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September 18, 2006

A House Built on Sand

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

Wall Street analysts and business reporters remain enthusiastic about the idea that a slowing economy will slow inflation, that profit margins will remain high (despite evidence of rising wage pressures) and that a Federal Reserve “on hold” will translate to higher valuations. Last week's inflation data was clearly hostile on import prices (+0.8%) and export prices (+0.4%), but “in-line” for the CPI (+0.2%). No positive surprises, but the benign CPI number did buy some time for the “Goldilocks” crowd. Until the data counter the “inflation has turned” thesis (which I expect, but our investment stance does not require), we have to allow for the possibility that investors might speculate on hopes of a “soft landing.”

That said, however, there's presently no evidence in the quality of market action that investors have adopted a robust speculative mood. Good investments are those based not on hope, but on some foundation of evidence – either of reliable “investment merit” (based on properly normalized valuations), or of measurable “speculative merit” (based on the quality of market action). Taking a significant exposure to market risk without such foundations is like moving into a house built on sand.

The NYSE registered 193 new highs on Friday. This was fewer daily new highs than we observed two weeks ago, and less than half the number registered in early May. Weekly new highs also fell far short of the April-May period. Despite the recent advance in the major indices, the Dow, S&P 500, Nasdaq and Russell 2000 all remain below their April-May highs. Since early April, when our measures of market action shifted from neutral to unfavorable, the S&P 500 has delivered a total return about equal to the return on risk-free Treasury bills (within a fraction of 1%). This simply is not a market that is “running away,” but rather one that is range-bound and now strenuously overbought.

Even outside of our own measures of market action, the weakness in investor sponsorship here can be seen in generally followed indicators. Lowry's, for example, observes that trading volume has fallen off substantially as the recent rally has progressed, while the apparently strong breadth of the NYSE has been driven mostly by interest-sensitive stocks.

While the link between trading volume and subsequent market action is not reliable as a single indicator, trading volume has a very useful role in either confirming or diverging from the indications given by prices, breadth, and other internals.

The chart below depicts the 30-day average of NYSE up-volume plus down-volume. It's long been observed that trading volume often precedes price, and that advances on dull volume are often suspect, because they indicate a lack of legitimate investor interest and instead indicate a “backing off of sellers.” Short-covering rallies, for instance, typically become low-volume moves fairly quickly. Presently, the dropoff in trading volume is the sharpest we've seen in a year, and matches the dropoff in volume that led into the spring 2005 market decline. Again, the correlation between volume and subsequent market fluctuations isn't strong in and of itself, but large divergences between volume and price action generally warrant attention.

The next chart depicts market breadth on two measures. The violet line shows the overall NYSE advance-decline line. The blue line is the NYSE advance-decline line restricted to common stocks (excluding preferred stocks, which behave essentially like bonds). Notice that in recent weeks, the recovery in common stocks has been very muted. This is also evident in the advance-decline profile of other exchanges.

In short, despite the enthusiasm about a “soft landing,” the recent advance has been selective and on deteriorating volume. This doesn't suggest very strong investor sponsorship at present.

If the quality of market action improves, we'll quickly shift our investment position by removing a portion of our hedges, but with neither investment merit from favorable valuations, nor speculative merit from favorable market internals, we remain defensively positioned. As frustrating as it can be to stand aside during a short-term market advance, we don't have enough evidence to risk shareholder capital in a market lacking any reliable underpinning, other than an uncompelling hope that unusually wide profit margins will persist and that rich valuations will become richer if the Fed stays on hold.

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 position. Again, we'll quickly remove a portion of our hedges if market action provides evidence of more robust investor sponsorship.

Presently, the market remains in an unfavorable Market Climate, and is once again strenuously overbought. That creates a greater likelihood of short-term weakness than usual, but Tuesday's PPI report (as well as housing starts) and the Fed statement on Wednesday will have a lot of influence this week. As usual, there's no need to make forecasts – the Market Climate remains unfavorable at present, and we'll shift our investment stance when the observable evidence shifts. Importantly, despite the recent bounce in the market, that evidence remains unfavorable for now.

In bonds, the Market Climate remained characterized last week by modestly unfavorable valuations and relatively neutral market action, holding the Strategic Total Return Fund to a relatively short 2-year duration, mostly in Treasury inflation protected securities. The Fund's exposure to precious metals shares was boosted slightly, toward 20% of assets, on price weakness in that group last week.

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