January 3

Albert Edwards, SocGen bear, takes a bite out of China. Guardian.

Edwards is thus sticking to two eye-catching predictions. Stock markets will revisit their March 2009 lows (3512 for the FTSE 100). And, despite the hints in recent months of a return of inflation, gilt yields will fall below 2% (from 3.5% today) as deflationary forces reassert themselves. Oh, and for good measure, prepare for the hard landing in China and the crash in commodity prices.

In Edwards' view, China is a "freak economy"; its investment-to-GDP ratio is off the scale in terms of size and endurance. "In development history, Korea is the only one that got close. It then collapsed. China is basing a growth model on the most unstable part of GDP. The Chinese authorities have recognised this and are trying to steer the economy over to consumption – which is fine, but it will take a long time."

The danger, he suggests, is that China has produced such strong growth for such a long time that investors assume the process will last indefinitely. "There is too much confidence in the lack of volatility."....

He and his colleagues (at the French bank Société Générale) have been the top-rated analysts in the "global strategy" category for seven consecutive years, despite being too quick out of the blocks with some of their predictions. "Often the call is right but it is early and the clients know that,"

As his final research piece of 2010 put it: "I've been doing this job long enough to recognise when the markets are entering a new phase of madness that leaves me scratching my head with bemusement. The notion that we are back in a sustainable economic recovery is as ludicrous as it was in 2005-07. But investors are backon the dance floor, waltzing their way towards the next, inevitable implosion, [which] yet again they will no doubt claim in retrospect was totally unpredictable!"

Setup and resolution. John Hussman.

We enter 2011 at a point where investors have pushed risk assets to a speculative extreme, on the belief that the Fed has provided a "backstop" against losses. While there's no assurance that we won't see a further extension of this over the short-term, we've found more often than not that speculative setups in the financial markets are followed by a striking degree of subsequent resolution in the opposite direction....

I still believe that existing post-war data was not representative of what we were observing in 2008-2009, and that significant problems were papered-over instead of resolved. But in hindsight, I was wrong to expect investors to share that assessment. The aversion of investors to risk has vanished, so every concern about risk has been unrewarding. Thanks to a tripling of the Fed's balance sheet, a suspension of fair-market disclosure by major financial companies, and an ongoing Federal deficit of more than 10% of GDP, the economy appears to be slowly recovering, and investors care little about the dangers of the policies that produced that outcome. Though my concerns about other major risks have generally been well placed, to this point, risk aversion has been a mistake....

the stock market remained characterized by an overvalued, overbought, overbullish, rising-yields condition that has historically produced poor average market returns, and consistently so across historical time frames. However, this condition is also associated with what I've called "unpleasant skew" - the most probable market movement is actually a small advance to marginal new highs, but the right tail is truncated and the left tail is fat, meaning that there is a lower than normal likelihood of large gains, and a much larger than normal potential for sharp and abrupt market losses....

The upshot is that there is little historical basis at present to expect positive returns as compensation for accepting risk in stocks, bonds, or precious metals. This will change, possibly soon, but the result of the recent speculative run is that risk premiums have been compressed to levels that have historically been inadequate to compensate for risk.

addendum to Hussman's valuation evaluations of small-caps vs large-caps and the Nasdaq vs SP500:
since 1900, the Q-ratio has only been higher than its current level of 1.14 during one period: 1997-2001