...from Dr. John

John P. Hussman, Ph.D.
All rights reserved and actively enforced.
Reprint Policy

"As of Friday, the S&P 500 was below its level of early November 2010, when the Federal Reserve initiated its second round of quantitative easing. Aside from a brief bump in demand that kicked the recession can down the road a bit, the U.S. economy is not measurably better off. Meanwhile, countless individuals in developing countries have been injured by predictable commodity hoarding and global price instability. The Federal Reserve has leveraged its balance sheet by over 55-to-1. As policy makers look to address the abrupt deterioration in U.S. and global economic prospects, we should ask ourselves: Do we really long for more of the Fed's recklessness?

I began drafting this update in a fairly measured way, but on further reflection, I think it is time to be blunt. The economic evidence now suggests that the U.S. and the global economy are again entering recession. Technically, this is not a "double dip." The National Bureau of Economic Research, which officially dates the beginning and end of U.S. recessions, was very clear about this last year - noting that it would view any future economic downturn as a new recession, not as a continuation of the one that ended in June 2009.

If there is one crucial point that should not be missed, it is this: the fundamental source of our economic challenges, from joblessness, to unresolved housing strains, to sovereign debt crises, is that our policy makers have repeatedly opted for fiscal band-aids and monetary distortions instead of addressing the core problem head-on. That core problem is simple: the careless encouragement of asset bubbles, and the refusal to restructure bad debt.

Encouraged by inappropriately easy monetary policy and lax regulatory oversight, the U.S. went on a debt-financed binge of consumption and unproductive investment that lasted nearly a decade. When that binge collapsed, policy makers ignored the fundamental need to restructure bad debt, and instead fought tooth and nail to defend bondholders and lenders who had extended credit carelessly. We are now left with a global financial system where the debtors are incapable of making good on those debts, and governments around the world are frantically trying to prop up bad debt with public funds and monetary policies aimed at distorting the financial markets even further.

The economy is an equilibrium - consumer spending is stagnant not only because unemployment is high but also because debt burdens remain daunting. Businesses are reluctant to hire because they don't see the likelihood of sustained demand. This isn't a problem of tax uncertainty, regulations, or budget worries - it's a low-level equilibrium produced by consumers trying to deleverage and businesses reluctant to hire without the promise of demand. Many workers can't even move elsewhere to accept job openings because they are locked into their current homes. Very simply, barring the emergence of some new economic sector that produces a tremendous supply of desirable new goods and simultaneously produces enough employment to generate the income to buy those goods, we're unlikely to get around the employment problem until we address the debt issue directly......"

Market Climate

"As of last week, the Market Climate for stocks remained hostile, coupling overvaluation with stark weakness in market internals. We continue to see evidence of significant complacency, with bullish sentiment still well ahead of bearish advisors. From a Bayesian standpoint, the likelihood is that stocks have entered a bear market, and that last week was an opening salvo, not a parting shot. On the economic side, I am very hopeful that the composite of evidence for an oncoming recession is utterly wrong. Still, that hope is pitted against data that has always and only been observed during or just prior to economic downturns.

Again though, we'll respond to the evidence as it emerges. Significant repair of market internals isn't impossible, but that hope runs contrary to the gathering economic evidence we're seeing. A market reversal on high volume, disproportionately positive breadth, and coupled with deeply bearish sentiment, might also create some opportunity to accept a modest to moderate exposure to market fluctuations. That said, given the historical tendency of those rallies to come off of much more significant declines than we've observed thus far, I suspect that our next opportunity to accept exposure to market fluctuations will come at lower levels. I have little doubt that the best approach is simply to remain open to the data as conditions evolve, adhere to our discipline, and respond in proportion to the expected return/risk profile we observe at each point in time. Strategic Growth Fund remains well hedged here, while Strategic International Equity is about 20% unhedged, owing to the greater dispersion in conditions and valuations in foreign markets.

In Strategic Total Return, we clipped our portfolio duration back to just 1.5 years in response to the plunge in Treasury yields. While the downgrade of Treasury debt from AAA by Standard & Poor's is reflective of broader disdain for the political process on budget matters, my impression is that U.S. Treasury debt continues to have the lowest risk of default of any security in the world. Though there's some risk of very brief liquidity pressures in the Treasury market, I doubt that the broad community of bond investors would miss the opportunity to capture a higher Treasury yield in an increasingly uncertain environment.

Meanwhile, it is certainly a negative for savers, but a positive on the inflation front that Treasury bill yields collapsed back to zero last week after climbing to 0.10% just before the debt ceiling deadline. As I've noted before, given the present size of the monetary base, even short-term interest rates of more than a few basis points would create significant inflation pressure (see Charles Plosser and the 50% Contraction in the Fed's Balance Sheet ). Barring exogenous upward pressure on short-term interest rates, I continue to believe that the primary window of inflation risk is probably in the back half of this decade.

Finally, from the standpoint of indicators correlated with the return/risk profile in precious metals shares, we continue to observe a very constructive ensemble of conditions. After clipping back our exposure in precious metals shares to about 15% in Strategic Total Return at the beginning of last week based on near-term risk factors, my expectation is to increase that position back toward 20% in the event that price weakness continues much further."