John Hussman: Maintain Market Discipline

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 |  Includes: DIA, IVV, QQQ, SPY, VTI
by: John Hussman

Excerpt from the Hussman Funds' Weekly Market Comment (4/16/12):

As of Friday, the S&P 500 was at about the same level as at the end of February. I noted then that our estimate of potential market losses over an 18-month window was in the worst 1.5% of historical observations. More recently, we've observed a marked deterioration in our measures of market internals. As a result, our estimate of potential market losses over a 6-month window is now in the worst 0.5% of historical observations. In particular, we're seeing a very broad-based downward shift in market action across nearly every industry group. While the depth of the breakdown is still fairly shallow, the uniformity of the signal suggests significant information content (for more on this distinction, see the note on extracting economic signals from multiple sensors in Do I Feel Lucky?). Though our market concerns are independent of our economic concerns, we see essentially the same downward uniformity in leading economic measures across the industrialized and developing world (for example, see the charts near the end of last week's comment Is the Fed Promoting Recovery or Desperation?).

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This is not an appeal for investors to sell, or even reduce their investment exposure, but is rather an appeal for investors to carefully examine their exposure to market risk, and to consider their willingness to adhere to their existing investment discipline through a steep and potentially extended market decline. We are enormous advocates of investment discipline, but we also know how uncomfortable that can be during various points of the market cycle. For buy-and-hold investors, the main thing to examine is the extent of loss you can tolerate without abandoning that strategy, in recognition of the actual size of the losses that investors have regularly experienced over time. It is best to ask that question when you are experiencing strength. You never want to be in a position of abandoning a sound long-term discipline because of discomfort over some portion of the market cycle.

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We remain defensive on the basis of an army of hostile syndromes (typified by the "overvalued, overbought, overbullish, rising yields" combination, but coupled with several others), now joined by a breakdown in market internals - not greatly observable on the basis of depth, but of high concern on the basis of uniformity. We also observe clear evidence of economic softening and recession around the world, and an early deterioration in U.S. indicators as well (though these data points are still dismissed as noise). In short, our concern about market risk persists. Our concern about the risk of an oncoming recession persists. Nothing in the recent data has removed my impression that the period ahead may become an unmanageable Goat Rodeo of market volatility, economic disappointments, sovereign debt concerns, and European banking strains. Our risk measures have been less extreme in about 99% of history, so even if they are incorrect in this instance, we are not likely to persist with such a strongly defensive view for long. I expect that we'll have good opportunities to accept a constructive investment stance at better valuations and without such extensive headwinds. But with the recent deterioration in market internals, we can't even see a speculative case for market risk here.