05/12/13 The Hussman Put

It's no surprise that even I am now all but convinced we are headed higher- it's not possible to create a market top without a convincing argument. The market is quite good at manipulating sentiment, and I am not immune. Once I recognize the change in sentiment, it requires a conscious effort on my part to actively fade the change. The same psychological 'twist' occurred the second week of March 2009. After months of trying to time a 'bottom,' I gave in on March 9- I closed all longs at the exact low. The same evening, I 'caught myself' and realized what had happened. The following day (March 10) I faded the previous day's sentiment and went long a combination of FAS (3x financials), TNA (3x Russell 2000), and QLD (2x QQQ). By September 2009 the portfolio was back to new highs. I have yet to throw in the towel and go long, so it's unlikely the top is imminent. But Hussman's latest missive is instructive: The perception that investors are “forced” to hold stocks is driven by a growing inattention to risk. But Investors are not simply choosing between a 3.2% prospective 10-year return in stocks versus a zero return on cash. They are also choosing between an exposure to 30-50% interim losses in stocks versus an exposure to zero loss in cash. They aren’t focused on the “risk” aspect of the tradeoff, because they believe that they will somehow be able to exit stocks before the tens of millions of other investors who hold identical expectations. Though the discipline to “sit by quietly while the mob has its day” can be nearly excruciating in the excitement of late-stage bull markets, as the market registers multi-year highs amid rich valuations and heavily optimistic sentiment, it’s worth remembering that the 2000-2002 bear market wiped out the entire total return of the S&P 500 in excess of Treasury bills all the way back to May 1996. Assuming that investors stuck it out to finally regain and surpass the market’s 2000 peak in 2007, the 2009-2009 bear market then wiped out the total return of the S&P 500 in excess of Treasury bills all the way back to June 1995. Think about that. One literally could have sat in Treasury bills through 1996, 1997, 1998, 1999, 2000, 2001, 2002, 2003, 2004, 2005, 2006, 2007, 2008, and into early 2009, and have done better than the S&P 500 did over that entire span of time. Moderate losses are frustrating, but deep, major losses from rich valuations are the ones that matter, because it is difficult to recover from them in a durable way. The recent advance is a gift in that regard. Consider that carefully now, not later. ...Europe has now entered a clear recession, with much of the developed world following suit. Real GDP growth and real final sales have both dropped from year-over-year growth rates above 2% to below 1.9% - a combined occurrence that has rarely emerged except during or immediately prior to recessions. Regional purchasing managers surveys and Federal Reserve surveys have turned uniformly lower in recent reports. Importantly, while non-farm payroll growth was surprisingly robust in April, the gain belied a significant decline in the average hourly workweek. It is the combination of workers and hours worked that determines production and income. If labor hours were held constant, total non-farm payrolls would have declined between 550,000 and 623,000 jobs in April (depending on whether one uses non-farm payrolls x average weekly hours or instead uses the index of aggregate weekly hours). The U.S. may or may not avoid recession, but there is no evidence of a material or durable acceleration in economic growth here. As a simple rule of thumb, I would suggest watching for a spike, sustained over at least a few months, in the Philly Fed index and the new orders component of the Chicago Purchasing Managers Index. We observe nothing of the sort at present. That constant and more immediate tendency to buy dips is a signature that is difficult to entirely dismiss. In itself, it doesn’t always lead to unfortunate outcomes, but in the context of rich valuations, overbullish sentiment, and global economic headwinds, it is worth monitoring. As Barron’s Magazine noted in early 1969, just before the market lost a third of its value in the 1969-1970 plunge: “The failure of the general market to decline during the past year despite its obvious vulnerability, as well as the emergence of new investment characteristics, has caused investors to believe that the U.S. has entered a new investment era to which the old guidelines no longer apply. Many have now come to believe that market risk is no longer a realistic consideration, while the risk of being underinvested or in cash and missing opportunities exceeds any other.”