John Hussman: Recession Warning

by: John Hussman

Excerpt from the Hussman Funds' Weekly Market Comment (8/8/11):

As of Friday, the S&P 500 was below its level of early November 2010, when the Federal Reserve initiated its second round of quantitative easing. Aside from a brief bump in demand that kicked the recession can down the road a bit, the U.S. economy is not measurably better off. Meanwhile, countless individuals in developing countries have been injured by predictable commodity hoarding and global price instability. The Federal Reserve has leveraged its balance sheet by over 55-to-1. As policy makers look to address the abrupt deterioration in U.S. and global economic prospects, we should ask ourselves: Do we really long for more of the Fed's recklessness?


If there is one crucial point that should not be missed, it is this: the fundamental source of our economic challenges, from joblessness, to unresolved housing strains, to sovereign debt crises, is that our policy makers have repeatedly opted for fiscal band-aids and monetary distortions instead of addressing the core problem head-on. That core problem is simple: the careless encouragement of asset bubbles, and the refusal to restructure bad debt.

Encouraged by inappropriately easy monetary policy and lax regulatory oversight, the U.S. went on a debt-financed binge of consumption and unproductive investment that lasted nearly a decade. When that binge collapsed, policy makers ignored the fundamental need to restructure bad debt, and instead fought tooth and nail to defend bondholders and lenders who had extended credit carelessly. We are now left with a global financial system where the debtors are incapable of making good on those debts, and governments around the world are frantically trying to prop up bad debt with public funds and monetary policies aimed at distorting the financial markets even further.


Last week, I reviewed the rapidly deteriorating condition of our Recession Warning Composite . While year-over-year GDP growth has dropped to just 1.6% - a rate that has been followed by a new recession in 10 of the 12 times it has occurred since 1950 - I preferred evidence from a wider set of market and economic measures. I noted "we would require only modest deterioration in stock prices and the ISM index to produce serious recession concerns."

With the pixels barely dry on that weekly comment, the ISM reported Monday that its Purchasing Managers Index dropped unexpectedly to 50.9, the slowest pace in two years. That report, coupled with an early slide in the S&P 500, completed the remaining holdouts (conditions 2 and 3) of the Composite. Coupled with the slowdown in year-over-year GDP growth, the composite of economic and financial evidence we presently observe has always and only been associated with ongoing or immediately impending recessions. This is not an opinion or a viewpoint, but a fact of the data. "Always and only" is the Bayesian equivalent of "certainty" (a Bayesian is someone who, vaguely expecting a horse, and glimpsing the tail of a donkey, concludes he has probably seen a mule).


Thinking in terms of equilibrium is helpful in contemplating the "roadmap" of potential outcomes for the market here. First, technical traders are not a very persistent source of demand. A rally that eases the short-term oversold condition of the market and approaches prior levels of technical support would likely be met by profit-taking from short-term technicians and also selling from longer-term technical investors that missed the first opportunity to sell the break of major support. As for fundamental investors, those with a long-term view based on normalized cash flows are unlikely to be very interested here in the first place, and the economic evidence suggests that forward expectations are likely to deteriorate in the weeks ahead. So while stocks may look cheap to investors with an affection for forward operating earnings, those investors have to hope that earnings estimates remain static or improve, which appears unlikely. For all of these reasons, there is good reason to expect an imbalance of selling pressure to develop quickly in response to rallies that clear the oversold short-term condition of the market.

Less likely, but not impossible, would be an advance that couples significant improvement in market internals with better economic news. A particularly encouraging event would be a move above prior support levels that "holds" for more than a few sessions. While that whole set of developments would go against the evidence that we're seeing on the economic front, and would require a reversal of the deterioration we've seen in market internals, it would contribute to a short-term imbalance of buying pressure that would have to be offset by selling by fundamental investors and "contrarian" technicians selling into overbought conditions. That scenario wouldn't change the unfavorable long-term prospects for total returns, but can't be completely ruled out as a short-term event.

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