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June 12, 2006

Ben Bernanke and Meat Powder

John P. Hussman, Ph.D.
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Ivan Pavlov was an accidental psychologist. The Russian scientist was actually interested in stomach ailments and the digestive systems of dogs. In order to study their saliva, he would offer them meat powder. At one point, Pavlov noticed that some of his dogs would start to salivate as soon as he walked into the room, but it only happened with dogs that had been in the laboratory. So he paired a bell with the meat powder, and showed that after a while, the dogs could be made to salivate just by ringing the bell.

Investors who experienced the 1987 market crash might remember that for months after that event, the market would get extreme jitters every time the trade balance was about to be released. The reason is that when the market crashed, investors and journalists looked for the news of that specific day to explain the move, and all they could find was a bad trade number. And just like pairing meat powder with a bell, pairing the market crash with a bad trade number made investors hypersensitive to trade numbers for months.

Investors are now pairing Ben Bernanke with the market's recent weakness as if they are legitimate cause and effect. Don't blame Bernanke. Make no mistake – the recent pullback has little to do with the Federal Reserve except that it creates enough of an excuse for the inevitable to happen. Are we actually to believe that the economy is so precariously perched on pins and needles that one single quarter-point move too-many in the Fed Funds rate means the difference between a continued economic “boom” and an economy driven to its knees? And if the economy is in fact that vulnerable, shouldn't investors be selling stocks anyway based on the prospective risks?

Look. Probable market weakness has been baked into the cake for months – resulting from a combination of unfavorable valuations, weakening internals, and speculation in low quality stocks. Nor does the historically insignificant wiggle that we've seen in the past few weeks do much to resolve those issues. That doesn't mean that stocks should or must decline in the immediate future, but it does mean that the problems for the market (being, as it is, still priced to deliver disappointingly low long-term returns) remain yet be resolved. (There's that “yet” word again).

Personally, I feel a little bad for Bernanke – though as I noted in the October 31, 2005 comment, he more or less invited all of this criticism by focusing on an inflation target which can't, in fact, be controlled by the Fed, and can only be measured effectively with a lag. Remember that the Fed does nothing except determine whether government liabilities will be held by the public in the form of bonds or in the form of cash (currency and bank reserves). The actual quantity of those government liabilities is not under the Fed's control, but is controlled by Congress through its fiscal policies. If fiscal policy makers insist on creating a flood of government liabilities (as they currently are), the Fed's decisions will have extremely little importance or impact in avoiding the resulting inflation. The Fed's policies are important when there is a panic for liquidity, such as bank runs and financial crises, but unless bank liquidity is actually constrained (and it doesn't appear to be presently), the Fed's moves are largely irrelevant.

So it's important to recognize that the economy just isn't that sensitive to little moves in a short-term, Fed controlled interest rate on bank reserves that back an insignificant portion of total lending activity (see Why the Fed is Irrelevant). The economy may very well be in for trouble (credit spreads are just starting to widen, consumer confidence spreads show sudden weakness in future versus present conditions, aggregate weekly hours are stalling, etc.), but though Bernanke may be used as an excuse, he really isn't going to be the cause, regardless of what the Fed does next.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully hedged investment stance.

As usual, our own investment approach doesn't focus much on identifying bull or bear markets (which can only be identified in hindsight), but instead focuses on prevailing, identifiable conditions of valuation and market action. For what it's worth, unfavorable Market Climates have a clear, but far from perfect overlap with periods that turn out to be “bear markets” in hindsight. Unfavorable Market Climates do tend to cover the worst portions of most bear markets, as well as periods within bull markets that were negated by abrupt weakness, which is important.

Given the present constellation of market and economic conditions, if I was to venture a guess, I'd guess that stocks have entered a bear market here. That opinion doesn't drive our actual investment stance, and we'll accept an exposure to market fluctuations on any significant improvement in valuations or market action, but I certainly would not rule out the potential for substantial further market weakness just because stocks are down a little bit from their highs. Nor, however, should we be surprised by a “fast, furious, prone-to-failure” rally to boost short-term hopes to the contrary. We're fully hedged regardless.

What?!! How can I even mention the notion of a bear market when we're so “clearly” oversold and close to a bottom? Well, the S&P 500 is only down about 5.5% from its peak of a few weeks ago, and it's precisely the “fast, furious, prone-to-failure” rallies that keep investors holding on until an enormous amount of damage is done. As I've noted before, bear market psychology typically evolves something like this:

"This is my retirement money. I can't afford to be out of the market anymore!"

"I don't care about the price, just get me in!!"

"It's a healthy correction"

"See, it's already coming back, better buy more before the new highs"

"Alright, a retest. Add to the position - buy the dip"

"What a great move! Am I a genius or what?"

"Uh oh, another selloff. Well, we're probably close to a bottom"

"New low? What's going on?!!"

"Alright, it's too late to sell here, I'll get out on the next rally"

"Hey!! It's coming back. Glad that's over!"

"Another new low. But how much lower can it go?"

"No, really, how much lower can it go?"

"Sweet Mother of Joseph! How much lower can it go?!?"

"There's no way I'll ever make this back!"

"This is my retirement money. I can't afford to be in the market anymore!"

"I don't care about the price, just get me out!!"

In bonds, the Market Climate was characterized last week by relatively neutral valuations and relatively neutral market action. This somewhat unenthusiastic picture is actually an improvement, and I would be inclined to increase our portfolio duration in the Strategic Total Return Fund (currently at about 2.5 years) on further bond price weakness, continuing to focus, for now, on Treasury inflation protected securities.

Upward inflation surprises continue to prevail, while negative economic surprises have also emerged, creating a predictable picture of “stagflation” that is somewhat confusing to investors conditioned to believe that economic growth is inflationary and economic weakness is deflationary. Inflation is essentially a problem of growth in government liabilities that exceeds the willingness of the public to hold them. In recent years, we've been bailed out by the huge appetite of foreigners for those liabilities, so we've been able to run huge fiscal deficits and deep current account deficits without consequence. That's not likely to continue. In an environment where fiscal policy creates an excessive stock of government liabilities, and foreign accumulation of those liabilities slows (as happened after the collapse of Bretton Woods in the 1970's and is beginning to happen today with respect to foreign central banks like China and Japan), dollar weakness and inflation, coupled with weak economic growth, is not a contradiction but a predictable outcome.

What helps the inflation picture in that event is not weak economic growth, but enough credit problems that investors begin to seek the safety of government liabilities (cash and Treasury securities) as havens from default risk. We're not quite there yet, so the environment continues to favor a combination of positive inflation surprises and negative economic surprises. But at the point where credit spreads begin to widen considerably (the difference between corporate yields and Treasury yields), we'll probably have a reasonably good opportunity to increase our maturity profile in straight Treasury bonds. For now, the Strategic Total Return Fund continues to lean toward the inflation-protected variety.

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