Monday, September 6, 2010

Hussman Weekly Market Comment: The Recognition Window

Over the course of the market cycle, one of the primary areas of risk for stocks (and conversely, one of the best periods for Treasury bonds) is typically the "recognition window" where economic activity begins to deviate from the upward trend that is priced into the market, and investors begin to recognize that an economic downturn is, in fact, likely. In my view, the instant relief provoked by the manufacturing PMI and the employment report was an overreaction to data that is still very early in that window. The typical lead times between deterioration in reliable measures such as the ECRI weekly leading index (and several of our own measures) and deterioration in "coincident" economic activity tend to be on the order of 13-26 weeks. For most economic indicators, we are not there yet. This is why I emphasized two weeks ago that "the much earlier deterioration in economic measures is not encouraging, but it also opens up the possibility that we may see some misleading 'improvement' in the data in the next few weeks before we get into the more typical window of deterioration."

Suffice it to say that it is premature to interpret last week's somewhat benign data as an "all clear" signal for the economy. Yes, this time may be different, and we may somehow skirt evidence that has historically been reliable, but we don't have a clear logical justification based in other data to support a rosy view. Even when statistical relationships are quite strong, the fact is that "coincident" evidence of economic weakness does not follow the leading indicators with flawless precision. We work with probability distributions - not forecasts - and distributions (picture a bell curve) have variation. There is no way to remove this uncertainty, and it is dangerous to assume that last week's data have done so. From my perspective, economic risks continue to be quite serious.


To clarify once again - I emphatically do not anticipate inflationary pressures until the second half of this decade. As I've repeatedly emphasized, the primary driver of inflation - historically and across countries - has been growth in government spending for purposes that do not expand the productive capacity of the economy. It does not matter what form the government liabilities take, because default-free government liabilities and central bank notes are nearly perfect portfolio substitutes (though extreme deficits do tend to be monetized eventually). That said, the seeds of inflation can often remain dormant for years before emerging.

The price level is nothing more than a ratio: the "marginal utility" of goods and services divided by the "marginal utility" of government liabilities. Heavy demand for goods and services in the presence of production constraints is inflationary because it increases the numerator, while credit fears and precautionary cash balances reduce inflation pressures because they increase the denominator. Presently, there is no reason to anticipate inflation until we observe some combination of robust demand for goods and services, production constraints, or reduced demand for cash balances and other government liabilities.

Quantitative easing does not pressure the dollar by fueling inflation. It has a much more subtle effect (but one that can be expected to be amplified if fiscal policy is long-run inflationary as it is at present). Normally, equilibrium in capital flows between countries is achieved through changes in interest rates. As a result, countries with greater capital needs or higher long-run inflation tendencies also have higher interest rates. If interest rates can adjust, exchange rates don't have to. But notice what quantitative easing does: by sitting on long-term bond yields (and creating a negative real interest rate differential versus other countries), quantitative easing prevents bond prices from acting as an adjustment factor, and forces the burden of adjustment on the exchange rate.

In short, quantitative easing is not a story about inflation. It is a story about capital market equilibrium and the need for exchange rates to act as the adjustment variable when the central bank lays its weight on the bond market. The likely outcome of quantitative easing is not hyperinflation. Rather QE is likely to provoke a relatively quick plunge in the exchange value of the U.S. dollar.

With respect to gold and precious metals, as I noted years ago in Going for the Gold, factors that influence real interest rates and the value of the U.S. dollar are the primary drivers of gold price fluctuations. Moreover, the level of gold stock prices relative to the price of the metal provides useful information that is well-correlated with subsequent long-term returns in those shares. While I consider our present holdings of gold shares in Strategic Total Return as moderate, and we would prefer some amount of share price weakness before establishing a more aggressive stance, the high gold/XAU ratio, weak leading economic indicators, and renewed real-interest rate pressures all appear supportive.