Stock Valuations At Bubble Levels

The outcome of years of yield-seeking speculation induced by central banks is that investors across the globe have now locked in zero prospective total returns in virtually in every asset class for the coming decade... We actually view this period as the extended top-formation of the third speculative bubble in the past 16 years, not as a representative sample of things to come. -- Dr. John Hussman, PhD, August 15, 2016

Hussman Says, "Run, Don't Walk"!

"Run, Don't Walk"

Wall Street continues to focus on the idea that stocks are "cheap"...

As I noted in our September 8, 2008 comment Deja Vu (Again), which happened to be a week before Lehman failed and the market collapsed, "Currently, the S&P 500 is trading at about 15 times prior peak earnings, but that multiple is somewhat misleading because those prior peak earnings reflected extremely elevated profit margins on a historical basis. On normalized profit margins, the market's current valuation remains well above the level established at any prior bear market low, including 2002 (in fact, it is closer to levels established at most historical bull market peaks). Based on our standard methodology, the S&P 500 Index is priced to achieve expected total returns over the coming decade in the range of 4-6% annually." Present valuations are of course more elevated today than they were before that plunge.

On the economic front, the recent uptick in new unemployment claims is consistent with the leading economic measures and "unobserved components" estimates that we obtain from the broad economic data here...

As I noted a few months ago, "examining the past 10 U.S. recessions, it turns out that payroll employment growth was positive in 8 of those 10 recessions in the very month that the recession began. These were not small numbers... while robust job creation is no evidence at all that a recession is not directly ahead, a significant negative print on jobs is a fairly useful confirmation of the turning point, provided that leading recession indicators are already in place."

The upshot is that while I expect a weak April jobs report, we should hesitate to take leading information from what remains largely a short-lagging indicator. We're already seeing deterioration in economic data, but it remains largely dismissed as noise. An acceleration of economic deterioration as we move toward midyear would be more difficult to ignore. My impression is that investors and analysts don't recognize that we've never seen the ensemble of broad economic drivers and aggregate output (real personal income, real personal consumption, real final sales, global output, real GDP, and even employment growth) jointly as weak as they are now on a year-over-year basis, except in association with recession. All of these measures have negative standardized values here. My guess is that we'll eventually mark a new recession as beginning in April or May 2012...

What I am adamantly against is the idea that speculators can successfully "game" overvalued, overbought, overbullish markets - particularly in the face of numerous hostile syndromes, near-panic insider selling, speculation in new issues, and broad divergences in market internals, all of which we are now observing.

Read Hussman's entire economic commentary here.

Hussman on Leading Vs. Lagging Economic Data

Read all of Dr. Hussman's weekly market commentaries here.

Accompanying the news of the "grand and comprehensive" European solution on Thursday was the news that GDP rose at an annual rate of 2.5% in the third quarter. There was already coincident data that the U.S. was not yet in contraction in August or September, so this was no surprise. Still, investors continued the habit of confusing lagging and coincident indicators for leading ones, so the positive GDP figure was taken as evidence that an oncoming economic downturn was "off the table."

I can't emphasize enough that leading evidence is in fact leading evidence. Take, for example, the ECRI Weekly Leading Index. It's certainly not a perfect indicator in itself, but its leading properties are instructive. If you look at the historical points where the WLI growth rate fell below zero, you'll find that weekly unemployment claims (a coincident indicator) were generally still about 3% below their 5-year average. It generally took about 13-16 weeks for unemployment claims to climb above that 5-year average, and even longer for the unemployment rate (a lagging indicator) to rise sharply. That's not much of a lag in the grand scheme of the full economic cycle, but allows a great deal of intervening and often contradictory action in the financial markets.

The tendency to demand predictable outcomes to also be immediate is a dangerous one, because it allows investors to be sucked in by temporary reprieves during what are, in fact, very negative conditions. As I noted in May (see Extreme Conditions and Typical Outcomes ), "It's clear that overvalued, overbought, overbullish, rising-yields syndromes as extreme as we observe today are even more important for their extended implications than they are for market prospects over say, 3-6 months. Though there is a tendency toward abrupt market plunges, the initial market losses in 1972 and 2007 were recovered over a period of several months before second signal emerged, followed by a major market decline. Despite the variability in short-term outcomes, and even the tendency for the market to advance by several percent after the syndrome emerges, the overall implications are clearly negative on the basis of average return/risk outcomes."

The same can be said here of economic prospects. Investors have almost entirely abandoned any concern about recession risk based on a few weeks of benign economic figures. Yet on the basis of indicators that have strong leading characteristics, a broad ensemble of evidence continues to suggest very high recession risks, and even sparse combinations of indicators provide a major basis for concern.

