John Hussman: Bear in Waiting or Emerging Bull?

by: John Hussman

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

Broad analysis of investor sponsorship and the broad quality of market internals goes into what I refer more concisely as “market action.” Historically, when the broad internal quality of market action has been favorable, valuations have tended not to matter much in the short-term, and the market has been able to advance even on concepts that ultimately proved incorrect (like the perception that the dot-coms and dot-nets would move relentlessly higher). In contrast, when market action has been unfavorable, market advances based on optimistic concepts have generally not worked out well, and have often ended abruptly, particularly when valuations have been rich.

So for example, if valuations are depressed and market action has turned favorable, it's dangerous and stubborn to stick to a defensive or bearish investment position, even if it seems that the economy is likely to worsen... Likewise, if valuations are rich and market action is unfavorable, it's dangerous and stubborn to stick to an aggressively bullish investment position, even if it seems that the economy is likely to improve...

The markets took heart last week in a modest decline in the Producer Price Index [PPI], as well as a core CPI inflation rate that came in a pip (0.2% versus expectations of 0.3%) below expectations... Here's the picture that concerns me:

Over the past year, consumer price inflation has clocked in at 4.15%. Producer price inflation (finished goods) has been a similar 4.12%. But if you look at intermediate goods, we're currently at an inflation rate of 8.83%. That's the most abrupt widening in the spread between intermediate and finished goods since the 1973-74 oil crisis...

Despite last week's rally on dubious investor hopes that inflation has peaked and is now headed down, what we've actually got is a clearly overbought market in a still unfavorable market climate, characterized by unfavorable valuations and still unfavorable market action. It's not usual for the market to become overbought in unfavorable market climates, because rallies typically fail early on. In situations where the market is able to push all the way to a clearly overbought condition, there are two fairly clear possibilities. The first, and most frequent, is a rather abrupt and substantial decline... The other possibility, that we can't rule out, is that investors are in the process of re-establishing a favorable inclination toward market risk... Still, the question is “What should we do?” given any possibility that our measures of market action might turn favorable.

The answer is that we wait for that evidence and then act when it arrives.