Alpha Power Investing Newsletter

March 10, 2010

What if Hussman is Right?

According to Dr. John Hussman, the Consumer Price Index (CPI) will double over the next ten years. Hussman, a Ph.D. in economics, runs the Hussman Growth Fund. He thinks that inflation will be non-existent for the next two years, then begin to spiral upward for eight years.

Hussman is, I think, one of the brightest and most enlightened commentators on the economy. He's a good fund manager, too. Most importantly, he's been pretty much on the money on important issues over the past decade. You can read his weekly investment newsletter at www.hussmanfunds.com.

Let's say that he is right. Ten years from today just about everything will cost twice as much as it does now. What do you need to do to preserve the purchasing power of your investment portfolio?

Well, we know that your portfolio will need to grow at a nominal, after-tax rate of 7.2% annually starting today. That return keeps you even - no real growth comes from it. To get a real growth rate of 5%, you'll need a nominal return of 12.2% (after taxes) annually over the next decade.

Bonds, of course, will be "out". At some point in this cycle, long-term bonds will become a losing proposition as interest rates begin to rise. Short-term bonds will pick up the higher rates, but with a significant lag both in terms of time and rate level.

Hard assets will be "in". Precious metals, real estate and commodities, along with their related securities, will be the winners. Today's debtors (including the government) will be made whole as the value of debt is cut in half. Conservative savers will be robbed as the purchasing power of their low-yielding savings accounts goes down.

Theoretically, it should not make a difference for the stock market. In a high inflation economy, companies raise prices and margins remain the same. Unfortunately, the investing public doesn't see it that way. Inflation is confusing - it adds an element of uncertainty which causes investors to de-value stocks. During the inflation of 1966-1981, the valuation of the S&P 500 went from 22x earnings to less than 7x, over 17 years. Stock prices were flat for almost two decades, until Paul Volcker took over the Fed.

If Hussman is right, one thing is abundantly clear: the conventional 60/40 balanced portfolio will be ravaged. It can get pretty ugly when both stocks and bonds are losing real value.

I hope Hussman is wrong, but if he isn't, investors will have to shed the buy and hold conventional wisdom in order to succeed in preserving their wealth. The likelihood of this happening is quite low because the investment advisory industry is still dogged in its support of the Efficient Market theory, which states that it is impossible to find a reliable tactical alternative to indexing. This is based on the claim that at any point in time the market price incorporates everything that is known.

This theory treats the market price as if it were determined solely by rational, calculating machines. In fact, the market price incorporates the entire human spectrum - what is known, what is believed, what is felt, what is fantasized, what is feared, hoped for, imagined, etc. The market is often wildly irrational - perhaps mostly so - especially on a short-term basis. As Warren Buffet put it, "In the short-term the market is a voting machine; in the long-term, a weighing machine."

Looking at the market as an emotional, irrational arena opens up tactical investment strategies based on predictable changes in investor psychology. Alpha's Mid-Cap Power Index strategy does just that. You can find it at the Programs section of our website.

Sincerely,
Jerry Minton, Ph.D.
President



© 2010 Alpha Investment Management Inc.

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