For example, since 1963, when the ECRI Weekly Leading Index growth rate has been below -5 and the ISM Purchasing Managers Index has been below 54, the economy has already been in recession 81% of the time, and the probability of recession within the next 13 weeks was 86%.

If in addition, the S&P 500 was below its level of 6 months earlier, the economy was already in recession 87% of the time, and the probability of recession within the next 13 weeks climbed to 93% (and then to 96% within 26 weeks). Under these conditions, once the PMI fell below 52, the probability of recession within 13 weeks climbed to 97%.

Hussman: Deterioration of Economic Fundamentals

In recent weeks, and particularly in last week's ISM, employment claims and unemployment reports, we've observed a substantial weakening in measures of economic growth. At present, the evidence of economic deterioration is not severe - as I noted in 2000, 2007 and last summer, recession evidence is best obtained from a syndrome of conditions, including the behavior of the yield curve, credit spreads, stock prices, production, and employment growth. While all of these components have weakened, they have not deteriorated to the extent that has (always) accompanied the onset of recessions.

To a large extent, the current softening of economic conditions is really nothing more than the recrudescence of the deterioration we saw last summer. Basically, we're coming up on the can that the Fed kicked down the road when it initiated QE2. While the Fed was successful in releasing a modest amount of pent-up demand, and was certainly successful in provoking speculative activity, there was never a realistic prospect of creating a beneficial "wealth effect" for the economy as a whole. The historical evidence is emphatic that people consume off of perceived "permanent income" - not off of volatile dollars. Wealth is driven by the creation of long-term cash flows through productive investment, not by boosting the valuation of existing cash flows by encouraging speculation. There was no reason for people to take much of a permanent signal from fluctuations in a stock market that has lost more than half of its value twice in a decade (and is likely to lose a good chunk of its value again if history is of any indication).

So while the Fed has been successful in fostering speculation, further impoverishing the world's poor through commodity price increases, and subsidizing banks by driving funding costs to zero (at the expense of the risk averse and the elderly), QE2 has clearly failed from an economic standpoint. This failure is not because we haven't given it enough time, or because monetary policy works with a lag. Rather, the policy has failed because it focused on easing constraints (bank reserves, short-term interest rates) that weren't binding in the first place. Very simply, neither the Fed's policy, nor the fiscal policy initiatives to date, address the central challenge that the U.S. economy faces, which is the debt burden on households. 

How much scope for intervention does the Fed have left? As of June 1, according to the Fed's consolidated balance sheet, the Fed is now leveraged 53-to-1 ($2.79 trillion in assets / $52.6 billion in total capital). This is more extended than Bear Stearns and Lehman were just prior to their failure. The principal difference being that the U.S. Treasury, and by extension, the U.S. public, is on the hook for any losses incurred by the Fed.

Risk On, Risk Off: Sitting on a Ledge of Ice

by John Hussman of Hussman Funds:


"If you have bad banks then you very urgently want to clean up your banks because bad banks go only one way: they get worse. In the end every bank is a fiscal problem. When you have bad banks, it is in a political environment where it is totally understood that the government is going to bail them out in the end. And that's why they are so bad, and that's why they get worse. So cleaning up the banks is an essential counterpart of any attempt to have a well functioning economy. It is a counterpart of any attempt to have a dull, uninteresting macroeconomy. And there is no excuse to do it slowly because it is very expensive to postpone the cleanup. There is no technical issue in doing the cleanup. It's mostly to decide to start to grow up and stop the mess."

MIT Economist Rudiger Dornbusch, November 1998

On the surface, the U.S. economy is gradually recovering. Based on mean reversion to potential GDP (which generally occurs over a 4-year horizon absent an intervening recession), we would expect GDP growth over the coming 4-year period to average 3.8%, with average monthly employment growth of 200,000 jobs. This would be my "benchmark" expectation if the U.S. and international banking systems were "clean." However, my concern is that the surface U.S. recovery is built over a foundation that is vulnerable to further strains. If our policy makers had made proper decisions over the past two years to clean up banks, restructure debt, and allow irresponsible lenders to take losses on bad loans, there is no doubt in my mind that we would be quickly on the course to a sustained recovery, regardless of the extent of the downturn we have experienced. Unfortunately, we have built our house on a ledge of ice.

