“The expected return/risk profile of the stock market has shifted to hard-negative”

Wall Street Fund Manager John P. Hussman

One of the most respected Wall Street fund managers has confirmed what every hedge fund manager in the world knows. The European Central Bank (ECB) will not keep inflating credit. Italy would need $1 trillion to $3 trillion, Greece $500 billion, Germany is leveraged up to 82% of GDP, France is in worse shape. It all adds up to a $30 trillion bail out by some estimates. The European banks have “rehypothecation,” a practice that occurs principally in the financial markets, where a bank or other broker-dealer reuses the collateral pledged by its clients as collateral for its own borrowing, to the edge of the financial cliff.
The “growth” in the USA last quarter can be summed up as follows. The GDP “increased” 2.0% and the Gross Domestic Income, what we are actually earning, grew at a 0.3% pace. You do the math.
The following appeared in Hussman Funds on 12-12-2011.
With the exception of extreme market conditions (see Warning- Examine All Risk Exposures , and Extreme Conditions and Typical Outcomes ), I try not to wave my arms around about near-term market risks, but I think it’s important to cut straight to the chase here. The present market environment warrants unusual concern, in my view. Based on a wide variety of evidence and its typical market implications over an ensemble of dozens of subsets of historical data, the expected return/risk profile of the stock market has shifted to hard-negative. This places us in a tightly defensive position. This isn’t really a forecast in the sense that shifts in the evidence even over a period of a few weeks could move us to adjust our investment stance, but here and now we observe conditions that have often produced abrupt crash-like plunges. This combination of evidence includes elevated valuations, overbullish sentiment, market internals best characterized as a “whipsaw trap” on the basis of typical follow-through, heightened credit strains, and clear evidence (on reliable forward-looking indicators) of oncoming recession, among other factors.
As always, we try to align our investment positions with the evidence we observe. If the evidence softens, our hedges will soften. While the quickest route to a modest exposure to market fluctuations (perhaps 20-30%) would be a clear improvement in market internals – which could justify a less defensive stance even in the face of recession risks and rich valuations – the most likely route to a significant investment exposure would be a decline to much lower prices and correspondingly higher prospective returns. Presently, avoidance of major market losses takes precedence in our analysis.