Hussman Sees Trouble Ahead

Stocks and the dollar could see "abrupt weakness."

By SHARE

John Hussman of the Hussman Funds says we're again seeing disagreement among optimistic stock investors and the reality of ongoing troubles in credit markets. If markets finally get that we're in a significant recession, a drop in stocks could come with little warning.

From his latest commentary (Bold is mine):

The stock, bond and foreign exchange markets continue to trade essentially on the theme that the global economy is weakening, but that the U.S. has dodged a recession. This strikes me essentially as an artifact of lagging indicators such as the unemployment rate (on which the full force of the current economic downturn has yet to be felt) as well as various coincident indicators such as the ISM survey and capacity utilization, which are still hovering at tepid levels without clearly breaking down.

I'll emphasize again that at the point we do observe sufficient evidence for investors to concede recession, the potential downside could be abrupt, leaving little opportunity to make defensive changes after the fact. As I've often said, the best time to panic is before everybody else does.

That complacency, he says, comes in part from investors who believe the government will step in to fix problems after watching the Fed and Treasury bail out Bear Stearns and prop up Fannie Mae and Freddie Mac.

Snip: There is a relative complacency in the stock market because investors are still convinced that the extreme "tail risk" in the markets has been removed by the Federal Reserve and the U.S. Treasury.

As for the markets right now, he's worried that widening credit spreads portend more defaults, and says stock traders are ignoring the amount of risk out there indicated by the still-ailing credit market.

Years ago, Larry Williams used to look for a situation he called the "Jaws of Death"—noting that when bond prices were weakening but stock prices were strengthening, the two differing trends opened a set of "jaws" that tended to snap shut, usually due to abrupt weakness in stocks.

He points to expectations for lower volatility in the stock market (measured by the VIX index) at a time when credit markets are getting more worried. See the chart below:

Those jaws could be setting markets up for a tough reckoning. Let's give Hussman the last word:

In short, the markets are presently trading on a theme that largely overlooks the potential (and in my view, the reality) of a significant U.S. recession. At the point of recognition, we may very well observe abrupt weakness in both stock prices and the U.S. dollar.