Debt burdens have not been meaningfully reduced in the mortgage sector - they have only been extended. Home values are still well above their historical norm relative to incomes. Yet more than 20% of homeowners already have "negative equity" - mortgages that exceed the current prices of their homes. A few months ago, Deutsche Bank projected that the negative equity rate may rise to 48% in 2011. Yet even if we ignore the mortgages that have been "modified" by slapping delinquent payments onto the back of the obligation, one in seven U.S. homes is presently delinquent or in foreclosure. As much as we have done to make lenders whole, nothing apart from a major restructuring of mortgage obligations will ease the continuing vulnerability on the debtor side.

Meanwhile, the dependence of the banking system on short-term deposits is worse than it was prior to the crisis. The FDIC reports that time-deposits have declined for the 7th consecutive quarter, while the cost of funding assets has dropped below 1%, as banks rely on the shortest liabilities possible in order to earn higher interest spreads. So while the month-to-month progress of the economy has been somewhat encouraging, our policy makers have put us in the position of continually revisiting a can that they simply kicked down the road.

As we look ahead to the coming years, I believe that the best way to avoid major losses will be to remain mindful of the distinction between surface economic progress and latent (underlying) risks. As a starting point, we'll look at the "benchmark" scenario - the potential growth in GDP and employment that we can expect in the absence of further economic shocks. Second I think it's useful to review the observations that the late MIT economist Rudiger Dornbusch made in 1998, many of which are directly applicable to the present environment. Finally, we'll review the current state of the economy and the financial markets.

The Mean-Reversion Benchmark

Although estimates by the Congressional Budget Office indicate potential GDP (driven by population growth and other factors) is likely to expand by only 2.3% annually over the coming four years, the "output gap" - the difference between actual GDP and current potential GDP - is large enough that simply closing that gap would require an additional 1.5% of GDP growth annually over the coming 4 years. In other words, simply closing the gap between actual and potential GDP over the coming 4-year period implies a "benchmark" expectation of roughly 3.8% annual real growth. This requires that we avoid fresh credit strains or other shocks.

Similarly, the pool of unemployed workers is sufficiently large, and potential gains from downsizing are sufficiently exhausted, that we would expect to observe a gradual expansion in employment simply on the basis of long-term mean reversion, provided that we avoid fresh credit strains or other shocks. The U.S. economy has lost over 7.5 million jobs in less than three years, putting non-farm payrolls at roughly 130 million jobs. Historically, the growth rate of payrolls has run at about half the growth rate of real GDP (with the remainder accounted for by productivity growth - this is a corollary to Okun's Law). So 3.8% real GDP growth implies job growth of about 1.9% annually. In an economy gradually reverting back to potential over the coming four year period, that would imply net job growth of about 2.5 million jobs annually, or about 200,000 jobs a month, on average.

As a side note, even if you tack on 2.2% inflation to get 6% growth in nominal GDP and corporate revenues, stock market investors are still stuck with the fact that any normalization profit margins and profits to GDP (which are highly cyclical and presently near their historic peak) would result in roughly zero earnings growth for the S&P 500 over the 4-year period.

These "benchmark" estimates assume that we avoid another economic downturn in the next few years. In the chart below, you can see the impact of such downturn on the actual 4-year growth of the economy, versus what one would have projected. Notice that in the chart below, periodic recessions have caused GDP growth to fall short of the benchmark expectations. For instance, the 1981-1982 recession caused a shortfall versus the 4-year growth that one would have anticipated in 1977-1978. The 1991 recession caused a shortfall versus what one would have expected in 1987. And the 2009 collapse caused a shortfall versus what one would have expected in 2005.

So the current "benchmark" expectation for 4-year real GDP growth is about 3.8% based on a gradual reversion to potential GDP, and the corresponding "benchmark" for job growth is about 200,000 jobs per month on a sustained basis. Still, these levels are highly dependent on avoiding a fresh recession in the interim, and unfortunately, the U.S. is perpetuating policy mistakes that threaten that result.

Hard Money and Clean Banks

In 1998, MIT economist Rudi Dornbusch gave a set of lectures in Munich on "International Financial Crises." I've excerpted some of his remarks below. Much of what Dornbusch discussed is particularly relevant to the present credit strains in Europe and various small countries across the globe, but is also important with respect to how we continue to approach difficulties in the United States. Dornbusch highlighted three essential concerns: 1) the vulnerability of banking systems that are dependent primarily on short-term deposits and funding that can be withdrawn on demand, 2) the risk of having national liabilities denominated in a foreign currency (which is essentially the case with Ireland, Portugal, Greece and Spain, all of which are constrained by the European Monetary Union and cannot simply print their own money), and 3) the importance of restructuring bad debt and avoiding bank bailouts.

