John Hussman: Overvalued Stocks, Recession Risk, Inflation

by: John Hussman

Excerpt from fund manager John Hussman’s weekly essay on the US market:

The U.S. economy is likely to slow and inflation is likely remain persistent, because the U.S. has ascended a mountain of debt upon which there are currently no promising directions to climb. All of the growth in U.S. gross domestic investment since 1998 has been financed by foreign capital inflows, and while the Federal government continues to expand the stock of U.S. debt, the appetite of foreigners for new debt, in addition to their existing holdings, can hardly do anything but slow.

As the growth of foreign capital inflows declines (I'm not suggesting that foreigners will actually sell their existing Treasury debt, just reduce their absorption of new debt), gross domestic investment is likely to stagger, particularly in the area of housing, and credit expansion in the U.S. is likely to slow as well. The excess Treasuries not purchased by foreigners will be forced into domestic hands, either the public, or the Federal Reserve, resulting in a decline in the marginal value of government liabilities that we commonly refer to as “inflation.” If credit defaults increase, then, yes, investors will probably increase their demand for “safe” (at least default free) government securities, which would then support the value of government liabilities and therefore result in lower inflation, but would do nothing to improve economic prospects.

The inability of the markets to think for themselves also leads to a parroting of common errors, rather than a search for unique truths. Analysts currently claim that stock valuations are below historical averages, but this is because the P/E ratios they use are based on forward (i.e. next year or beyond) “operating earnings” (i.e. stripped of virtually any factor that reduces the predictability of earnings), while the historical averages that they reference are based on trailing net earnings. On no soundly reported fundamental (for which a long historical record exists) is the stock market even near its historical averages.

So we are left with the reasonable prospect of tepid economic growth, very possibly rolling into recession late this year or early next (though the evidence doesn't yet suggest recession as a “probable” outcome), persistent structural inflation that will probably not behave “cyclically” by declining as the economy slows, a presently unfavorable Market Climate in stocks (which, as always, will change as the observed evidence changes, but for now holds us to a strongly defensive stance), and a relatively neutral Market Climate in bonds, which is insufficient to accept a great deal of interest rate risk regardless of whether or not the Fed might “pause.”