John Hussman: Renewed Concern About Credit Default Spreads

Includes: DIA, QQQ, SPY
by: John Hussman

Excerpt from the Hussman Funds' Weekly Market Comment (1/12/09):

On the hopeful side, the market appears generally oversold, and is near what could be considered reasonable support. Given the loss of favorable market action, we wouldn't invest on the expectation that this support will necessarily hold, but as noted above, about half the Fund's exposure is hedged with option combinations that amount to in-the-money put coverage. So a recovery in the market will put us in a more constructive position somewhat automatically, without having to rely on that outcome.

Another hopeful aspect to current conditions is the possibility of some significant policy announcement regarding financials as the Obama administration begins. From my perspective, the factor of immediate concern is again the capital cushion on the liability side of bank balance sheets. As banks experience losses on the asset side of their balance sheets, the same amount has to be subtracted from the liability side, and that amount comes out of “shareholder equity,” more commonly known as “capital.” Failing new capital injections, and quickly, could rapidly produce conditions similar to what we observed in October and November. That is what the rapid spike in credit default spreads is telling us here.

Second to fresh capital injections from TARP funds, the new Obama administration will need to directly address foreclosure abatement. Government policy is strongest and most appropriate in areas where there is a “coordination failure” that the private markets simply cannot address, and dealing with distressed mortgages is a prime example.


Unfortunately, the fresh deterioration in market action and credit default spreads suggests that the need for intervention is becoming urgent. Again, there is a possibility that the new Obama administration will address some of these issues fairly quickly – particularly in regard to immediate capital infusions to major money center banks. In that event, a recovery of more than a few percent in stock prices would put us in a position to moderately participate in market fluctuations. Here and now, however, our immediate response is to move with the evidence at hand, and we have done so by tightening our hedges against the risk of fresh deterioration in the market.