"So let me focus on these new financial crises and ask where do they come from? It's very easy to predict a crisis, but then you have to wait for two years until it happens. There is the issue of contamination. Why innocent bystanders get hit. And there is the last issue of the depth of crisis. Why are they so traumatic, leaving a crater that is unbelievably deep?

"The argument is that the national balance sheet is extremely vulnerable. You could live for years and years and years with a balance sheet like that, and nothing ever happens, and nobody ever talks about you, and you are a great story of success, with high growth and a miracle. In a very rich country you can afford to do bad things very, very long.

"And then something happens and then it turns out that that very vulnerability is such that it's a dramatic end of all success. Suddenly in the afternoon of an otherwise sunny day, the world financial system wants 50 billion dollars from a country, and the country doesn't have the 50 billion dollars, and the IMF cannot get there fast enough, and the next thing, the place blows up, and there is a massive depreciation of the currency, pervasive bankruptcy, and the fire spreads to the next country.

"A banking system is a very important part of how a country hangs together... Very, very large, very, very short term liabilities can in no time become a bankruptcy issue for an entire banking system, more so if it's unregulated. And that means people can want to get their money back tomorrow afternoon, and when someone wants their money back, they all want their money back. And if they all want their money back, there is no way for an economy to pay at short notice. And if I can't repay, then they'll be much more eager to get their money, and as the bank run occurs, of course the rest of the economy will collapse with it. Maturity is the first issue.

"The second issue is denomination. There is a very big risk for a country to denominate its liabilities in foreign exchange. Something that they cannot print, something that they cannot get their hands on, and therefore something that is very vulnerable if in fact the exchange moves, the burden of those liabilities increases and bankruptcy of the country and the underlying companies becomes a big issue. Because if that is seen to be happening, then of course, everybody wants their money before it happens, and as they try to get it, they provoke the very collapse that I'm describing.

"If a country has an extraordinary withdrawal of short-term credit and they made the mistake of having short-term credit positions, then they should have a debt restructuring. Then they should say, 'We are now going to default on our debt and we are very, very sorry and what you thought was an overnight loan actually isn't an overnight loan - it is a long-term stabilisation loan.' That makes an extraordinary important distinction between direct investment, which should be favoured at all times, and you should create a history of always treating direct investment extremely well, and short-term debt, which if things go bad may turn out to be long-term debt.

"If you have bad banks then you very urgently want to clean up your banks because bad banks go only one way: they get worse. In the end every bank is a fiscal problem. When you have bad banks, it is in a political environment where it is totally understood that the government is going to bail them out in the end. And that's why they are so bad, and that's why they get worse. So cleaning up the banks is an essential counterpart of any attempt to have a well functioning economy. It is a counterpart of any attempt to have a dull, uninteresting macroeconomy. And there is no excuse to do it slowly because it is very expensive to postpone the cleanup. There is no technical issue in doing the cleanup. It's mostly to decide to start to grow up and stop the mess.

"If you have a hard money and if you have clean banks then you don't have macroeconomics as a problem anymore. Yes, you have slowdowns in the economy and yes you have booms and the key macro problem, the government, has been taken out of it. That's very important to understand that in the economies we are talking about, the problem is the government. The government is not the solution. Hyperinflations are made by governments, debt defaults are made by governments, exchange rates crises are made by governments. And if they don't know how to do it well, and the assumption is: no they do not know how to do it well, then take them out of the business."

Dornbusch likens an unsound financial system to drunk driving. "Think of someone who has made a great expertise of drunk driving, regularly drives drunk, tells you that he never has a problem, and one day there is a terrible, terrible accident. And he'll say, “Well, it was the red light. It wasn't my being drunk. Normally that light is green.” Drunk driving, which for years has worked, with a financial structure that is recklessly, recklessly unsound. But the light was green and then one day it wasn't green, and then the house of cards came crumbling down."

In applying Dornbusch's observations to the recent financial crisis, it is important to distinguish liquidity from solvency. During a bank run, it is essential to provide sufficient liquidity to ensure that depositors can get their money back. That is the only way to stop the run. But if the government does that, the only thing it should buy outright when providing liquidity is its own Treasury debt - everything else should be on a repurchase basis. The Treasury can even provide capital provided that its claims are senior to those of the bank's bondholders. U.S. policy makers did some of this correctly during the recent crisis, but they also bought bad mortgage debt outright, suspended disclosure, and avoided every attempt to restructure, which stemmed the bleeding without addressing the underlying problem.

