I like John Hussman.  He does truly brilliant analysis of the stock market.  But at the root of it, he misses a key point that has compromised his investment record.  He’s hardly unique in that respect; if it looks like I’m singling him out here, if anything it’s because his equity analysis is so deep you’d think he couldn’t have missed anything.

The problem lies in treating stocks as securities that are the object of analysis while the metric the whole analysis is based on is itself a security that escapes an analogous scrutiny.  You can be in or out of the market, or somewhere in between.  The reality is however that it’s not a choice of being in or out of securities.  Even if you are 100% in cash you’re still invested in securities.  They’re simply a different kind of security.

If for example you buy shares of Apple you own securities issued by the corporation known as Apple.  If you sell them, you haven’t exited the securities market though, you’ve simply traded them for securities issued by the Federal Reserve.  You can perform an in depth analysis of the securities issued by Apple, but if you don’t compare them on an apples-to-apples basis with the alternative, you’ve only done half your homework.

Hussman chalks up his failure to catch the enormous upwave in stocks out of 2009 to a failure to appreciate the investorate’s capacity for speculation in the face of zero interest rate policy.  What this boils down to though is that investors weren’t so much speculating in stocks as they were fleeing the dollar.  It was more flight to safety than risk seeking.  Investors were behaving perfectly rationally in preferring a more attractive yield on one set of securities to a less attractive one on another, and one whose issuer was determined to depreciate.  Like most conventional analysts, Hussman assumes that owning the security issued by the Federal Reserve is being “out of the market”.  It’s not … it’s just being in a different market.

It’s an easy mistake to make if for no reason than the depreciation of the dollar appears first in the securities markets.  Only later does it begin to spill over into the realm of goods and services.  But once grasped, it’s clear that no analysis is complete without acknowledging that the real investment choice isn’t to invest or not, but what to invest in.

The tricky part is this.  Stocks provided a hedge against inflation, but you had to be in the stocks before it showed up in consumer prices to benefit.  In other words they’re only effective as an inflation hedge ex ante.  As is the case currently, by the time consumer price inflation is making headlines, it’s time to sell.