...excerpts from Dr. John

http://www.hussman.net/wmc/wmc110815.htm

..."Short-term measures of market action became extremely oversold on Wednesday, and investors took the Fed's latest statement as an occasion to launch a fairly typical "fast, furious, prone-to-failure" rally to clear those conditions. Beyond that, however, the full ensemble of evidence remains negative at present, and we remain defensive as market internals have collapsed, our Recession Warning Composite is fully active, credit spreads have blown out as in 2008, advisory bullishness is excessive and has paradoxically increased, and valuations remain too rich.

There are certainly developments that could move us quickly to a more constructive investment stance, but the most promising one would involve a deeper decline, coupled with significant turn toward bearish sentiment and then a reversal from negative to positive breadth. While we focus more on aligning ourselves with prevailing conditions than on distinctions like "bull" or "bear" (which can only be confirmed in hindsight), strong reversals from negative to positive breadth can be useful in identifying the potential for multi-week advances during what are, in hindsight, continuing bear markets. Unfortunately, those reversals don't tend to hold if overvalued and overbullish conditions are in place. This is particularly true given that typical pre-recession conditions are active, because further advances are likely to be used as selling opportunities.

It is important to recognize that the S&P 500 is presently only about 13% below its April peak, and the word "only" deserves emphasis. Our valuation impressions align fairly well with those of Jeremy Grantham at GMO, who puts fair value for the S&P 500 "no higher than 950" - a level that we would still associate with prospective 10-year total returns of only about 8% annually. I would consider investors to be very fortunate if the market does not substantially breach that level in the coming 12-18 months. Wall Street continues its servile attachment to forward operating earnings, seemingly unconscious that the perceived "norms" for the resulting P/E are artifacts of a bubble period. The fact is that historical periods of overvaluation and poor subsequent long-term returns correspond to forward operating P/E multiples anywhere above 12, while secular buying opportunities such as 1950, 1974 and 1982 map to forward operating multiples of only 5 or 6 (based on the strong correlation but downward-biased level of forward operating P/E ratios, when compared with multiples based on normalized earnings - see Chutes and Ladders for a graphic)."

Schumpeter

..."During the 1930's, the Austrian economist Joseph Schumpeter captured the importance of productive investment nicely in his discussion of credit. The goal of lending activity is not the stimulation of demand per se, but rather the temporary relaxation of constraints in order to increase the stream of goods and services available to the economy:

"By credit, entrepreneurs are given access to the social stream of goods before they have acquired the normal claim to it. It temporarily substitutes, as it were, a fiction of this claim for the claim itself. Granting credit in this sense operates as an order on the economic system to accommodate itself to the purposes of the entrepreneur, as an order on the goods which he needs: it means entrusting him with productive forces. It is only thus that economic development could arise from mere circular flow in perfect equilibrium. And this function constitutes the keystone of the modern credit structure.

"The entrepreneur must not only legally repay money to his banker, but he must also economically repay commodities to the reservoir of goods - the equivalent of borrowed productive means; or, as we have expressed it, he must ultimately fulfil the condition upon which goods may normally be taken out of the social stream. The result of the borrowing enables him to fulfil this condition. After completing his business ... he has, if everything has gone according to expectations, enriched the social stream with goods whose total price is greater than the credit received and than the total price of the goods directly and indirectly used up by him.

"Loss always occurs if the entrepreneur does not succeed in producing commodities at least equal in value to the credit plus interest. Only when he succeeds in doing so has the bank done good business - then and only then however, is there also no inflation."

Market Climate

As noted at the outset, the Market Climate in stocks last week remained hostile, with valuations still rich, market action clearly negative, a paradoxical increase in advisory bullishness coupled with a reduction in bearishness, and recession warning conditions in place. If we were provided lower valuations and a shift to bearish sentiment, even market action identical to last week might be enough to warrant a moderate exposure to market fluctuations. The main problem here is that we essentially have nowhere constructive to go on the upside - advisory sentiment is already overbullish, and despite the recent decline, our 10-year total return projection for the S&P 500 has still only climbed to 5.1% annually. The ensemble of evidence remains steeply negative here. There are certainly many possible combinations of evidence that would be associated with a positive return/risk profile, on average. Unfortunately, we don't observe any of them at present, so both Strategic Growth and Strategic International Equity are well-hedged for now.

In bonds, we saw a nearly parabolic surge in long-term inflation-protected Treasury securities last week, bringing long-term real yields to a fraction of a percent. We used that spike to liquidate the majority of our holdings in that area. Passive investors in Treasury securities may very well earn flat or negative long-term real returns from present levels, but we see no reason to lock that prospect in. Strategic Total Return presently has a duration of only about 1.5 years, as the evidence suggests that risk is most efficiently taken in other areas, particularly in precious metals shares, where we boosted our allocation on weakness last week, back to just under 20% of assets.