As I've frequently noted, even if a bank "fails," it doesn't mean that depositors lose money. It means that the stockholders and bondholders do. So if it turns out, after all is said and done, that the bank is insolvent, the government should get its money back and the remaining entity should be taken into receivership, cut away from the stockholder liabilities, restructured as to bondholder liabilities, recapitalized, and reissued. We did this with GM, and we can do it with banks. I suspect that these issues will again become relevant within the next few years.

The present situation

Europe will clearly be in the spotlight early this week, as a run on Irish banks coupled with large fiscal deficits has created a solvency crisis for the Irish government itself and has been (temporarily) concluded with a bailout agreement. Ireland's difficulties are the result of a post-Lehman guarantee that the Irish government gave to its banking system in 2008. The resulting strains will now result in a bailout, in return for Ireland's agreement to slash welfare payments and other forms of spending to recipients that are evidently less valuable to society than bankers.

Essentially, the problem in Ireland is exactly what Dornbusch described: First, Ireland has a banking system that like other countries around the world, including the United States, carries a mountain of bad long-term debt on the asset side, and has become increasingly dependent on funding them with short-term deposits over the past decade, thanks to the allure of "cheap" money at the short-end of the maturity curve.

Next, Ireland and other countries in the European Monetary Union have their liabilities denominated in a currency (the euro) that they cannot actually print on their own. As Ireland, Greece, Portugal and other European countries run budget deficits, they have to induce the private market to buy their government bonds, which are denominated in the common currency. This is effectively like being on a fixed exchange rate or a gold standard, so rather than being able to print money or depreciate the currency, the only adjustment variable is the interest rate. So rates have been soaring in these countries. To some extent, states and municipalities in the U.S. are in a similar situation.

Over the short run, Ireland will promise "austerity" measures like Greece did - large cuts in government spending aimed at reducing the deficit. Unfortunately, imposing austerity on a weak economy typically results in further economic weakness and a shortfall on the revenue side, meaning that Ireland will most probably face additional problems shortly anyway.

Germany's Chancellor Angela Merkel is effectively the only major leader who recognizes the correct prescription, which is - as Dornbusch advises - to grow up, restructure the debt, and clean up the banks, because bailing them out will simply make the problem worse down the road. Merkel calls this "burden sharing" - which is another phrase for "restructuring" - but she is also vilified for it, because lenders would much prefer to have the government make them whole at public expense (and mostly the German public at that). And so, predictably, Europe is now choosing to kick the can down the road.

Here at home, the situation is only a little different from the standpoint of underlying fundamentals, but as noted at the outset, month-to-month economic progress has been reasonably positive in the U.S. lately, so there is a larger distinction between surface conditions and latent ones.

The main problem, of course, remains mortgage debt. Unfortunately, because of the suspension of FASB mark-to-market rules, investors don't actually have the ability to fairly assess the balance sheet of the banking system. Still, various mortgage statistics provide a partial, if incomplete picture. The latest report from Lender Processing Services notes that the inventory of homes in foreclosure is now 7.4 times the historical average, and rising. When a home actually enters foreclosure, it is removed from "delinquent" status, so distressed housing can shift from "delinquent," to "foreclosure," to "real-estate-owned" classifications depending on where they are in the chain, which is important when interpreting these statistics.

Though about 20% of homes that have been delinquent for more than two years are still not in foreclosure, distressed mortgages eventually either go into foreclosure, or they are "cured." What is interesting about this is that a growing portion of homes classified as newly delinquent are actually re-defaults of homes that were previously delinquent and were temporarily "cured" through modification. Typically, these modifications involve taking all of the missed payments (which in more than one-third of the cases have been delinquent for well over a year), and tacking them on to the back-end of the loan, essentially extending the maturity, and often reducing the interest rate for the first year of the modified loan. Because of this repeated cycle of cure and re-default, the number of distressed properties is most likely significantly higher than the still-elevated delinquency and foreclosure rates might suggest.

From my perspective, this is another perpetual game of kick-the-can-down-the-road to prevent mortgages from being classified as delinquent, which prevents banks from having to reserve against loan losses or write down the value of the assets. The real question is whether this is sustainable. Since perpetuating this Ponzi scheme seems to be official U.S. policy at every level, further strains may follow Dornbusch's law: "The theorem is that financial crises take much, much longer to come than you think and then they happen much faster than you would have thought. So you have a chance to be wrong twice."

That said, we've observed a gradual improvement in a variety of economic indicators in recent months, particularly in new unemployment claims. While some of the regional Fed indices (Philly, Empire State) have enjoyed positive surprises, the Chicago Fed survey, which is national, was disappointing, and at a level consistent with GDP growth of about 1.25%. That is still positive, but the confidence interval easily includes zero, so we're not quite to the point where we would conclude that a fresh economic downturn is "off the table." Financial strains tend to come on abruptly. Until we observe debt restructuring and transparent accounting rules (especially some modified version of mark-to-market), it will be dangerous to think of economic risks as being "off the table," when they are probably just hidden under a napkin.

