Confidence and Enthusiasm (Hussman)

Monday, August 20th, 2012

by John Hussman, Hussman Funds

The present confidence and enthusiasm of investors about the ability of monetary policy to avoid all negative outcomes mirrors the confidence and enthusiasm that investors had in 2000 about the permanence of technology-driven productivity, and in 2007 about the durability of housing gains and leverage-driven prosperity. Market history is littered with unfounded faith in new economic eras, and hopes that “this time is different.” Those periods can be difficult, at least for a while, for investors who are less willing to abandon evidence and lessons of history, not to mention basic principles of economics and valuation. We endured similar discomfort in periods like 2000 and 2007, before hard reality set in.

Investment notes

The recent market cycle has required two changes to our hedging approach. One was in 2009, when our existing approach was dramatically ahead of the S&P 500, but I insisted on making our methods robust to the worst of Depression era data. The other was earlier this year, when we imposed criteria to restrict the frequency of defensive “staggered strike” option positions in Strategic Growth Fund, requiring not only strongly negative expected returns, but also either unfavorable trend-following measures or the presence of unusually hostile indicator syndromes. There’s little doubt that massive central bank interventions have pushed off economic and market difficulties that might have occurred more quickly. The tighter criteria help adapt to that reality, without foregoing the benefit that defensive option positions would have historically had over the course of the market cycle.

These hedging changes would clearly have altered many of our investment positions during the most recent cycle, particularly during the 2009-early 2010 period, but would not alter the strongly defensive position we’ve maintained since early March (see Warning: A New Who’s Who of Awful Times to Invest). Based on a blend of investment horizons from 2 weeks to 18 months, we presently estimate the prospective return/risk profile of the market as being among the most negative 0.5% of historical instances. On the technical front, the S&P 500 is either at or just short of its upper Bollinger band on nearly every resolution (daily, weekly, monthly), while numerous divergences are already in place, including the failure of many sectors and indices to confirm the recent high.

Valuations remain unusually rich on our measures, and only seem benign to Wall Street because profit margins are nearly 70% above their historical norms as a result of depressed savings rates and unsustainable government deficits (see Too Little to Lock In). On that note, it should be of some concern (though it is clearly not) that the price/revenue multiple of the S&P 500 is now above any level seen prior to the late-1990’s market bubble. Prior to that time, the highest post-war peaks were in 1965 (which was not followed by a deep or immediate decline, but marked the onset of what would ultimately become a 17-year secular bear market), and 1972, just before the S&P 500 lost nearly half of its value. Stocks are emphatically not a claim on next year’s projected earnings. They are a claim on a very long-term stream of cash flows that will be delivered to investors over time, and however speculative hopes or fears might move prices in the short-term, the factors that drive long-term prospective returns have remained durable for a century.

We presently estimate that the S&P 500 is likely to achieve a 10-year total return (nominal) of about 4.5% annually, but that alone is not what concerns us. We generally target an exposure to market risk that is proportional to the expected return/risk profile of the market on a blended horizon of 2 weeks to 18 months. Valuations exert a significant effect on those estimates, but numerous other considerations such as broad market action, trend-following measures, and a variety of indicator syndromes (e.g. overvalued, overbought, overbullish) also have significant effect. It is the full combination of evidence that concerns us.

As a side-note, our exposures are generally not directly proportional to the prospective 10-year return that we estimate on the basis of valuations alone. The difficulty with setting an exposure proportional to the 10-year prospective return is that there is little to stop a 10% prospective return from turning into a 15% or even 20% prospective return as a result of much steeper market losses (which we saw in the 1930’s, 1950’s, 1970’s and early 1980’s). Indeed, in 1931, the stock market’s dividend yield exceeded 6%, the Shiller P/E was well below prior and subsequent historical norms, and the market’s prospective 10-year return was above 10% annually, by our methodology. Yet this did not stop the stock market from losing two-thirds of its value over the following year, for an overall Depression-era loss of about -85%, taking the stock market – on a total return basis – to one-seventh of its 1929 level. That said, we certainly don’t require clear undervaluation in order to reduce hedges and establish a constructive position. Absence of severe overvaluation coupled with a shift to favorable market action on our measures is typically sufficient, as was the case in 2003, and might have been possible in 2009 had we not faced the “two data sets” uncertainty.

