John Hussman: Poor Long-Term Returns May Be Inevitable

Excerpt from the Hussman Funds' Letter to Shareholders [.pdf]:

For most families, the most binding constraint right now is not the ability to spend out of current income, but the ability to service debt. A temporary boost to current income is likely to be spread out in a way that best allows that family to operate under its constraints, which means that the predominant use of ”stimulative” tax rebates will be for debt service. This may very well provide the economy with a modest reduction in credit strains, but it certainly won't avoid delinquencies and foreclosures. Most mortgage obligations will swallow down the entire rebate in a single month. There is not much fiscal policy can or should do to bring back the "good old days" of irresponsible lending and a housing bubble. Once a market becomes overvalued - in stocks, bonds, or housing - either falling prices or poor long-term returns become inevitable.

In the bond market, the flight to the safety of Treasury securities recently pressed the 10-year Treasury yield to less than 3.4%, nearly one percent less than the most recent year-over-year CPI inflation rate. It seems unlikely that fixed income investors will be content to sustain such low levels of prospective total return for a full decade, which suggests that there is a substantial speculative component in current Treasury prices. Historically, the level of yields has been a much better indication of subsequent bond market returns than the prevailing trend of yields has been. Accordingly, I would expect to maintain a relatively low duration in bonds for the Strategic Total Return Fund, with higher yields or wider credit spreads being the primary factors that would prompt an increase in the maturity of the Fund’s holdings...

Although we believe that current conditions suggest an economic downturn, dollar weakness, and an absence of compelling value in the stock and bond markets, we do not require the market to decline to undervalued levels to warrant a substantial or complete removal of our hedges. It is the nature of financial markets to experience a wide variety of conditions over the course of a complete cycle. As we enter 2008, we remain defensive based on the prevailing evidence, but remain open to increasing our exposure to stock and bond market fluctuations as the evidence from valuation and market action becomes more constructive.