Research Update

In the meantime, we have to work with the economy and the markets that we have. As I've noted in recent weeks, our present defensiveness is not driven by concerns about fresh credit or economic difficulties, but rather by a combination of overvalued, overbought, overbullish, rising-yield conditions that has generally turned out badly in post-war data. While we will remain mindful of underlying economic risks, I do believe that there is a wide enough range of outcomes in post-war data to allow us to manage the residual economic risks we face. As we clear various unfavorable elements of the current market environment, we will be able to periodically accept small or moderate exposures to market fluctuations, even in the absence of undervalued conditions. For now, however, we remain defensive on the basis of conditions that have rarely worked out well for stocks.

Our investment approach is fairly straightforward - accept proportionately greater exposure to risk when the expected return per unit of risk is high, and proportionately reduce exposure to risk when the expected return per unit of risk is low. The details are in the implementation, and that is where we focus most of our research. Over the past two years, most of these efforts have focused on the proper use of multiple data sets, on broadening the range of classifications that we define as distinct "Market Climates," and on enhancing the "robustness" of these classifications across subsets of the data.

Without going into technical details that would be useful only to competitors, the basic outcome of this research is that we continue to refine the Market Climates we identify, and have developed additional methods to make robust estimates of their associated return/risk profiles. I expect that you'll observe the first fruit of this research in the form of modest, transitory exposures to market fluctuations on a more frequent basis. This isn't a major change - large, persistent exposures will still await some combination of significantly improved valuations, downward yield pressures, and economic clarity - but we should be able to better exploit our latitude for modest variations in our market exposure as conditions vary over time. As always, we retain a strong emphasis on risk management, with the objective of outperforming our benchmarks with smaller periodic drawdowns than a passive investment strategy.

I continue to view the stock market as richly valued, and priced to achieve returns of less than 5% at every horizon out to a decade. The expected returns at the shorter horizons are more volatile, of course, than those at longer horizons, and it is there that a broader range of "Market Climate" classifications can be helpful. We'll modestly alter our exposure to market fluctuations in response to modest changes in conditions, but of course, we would prefer a large shift in valuations which would allow us to accept an unhedged exposure.

Here and now, we remain tightly defensive. We can certainly identify conditions under which one could have expected a speculative benefit, on average, from taking market risk despite overvaluation. But when overvaluation has been coupled with overbought, overbullish, rising yield conditions, the average outcomes have been quite poor.

Market Climate

As noted above, the Market Climate in stocks remains characterized by overvalued, overbought, overbullish, rising-yield conditions that have historically been associated with poor market returns. Strategic Growth and Strategic International Equity remain tightly hedged at present.

In recent weeks, we've observed a decided tendency toward "risk on" and "risk off" days, where entire classes of securities are treated as if they were a single object. During "risk on" days, the market advances, paced by financials, cyclicals, commodities, and smaller speculative issues, while the dollar weakens. During "risk off" days, the market declines, with relative strength in consumer, health, and high-quality stocks, while the dollar rallies. Since our stock selection generally focuses on higher quality issues, which has served us very well over the long-term, this type of pointed "risk on/risk off" behavior creates a situation where our stocks appear to have a smaller "beta" on a day-to-day basis than we actually believe is applicable over large moves or longer horizons.

As a result, the equity funds may respond slightly counter to general market movements on a day-to-day basis. While I expect that this is short-term behavior, we are still gradually modifying our hedge ratios in response. We are doing this carefully, since it is likely that our stock holdings will pop back to having their normal, full betas in the event of a serious market decline. Suffice it to say that our emphasis on what we view as higher quality stocks (e.g. stable revenue growth, profit margins and balance sheets) makes us a bit more sensitive to the recent risk on/risk off pattern of market action, and while we see this primarily as local, day-to-day behavior, we are gradually modifying our hedge ratios accordingly.

John Hussman: Leading, Lagging, and Coincident Indicators

from HussmanFunds:

"Series that represent early stages of production and investment processes (new orders for durable goods, housing starts, or permits) lead series that represent late stages (finished output, investment expenditures). Under uncertainty, less binding decisions are taken first. For example, hours of work are lengthened (shortened) before the work force is altered by new hirings (layoffs)."

