Not Over by a Longshot – September 26, 2011

John P. Hussman, Ph.D.

All rights reserved and actively enforced.

On Friday, the yield on 1-year Greek government bonds closed above 135%. As I’ve noted in recent weeks, the bond markets continue to reflect expectations of certain default on Greek debt. All they are working out now is the recovery rate. As of last week, the expected recovery rate implied by bond prices stands at about 43% of face value. Since Greece is still running a primary deficit (it can’t pay its bills even if debt servicing costs drop to zero), my impression is that the eventual default may be even worse. Still, if I were to venture a guess, it would also be that Greece will be given a small amount of new funding in the coming weeks in order for the government to continue running and delay the inevitable. The reason is that Europe needs time to better prepare for a default, and European leaders appear to be scrambling to get banks to bolster their capital as quickly as possible (somehow investors responded to that news with a short-lived rally last week, as if the need to accelerate the timeline for banks to acquire additional capital is a good thing).

If you’re attentive to how European leaders are phrasing things these days, you’ll notice that (except for officials in Greece) they’ve stopped saying that Greece itself will not be allowed to default, and instead insist that the European financial system and the European monetary union will be defended. While it’s possible that the equity markets will mount a relief rally in the event of new funding to Greece, it will be important to recognize that handing out a bit more relief would be preparatory to a default, and that would probably be reflected in a failure of Greek yields to retreat significantly on that news.

As for the euro itself, we presently estimate the value around $1.42, which wouldn’t change much unless Europe inflates to avoid peripheral defaults. Ultimately, the value of a currency is determined by relative price levels and interest rates (see Valuing Foreign Currencies ). While the euro may come under pressure as default concerns develop, we actually expect the euro to survive among its strongest members, with some fiscally unstable peripheral members exiting and pegging instead. So we’re not particularly compelled by the notion that the euro will collapse if Greece fails, and with European equities looking increasingly reasonable on a valuation basis, we’re inclined to use significant further weakness as a longer-term opportunity. Massive buying of peripheral debt by the European Central Bank would dramatically weaken the prospects for a stable euro, but there seem to be more responsible policy makers overseeing the ECB than we have at the Federal Reserve.

On the bright side, our estimate of the return/risk profile for stocks moved from hard-negative to more moderately negative last week. It’s a start. Undoubtedly, the best chance for a sustained advance (aside from short-term spikes on short covering or bailout hopes) would be for that advance to begin from significantly lower levels. Unless we observe a robust improvement in market internals from current levels, which appears doubtful given further confirmation of oncoming recession, the broad ensemble of data we observe doesn’t offer much latitude to establish a constructive position based on, say, weak technical reversals or other scraps that the markets might toss out in the near term. The first 13 weeks of a recession are among the most predictably hostile periods for equities in the data. We’ll take our evidence as it comes, but the primary risks – recession, default and global credit strains – continue to increase

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via Hussman Funds – Weekly Market Comment: Not Over by a Longshot – September 26, 2011.


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