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May 19, 2008

Poor Fundamentals with Borderline Market Action

John P. Hussman, Ph.D.
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One of the lessons that kids sometimes learn the hard way is that mid-air is the wrong place to be asking “what now?”

Investors may end up learning that lesson the hard way too. In recent weeks, investors have chased stock prices higher (though on relatively dull volume and narrow, cyclical leadership) like kids riding their bikes up a board they've laid over a pile of bricks to take a sweet jump. Once in the air, the question is “what now?”

The S&P 500 currently trades at 22.9 times trailing net earnings, but these earnings are somewhat depressed and not representative of normal long-term earnings power. What is more important is that the S&P 500 presently trades at over 20 times normalized earnings (sustainable earnings at normal profit margins). More friendly price/earnings multiples on the basis of “forward operating earnings” or even price-to-peak-earnings are had only on the assumption of a remarkable earnings rebound in the second-half, or a permanent return to the record-high profit margins of recent years.

This is a lot like a kid imagining, once airborne on the bike, that a foam pit will suddenly appear to break the impending fall.

As of last week, valuations remained unfavorable for stocks. Meanwhile, however, market action continued to hover near the point where speculation could begin to feed on itself. The behavior of trading volume and leadership remains relatively uninspiring, but some popular moving averages have been crossed (such as the 200-day moving average of the S&P 500), which has fed some amount of technical buying. Stocks are clearly overbought on a short-term basis, and given that, it's likely we'll observe some sideways movement for a bit even if the speculative interest of investors ends up continuing in the weeks ahead. Meanwhile, that same overbought condition, given a still-unfavorable Market Climate overall, leaves us braced for a possibly hard retreat.

In short, the fundamentals continue to appear very poor, but market action is at something of a crossroads. The reality is that as recessions develop (and I continue to believe the U.S. faces a much more significant downturn than we've observed to date), the data can take months to accumulate to a compelling verdict, and in the meantime, speculative pressures can remain alive. If the consolidation to clear the current overbought condition is fairly shallow, it will suggest that speculation might begin to feed on itself for a while. A sharp selloff from current levels, particularly on lopsided negative breadth, would suggest that the second round of negative financial and economic news is somewhat nearer.

On the economic front, we learned last week that April capacity utilization dropped below 80%. As I had noted in my March 10 comment, “Indeed, among indicators that have generally turned negative early into recessions, about the only one that has not is manufacturing capacity utilization, which generally drops below 80% as the economy turns down.” So much for small comforts. It is important to recognize that the kinds of indicators that investors are looking to for verification of a recession (spiking unemployment, negative GDP reports, bankruptcies, margin-related cost cutting, etc) are generally seen further into a recession than we probably are.

As Martin Feldstein of the NBER (the group that officially dates U.S. recessions) noted a week ago, January appeared to be the recent peak in economic activity, and “there's no question that the economy is down by just about every measure” since then. That suggests that an economic recession would currently be only a few months old, so the recent low in the stock market would have occurred with the U.S. economy only about a month into that recession. This is very implausible from a historical perspective.

So there appear to be two possibilities at hand. Either the March low marked the final trough of the recent decline, and the economy will avert a recession despite the fact that virtually every measure that has historically signaled recession risk has now turned negative, or further trouble is ahead for both the stock market and the economy. Some near-term speculative potential aside (which we would respond to using a modest amount of call option exposure only, leaving our defensive put options in place), the evidence continues to suggest continued caution.

Market Climate

As noted above, the Market Climate for stocks last week was characterized by unfavorable valuations and borderline market action – overbought, but also near the point where speculation could be fed by technical “trend followers.” The character of any consolidation here will affect the staying power of that speculation, so we'll be paying close attention to breadth, leadership, and price/volume features of any pullback we observe in the next week or two. In any event, we will continue to hold a defense against fresh or abrupt losses, but we may establish a 1-2% of exposure in call options if market internals hold or strengthen here.

In bonds, the Market Climate last week was characterized by relatively neutral yield levels and moderately unfavorable yield pressures. CPI inflation is now about even with 10-year Treasury yields, suggesting that we are near the point where commodity price weakness could emerge. The Strategic Total Return Fund continues to carry a very short duration of less than 1 year, primarily in Treasury bills, with about 15% of assets in foreign currencies. Last week's strong rally in precious metals shares gave us an opportunity to clip our exposure in precious metals down to less than 2% of assets. We are about at the point where economic slack may begin to restrain demand for many commodities, and it is typical for commodities to retreat from their peaks with very little in the way of upward corrections.