Victor Zarnowitz and Geoffrey Moore, "Sequential Signals of Recession and Recovery"
Journal of Business, 1982

Last week, we got a fresh set of economic indications from the Philadelphia Fed Survey. While the market evidently took relief from the modest uptick in the composite index to -0.7, a quick look at the component indices suggests a worsening of economic conditions in the latest report. Specifically, the Philly Fed new orders component fell to -8.1 from -7.1, which is the third month in negative territory. While there was a slight uptick in the index for number of employees (to 1.8 from -2.7), the better leading measure is the average employee workweek, where the index weakened to -21.6 from -17.1.

As I've emphasized in recent weeks, the U.S. economy is still in a normal "lag window" between deterioration in leading measures of economic activity and (probable) deterioration in coincident measures. Though the lags are sometimes variable, as we saw in 1974 and 2008, normal lags would suggest an abrupt softening in the September ISM report (due in the beginning of October), with new claims for unemployment softening beginning somewhere around mid-October. It's possible that the historically tight relationships that we've reviewed iin recent weeks will not hold in this particular instance, but we have no reasonable basis to expect that. Indeed, if we look at the drivers of economic growth outside of the now fading impact of government stimulus spending, we continue to observe little intrinsic activity.

The strongest forces driving economic expansion during a post-recession recovery phase is expansion in credit-sensitive expenditures such as housing, durable goods (such as autos) and gross investment, and in particular, inventory rebuilding. While capital expenditure for upgraded information technology is the clearest bright spot in recent GDP reports, it also represents a very small share of the economy. Other credit-sensitive classes of expenditure continue to face strong headwinds.

It is also important to understand that while consumption represents roughly 70% of economic activity, it is by far the least volatile component of GDP, particularly when durable goods are excluded. The main sources of fluctuation in GDP growth are credit-sensitive expenditures and inventories. Given the recent buildup of inventories and the expenditures on autos and home buying that were brought forward by programs such as cash-for-clunkers and the first-time homebuyers' credit, we are likely on the downside of those bursts of spending. For that reason, it appears likely that the positive growth of GDP in recent quarters will have relatively poor follow-through. A careful examination of sub-components of GDP growth leaves little reason to expect actual economic activity to deviate from what is already suggested by weak leading indicators.

If we observe both an improvement in those leading indicators and an improvement in market internals, our evaluation of investment conditions would be more constructive. For now, however, we remain defensive about risks that still appear significant.

On the housing front, last week's comments from Rick Sharga, the V.P. of RealtyTrac, are worth noting - "We're on track for a record year for homes in foreclosure and repossessions. There is no improvement in the underlying economic conditions. Whether things fall precipitously depends on government and lenders controlling the inflow of new foreclosure actions. If the market is left to fend for itself, you may see more serious price depreciation."

Lender Processing Services concurred, with its senior V.P. noting "Loans that have been delinquent for a historically long period of time are just now beginning to move through the pipeline. As of July 2010, the average length of time a loan in foreclosure had been delinquent was nearly 470 days. Now, after the intensive efforts of the last year or two, remaining home retention options appear to be exhausted and servicers are beginning to process more of these seriously delinquent loans."

My view remains that the underlying condition of the U.S. housing market is one of deep insolvency. The Treasury, Fed and the FASB have effectively made a policy out of opaque disclosure, so that at least the deterioration in the housing market is slow to appear on the balance sheets of major banks and financials. At present, the FASB allows "substantial discretion" in the valuation of mortgage-backed securities, which I suspect are being carried at a higher level than the value that the underlying cash flows (mortgage repayments) can actually support. Given that there is little pressure to disclose losses, and that mechanisms are in place (at least until the end of 2012) for the Treasury to bail out the entire flow of bad mortgages that funnel through Fannie Mae and Freddie Mac, it's not clear whether the growing mountain of delinquent and unforeclosed mortgages will provoke an abrupt crisis. My own expectation is that fresh economic pressure would provoke contagious pressure on the housing market to an extent that would be difficult to obscure.

That said, if the U.S. economy averts a period of fresh economic weakness, we could instead observe a more drawn out period of stagnation and price pressure. Ultimately the bad assets have to be placed on the market, which suggests further price pressure in the next few years. Weak labor conditions would also contribute further mortgage deterioration. Long-term, deficit-led inflation might be able to avert mortgage losses as home values gradually rise above the principal balances, eroding the real value of the debt, but this appears very unlikely in the immediate few years.

