John Hussman: "Unpleasant Skew"

John Hussman shares his thoughts that the market is in the final advance of its rally, marked by new, but muted, highs that are "unpleasant" for investors sitting in a defensive position.

With stock market conditions characterized by strenuous overbought conditions, strenuous overvaluation, overbullish sentiment and hostile yield trends, a few features of the present market environment are worth noting. Some of this will be familiar to regular readers of these comments, as they reflect observations that I made the final months of the advance to the 2007 market peak, and over recent months (and for those of you who have been with me that long, during the advance to the 2000 bubble peak).

The first crucial observation is that high risk market conditions like we observe at present come with an "unpleasant skew." If you look at overvalued, overbought, overbullish, hostile yield conditions of the past, you'll find that the most likely market outcome, in terms of raw probability, is a continued tendency for the market to achieve successive but slight marginal new highs. While this movement tends to be fairly muted in terms of overall progress, it can be somewhat excruciating for investors in a defensive position, because the market tends to pull back by a only a few percent, followed by bursts that recover that lost ground and achieve minor but widely celebrated new highs. That is the "unpleasant" part.

The "skew" part is that although the raw probability tends to favor slight successive new highs, the remaining probability tends to feature nearly vertical drops, typically well over 10% over a period of weeks. Frankly, I thought we had begun that process in the decline from the January highs, but much like we observed in early 2007, that initial decline was quickly recovered and followed by a restoration of overvalued, overbought, overbullish, hostile yield conditions. Eventually, of course, the outcome for investors was very bad, but that in no way rescued us from discomfort as the market approached its final peak in 2007. I suspect something similar is at work at present, but we will take our evidence as it comes.

Here and now, it does not matter which "data set" we live in - whether we are presently in a temporary lull prior to a second wave of credit difficulties, or whether we are in a typical post-war recovery, the present set of conditions would hold us to a defensive investment stance.

On the subject of credit conditions, the Federal Reserve was forced last week to reveal the assets that it acquired during the Bear Stearns and AIG bailouts (the "Maiden Lane" portfolios - remember, the ones that Bernanke and Geithner assured Congress were made up of extremely high quality assets on which it would most likely turn a profit?) As Bloomberg reports, it turns out that the assets that can be valued are currently worth between 39-44 cents on the dollar.

My concern is that this is something of a microcosm of the gap between...

Read the whole update from John Hussman, Hussman Funds, April 5, 2010

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