Panic Sufficiently Before Everyone Else Does

“panic sufficiently before everyone else does”
John Hussman

I have been asked to translate “Extraordinarily Large Band-Aids,” an article written by the very erudite fund manager, John Hussman into English. This will not be an easy task. In a sentence, Hussman believes that in the remainder of 2010 there is an 80% chance for a major drop in all stock market indices and a double dip in the recession. His worries stem from an exceedingly rare combination of negative indicators. He recommends that even buy and hold investors should consider altering their strategy by lowering their exposure to market risk in small steps. In other words, he advises the individual investor to start moving out of stocks and into bonds and cash. The exception to this rule would be precious metals. Here he recommends building a small position. He is not recommending short selling or other forms of “bearish speculation” even though he is limiting risk to his own fund by a option strategy that is somewhat similar to short selling with a small guaranteed return (similar to interest from a bond) no matter how the market actually moves.

Hussman is frightened by what he perceives as an unreasonable overvaluation of stocks by the markets, combined with very bad technical indicators, persistently high unemployment, irresponsible behavior by the world’s governments, and a large unaddressed overhang of bad debt that needs to be repudiated or restructured since it will never be repaid.

Currently the Government’s four week moving average is reporting about 468,000 new unemployment claims. Hussman believes this to be the single most useful unemployment statistic. In a “flat” condition in which no net new jobs were either created or destroyed, the four week moving average would be expected to run between 400,000 and 425,000. Therefore, even with a significant spike due to the creation of a large number of temporary census jobs, the country is experiencing a net loss of more than 40,000 jobs per week. Remember, due to an increasing population, the U.S. requires a growth of approximately 120,000 new jobs a month just to stay even.

Hussman considers the rescue of Greece, bad banks, Hungary, Spain, General Motors, Fannie Mae, and Freddie Mac by the governments of the developed world to be reckless and irresponsible. At these levels (multiple trillions of dollars), he views using more debt to cover existing bad debt as simple, unsustainable insanity. Also, he considers the moral hazard associated with rescuing rich irresponsible bankers and nations with tax revenue taken from hard working, responsible citizens to be morally repugnant.

He points out that while hope generated by government stimulus packages are the only possible reason the markets have been on a tear from March 2009 until May 2010, they are not producing the desired increase in the Gross Domestic Product. In fact the current level of GDP growth excluding Federal Deficit Expenditures, although improved since the depths of the current Great Recession is still at the second lowest level since 1961.

To better understand Hussman’s technical concerns, I read his article from May 24 as he does not detail these factors in his current post. In mid-May Hussman observed a rare collapse in market internals. The number of declining stocks compared with the number of advancing stocks was at a historically high ratio. This was combined with a “leadership reversal” in which the number of new 52 week lows exceeded the number of new 52 week highs. These two events have only simultaneously occurred 19 times in the last 50 years. Following such an event, on average, the S&P lost another 7% within 12 weeks and 20% within the next year.

To protect himself and his investors from these potential risks, Hussman indicates his largest single position is in 3 to 4 year treasuries. As mentioned earlier he is building a 4% position in precious metals and a similar position in foreign currency (although he does not state which foreign currencies). Given his opinion of European policy, I believe we can safely assume he is not buying Euros. In addition, Hussman is “hedging” his fund’s positions in the S&P and similar indices by writing calls and buying puts.

Hussman states, “The Strategic Growth Fund remains fully hedged. A few side notes - when the long put / short call combinations we use to hedge have the same strike price and expiration, as our S&P 500 combinations do, the combination behaves as an interest bearing short sale on the underlying index, regardless of the level of implied volatility.”

I will not pretend I understand what he is doing, as I am still working up the nerve to write some covered calls on my own portfolio. However, let me add this basic information courtesy of liffe.optioneasy.com.

Writing a call or what is sometimes called a short call assumes:

1. belief that stock will fall (bearish outlook);
2. maximum reward limited to premium received;
3. risk potentially unlimited (as stock price rises); My note: this is only true if the option is not covered.
4. can be combined with another position to limit the risk.

Buying a put or what is sometimes called a long put

1. belief that stock will fall (bearish outlook);
2. risk limited to premium paid;
3. unlimited maximum reward up to the Strike Price less the premium paid.

And, Please! Please! Please! Let’s be careful out there.