Hussman Funds 12/10 Semi-Annual Report
For the third time in a decade, the Federal Reserve has embarked on a policy that addresses structural economic problems by provoking speculation in asset prices. The first two attempts were ultimately followed by stock market declines greater than 50% each. As we enter 2011, the stock market remains in what we view as an already strenuously overvalued advance, which has driven our estimates for S&P 500 Index total returns to less than 3.2% annually over the coming decade. My expectation is that this attempt to create what the economist Ludwig von Mises called “illusory prosperity” will end no better than it has in the past. As von Mises wrote in 1931, before the worst portion of the Great Depression:
“Credit expansion cannot increase the supply of real goods. It merely brings about a rearrangement. It diverts capital investment away from the course prescribed by the state of economic wealth and market conditions. It causes production to pursue paths which it would not follow unless the economy were to acquire an increase in material goods. As a result, the upswing lacks a solid base. It is not a real prosperity. It is illusory prosperity. It did not develop from an increase in economic wealth [i.e. the accumulation of savings made available for productive investment]. Rather, it arose because the credit expansion created the illusion of such an increase. Sooner or later, it must become apparent that this economic situation is built on sand.”
None of this, however, implies that a severe market downturn should be expected over the near term. Though it is not possible to rule out a substantial decline in market valuations, our main reason for defensiveness as we enter 2011 is that the market environment is characterized by a syndrome of elevated valuations, overextended price trends, overbullish investor sentiment, and rising interest rates. This combination of conditions typically does not persist for more than a few months, but when the complete set has been observed, the stock market has often been vulnerable to abrupt losses that can erase weeks or months of gains in a few trading sessions.