On the subject of inflation, I should emphasize that while I expect inflation pressures to be contained for several years, the impact of massive deficit spending should not be disregarded simply because Japan, with an enormously high savings rate, was able to pull off huge fiscal imbalances without an inflationary event. We may be following many of the same policies that led to stagnation in Japan, but one feature of Japan that we do not share is our savings rate. It is one thing to expand fiscal deficits in an economy with a very elevated private savings rate. In that event, the economy, though weak, has the ability to absorb the new issuance. It is another to expand fiscal deficits in an economy that does not save enough. Certainly, the past couple of years have seen a surge in the U.S. saving rate, which has absorbed new issuance of government liabilities without pressuring their value. But it is wrong to think that the ability to absorb these fiscal deficits is some sort of happy structural feature of the U.S. economy. It is not. It relies on a soaring savings rate, and without it, our heavy deficits will ultimately lead to inflationary events.

Hyperinflation is a much different story, and as I've said before, I am not in that camp. This doesn't exclude the possibility that enough policy mistakes will change that, but for now, my inflation outlook is flat for several years and then accelerating in the second half of this decade.

As Peter Bernholz notes in Monetary Regimes and Inflation (an economic study of inflation, including more than two dozen cases of hyperinflation), "The figures demonstrate clearly that deficits amounting to 40 per cent or more of expenditures cannot be maintained. They lead to high [inflation] and hyperinflations, reforms stabilizing the value of money, or in total currency substitution leading to the same results. The examples of both Germany and Bolivia suggest that at least deficits of about 30 per cent or more of gross domestic product are not maintainable since they imply hyperinflations... [In nearly all] cases of hyperinflation deficits amounting to more than 20 per cent of public expenditures are present."

At present, U.S. federal expenditures are about $5 trillion, versus about $4 trillion of revenues, and GDP of about $14.6 trillion. So the federal deficit is running at about 20% of expenditures, but less than 7% of GDP. This is not a profile that is consistent with hyperinflation, but it is also not a benign policy. Continued deficits will have substantial economic consequences once the savings rate fails to increase in an adequate amount to absorb the new issuance, and particularly if foreign central banks do not pick up the slack. We're not there for now, but it's important not to assume that the current period of stable and even deflationary price pressures is some sort of structural feature of the economy that will allow us to run deficits indefinitely.

Finally, given probable economic pressures and continued strong demand for default-free instruments, the likelihood of sustained upward pressure on bond yields remains limited here. At some point, probably years from now, we'll face a likely sustained increase in bond yields. We're often asked how that sort of environment would affect the Strategic Total Return Fund, given that we don't short bonds, and we don't buy "inverse floaters" or the like. A simple answer is that just as poor valuations and weak market returns have kept us from taking much exposure to stock market risk during the past decade, while the S&P 500 has gone nowhere, rising interest rates will limit the ability to profit from interest rate exposure. Water can't be squeezed from stones. Frankly, however, the returns of the Strategic Total Return Fund since its inception have not been dependent on a great deal of interest rate exposure in the first place. Even our present portfolio duration of 4 years is well below the average duration of the bond market.

So to a large degree, I expect we'll simply continue what we normally do, which is to vary our exposure in proportion to the expected return/risk profile of the various markets and security groups that we invest in. Markets rarely move in a straight line, and there is typically enough cyclical fluctuation within secular trends to present many opportunities to vary market exposure and portfolio duration. We have the ability to invest in a range of assets such as inflation protected securities, precious metals shares, and foreign currencies, as well as utility shares and other assets. An extended period of rising interest rates is likely to produce a bias toward shorter portfolio durations rather than longer ones. However, I don't expect that economic cycles would be eliminated, and to that extent, I don't expect that we'll be at a loss for opportunities to vary our investment exposures over the course of those cycles.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations, mixed market action, increasing bullish sentiment (approaching levels of overbullishness), and clear overbought conditions. As we've observed for months now, the stock market is still trading between widely followed support and resistance levels, with the S&P 500 bouncing off of the higher end of that channel last week. My primary concern is still the "recognition window" that I believe we have entered. The next several weeks will be important. As noted above, however, if leading measures of economic activity improve and internals improve, we'll be willing to accept a moderately more constructive position, but even here, our latitude to do so is somewhat restricted by valuations that are historically rich. As always, our intent is to align our position in proportion to the return/risk profile we expect. There's a moderate positive range that we'd be willing to operate within if we observe improvement in various economic measures, but for now, the evidence continues to warrant a strong defense. Both the Strategic Growth Fund and the Strategic International Equity Fund are tightly hedged.

In bonds, the Market Climate remained characterized by moderately unfavorable yield levels and favorable yield pressures. The Strategic Total Return Fund continues to carry a duration of about 4-years, and we are maintaining a range of 15-20% of assets allocated between precious metals shares, foreign currency exposure and modest holdings of utility shares.