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Hussman Weekly: Confidence and Enthusiasm

August 20, 2012

The present confidence and enthusiasm of investors about the ability of monetary policy to avoid all negative outcomes mirrors the confidence and enthusiasm that investors had in 2000 about the permanence of technology-driven productivity, and in 2007 about the durability of housing gains and leverage-driven prosperity. Market history is littered with unfounded faith in new economic eras, and hopes that “this time is different.” Those periods can be difficult, at least for a while, for investors who are less willing to abandon evidence and lessons of history, not to mention basic principles of economics and valuation. We endured similar discomfort in periods like 2000 and 2007, before hard reality set in.

Investment notes

The recent market cycle has required two changes to our hedging approach. One was in 2009, when our existing approach was dramatically ahead of the S&P 500, but I insisted on making our methods robust to the worst of Depression era data. The other was earlier this year, when we imposed criteria to restrict the frequency of defensive “staggered strike” option positions in Strategic Growth Fund, requiring not only strongly negative expected returns, but also either unfavorable trend-following measures or the presence of unusually hostile indicator syndromes. There’s little doubt that massive central bank interventions have pushed off economic and market difficulties that might have occurred more quickly. The tighter criteria help adapt to that reality, without foregoing the benefit that defensive option positions would have historically had over the course of the market cycle.

These hedging changes would clearly have altered many of our investment positions during the most recent cycle, particularly during the 2009-early 2010 period, but would not alter the strongly defensive position we’ve maintained since early March (see Warning: A New Who’s Who of Awful Times to Invest). Based on a blend of investment horizons from 2 weeks to 18 months, we presently estimate the prospective return/risk profile of the market as being among the most negative 0.5% of historical instances. On the technical front, the S&P 500 is either at or just short of its upper Bollinger band on nearly every resolution (daily, weekly, monthly), while numerous divergences are already in place, including the failure of many sectors and indices to confirm the recent high.

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