Hussman: Don’t Be Fooled by Market ‘Rally,’ Stay Defensive

Wednesday, 01 Aug 2012 08:13 AM

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Economist and fund manager John Hussman cautions investors not to yield to the temptation to give up a defensive position in what appears to be a market rally.

“[W]hat I worry about most is that conservative investors will become impatient with maintaining a defensive position in a dangerous and elevated market — not because investment prospects have materially improved, but simply because short-lived runs of speculative relief seem too enticing to miss,” Hussman writes in a note to investors.

“Volatile but ultimately directionless periods of elevated valuations, as we saw in 2000 to early 2001, 2007 to early 2008 and which we’ve observed since April 2010, tend to exhaust defensive investors and encourage complacency toward market risk at the worst possible time.”

Editor's Note: Unthinkable Haunts Investors: Evidence for Imminent 90% Stock Market Drop. 

In the United States, notes Hussman, quantitative easing (QE) has helped oversold markets recover or slightly surpass the peak that the Standard & Poor’s 500 Index achieved during the preceding six-month period. However, there is less evidence that QE will do much for the markets when prices are already elevated and risk premiums already depressed.

According to Hussman, the best estimate for the market’s upside potential if the Federal Reserve initiates a third round of QE is for an S&P 500 of 1430.

“Given that our economic measures continue to indicate that the United States has entered a new recession, it is not clear that another round of QE will even achieve that effect,” Hussman says.

“I worry that investors forget how devastating a deep investment loss can be on a portfolio. I worry that the constant hope for central bank action has given investors a false sense of security that recessions and deep market downturns can be made obsolete. I worry that the depth of the recessions and downturns – when they occur – will be much deeper precisely because of the speculation, moral hazard and misallocation of resources that monetary authorities have encouraged,” he writes.

“I worry that both a global recession and severe market downturn are closer at hand than investors assume, partly despite, and partly because, they have so fully embraced the illusory salvation of monetary intervention,” Hussman adds.

The Federal Open Market Committee will announce its decision on interest rates Wednesday.

According to a recent CNNMoney survey, most Wall Street investment experts believe that more stimulus from the Fed is coming. Specifically, of the 30 experts polled, two-thirds said the Fed’s extension of its Operation Twist policy was warranted, and the same percentage believed the Fed will reconsider a QE3.

Editor's Note: Unthinkable Haunts Investors: Evidence for Imminent 90% Stock Market Drop. 

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