Monday, March 22, 2010

Hussman Weekly Market Comment: Zombies and Rube Goldberg Machines

It is important to note that our current defensive position is driven by the present combination of overvalued, overbought, overbullish conditions, coupled with upward yield pressures, and is independent of my larger concerns about the potential for a second wave of credit strains. So there are two distinct sets of concerns here, one that would exist even in the absence of credit concerns, and the other that directly involves those concerns.

This distinction is important, because as we've anticipated for months now, we have finally entered the window in which additional credit strains - if they are indeed likely to emerge - should actually begin appearing in the data. Specifically, beginning with data for February 2010 and later, the concern is that we will begin to observe a spike in delinquencies - first in the form of "30-day delinquencies" and gradually in either large increases in loan loss provisions or in the actual onset of foreclosures.

Moreover, first quarter earnings reports will give us the first look at various off-balance sheet entities that are now required to be brought onto corporate balance sheets.

So the several few months will be important in gauging the extent to which "second wave" risks are or are not materializing. While it would be difficult to take a lack of fresh credit strains as evidence of restored health in the banking and lending system, we can't rule out the possibility that the Rube Goldberg machine created by the Fed and the Treasury will be enough to take us through a period of years (or if we follow Japan's example, decades) where we will gradually bury the losses of the banking system, trading a short-lived period of adjustment instead for a long-term period of stagnant credit.

We will not retain our concerns about second-wave credit strains if the data do not support it. As we move through this year, absent fresh credit strains, we will gradually assume a "post-war" world. If these strains do not emerge, we will scale (in an approximately linear way) our weights through 2010 to place greater weight on the "typical post-war recovery" dataset, while gradually fading our concern about abrupt solvency problems in our financial system. That is, we will move gradually with the evidence.