Other comments

A few remarks regarding world events. For the past several years, the Hussman Foundation has been active in providing aid to refugees from Burma (Myanmar), particularly children, who have fled the attacks of the military government (SPDC) on its own people, most egregiously in the Karen State. In the aftermath of the cyclone two weeks ago, we are hearing of an urgent need for water purification tablets and basic medications because of outbreaks of cholera and other water-borne diseases. Fatality estimates from the government appear to be grossly underestimated.

The immediate problem is not money, but the obstacles imposed by the SPDC in delivering aid, and the confiscation of aid provisions by the government itself (in some areas aid workers have resorted to driving through the streets to throw food and medicine from car windows directly to the people before they are caught). The neglect of the government has been ruthless. Thousands of decomposing bodies have been left without removal or attempted identification. Our project coordinator on the ground there commented "I've never seen anything like this in my life."

The behavior of the Burmese government is, in effect, a form of genocide, and far more needs to be done beyond simply opening a few local routes to a few neighboring countries. The appeal from Nobel Laureates in support of U.N. Security Council intervention in Burma (Myanmar) is worth disseminating. Coordinated international action in this case would not be inappropriate if broad routes to provide aid are not quickly opened. Ideally, diplomatic solutions can be achieved, with the potential for military intervention being a credible stick to pry an entryway for the carrots. The fact that we've mortgaged ourselves to China is the largest problem for a U.S. role, since China opposes even a humanitarian intervention, but France and Britain appear increasingly willing to create enough pressure to convince the SPDC that a diplomatic resolution would be in its best interests.

Meanwhile, last week's flap about "appeasement" touched on a subject that is familiar to long-term readers of these comments. I've included some of my previous remarks below. As I wrote in February 2003, just before the Iraq war was launched,

"The willingness to choose long and frustrating diplomacy instead of war does not constitute "appeasement" - a word that has been recklessly contorted in recent months. Appeasement involves the grant of concessions - generally dishonorable ones - to an enemy, in return for assurances of nonaggression (as when Hitler was offered part of Czechoslovakia in the Munich Agreement, over the objections of Czechoslovakia, which was barred from attending). Appeasement is not inherent in the pursuit of diplomacy, nor in the demand for grave justifications as a precondition for war.

"The argument against war is also not an argument against U.S. security or the defense of its interests, but rather a recognition of the elements that are necessary to achieve those aims. It is exactly in pursuit of American security and interests that the Administration should emphasize containment, deterrence and diplomacy - even years of it if necessary - instead of a war on a government that, while tyrannical, is of questionable threat. A war would predictably increase international resentments, further destabilize very tangible risks in North Korea, and ultimately radicalize countless potential terrorists, with no central authority from which surrender could be obtained.

"As John Jay wrote in The Federalist in 1787, "the safety of the People of America against dangers from foreign force, depends not only on their forbearing to give just causes of war to other nations, but also on their placing and continuing themselves in such a situation as not to invite hostility or insult; for it need not be observed, that there are pretended as well as just causes of war... and that whenever such inducements may find fit time and opportunity for operation, pretences to colour and justify them will not be wanting. Wisely therefore do they consider Union and a good national Government as necessary to put and keep them in such a situation as instead of inviting war, will tend to repress and discourage it."

The following remarks are from March 2007:

"The outlook for fiscal stability and international peace will continue to be undermined so long as our leaders imagine that violence can remove violence – especially when there is no central authority from which to extract surrender, and when each act of escalation creates far more enemies than can ever be destroyed. The effort to open a dialogue as a step toward peace (rather than requiring peace as a step toward dialogue); to understand those we call enemies; would not be an act of weakness but an act of strength and self-defense. Particularly with numerous, scattered factions, the attempt to find common ground and negotiate disputes is also most probably the only way to achieve peace.

"It is the beginning of wisdom to listen and understand the motivations of each side - their fears, hatreds, misconceptions, ignorance, suffering, feelings of injustice, and aspirations, without each side branding the other as inhuman, and somehow unworthy of human rights, or lacking any human commonalities. Diplomacy doesn't require us to appease an enemy by granting dishonorable concessions, but only to ask “To what is each side entitled?” For a nation with a history of respect for diplomacy, international cooperation, human rights, and beyond all else, the sacrifice of our troops, the present course is no path to peace, and is no way to lead."


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