Bear Mountain Bull

John Hussman, on the stock market:

At any given time, there are a good number of historical points where market data have been generally similar in terms of broad valuation and market action, and these references provide specific examples that we can look at as we evaluate the distribution of likely market returns and risks.

In reviewing the status of the market late last week, the condition of the data was something of an anomaly in that regard. On the valuation front, stocks are presently overvalued, but to levels that we’ve observed at least several times in history. The anomaly relates to market action, where we can no longer find a single historical instance where stocks were more overbought on the combination of short- and intermediate-term measures we respond to most strongly. Indeed, only one instance comes close, which is November 28, 1980.

Oh-oh, he used that ‘O’ word…

The anchoring of investor expectations to a period of rich valuations and unusually wide profit margins may not be reasonable, but it prevents any ability to “forecast” a significant near term decline, much less a sustained downtrend. At the same time, we do have sufficient evidence to indicate that market risk is not worth taking on the basis of average outcomes from the combination of valuation and market action we currently observe.

The foregoing should not be interpreted as a “call” or forecast about sustained market direction. Rather, it outlines some of the factors are behind our defensive stance. As always, we align our investment position with the prevailing Market Climate, which does not require large or extended forecasts. I would be less than forthright, however, if I didn’t admit that I suspect the current overbought condition may be cleared somewhat violently.

On the banks:

My impression of the U.S. banking system is that it is quietly going insolvent, in a manner that will become evident only when the slack for “significant judgment” (provided by the FASB earlier this year when it altered mark-to-market rules) is taken up so tightly that the rope snaps. Presently, this slack has allowed banks some time, but the question is, time for what? The rules encourage banks to neither modify loans nor foreclose, both which would trigger a restatement of value on the mortgage asset. Meanwhile, banks are reluctant to allow “short sales” in lieu of foreclosure (where a homeowner sells a home to avoid foreclosure, but at a price less than the residual loan value, so the bank has to essentially eat the loss). This again defers the restatement of asset values for a while, but makes business sense only if home prices are expected to recover faster than the foregone interest that could be earned on new loans.

So if you talk to people who oversee these assets, including people who work with the FDIC, you’ll hear that there is an inventory of unrecognized losses being built up, in hopes that the underlying mortgages will turn around without the need for loss reporting. In view of the CRL foreclosure projections, all we can think is – fat chance.

The FDIC itself is already essentially broke, and is looking at options like taking premium prepayments to try and shore up its own books. Last week, an FDIC spokesman offered the interesting assurance that “our ability to raise premiums essentially means that the capital of the entire banking industry — that’s $1.3 trillion — is available for support.”

So the banking system, which is most likely quietly undergoing its own erosion of capital, can expect to see its capital tapped by the FDIC to pay for, well, the erosion of capital in the banking system. Still, don’t blame the FDIC. Our policy makers bailed out bank bondholders instead of focusing on debt restructuring. The bad assets are still in the banking system, millions of families will still lose their homes, the Treasury and Fed have jointly issued trillions in new government obligations, but the bondholders of Bear Stearns will still get 100% of their principal and interest.

Despite the current enthusiasm of Wall Street, this story has probably not ended, and the evidence suggests it will end badly.