The DJIA is down 225 points today and economist John Hussman says that investors have good reason to be so gloomy. According to Hussman, the deteriorating credit environment is due to give investors a very rude awakening. Widening credit spreads often precede big sell-offs, and Hussman argues that the best time to panic is before everyone else does, i.e., yesterday. Hussman:
Among the factors that concern me here is the continued widening of credit spreads, which increasingly suggests that default risk may be starting to spread beyond the financial sector into the broader economy. Meanwhile, 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.
Of particular concern to Hussman is the growing gap between declining volatility, as measured by the Chicago Board Options Exchange Volatility Index (VIX) and the spread on 5-year treasuries. When this gap grows too large, it signals a disconnect between an overly-optimistic equities market and real risk as measured by credit spreads. Hussman:
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. On that note, Bill Hester sent a chart over the weekend noting “I thought this was an interesting graph. The blue line is the 5-Yr Swap Spread, and the red line is the VIX. Credit investors are getting very nervous while equity investors are mostly whistling Dixie. It looks like a variation on the jaws of death that you’ve mentioned to me before….” Nothing like a good picture to complete the story (thanks Bill)
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.
Translation: Be aftraid. Be very afraid.
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