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More Than Meets the Eye by John Hussman

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More Than Meets the Eye by John HussmanOn the surface, the agreement on the U.S. debt ceiling can be expected to produce a significant relief rally in the financial markets, particularly if one views uncertainty on that front to be the reason for last week’s market weakness. That prospect, coupled with the predictable support that investors gave the S&P 500 precisely at its 200-day moving average, prompted us to cover just over 10% of our short calls, but retaining full hedge on the remainder of our holdings, and keeping a strong line of protection about 2% below Friday’s closing levels using index put options (near that 200-day). That’s still a fairly tight hedge, because unfortunately, the ensemble of observable data continues to indicate negative expected returns. So while we’ve modified our position slightly to allow for reduced uncertainty on the deficit front, and the likelihood of “knee jerk” technical support at the widely-followed 200-day average, the expected return/risk profile in stocks remains negative in our estimation. Of course, our precise hedge will change from day-to-day as market conditions change. Part of the problem here is that market internals have deteriorated badly, particularly last week, where breadth was nearly 10-to-1 in favor of declining issues, and downside leadership exerted itself with more stocks hitting new 52-week lows than new highs. Meanwhile, though new claims for unemployment dipped just below 400,000 last week, we would be more encouraged if the margin was greater, and sustained over a period of many weeks. At present, the 4-week average is running at about 414,000, a level which has historically been associated with growth of only about 30,000-50,000 in monthly non-farm payrolls on average (see the July 11 comment), though there’s certainly month-to-month noise around those averages.

The overall impression from the data suggests the possibility that there is more information in the recent breakdown in market internals than can be explained by debt ceiling concerns alone. On that note, there are emerging economic signals whose leading tendencies are strong enough to make a review worthwhile.

We’ll begin with our own recession warning composite, which accurately signaled oncoming recessions in 2000 and 2007 (see the November 12, 2007 comment Expecting A Recession ). That particular conformation of indicators never deteriorated sufficiently in 2010 to provoke a recession warning, though the deterioration in the ECRI leading index and other measures clearly indicated serious concern. In any event, QE2 effectively forestalled incipient economic weakness in 2010. Given that second quarter GDP came in at just 1.3% annually, and first quarter GDP growth was revised down to just 0.4% (from a prior estimate of 1.9%), it is wholly unclear that the Fed’s extraordinary actions have been worth the market distortions, predictable commodity hoarding, injury and social unrest among the world’s poor (resulting from food and energy price increases) and significant “unwinding” risks that this policy has produced.

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