the Middle East where the poor are dealing with enormous increases in the prices of basic commodities (and where the much of their budgets go for food and fuel), at the same time that others in the same societies are enjoying disproportionate wealth, particularly based on strong oil revenues. Certainly, inequality and oppressive leadership has existed in many of these countries for a long time. But we have to ask what has heightened these tensions to the tipping point at this particular time.

The Buddha taught that you can only understand something by looking deeply at its interconnectedness to other things, and to our own selves - nothing has a separate existence. "This is, because that is; this is not, because that is not." The problems and imbalances that have inflamed the world did not emerge from a vacuum. Rather, this is, because that is. It cannot possibly help that the Fed continues to pursue an aggressive policy that drives short-term interest rates to negative levels (after inflation), which predictably encourages commodity hoarding around the globe, and the unintended consequences that result.

In any event, our present investment stance is not driven by a thesis regarding QE2, underlying credit issues, or even the sustainability of economic growth. It is driven by present, observable conditions on a wide variety of measures. On the basis of a large ensemble of historical time periods, valuation thresholds, and indicator sets, present conditions map into the expectation of negative total returns per unit of risk. Strategic Growth and Strategic International Equity remain well-hedged, though the composition of those hedges reflects the conditions we observe in the U.S. versus other countries (risk aversion is weaker in the U.S., which creates the potential for more speculation, particularly if we clear overbought or overbullish conditions).

In Strategic Total Return, we've observed a reduction of interest rate pressures on short- and intermediate-term measures, partly reflecting events in Japan, but also an extension of the gradual decline in yields that began in early February. It is not yet sufficient to be a positive for stocks, but yield pressures are increasingly neutral rather than unfavorable. In precious metals, we've seen a substantial decline in precious metals shares despite a relatively stable gold price. That improves our margin of safety, and could be beneficial in the event that gold runs higher. I noted last week that my concern about a gold bubble could intensify in the event of a weakly-corrected approach toward $1500 an ounce, but we're not at that point here. We slightly increased our position in gold shares on last week's pullback. Strategic Growth presently has a duration of just over 4 years in bonds (meaning that a 100 basis point move in interest rates would be expected to impact the Fund by just over 4% as a result of bond price changes), with just under 10% of assets in precious metals shares.