It may seem overly cautious that I demanded that our hedging models should perform well in cross-validation (“holdout”) data from both post-war data and more extreme Depression-era periods. My view is that the arithmetic of deep losses is devastating to long-term returns, and the behavior of the market and the economy in 2008 and early 2009 was simply out-of-sample from a post-war perspective. I don’t share the confidence and enthusiasm of investors about the ability of central banks to make recessions, debt crises, and major market losses a thing of the past. Again, while the resulting changes in our methods (ensemble models, more restrictive criteria on staggered-strike positions) would have produced substantially different investment positions over the most recent cycle than we took in practice – particularly during the 2009-early 2010 period – the fact is that our defensive stance here is fully intentional, and the “heat” that we experience during points of investor enthusiasm is something that this same discipline would have occasionally experienced in numerous prior cycles.

In Strategic Growth Fund, part of the setback in recent months has been due to hedging costs, and part has been due to a modest lag in our stock holdings, relative to the indices we use to hedge. Neither outcome is extremely rare, or even particularly deep relative to the volatility regularly experienced by a passive buy-and-hold approach, but it’s uncomfortable to experience erosion in both aspects of our approach at the same time. That said, I doubt that this fairly run-of-the mill setback – especially since March – would feel nearly as uncomfortable if it did not blend in with our “miss” of 2009 through early-2010 (which I would not expect to be repeated in future cycles even under identical conditions).

In any event, I believe that the challenges we experienced during the recent, extraordinary cycle have been addressed. We’ll always work to learn new things and to bring new knowledge into practice, but unless we go back to the South Sea Bubble or the Dutch Tulip Mania, there isn’t a great deal of historical context available to augment what we’ve already incorporated into our methods. On the question of whether I believe our present methods require additional stress-testing or remediation, the answer is no, because I am satisfied that these methods would have strongly navigated not only the most recent cycle, but also post-war data, and also Depression-era data (without the exposure to significant periodic losses that our pre-2010 methods would have experienced during the Depression). On the question of whether I believe it was necessary to make our methods so robust to extreme outcomes and economic risks, my answer unfortunately remains an emphatic yes. I believe that investors should be prepared for far greater turbulence than present valuations and complacent sentiment seem to envision.

In my view, this time is not different. It may be more drawn out, but it bears repeating that the 2008-2009 market decline, when it arrived, wiped out the entire total return that the S&P 500 had achieved, in excess of Treasury bill returns, all the way back to June 1995. Regardless of any immediate relief from the Federal Reserve or the European Central Bank (both which I suspect are largely priced into the markets, and leave investors vulnerable to disappointments), I expect that stocks will achieve weak overall returns over the next few market cycles, and I am confident that we are well-prepared to navigate the full course of those cycles, if not always shorter segments (particularly the richly valued portion of mature bull advances, which is where I believe we are today).

What Merkel actually said

What’s fascinating about the present confidence and enthusiasm about central bank intervention is that investors have stopped actually listening for fact, and are increasingly hearing only what they want to hear. A good example of this is the notion last week that German Chancellor Angela Merkel now supports a major round of distressed debt purchases by the European Central Bank. As background, recall that ECB head Mario Draghi indicated a few weeks ago that the central bank was prepared to do “everything” to support the Euro, “and believe me, it will be enough.” Yet immediately after these words, the ECB had a meeting in which it initiated – nothing.

Germany’s position on ECB purchases of distressed country debt (Greece, Spain, Italy) has always been that this support must be conditional on the imposition of centralized control over the fiscal policies of those countries. This is what Germany calls “political” action, and that is why when Germany talks about its willingness to do everything necessary to save the euro, it typically uses the phrase “everything politically necessary.” Merkel’s most concise summary of this position – “Liability and control belong together.”

Fast-forward to last week, when Merkel was in Canada discussing trade issues. There, she gave a statement that was widely reported as suggesting that ECB action is “completely in line with what we’ve said all along.” That phrase was then reported as if Merkel was endorsing a massive and unconditional ECB intervention, which is what Wall Street now seems to be anticipating.

The problem is that here is what Merkel actually said: “The European Central Bank, although it is of course independent, is completely in line with what we’ve said all along. And the results of the meeting of the central bank and their decisions, actually shows that the European Central Bank is counting on political action in the form of conditionality as the precondition for a positive development of the Euro.”

So look at the “results of the meeting of the central bank, and their decisions” that Merkel mentions. The ECB decided to do nothing. No unconditional bailout. No liability without control. That result was indeed completely in line with what Germany has said all along. It just wasn’t what investors wanted to hear, so they heard something else entirely.

Meanwhile, nonperforming loans in Spanish banks surged from 8.96% in May to a record 9.42% in June. There remains an urgent but fully-denied need for broad receivership and restructuring of undercapitalized Spanish banks. It is important to recognize that bailing out the debt of insolvent entities is not a loan, because it is money that can’t be paid back. It is either a direct fiscal expenditure or it is permanent money creation – which is effectively indirect fiscal expenditure since the proceeds of money creation could otherwise be used to finance new government spending. The simple way to understand the Euro crisis is to understand that countries like Germany and Finland expect to be paid back, and failing that expectation, they are unwilling to transfer more fiscal resources than they already have. As the German finance minister said over the weekend, “It is not responsible to throw money into a bottomless pit.” That’s hardly a tone that indicates a willingness to accept unconditional ECB bailouts. All of this will remain very interesting, and most likely very turbulent. In any event, my impression is that the confidence and enthusiasm about easy central bank fixes is sorely misplaced.

Market Climate

As of last week, our estimates of prospective stock market return/risk on a blended horizon from 2 weeks to 18 months remains in the most negative 0.5% of historical instances. It’s easy to blur our present defensiveness in response to extreme conditions we’ve observed since early March into a much longer period of defensiveness : our strategic and intentional defensiveness in anticipation of the 2008-2009 credit crisis, our stress-testing period in 2009-early 2010 which was “non-strategic” in that we would expect to be similarly defensive in future cycles even under identical conditions, and our strategic and intentional defensiveness since April 2010 (though tighter criteria on staggered strike index option positions would have avoided some amount of hedging costs during much of this period). Still, the fact is that present conditions correspond to less than half of one percent of historical observations going back nearly a century.

The issue now is what we should do going forward. In my view, we’ve wholly addressed the “two data sets” problem that we had to address in 2009, and as a result, I am convinced that our approach is well-suited to navigate both run-of-the-mill and very extreme market behavior over the course of future market cycles. I am also convinced that investors should not easily dismiss conditions that are more negative than more than 99% of market history, particularly when they are accompanied with evidence of emerging global recession, overbought conditions at the upper band of daily, weekly and monthly Bollinger channels, and a variety of historically hostile indicator syndromes (Aunt Minnies such as “overvalued, overbought, overbullish” conditions, and evidence of technical divergence and exhaustion).

There is no reason to expect that the Fed will refrain from periodic interventions aimed at encouraging speculation for some period of time. But the effect of previous rounds of quantitative easing have typically been restricted to little more than a recovery of decline in stock prices over the preceding 6-month period, and I am doubtful that we will see much effect when the market is already near the top of its Bollinger channels (2 standard deviations above 20-period moving averages at daily, weekly and monthly resolutions). I am even more doubtful that Fed purchases of Treasury securities to create an even deeper ocean of zero-interest currency and reserves – when banks hold trillions of idle currency and reserves already – will have any material effect on a global recession that we view as already quietly in progress. In any case, our approach is always focused on the average outcomes associated with a given set of market conditions, and individual instances may deviate from the average. Suffice it to say that we continue to adhere to our investment discipline here.

We are presently in an environment that has historically been associated with the overvalued segment of late-stage bull markets. This segment of the market cycle has been frustrating for us before, and that frustration may not be over. Yet in each instance, our defensiveness was overwhelmingly vindicated. The drum-beat of investors is that “this time is different.” Simply put, I doubt that this time is different.

Strategic Growth Fund remains fully hedged, with a staggered-strike position representing about 1.6% in additional option premium cost (versus a standard matched-strike long-put/short-call hedge), looking out to year-end. Strategic International remains fully hedged. Strategic Dividend Value fund remains hedged at close to 50% of the value of its stock holdings (its most defensive stance), and Strategic Total Return carries a fairly conservative duration of about 1.8 years in Treasury securities, 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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Copyright © Hussman Funds

Tags: Basic Principles Of Economics, Blen, Defensive Position, Durability, Eras, Hussman, Hussman Funds, Interventions, Investment Positions, John Hussman, Lessons Of History, Market History, Monetary Policy, Negative Outcomes, Option Positions, Periods, Permanence, Principles Of Economics, Productivity, Prosperity, Strike Option
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Begging for Trouble (Hussman)

Monday, August 13th, 2012

Begging for Trouble

by John P. Hussman, Ph.D., Hussman Funds

With the daily focus on European crisis and the hope of central bank intervention, one of the essential features of the investment climate – at least for long-term investors – is easy to lose in the shuffle. That feature is valuation. It’s an easy concern to overlook, because with corporate profit margins close to 70% above historical norms (largely because of unsustainably large government deficits coupled with low private savings rates – see Too Little to Lock In), Wall Street is quite happy to look at the ratio of prices to near-term earnings estimates and conclude that valuations are satisfactory. But stocks are not a claim on one year of earnings. They are a claim on a very long stream of cash flows that will actually be delivered into the hands of investors. Unfortunately, the conclusion that stocks are appropriately valued rests on the implicit assumption that profit margins will remain elevated into the indefinite future.

We presently estimate a projected 10-year total (nominal) return for the S&P 500 of less than 4.6% annually. Nothing in recent years, much less the past decade, indicates any material change in the relationship between actual market returns and expected market returns as we estimate them using a range of fundamentals including normalized earnings. Indeed, the 5.1% total return of the S&P 500 over the most recent 10-year period has been right on target (see also my July 7, 2002 comment). It’s notable that even without compelling valuations a decade ago, we lifted 70% of our hedges several months later in early 2003, at what turned out to be the start of the next bull market – something to remember for those who misunderstand our two-data sets issue of 2009-early 2010 and assume that we’ll never lift our hedges until the market is deeply undervalued.

I anticipate that a decade from now, the S&P 500 will have achieved a total return that is very weak from a long-term perspective. Remember also that you don’t “lock in” a 10-year return. You ride it out. I continue to expect that investors will have numerous opportunities to accept risk in the coming years in expectation of much better prospective returns than are presently likely.

Of course, with the yield on the 10-year Treasury bond at just 1.6%, one might argue that a prospective 10-year return of nearly 4.6% on stocks is still very good by comparison, and should be enough to prevent any substantial adjustment to lower prices and higher prospective returns. To inform that argument, I’ve added the 10-year Treasury bond yield to our standard chart below. Note that the correlation between 10-year S&P 500 returns and 10-year Treasury bond yields (which reflect both expected and actual 10-year returns, provided no default occurs) is just 0.1. There is virtually no relationship at all, with the exception of the early-1980’s, when the prospective and actual returns were quite high for both as a result of inflation shocks.

While the simultaneous rally in both stocks and bonds from the early 1980’s through the late-1990’s gave the illusion that the 10-year bond yields and forward operating earnings yields had a precise point-for-point relationship, spawning an unfortunate little cottage industry of adherents to the “Fed Model”, this model is based entirely on the relationship between stock yields and bond yields during a specific 16-year period of sustained disinflation, and there is no evidence – or even sound theory – supporting that spurious one-to-one correlation more generally.

Why aren’t the 10-year returns of stocks and bonds (prospective or actual) more closely related? The reason is simple, really. 10-year bonds have an effective duration of only about 7-8 years, depending on the coupon, which means that your ending wealth is nearly completely determined within that horizon. In contrast, stocks are very long-term assets, with an effective “duration” roughly equal to the price/dividend ratio*, which means that changes in valuation dramatically affect the terminal value of your investment even for horizons out to 30-40 years, and sometimes longer when valuations are rich and yields are low.

[*Geek’s note: You can derive this by differentiating the Gordon growth model P = D/(k-g) with respect to k, and calculating the elasticity of price to changes in the gross return: (dP/P)/{dk/(1+k)}].

Consider investors who bought stocks back in 1999 when the price/dividend ratio was 70. Those investors were assured that the value of their investment would be dramatically affected by even very small changes in yields. The S&P 500 has now underperformed Treasury bills for over 13 years – even when recent market advance is included. If the S&P 500 indeed achieves a total return of 4.6% annually over the coming decade, those investors will have achieved a 23-year total return of just 3.2% annually. But even if the S&P 500 achieves a 10% annual return over the next decade, the 23-year total return for those investors would still only work out to 5.6% annually. When investors commit funds at rich valuations, the inevitable return to more normal valuations matters, and it matters for a very long time.

The most controllable determinants of investment returns are the level of valuation at which investors choose to initiate their investment and the level of valuation at which they choose to terminate their investment. Once you choose to initiate your investment at a rich level of valuation, you require a rich terminal valuation at some point in the future – and the good fortune to sell at that point – in order to achieve an acceptable long-term return. At present, rich valuations promise a very challenging decade for stock market investors, regardless of any fleeting short-term relief that monetary policy might provide.

Keep this in mind – when the market is deeply oversold and market internals are demonstrating positive divergences and recruiting favorable breadth, it can be sensible to accept market risk despite uncompelling valuations, as we did in early 2003. But speculating in a richly valued market where internals are showing increasing divergences, and the environment features an exhaustion syndrome and other historically dangerous conditions (see An Angry Army of Aunt Minnies) – is just begging for trouble.

Begging for Trouble

Investors remain so addicted to the temporary high of monetary intervention that they continue to ignore very real downturn in global economic indicators, to an extent that we have not seen since the 2007-2009 recession. This is particularly evident in the deterioration of new orders and order backlogs, which are short-leading indicators of production, which in turn is a short-leading indicator of employment.

Trading volume has been unusually low, while a 14-handle on the CBOE volatility index also suggests unusual complacency.  It’s understandable that people are reluctant to place trades in a weakening economy, yet one where quantitative easing is widely expected. Wall Street is scared to death of being out of the market when the perceived salvation of QE3 is announced, and at the same time is increasingly encouraged by negative economic data in the belief that this will accelerate delivery. In short, investors are practically begging to be shot, mauled by dogs, and diced by a Veg-O-Matic so they can get their next fix of pain-killers.

The chart below shows the average standardized value (mean zero, unit variance) of the overall, new orders, and order backlogs components of numerous regional surveys from the Federal Reserve and the Institute of Supply Management (ISM). We observe the same sustained deterioration in economic data across the world, including Europe and China (where the absolute values are higher, but the standardized values are similarly bad). The overall pattern reflects what Lakshman Achuthan of ECRI often describes as the “three P’s” – pronounced, pervasive, and persistent. Those three P’s help to distinguish signals from noise. Presently, our own noise-reduction methods suggest that a global recession is at hand.

One problem with the widespread faith in QE3 is that quantitative easing has had very weak and temporary effects on real economic activity or employment. Regional Fed governors like Eric Rosengren (Boston), John Williams (San Francisco) and others have increasingly advocated another round of quantitative easing, feeling extreme pressure for the Fed to “do something” about the economy. But as I’ve asked before, suppose that Ben Bernanke announces that he is going to stop spitting watermelon seeds into a can. Should we all become concerned that the Fed is suddenly not doing enough to stimulate the economy? Well, only if you think that spitting watermelon seeds into a can is stimulative.

Unfortunately, the impact of QE has been almost exclusively restricted to marginal changes in interest rates that have little effect on economic activity, and provoking temporary speculative bouts in the financial markets. This ineffectiveness has been predictable, not only because of the very weak relationship between GDP growth and stock market changes (a 1% change in stock market value has historically been associated with just a 0.03-0.05% change in GDP), but also because – drumroll – with trillions of idle reserves already sloshing around in the banking system, QE doesn’t relax any constraint that is actually binding on the economy.

The typical effect of QE-induced speculative runs has been little more than to help the stock market recover the decline that it experienced over the prior 6-month period (see What if the Fed Throws a QE3 and Nobody Comes?). In effect, QE is a policy that has negligible effects on the real economy, and is effective only in suppressing spikes in risk premiums and supporting the stock market after hard declines. We should not be surprised if it turns out to be fairly ineffective in lowering risk premiums when they are already depressed, reducing interest rates that are already near record lows, or supporting stock prices that are already quite elevated. Needless to say, the Fed is virtually certain to initiate another round of QE3. But the fact that it is needless to say this should be of some concern, because it suggests that the intervention is already fully discounted.

The suspended animation of the market here is very reminiscent of the similar suspension that occurred in 2008, as the markets eagerly awaited the near-certain passage of the Troubled Assets Relief Program (TARP). If you recall, within one minute of the passage of that bill by the House of Representatives, the stock market entered a free fall. Buy the rumor, sell the news.

Given the spike in risk premiums across Spanish and Italian debt, it is clear that a round of massive bond purchases by the European Central Bank would come as quite a relief to those debt markets and the European stock market. So massive ECB purchases would almost certainly have greater short-run impact than another round of QE by the Fed. But ECB monetization of distressed European debt is a policy that is still vehemently opposed by stronger European countries, and even what has been done already dabbles at the very edge of German constitutional law.

I continue to expect that the Euro will eventually break apart, and that it would be least disruptive for the stronger countries (Germany, Finland, Holland, etc) to exit first, allowing the remaining countries to print money and depreciate the Euro as they desire. The reason is that existing contracts in Euro could still be honored, without the massive corporate and private defaults that would occur if peripheral countries had to revert back to their previous national currencies and yet have to honor contracts in a dramatically stronger currency.

In my view, it is unwise to dismiss the possibility that the stronger European countries will split off either into their pre-Euro currencies, or into a new common currency with a more restricted membership. That is essentially what the sovereign bond markets foreshadow. Government bonds in Finland, Germany, Holland and several other countries are presently sporting negative interest rates, with German yields reaching record negative levels just last week. As Ray Dalio of Bridgewater recently wrote, “we think that there are good reasons to doubt that European bank and sovereign deleveragings will be prevented from progressing to the next stage in a disorderly way, without a viable Plan B in place. This fat tail event must be considered a significant possibility.”

For the United States, the main force of policy here should be on measures to ensure that the financial system is as immunized as possible from deterioration in the European banking system. On that front, Reuters reported last week that major banks have been directed to develop plans in the case of a renewed credit crisis.

With regard to the preparation of the U.S. financial system, I remain skeptical, but am somewhat more hopeful than I was a few years ago. Part of the Dodd-Frank act was the creation of an Orderly Liquidation Authority (OLA) to resolve too-big-to fail banks (Systemically Important Financial Institutions or SIFIs). The objective is to preserve large financial firms as going concerns in the event of insolvency, while ensuring that shareholders and creditors bear all the losses and customers and depositors are protected. The mechanics: following receivership, a temporary bridge company would be created, the FDIC would write down the assets to market value, old equity would be written off, and liabilities would be transferred by seniority (senior secured debt first) until the  bridge company had 10% equity. Remaining debt would be exchanged for equity in the new company.

The JP Morgan resolution plan provides a good example of how this would work. Notably, JP Morgan’s illustration suggests that an after-tax loss of $50 billion (just 2.2% of total assets) could be sufficient to take the company to insolvency, driving the company to a negative $16 billion equity position (h/t DailyBail). How could that happen? The example presented by JPM assumes two additional driving changes: a deposit run of 20%, which would be a substantial reduction in deposits, but certainly not unprecedented in other banking crises; and a $150 billion mark-down of asset values by the FDIC upon creation of the bridge company. Now, I’ve been quite critical of the 2009 FASB ruling that removed the need for banks to mark their assets to market, but a difference of $150 billion between the reported value of assets and the value that would be recognized in a reorganization? That would represent about 80% of the equity presently reported by JPM. One hopes that this figure has no relationship to reality.

Market Climate

As of last week, our estimates of prospective return/risk for stocks remained in the most negative 0.6% of historical observations, based on a blend of horizons from 2-weeks to 18-months. Strategic Growth remains fully hedged, with a “staggered strike” position that raises the strike prices of the put side of that hedge closer to market levels, presently representing about 1.6% of assets in time premium looking out toward year-end. Strategic International also remains fully hedged. Strategic Dividend Value is hedged at 50% of assets – it’s most defensive position. In Strategic Total Return, we used the spike in yields last week to very slightly increase the duration of the Fund to about 1.8 years. About 10% of assets remain in precious metals shares, with a few percent in utility shares and foreign currencies.

Copyright © Hussman Funds

Tags: Amp, Cash Flows, Central Bank Intervention, Corporate Profit, Daily Focus, Dalio, Earnings Estimates, Government Deficits, Hedges, Hussman, Hussman Funds, Implicit Assumption, Investment Climate, Material Change, Norms, Private Savings, Profit Margins, Shuffle, Target, Term Earnings, Term Investors, Valuations
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Erasers (Hussman)

Tuesday, August 7th, 2012

by John Hussman, Hussman Funds

August 6, 2012

I’ve never been very popular in late-stage bull markets. Defending against major losses and achieving our investment objectives over the complete bull-bear market cycle (bull-peak to bull-peak, or bear-trough to bear-trough) requires us to maintain an investment exposure that is essentially proportional to the expected return/risk ratio that is associated with each given set of market conditions. When prevailing market conditions are associated with a sharply negative expected return/risk ratio, as they are at present, and either trend-following measures are negative or several hostile indicator syndromes are in place (what we call Aunt Minnies), we will typically be fully-hedged, and will raise the strike prices of our put options toward the level of the market, in order to defend against steep market losses and indiscriminate selling. At present, we expect an average 10-year total return on the S&P 500 of about 4.7% annually in nominal terms, on the basis of rich normalized valuations. Based on a much broader ensemble of evidence, and considering horizons between 2-weeks and 18-months, we estimate the prospective return/risk ratio of the S&P 500 to be in the most negative 0.6% of all historical observations.

Moderate losses may be a necessary feature of risk-taking, but deep losses are erasers. A typical bear market erases over half of the preceding bull market advance. It is easy to forget – particularly during late-stage bull markets – how strongly this impacts full-cycle returns. The most obvious example, of course, is the 2008-2009 decline, which erased not only the entire total return of the S&P 500 since its 2002 low, but also erased the entire total return of the S&P 500 in excess of Treasury bill yields (its “excess return”) going all the way back to June 1995 – making all of the benefit from risk-taking during the late-1990’s completely for naught. Similarly, the 2000-2002 bear market wiped out the excess return that investors had enjoyed in the S&P 500 all the way back to February 1996. The 1990 bear market wiped out the excess return of the S&P 500 all the way back to January 1987.

Recall that at the 1987 peak, the S&P 500 had quadrupled (including dividends) from the secular low of August 1982. The 1987 crash – which in terms of size was a fairly run-of-the-mill bear of -33.51% from peak to trough – was enough to wipe out nearly half of that preceding total return (do the math: [(4*(1-.3351)-1]/(4-1)-1 = -45%), and slashed the excess return that investors had enjoyed since 1982 by even more than half. This chronicle of unpleasant arithmetic can be extended indefinitely over market history. Regardless of whether stocks are in a secular bull market or a secular bear market, the mathematics of compounding are brutal where large losses are concerned.

It’s instructive that $1 invested in Strategic Growth Fund at its inception, near the beginning of the 2000-2002 bear market was worth 2.72 times the value of an equivalent investment in the S&P 500 by the end of that bear market. Likewise, $1 invested in the Fund at the beginning of the 2007-2009 bear market was worth 2.09 times the value of an equivalent investment in the S&P 500 by the end of that bear market (see The Funds page for complete performance information). Performance gaps that can arise in the overvalued but still-advancing part of the full market cycle can be dramatically recovered by defensive strategies in the declining part of the cycle, which is why we don’t pay excessive attention to short-term tracking differences when market conditions are hostile.

Of course, there’s no assurance that we’ll always achieve our objective of outperforming the market with significantly smaller drawdowns over the complete market cycle. Though we’ve certainly had far less volatility and drawdown than the S&P 500 over the most recent cycle, Strategic Growth Fund lagged the total return of the S&P 500 by just shy of 13% cumulative from the 10/09/2007 peak in the S&P 500 to its most recent peak on 04/02/2012. This outcome primarily reflected my insistence on making our hedging approach robust to Depression-era data (an effort that caused us to miss returns in 2009-early 2010 until we achieved a robust solution using ensemble methods), and the smaller issue that purchasing actual put options has been less effective in periods where central banks have seduced investors to place their faith in “Bernanke puts” and “Draghi puts.” Our 2009-early 2010 miss was not “strategic” in that we would not be similarly defensive in future cycles if presented with identical conditions and evidence. But the fact is that our present defensive stance, particularly since early March, is something that we can be expected to establish over and over again in future cycles if presented with the same evidence.

Our measures of prospective return/risk became steeply negative in early March (see Warning: A New Who’s Who of Awful Times to Invest). Since then, market conditions have satisfied a restrictive set of criteria that have been similarly negative in a very small percentage of historical observations. At present, Strategic Growth Fund is fully-hedged, with most of our index put option strikes raised within about 4% of prevailing market levels, at a cost of less than 2% of assets in time premium looking out toward late-2012. This time premium will decay if the market remains unexpectedly resilient in the coming months and we observe no shift in presently negative market conditions. That said, with an angry army of negative indicator syndromes in place, I don’t expect speculation – even on hopes of further central bank intervention – will be significantly or durably rewarded here.

Suffice it to say that our present defensiveness is an intentional and repeatable aspect of our investment strategy. There are certainly some extraordinary factors that we had to address in the most recent market cycle as a result of the credit crisis and government attempts to defend bad debt, avoid restructuring, and to extend, pretend, and print at all costs. I believe that we can manage a continuation of that policy environment well over time, though periodic frustrations may be more frequent due to short-lived “risk-on” advances. In any event, I have no belief that central bank operations (which do little more than purchase a fraction of the new additions to the mountain of global government debt and replace them with currency and bank reserves) are actually capable of making recessions, bear markets, or the basics of arithmetic things of the past.

Economic Notes

Friday’s headline non-farm payroll employment gain (establishment survey) of 163,000 jobs was surprisingly positive, but far less informative about economic prospects than investors appeared to assume. The household survey, which is used to calculate the unemployment rate, actually showed a drop in civilian employment of 195,000 jobs in July. The increase in the unemployment rate would have been greater if not for the fact that another 150,000 people left the labor force altogether and were therefore not counted as unemployed. The picture was particularly weak for workers 20 years of age and older (where 213,000 jobs were lost), but was slightly rescued by a gain of 18,000 jobs among 16-19 year-olds. While the difference between the establishment and household surveys was unusually large, these disparities aren’t entirely uncommon, and don’t have a great deal of predictive value for either series. It’s probably most accurate to say that the July employment figures were mixed.

Even focusing on the bright spot, which is the establishment survey figure, one immediate fact to note is that year-over-year growth in non-farm payrolls fell below 1.4% back in April, following a brief excursion above that level, and has remained weak since then. As the chart below indicates, a decline in year-over-year payroll employment growth below 1.4% has occurred just before, or already into, each of the past 10 recessions, with no false signals. As usual, we’re skeptical of drawing inferences from a single indicator, and this instance may be different. But given the collapse in new orders and other measures of economic activity across numerous Fed, ISM and global surveys (and a continued decline in the most leading signal that we infer from our unobserved components models), there seems to be little reason for that expectation.

Keep in mind, as we’ve noted regularly over the years, that employment is a lagging economic indicator. The “stream of anecdotes” school of economic analysis may treat every economic report as having equal weight in determining the course of the economy, but the actual sequence is generally as follows: falling consumption growth and new orders -> falling production -> falling employment. The latest employment report appears to be little more than the wagging tail of an already sick puppy, and the tail is not likely to wag that dog to health.

In contrast, the latest JP Morgan global manufacturing report observes that “production and new orders both fell for the second month running in July, with rates of contraction gathering pace.” The chart below presents the global purchasing managers index (PMI), which has now weakened to levels last seen during the last two recessions.

With regard to Europe, it’s interesting how the semantics of the phrase “everything necessary” has been used to obscure the differences between Euro-area countries when it comes to monetizing bad debt. The distinction can be seen in a comment last week by German government spokesman Georg Streiter: “The ECB president said that the ECB will do everything necessary to preserve the euro and the government will do everything politically necessary to preserve the euro.” As long as the phrase is shortened to “everything necessary,” everyone is in agreement. The differences are in the subset of actions that constitute “everything.” For the German government, it is everything politically necessary. For Finland, it is everything necessary provided that collateral is pledged for every loan. For the German courts, it is everything legally necessary. While everyone can be unanimous about their commitment to doing “everything necessary,” it’s important to recognize that “everything” means something different to each party.

Even Mario Draghi had to resort to oxymorons to explain why the ECB did not initiate bond purchases last week despite what investors had taken as a pledge to do so, saying that the endorsement of bond purchases among ECB council members was “unanimous with one reservation” (he then left to enjoy some jumbo shrimp in a plastic glass, but they were found missing, leaving Draghi and his broken fix for an enduring Euro alone together in the deafening silence).

My impression regarding the Euro remains unchanged – liquidity will not durably counter insolvency, and the solvency problem among peripheral European countries is too great to be addressed without debt restructuring. ECB purchases of distressed sovereign debt would most likely have to be permanent purchases, and would therefore represent a fiscal transfer at the expense of stronger countries that would prefer to use the proceeds of money creation for the benefit of their own citizens. Doing those purchases indirectly – the ECB buying the debt of an ESM with a banking license, and the ESM buying distressed debt – does not change the arithmetic. Very reasonably, Germany is only willing to mutualize the debts of its neighbors if it can exert centralized authority over their fiscal policies – in Angela Merkel’s words “liability and control belong together.” But while Europe is geographically united, it is culturally and politically diverse, and a surrender of national sovereignty to the required extent is unlikely.

As a result, the Euro is likely to be pulled apart, and the tensions will probably be greatest across geographic and socioeconomic fault lines. From a geographic perspective, Finland (which insists on good collateral even for EFSF actions) and Italy (where popular sentiment against the Euro is strongest) have the greatest divide. From a socioeconomic standpoint, Germany (which is strongly anti-inflation and more oriented toward free enterprise) and the southern European states of Greece, Italy, