No Such Thing As Risk? (Hussman)

Monday, July 30th, 2012

by John Hussman, Hussman Funds

The enthusiasm of investors about central-bank interventions has reached a pitch that is already well-reflected in market prices, and a level of confidence that with little doubt, investors will ultimately regret. In the face of this enthusiasm, one almost wonders why nations across the world and throughout recorded history have ever had to deal with economic recessions or fluctuations in the financial markets. The current, widely-embraced message is that there is no such thing as an economic problem, and no such thing as risk. Bernanke, Draghi and other central bankers have finally figured it out, and now, as a result, economic recessions and market downturns never have to happen again. They just won’t allow it, printing more money will solve everything, and that’s all that any of us need to understand. And if it doesn’t solve everything, they can just keep doing more until it works, because there is no consequence to doing so, and all historical evidence to the contrary can finally, thankfully, be ignored. How could anyone ever have believed, at any point in history, that economics was any more complicated than that?

Unfortunately, the full force of economic history suggests a different narrative. Up to a certain point, which seems to be about 100-120% debt-to-GDP, countries can pull themselves from the brink of sovereign crisis through a combination of austerity (spending reductions), restructuring (putting insolvent financial institutions into receivership and altering the terms of unworkable private and public debt), and monetization (relief of government debt through the permanent creation of currency). Austerity generally reduces economic growth (and corporate profits) in a way that delivers less debt reduction benefit than expected, restructuring is often stimulative to growth because good new capital no longer has to subsidize old misallocations, but is politically contentious, and monetization of bad debt produces clear but often quite delayed inflationary pressures. None of these choices is simple.

Moreover, once countries have created massive deficits and debt burdens beyond about 120% of GDP – typically not to accumulate of productive assets and investments that service that debt, but instead to fund consumption, bail out insolvency, and compensate labor without output – austerity produces further economic depression, restructuring becomes disorderly and produces further economic depression, and attempts at monetization tend to be hyperinflationary.

Europe is fast approaching the point at which every solution will be disruptive, and remains urgently in need of debt restructuring, particularly across its banking system. It is a pleasant but time-consuming fantasy to believe that governments that are already approaching their own insolvency thresholds can effectively bail out a banking system that has already surpassed them. To expect the ECB to simply print money to solve the sovereign debt problems of Spain, Italy and other members is also dangerous. This hope prevents these nations from taking receivership of insolvent institutions now, and allows them to continue to operate in a way that threatens much more disorderly outcomes later. The reality is that Europe is not a unified economic and political entity with a single national character and obligations that are mutualized among its members. It is instead a geographic region where the economic, political and cultural differences remain very distinct. While each country is willing to cooperate in setting common rules and practices that are to their own benefit, they are unlikely to cooperate when it comes to decisions that require the stronger economies to interminably subsidize the insolvent ones through direct fiscal transfers or permanent money creation that has the same effect.

With regard to last week’s ebullience over the possibility of ECB buying of sovereign debt, my concern continues to be the danger of assuming that a solvency problem can simply be addressed as a liquidity problem. If the European Central Bank buys Spanish or Italian debt in volume, there is very little likelihood that it will ever be able to disgorge this debt. This is because: any eventual ECB sales of debt holdings – or failure to roll those holdings over – will have to be offset by private demand in the same amount, when Spanish and Italian debt/GDP ratios are unlikely to be smaller; the European banking system is already largely insolvent, and; the European continent is already in recession, which means that the volume of distressed sovereign debt is likely to expand even beyond the reasonable capacity of the ECB to absorb it. So major ECB purchases would effectively amount to money-printing, and Germany, Finland and other countries in opposition are fully aware of that. Reversible liquidity operations may be monetary policy, but non-reversible money-printing is quite simply fiscal policy.

For a review of some of the issues the ECB faces, see Why the ECB Won’t (and Shouldn’t) Just Print. In evaluating the repeated assurances that emerge out of Europe, keep in mind that details matter. For example, the phrase “Germany is prepared to do everything that is necessary to defend the Euro” has repeatedly meant “everything that is politically necessary” and “everything that is legally required.” It has also been demonstrated again and again that Germany (among other stronger European countries) has no intention of allowing a blank check for direct EFSF or ECB bailouts without a change in the EU law that imposes a surrender of fiscal sovereignty and centralized fiscal control of Euro member countries. Following Thursday’s assurances by ECB head Mario Draghi to protect the Euro (just after Germany’s Angela Merkel left on a hiking trip), it took until Saturday for the German finance minister to step into the void with the predictable, “No, these speculations are unfounded.” It was widely reported that Germany again tossed out the “everything that is necessary” bone on Sunday, but one had to read the French dispatch to find that this accord referred to nothing but an agreement between Germany and Italy to do everything necessary to quickly implement June’s plan for a plan to establish a centralized banking regulator: l’Allemagne et l’Italie sont d’accord pour “que les conclusions du conseil européen des 28 et 29 juin soient mises en oeuvre aussi rapidement que possible.”

In the U.S., quantitative easing has had the effect of helping oversold financial markets recover or slightly surpass the peak that the S&P 500 Index achieved over the preceding 6-month period, but there is much less evidence that it will do much for the financial markets when prices are already elevated and risk-premiums already deeply depressed (see What if the Fed Throws a QE3 and Nobody Comes?). The upper Bollinger band of the S&P 500 on both weekly and monthly resolutions is at about 1430. That level represents our best estimate for the market’s upside potential in the event that the Federal Reserve initiates a third program of quantitative easing. Given that our economic measures continue to indicate that the U.S. has entered a new recession, it is not clear that another round of QE will even achieve that effect.

In the event that another round of QE has a greater or more durable effect, we’ve introduced enough additional constraints on our staggered-strike hedges that we wouldn’t expect the decay in option premium that we experienced during QE2. The market reestablished an “overvalued, overbought, overbullish” syndrome last week, so another round of QE is unlikely to move us to a significantly constructive investment stance as long as that syndrome is in place. Still, we don’t expect to move our strike prices higher in the event of further improvement in market internals, so the “tight” character of our present hedge will moderate in the event the market advances from here. Suffice it to say that I’m not worried that another round of QE will create difficulties for our approach, though it should also be clear that such an event wouldn’t automatically prompt us to shift to a bullish investment stance.

What worries me most

Investors sometimes ask what I worry about most from the perspective of our investment strategy. Do I worry that the Fed will initiate another round of QE and distort the markets to such an extent and duration that our approach will not capture new realities? Do I worry that government interventions have created a world where old economic rules and relationships no longer apply? Do I worry about the quality of government statistics or the potential for misreporting or seasonal adjustment distortions in the data we use? The answer is that all of these issues can exert a short-run influence on the course of our investment approach, but none of them alter the relationship between valuations and long-term returns, and I don’t expect any of them to significantly reduce the effectiveness of our strategy over the complete market cycle.

As I noted as the market approached its highs a few months ago, what I worry about most is that conservative investors will become impatient with maintaining a defensive position in a dangerous and elevated market – not because investment prospects have materially improved, but simply because short-lived runs of speculative relief seem too enticing to miss. Volatile but ultimately directionless periods of elevated valuations, as we saw in 2000-early 2001, 2007-early 2008, and which we’ve observed since April 2010, tend to exhaust defensive investors and encourage complacency toward market risk at the worst possible time.

Certainly, for our shareholders in Strategic Growth Fund, I’ve compounded this impatience, because our “miss” in 2009-early 2010 – which I would not expect to be repeated in future cycles even under identical conditions – blends in with our defensiveness since early-2010, which aside from a few differences related to option positions, I would expect to be repeated in future cycles under identical conditions. The result is one long period of defensiveness, which understandably leaves those unfamiliar with that 2009-early 2010 period with the assumption that our approach will never be constructive.

I view these weekly comments as something of a conversation with shareholders, so I do my best to address questions that come up more than once or twice in a short period of time. In Strategic Growth Fund, understanding performance in recent years is one of those questions, so I ask the indulgence of shareholders who have walked through this discussion before, and I hope that the comments are useful even for those that have. Thanks.

Let’s first address the period since early 2010. Given the policy of central banks in recent years to provide what amount to free put options to investors, there are certainly ways we could have saved a few percent in actual put option premium (incorporated in our present methods as added criteria related to trend-following measures). But the fact is that the S&P 500 Index was within 5% of its April 2010 peak only a few weeks ago, and there remains a strong risk that the market will move significantly below that level in the months ahead. From a historical standpoint, the conditions we’ve seen since early-2010 have warranted a generally defensive position, and the negatives have accelerated significantly in recent months. We would expect to adopt a similarly defensive position again in future cycles under the same conditions. The only way to get around that would to be to take actions that would have produced significant losses if they were taken regularly on a historical basis.

Unfortunately, the warranted and repeatable defensiveness we’ve adopted since 2010 blends in with a non-recurring intervention during 2009-early 2010 (which I discussed regularly during that period) to ensure that our hedging approach was robust to Depression-era data.

Recall that this intervention was not driven by any problem with the performance of our investment approach. Indeed, by the beginning of 2009, a dollar invested in Strategic Growth Fund at its inception in 2000 had grown to about four times the value of the same investment in the S&P 500 Index. The Fund was ahead of the S&P 500 at every standard and non-standard investment horizon, with dramatically smaller losses. For example, from the 2007 stock market peak, the S&P 500 Index had suffered a peak-to-trough loss of 55.25%, while the deepest loss experienced by Strategic Growth Fund was 21.45%. To put that difference in perspective, note that simply moving from a 55.25% loss to a 21.45% loss requires an offsetting recovery of 75.53%. It takes extraordinary good fortune to recover from deep drawdowns, which is why we make such an effort to avoid them.

Still, as the credit crisis worsened in 2009, it became clear that both the economy and the financial markets were behaving in ways that were “out of sample” from the standpoint of the post-war data on which our existing return/risk estimates were based. That kind of situation demands stress-testing; a concept that too few investors take seriously until it’s too late. I took our existing approach to Depression-era data and found that though it performed reasonably well over the full period from a return perspective, it also allowed a number of very deep interim losses before recovering. Even though our approach had performed well, a Depression-like outcome could not be ruled out (and to some degree still can’t), so I insisted that our methods should be robust to “holdout” data from both the Depression era and the post-war period. I discussed that challenge repeatedly in the weekly comments and annual reports as our “two data sets” problem. We reached a satisfactory solution in 2010 through the introduction of ensemble methods in our hedging approach. But by that point, we had also missed a significant market rebound.

The result has been my elevation to the title of Permabear, Doomsayer, and other lovely aliases. It’s kind of tragic that I both lessened my reputation and missed returns for shareholders – though I expect only temporarily – because of what I viewed (and continue to view) as fiduciary duty. At least shareholders can be sure that I’ll never knowingly lead them down a rabbit hole. While we have – apart from the most recent cycle – been successful in strongly outperforming the market over complete cycles (bull-peak to bull-peak, bear-trough to bear-trough) with substantially smaller drawdowns, it’s important to recognize that we do have a much greater tolerance for tracking differences versus the S&P 500 over the course of the market cycle than some investors can accept. Our investment approach is simply not appropriate for those investors. Significant tracking differences will occur again and again over time, because they are inherent in our approach, particularly in the richly-valued portion of a given market cycle.

Meanwhile, I’m confident that that our stress-testing miss during the most recent cycle (which works out to a cumulative lag of just under 13% over the peak-to-peak market cycle from 2007-2012) is something we can more than offset in future cycles. Also, given our willingness to remove the majority of our hedges in early 2003 at valuations that were in no way compelling from a historical standpoint, it should be clear that we don’t require Armageddon to adopt a constructive or even aggressive investment stance.

So what do I worry about? I worry that investors forget how devastating a deep investment loss can be on a portfolio. I worry that the constant hope for central bank action has given investors a false sense of security that recessions and deep market downturns can be made obsolete. I worry that the depth of the recessions and downturns – when they occur – will be much deeper precisely because of the speculation, moral hazard, and misallocation of resources that monetary authorities have encouraged. I worry that both a global recession and severe market downturn are closer at hand than investors assume, partly despite, and partly because, they have so fully embraced the illusory salvation of monetary intervention.

Market Climate

Our measures of prospective stock market return/risk deteriorated slightly last week, from the most negative 0.8% of market history, to the most negative 0.6%. These are minor distinctions, of course, but it is important to emphasize how rare and negative present conditions are from a historical standpoint. I recognize that many analysts consider stocks to be cheap on the basis of “forward operating earnings,” but I continue to believe that the 50-70% elevation in profit margins relative to historical norms is an artifact of extreme deficit spending and depressed savings rates, and that as a U.S. recession unfolds, profit margins and forward earnings estimates will collapse. This is currently seen as heresy (as was my assertion just before the tech-collapse that technology earnings would turn out to be cyclical), but that’s how earnings and profit margins work.

Looking out anywhere from 2 weeks to 18 months, our measures remain very defensive, with the worst horizon being about 7 months out. Additional firming in market action from here would modestly improve our near-term measures of prospective return (which are more dependent on trend-following factors), but would generate little improvement beyond a horizon of several weeks. Meanwhile, our estimate of prospective 10-year S&P 500 total returns (nominal) is now only 4.7%. This figure may seem appealing relative to a 1.5% yield on 10-year Treasury bonds, but as I’ve noted before, you don’t “lock in” a long-term return on an investment; you ride it out over time. My expectation is that this ride will be extremely uncomfortable for passive buy-and-hold investors over the coming decade, and that there will be numerous opportunities to accept both stock and bond market risk at substantially higher prospective returns.

Strategic Growth and Strategic International remain tightly hedged, Strategic Dividend Value remains hedged at about half of the value of its holdings – its most defensive stance, and Strategic Total Return continues to carry a duration of about one year, with about 10% of assets in precious metals shares and a few percent of assets in utility shares and foreign currencies.

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Tags: Austerity, Bad Debt, Brink, Corporate Profits, Debt Reduction, Draghi, Economic Growth, Economic History, Economic Problem, Economic Recessions, Evidence To The Contrary, Financial Institutions, Financial Markets, Fluctuations, Full Force, Government Debt, Hussman, Hussman Funds, John Hussman, Public Debt, Receivership
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Learn from the Experts: Natural Resources Outlook 2011

Monday, January 10th, 2011

As we begin a new year, we’re taking the opportunity to look ahead at the market sectors that really impact us the most. You might know that gold was up over 29 percent in 2010, but did you know that silver was up 83 percent, and palladium skyrocketed 96 percent? Given the amazing gains of some commodities and natural resources over the past year, where do we go from here?

We’ll be hosting a series of Outlook 2011 webcast events, and we’re starting with the natural resources sector. Join us tomorrow afternoon at 4:15 PM Eastern. Our resident experts, Brian Hicks and Evan Smith, co-portfolio managers of the Global Resources Fund, will be joining me to present our outlook for natural resources.

Follow this link to register for this not-to-be-missed event.

Tags: Brian Hicks, Commodities, Currency Fluctuation, Emerging Market, Evan Smith, Fluctuations, Fund Prospectus, Global Resources, Gold, Investment Objectives, Market Sectors, Natural Resources Sector, New Year, Opportunity, Outlook, Palladium, Political Risk, Portfolio Managers, Public Disclosure, Resident Experts, Resources Fund, Silver, Smith Co, Tomorrow Afternoon, Webcast Events
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Can the World Hold 7 Billion?

Thursday, January 6th, 2011

Some time this year, there will be 7 billion people on the planet. If we all stood shoulder-to-shoulder, we would fit inside the city of Los Angeles.

National Geographic just kicked off its year-long series dedicated to this global milestone. Check out this video.

According to National Geographic, no human had lived through a doubling of the human population before the 20th Century. Now, there are people on this planet who have seen it triple. In fact, the world population hasn’t fallen since the Black Death wiped out nearly 60 percent of Europe’s population.

The problem with population isn’t space—we have plenty of it—it’s resources. Nearly 1 billion people go hungry every day and 20 years from now there will be 2 billion more mouths to feed.

If you’re analytical, you can think of it this way—the Earth has a finite number of resources but the demand and use of these resources are the variables. That demand not only depends on the number of people, but how intense their usage is.

Today, usage intensity is picking up in the emerging world—which happens to be home to the majority of the global population. As these people move, for example, from using bicycles to cars, or candles to electricity, the pressure on that finite amount of resources rises.

This, in a nutshell, is why we’re positive on natural resources—the supply of resources is limited while the demand is rising. Daily, monthly and even yearly fluctuations in demand or geopolitical events will cause volatility in prices, but the overall supply/demand fundamentals remain intact, and we believe these fundamentals lead to higher prices for these increasingly rare commodities.

Since this population theme is a cornerstone of the natural resources story, we’ll check back in on the National Geographic series as it progresses.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor.

Tags: Bicycles, Black Death, Commodities, Cornerstone, Finite Number, Fluctuations, Geopolitical Events, Global Population, Human Population, Intensity, Milestone, Mouths, National Geographic, National Geographic Series, Natural Resources, Nutshell, Rare Commodities, Shoulder To Shoulder, Volatility, World Population
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What’s Driving $1,300 Gold?

Sunday, September 26th, 2010

The price of gold has reached another big round number, breaking through the $1,300 mark today [09/23/2010] for the first time ever.

And at more than $21 per ounce, silver is higher than it’s been in three decades.

The Financial Times today ran an article that echoes something that we have been saying for months – the risk of “competitive currency devaluation” may now be the most important driver for precious metals investing.

Japan brought attention to the benefits of strategic devaluation when it openly took steps last week to weaken the yen. Japan’s prime minister says his government will do what it takes to keep the currency down.

And this week the Federal Reserve hinted at another round of quantitative easing, and as a result the dollar has seen a decline in value.

Japan, the U.S. and the European Union are all dealing with little to no economic growth at home, so they’re hoping their export sectors can lead the way. Keeping their currencies down is an important part of turning that hope into reality.

Here’s a link to a commentary I wrote back in February that discusses gold in a deflationary context, and which also touches on competitive currency devaluation. The basic view is that both deflation and devaluations make gold more attractive as a safe-haven investment.

And I also encourage you to visit Morningstar.com, which today has an article on how some funds have benefitted from their exposure to gold. Our Global Resources Fund (PSPFX) is one of the funds mentioned in the article.

Foreign and emerging market investing involves special risks such as currency fluctuation and less public disclosure, as well as economic and political risk.

Because the Global Resources Fund concentrates its investments in a specific industry, the fund may be subject to greater risks and fluctuations than a portfolio representing a broader range of industries.

Tags: Currency Devaluation, Currency Fluctuation, Deflation, Echoes, Economic Growth, Emerging Market, Export Sectors, Federal Reserve, Financial Times, Fluctuations, Fund Prospectus, Global Resources, Investment Objectives, Morningstar, Ounce, Political Risk, precious metals, Price Of Gold, Public Disclosure, Resources Fund, Safe Haven, Silver, Three Decades, Yen Japan
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Hussman: Violating the No-Ponzi Condition

Monday, May 3rd, 2010

This article is a guest contribution by John Hussman, Hussman Funds.

Over the past few months, the stock market has been characterized by an overvalued, overbought, overbullish, rising yields syndrome that has historically proved unrewarding and often particularly dangerous for investors. It’s important to underscore that even in post-war data, and even if we assume that the economy is in a typical post-war recovery, this particular syndrome has been unrewarding, on average, which places the Strategic Growth Fund in a fully hedged investment stance (essentially, the Fund holds long-put / short-call index option combinations having a notional value equal to the value of the stocks we hold).

As in 2007, the unusually low level of implied volatility, coupled with the syndrome of overextended conditions, has prompted us to establish a tight “staggered strike” position, raising the strike prices of our defensive put options close to the level of the S&P 500. Compared with a standard matched-strike hedge (long put options / short call options having the same strike price and expiration), a staggered position typically maintains about 1% of assets in additional put option premium. The Fund does not establish option combinations where more than one side is “in the money” when the position is initiated. Since we keep the new strike price of the put options below the level of the market, the potential downside (compared with a standard hedge) is limited to a modest loss of time premium if the market continues to advance.

Conversely, if the market declines below the strike price of the puts, the hedge provides a tighter defense for the stocks we hold, which can be helpful if the early sell-off is indiscriminate. This requires us to take day-to-day fluctuations with a slight grain of salt, because once the put options go “in the money” (i.e. the S&P 500 drops below the strike price of the puts), if the market then reverses back toward or above our strike prices before we have a good opportunity to reset our strike prices, we can give back some or all of our recent gains from those puts. So the puts can’t lose more than the amount of time premium we originally invest, even if the market advances, but can result in gains (that are occasionally transient) if the market drops below their strike prices.

I note this because when the S&P 500 moved well above 1200 in recent weeks and implied volatility dropped toward 16-17%, we raised our strikes to the 1200 level at relatively low cost. Those strikes are now in-the-money, so we expect to be well-protected against the impact of general market declines. Though we continually adjust our position to reduce the potential for “give back” (as we did near the market close on Friday), it is probably best to anticipate a few transient day-to-day gains and give-backs if the S&P 500 extends its decline substantially below 1200.

More generally, the primary source of our day-to-day fluctuations when we are hedged is the difference in performance between the stocks held by the Fund and the indices we use to hedge. For example, the most notable source of fluctuation in the Strategic Growth Fund last week was not hedging, but volatility in restaurant stocks that led the recent rally.

Geek’s Note: This asymmetry or “curvature” in the profile of option returns is called “gamma” (the second derivative of the option value with respect to price). Ideally, you would prefer to let this curvature run, and only adjust your position at the turning points of a market trend. In practice, we look for short-term overbought and oversold conditions to reset our strikes – a practice known as “gamma scalping.” Gamma is really what you are paying for when you purchase an option. If the actual short-term volatility of the market is greater than the implied volatility that was priced into the option when you established the position, effective gamma scalping can substantially reduce the impact of time decay even if the market is ultimately unchanged.

Violating the No-Ponzi Condition

The credit picture remains mixed at present, though the next several months are likely to provide significantly more clarity. The Greek debt concerns are interesting in the lesson that investors are hoping to be taught, which is that all debt, no matter how foul, should be considered risk-free and can be counted on to be bailed out, so that market discipline need not provide any impediment to the poor allocation of the world’s financial resources.

The basic problem is that Greece has insufficient economic growth, enormous deficits (nearly 14% of GDP), a heavy existing debt burden as a proportion of GDP (over 120%), accruing at high interest rates (about 8%), payable in a currency that it is unable to devalue. This creates a violation of what economists call the “transversality” or “no-Ponzi” condition. In order to credibly pay debt off, the debt has to have a well-defined present value (technically, the present value of the future debt should vanish if you look far enough into the future).

Without the transversality condition, the price of a security can be anything investors like. However arbitrary that price is, investors may be able to keep the asset on an upward path for some period of time, but the price will gradually bear less and less relation to the actual cash flows that will be delivered. At some point, the only reason to hold the asset will be the expectation of selling it to somebody else, even though it won’t be delivering enough payments to justify the price.

Transversality forces the price of the asset to be equal to the value of the discounted cash flows. It’s not enough for a borrower to keep the payments up over the short term, and it’s not enough for price of an asset to be on an upward track for a while – over time, securities actually have to be able to deliver enough cash flows to justify the price that investors pay. When investors abandon this requirement (as they did with dot-com and technology stocks during the runup to the market peak in 2000), the price they pay stops having any relationship with the stream of cash flows that will be delivered to them over time. An increasingly large portion of the asset price represents real money that is being paid for a “phantom asset” in the distant future, that bears no cash flows, and yet gets assigned positive value because investors assume they’ll be able to sell it to a greater fool. Every asset bubble fundamentally reflects this error in thinking. Ponzi schemes violate transversality conditions, as do sub-prime (not to mention Alt-A and Option-ARM) mortgages when they are assigned higher values than the expected cash flows can justify. If not for the ability to print money, which will become increasingly handy in future years, the U.S. government might be in the same situation, resulting from existing debt, probable future deficits, and unfunded liabilities.

Unless Greece implements enormous fiscal austerity, its debt will grow faster than the rate that investors use to discount it back to present value. Moreover, to bail out Greece for anything more than a short period of time, the rules of the game would have to be changed to allow for much larger budget deficits than those originally agreed upon in the Maastricht Treaty. One can’t rule this out, seeing as how our own nation has proved quite adept at dispensing with accounting provisions and other discipline that might have threatened bondholders. But if that is the case, our concerns about inflation pressures in the second half of this decade will only become more pointed.

We may very well see some short-term bridge financing in return for promises of greater fiscal discipline. This will do little but kick the can down the road a bit. [Late note - The EU and IMF announced late Sunday a 110 billion euro - roughly $146 billion - rescue plan for Greece, attached to an austerity plan that unions immediately denounced as "savage"]. Greece is a beautiful country, but its economy is not a model of flexibility. Anecdotally, having been, in my earlier years, among a train full of passengers tossed out near a field in the middle of the night upon arriving at the Greek border, hoofing it in the dark to the nearest town, bumming a ride to Thessaloniki, and eventually hiring a taxi to drive the full length of the country to Athens with five chain-smokers who refused to crack a window, while every other form of transportation was on a nationwide strike, I suspect that budget discipline to the extent required will not be easily implemented, and may be so hostile to GDP and tax revenues as to make default inevitable in any event.

With respect to mortgages, the most recent figures from Bloomberg covering residential delinquencies for over 12 million active, non-agency loans continue to show a record proportion of troubled loans. Non-agency (Fannie/Freddie) loans are those originated by the private sector, typically at even less stringent credit standards than Fannie and Freddie imposed. Bloomberg reports that delinquent, REO (real-estate owned), foreclosed, and bankrupt loans represented 33.78% of the total in March, the same level as in February. Of these, more than half (16.93%) were delinquent but not in foreclosure. While Subprime loans in foreclosure declined from 16.85% in January to 16.35% in March, and 30-day Subprime delinquencies declined from 4.86% in January to 4.34% in March, these declines were offset by increases in Alt-A foreclosures (12.23% to 12.43%) and delinquencies (4.18% to 4.45%). Overall, we clearly appear to be past the trouble in Subprime, but the rates for Alt-A and Option-ARM mortgages are trending the wrong way.

Jonathan Weil of Bloomberg made some observations a few weeks back about last year’s FASB change, which suspended “mark-to-market” accounting for banks. He notes that in early 2009, the Federal Home Loan Bank of Seattle was the “poster child for everything supposedly wrong with mark-to-market accounting.” While mark-to-market rules had forced the bank to write down its portfolio of mortgage backed securities by $304 million, the bank’s executives said they expected to lose only $12 million on these loans. At a March 12, 2009 congressional hearing, this disparity was presented as a “disturbing” example of the problem with mark-to-market. Paul Kanjorski pointed to a similar “absurd” example that “fails to reflect economic reality”, where the Federal Home Loan Bank of Atlanta was forced to report an $87 million mark-to-market writedown on a portfolio the bank expected to generate losses of only $44,000. In response to this pressure, the FASB ultimately caved. Unfortunately, the Federal Home Loan Bank of Seattle now says it expects $311 million of credit losses on its portfolio, while the Federal Home Loan Bank of Atlanta has raised its credit loss estimate to $263 million – both even worse than the original mark-to-market indications. The Seattle FHLB has filed lawsuits against Goldman Sachs and Morgan Stanley, among others, seeking refunds for mortgage-backed securities they underwrote.

Overall, it strikes me that the markets have wholeheartedly embraced the view that the recent downturn was nothing but a typical and purely transitory post-war wrinkle. Yet income continues to deteriorate once government transfer payments are backed out, in stark comparison to other post-war recoveries (see Bill Hester’s recent piece Business Cycles, Election Cycles and Potential Risks).

Investors have looked past the effects of temporary stimulus and opaque accounting, maybe on the Madoff-like thesis that neither sustainability nor accurate disclosure really matter as long as the numbers are good. Yet there’s also no denying that this thesis has worked beautifully, and we’ve missed out by questioning it. As I detailed last week in Looking Back, Looking Forward, the criteria for accepting risk – on the basis of valuation and market action – have been more stringent in periods of credit crisis (both U.S. and internationally) than we could have, in hindsight, got away with last year. I continue to believe that the market’s enthusiasm may turn out badly, given the extent to which GDP gains have been induced by unparalleled deficit spending, and earnings gains have been predominated by financials enjoying suspended accounting transparency. But we’ll see how this plays out over time.

That said, even the guidance from strictly post-war models has been decidedly defensive during 2010, and remains so today. If the evidence based on post-war data improves, we’ll become moderately more constructive. We’re currently giving about as much weight to a standard post-war recovery as we are to a continued credit crisis, but the evidence currently suggests a fully hedged investment stance for both cases, so these possibilities represent a distinction without a difference. To the extent that valuations or market action improve in a manner that would, in a normal post-war world, justify accepting some amount of market risk, we would presently move about half-way in that direction. If we observe no further crisis-level credit strains, I expect that we’ll be applying strictly post-war criteria by year end. So we’re allowing some time to move into our main window of concern, but our defensiveness won’t persist indefinitely without obvious evidence of credit deterioration.

Market Climate

As of last week, the Market Climate for stocks was characterized by strenuously unfavorable valuations, and a syndrome of overvalued, overbought, overbullish, rising-yield conditions that has historically been associated with poor outcomes. As noted above, our present hedged position is not dependent on the expectation of further credit strains. Needless to say, the additional clarity regarding credit risks that we expect in the months ahead will be welcome, regardless of the outcome.

In bonds, the Market Climate remained characterized last week by relatively neutral yield levels and unfavorable yield pressures. Credit spreads have been generally widening in recent weeks, with a somewhat unstable spike in the credit default swap spreads of major banks. I say “unstable” because it may be based on immediate concerns about Greece, rather than more persistent risk concerns. Broader measures of credit risk have ticked up modestly, but not as notably as CDS spreads. My expectation continues to be that inflation pressures will pose a significant challenge to the economy in the second half of this decade, benefiting inflation hedges and TIPS. However, over the shorter term, commodities appear overbought and a bit vunlerable.

The uncertainty about Greece and, by extension, the euro, has been a positive for precious metals recently, and while a default event could generate a “fear” spike in the metals, intermediate concerns about economic consequences and deflation in that event could result in a subsequent period of commodity weakness. In contrast, a near term agreement to provide bridge financing would ease fears and might take some air out of commodities more immediately. In short, the longer term prospects for precious metals and inflation hedges continue to diverge somewhat from near and intermediate term prospects. We closed our small 2% of precious metals exposure from the Strategic Total Return Fund last week on strength, and also have a limited exposure of only about 2% in foreign currencies here. Among currencies, the euro appears somewhat undervalued on our metrics, and possibly for good reason (versus a central value of about $1.49-$1.51 based on our “joint parity” methodology – see Valuing Foreign Currencies), as does the British pound, while the yen appears about fairly valued, and the Canadian dollar appears somewhat rich. I continue to believe that a credit shock would provide the best opportunity to accumulate longer-term positions in commodities, TIPS and certain foreign currencies, but I expect that we’ll respond to smaller opportunities – particularly fresh precious metals weakness – to establish more moderate exposures.

copyright (c) 2010 Hussman Funds

Tags: Assets, Call Options, Commodities, Defense Stocks, Downside, Economy, Fluctuations, Gold, Grain Of Salt, Hussman Funds, Implied Volatility, Index Option, Investors, John Hussman, Money, Notional Value, Option Combinations, Post War, Stock Market, Stri, Value Stocks
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Setting Stop Loss Levels

Saturday, April 10th, 2010

This article is a guest contribution from Richard Shaw, QVM Group LLC.

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We increasingly receive questions about how to set stop loss levels.  Let’s look at one objective, data driven way to do that.

You may have a better way, and that’s a good thing, but if you don’t have a way, and you need a way, this discussion may be a helpful starting place to design your own stop loss setting method.

This discussion is not relevant to short-term trading, and would not be useful to those who do not believe in exiting positions (who are strict “buy and hold” adherents),  to those with very long-term horizons AND iron stomachs capable of withstanding large fluctuations in portfolio value, or to those who would have the opposite reaction of a stop and instead wish to buy more when their positions tank.

First, recognize these three important concepts:

1. you want your stops to be outside of the “noise” level of seemingly random price fluctuation
2. you want your stops to be outside of the “reaction” range that is likely to occur
3. you want your stops to be within your personal emotional or financial limits.

If you place stops outside of “reaction” levels, you will automatically be outside of the “noise” level.  If the “reaction” level is outside of your personal emotional or financial limits, then you probably should not own the security.

Your personal limits are something only you can know.

“Reaction” levels may be reasonably estimated by examining three quantitative parameters that are easily accessible, and then setting your stops outside of the greater of the three.  We think these three parameters each divided by the price are informative and useful in selecting a stop loss percentage for trailing percentage stops:

1. the width of the 3-month price channel
2. the width of the 3-month 2 standard deviation Bollinger Bands
3. the spread between the price and the 200-day simple moving average

It may also be good to consider the 3-month average of the 3-month Bollinger Band width as an additional parameter.

As an example, if you were to do that today to see where percentage trailing stops might be set for six ETFs representing key asset categories, we come up with these values:

• US stocks (VTI) 13.6%
• EAFE stocks (VEA) 14.2%
• Emerging market stocks (VWO) 17.4%
• Aggregate US bonds (BND) 2.0%
• Developed non-US sovereign local currency bonds (BWX) 7.0%
• Emerging market sovereign Dollar bonds (EMB) 7.2%

We must admit that the 2% on aggregate US bonds seems thin, but that’s what the current numbers say.  If you feel the same way, you might chose a longer term factor,  maybe as far as the current yield level of 3.9% (so you would do no more than give up the equivalent of one year of income, but not principal).

Note also that for BWX, the price is below the 200-day simple moving average so there is no way to use that parameter in the stop calculation — except to say that we think you should not own it while the price is below the 200-day average — unless you have some special knowledge or beliefs about the Euro/Dollar and the Dollar/Yen, and the European sovereign credit crisis.

Here is the raw data we used to calculate the stop levels above:

Holdings Disclosure:
As of April 9, 2010, we hold BND, EMB, and VWO in some, but not all managed accounts, and not necessarily all in any single account.  We do not have current positions in any other securities discussed in this document in any managed account.

Disclaimer:
Opinions expressed in this material and our disclosed positions are as of April 9, 2010. Our opinions and positions may change as subsequent conditions vary. We are a fee-only investment advisor, and are compensated only by our clients. We do not sell securities, and do not receive any form of revenue or incentive from any source other than directly from clients. We are not affiliated with any securities dealer, any fund, any fund sponsor or any company issuer of any security. All of our published material is for informational purposes only, and is not personal investment advice to any specific person for any particular purpose. We utilize information sources that we believe to be reliable, but do not warrant the accuracy of those sources or our analysis. Past performance is no guarantee of future performance, and there is no guarantee that any forecast will come to pass. Do not rely solely on this material when making an investment decision. Other factors may be important too. Investment involves risks of loss of capital. Consider seeking professional advice before implementing your portfolio ideas.

Richard Shaw
QVM Group LLC

Tags: Adherents, Bollinger Bands, Buy And Hold, ETF, ETFs, Fluctuations, Group Llc, Horizons, Important Concepts, Iron Stomachs, Loss Percentage, Moving Average, Noise Level, Objective Data, Personal Limits, Portfolio Value, Price Fluctuation, Quantitative Parameters, Qvm, Richard Shaw, Silver, Standard Deviation, Stop Loss
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Inflation expectations approach pre-crisis range

Tuesday, January 12th, 2010

On the burning issue of inflationary pressures, Asha Bangalore (Northern Trust) yesterday remarked as follows: “Inflation expectations as measured by the difference between yields of the nominal US 10-year Treasury note and the 10-year inflation protected security are now at levels seen prior to the onset of the financial crisis in August 2007. As of January 8, the difference between the nominal yield and yield on the inflation protected 10-year US Treasury securities was 245 bps. Inflation expectations have climbed 28 bps during the last 20 trading days.

“The movements of inflation expectations will be watched closely in the near term.  The Fed’s ability to influence the course of economic growth will be prevented if inflation expectations become unhinged,” she said.

The minutes of the December 2009 FOMC meeting indicate that the staff did a special presentation on inflation and inflation expectations. The highlights of this discussion were reported as follows: “Evidence suggested that sizable shifts in the longer-run inflation expectations of households and firms had influenced the evolution of inflation over previous decades; in contrast, the anchoring of inflation expectations in recent years likely had damped somewhat the response of actual inflation to the recent economic downturn and to fluctuations in the prices of energy and other commodities. In discussing these issues, participants noted that they bear in mind the shocks hitting the economy and regularly monitor more than one measure of resource slack as they assess the outlook for economic activity and inflation. They also noted the importance of formulating monetary policy in ways that would work well across a range of possible economic structures rather than relying on any one analytical framework. Finally, they underscored the importance of keeping longer-run inflation expectations firmly anchored to help achieve the Federal Reserve’s dual mandate for maximum employment and price stability.”

Meanwile Peter Boockvar reported on The Big Picture blog as follows: “The 10 yr TIPS auction was good as the yield was about in line with expectations but the bid to cover at 2.65 is above the ‘09 average of 2.59 and the average over the past 2 yrs of 2.30. It’s the 2nd highest going back to 2000. Ahead of the auction, the implied inflation rate in the 10 yr TIPS was 2.45% which means if one believes inflation will run above that over the next 10 yrs on average then buy inflation protection and vice versa.”

“Bullish economic reports are most likely to lead to pressure on long-term interest rates and push inflation expectations into a new range. Having said that, a caveat is necessary, final demand in the US economy is significantly weak and it is unlikely to post robust growth until the final three months of the year. Therefore, it is reasonable to expect that inflation expectations will remain anchored in the months ahead,” concluded Bangalore.

Perhaps, but I am in no hurry to see my gold holdings protecting my portfolio against the biggest monetary reflation in human history.

Tags: Bps, Commodities, Dual Mandate, Economic Activity, Economic Downturn, Economic Growth, Economic Structures, Federal Reserve, Financial Crisis, Fluctuations, Fomc, Gold, Households, Inflation Expectations, Inflationary Pressures, Monetary Policy, Nominal Yield, Northern Trust, Shocks, Slack, Treasury Securities, Us Treasury, Year Treasury Note
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Roundup: Economy and Bond Market (12/24/2009)

Sunday, December 27th, 2009

The Economy and Bond Market

The yield on the 10-year Treasury note increased by 26 basis points during the holiday-shortened week, leaving the yield at 3.80 percent. The spread between the two-year note and the 10-year note reached a record 285 basis points during the week, likely reflecting investor concern about future inflation levels.

Current inflation, as measured by the Personal Consumption Expenditure Core Price Index (PCE Deflator) shown below on a year-over-year basis, remains relatively contained. The November data released this week showed a 1.4 percent year-over-year increase and was flat on a month-to-month basis.

Strength

• Sales of existing U.S. homes in November rose 7.4 percent to an annual rate of 6.54 million homes, greater than the forecasted rate of 6.25 million.
• Price inflation data this week slightly beat expectations. The Personal Consumption Expenditure (PCE) Price Index for November was up 1.5 percent year-over-year versus a 1.6 percent consensus.
• Personal income in November increased 0.4 percent from October, the fifth consecutive month-over-month increase and the biggest monthly increase since May, while personal spending increased 0.5 percent. The increases left the savings rate unchanged at 4.7 percent for November.
• Initial jobless claims last week declined to 452,000, down from 480,000 the previous week. This was the lowest level since September, 2008. The four-week average for claims, which smooths out fluctuations, fell to 465,250, its sixteenth-straight weekly decline.
• Orders for durable goods increased 0.2 percent in November. However, durable goods orders excluding transportation increased by 2.0 percent, almost twice the 1.1 percent forecast.

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Weakness

• Sales of new U.S. homes in November fell 11.3 percent to a seasonally adjusted annual rate of 355,000, below the expected rate of 438,000.
• Real U.S. gross domestic product (GDP) for the third quarter was revised downward to 2.2 percent from the previously reported 2.8 percent.
• The Richmond Federal Reserve Bank’s Manufacturing Sector Activity Index fell to minus four in December from a positive one in November and a positive seven in October. The consensus expected it to rebound to five.

Opportunity

• Expectations continue to build for growth in the U.S. in the current quarter, possibly as much as 4-5 percent. The global economic recovery appears to be taking hold.

Threat

• The Fed reiterated their monetary policy stance in the prior week and on the surface nothing really changed but they are incrementally moving to reduce the policy accommodation and often these things move quicker than many expect.

Tags: Admin Post, Avw, Basis Points, Bond Market, Cb, Ck, Consensus, D1, Decline, Deflator, Durable Goods Orders, Economy, Fluctuations, GDP, Gross Dom, Gross Domestic Product, Img Src, Inflation Data, Initial Jobless Claims, Investor Concern, Market Economy, Openx, Personal Consumption Expenditure, Personal Income, Price Index, Price Inflation, Random Number, Roundup, S Gross, Year Treasury Note
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