John Hussman’s latest weekly letter contains plenty of meat.
Let’s get right to the key parts, the first of which regards the whole deflation vs. inflation debate:
Over the short and intermediate-term, credit crises are invariably deflationary, because they prompt a frantic demand for default-free government paper, which raises its value relative to goods and services (another phrase for deflation). So despite the huge increase in government obligations during these periods, you generally don’t see inflationary pressures in the early years because that supply is eagerly absorbed. Short-term interest rates are pressed near zero, and monetary velocity tends to collapse. Commodities are usually hard hit as well, so investors who are concerned about inflation risk or are chasing gold here may have the long-term story right, but they probably have it too early to weather the interim volatility comfortably.
Over the long-term, massive increases in government liabilities do have inflationary impact. This imposes a real burden, not simply a paper one. If the holder of government currency can command a certain stock of real goods and services, and then the government debases that currency so that it can command a lesser stock of real output, then it is undeniable that the difference in real value has been implicitly transferred to the government to finance its spending. While I do expect that TIPS, commodity exposure and precious metals will be important inflation hedges in the years ahead, investors chasing these assets here may have a difficult road. It is best to accumulate such assets when they are in liquidation, not when they are being chased on the basis of overly simplistic theories of inflation.
In terms of what we can do to fix things, he argues for the complete repudiation of GSE debt (making it clear that they are no longer wards of the state that will be bailed out by taxpayers), and the “handcuffing” of our top econ leaders:
Meanwhile, I continue to believe that both Bernanke and Geithner’s hands should be tied quickly. If we have learned anything over the past 18 months, it is clear that these bureaucrats can misallocate an enormous quantity of public resources with mind-numbing speed. The diversion of public resources to the bondholders of failing financials – to precisely the worst stewards of capital in society – is not stimulative, but ruthless. A second economic downturn should encourage the repudiation of the policies that Bernanke and Geithner pursued during the first.
And as for the market, well, we’re in the early stages of the fall:
The overwhelming risk at present is that we are in what I’ve called the “recognition phase” where economic reality and earnings guidance deviates substantially from the expectations that have been priced into stocks. Two phases of a market downturn are generally the most hostile. The recognition phase and the capitulation (or “revulsion”) phase. This market is nowhere near completing the shift in psychology that one would expect in a recognition phase, much less a capitulation phase. At worst, we see reports like “A few naysayers are worried about a double dip, but this can be ignored because double dips are rare.” We will be fine, and even willing to shift to a moderately constructive position if we observe a sufficient reversal in market internals and economic statistics. But here and now, the strongest indications are highly defensive, and the required shift in evidence – at least at present – would have to be so broad that it appears unlikely.
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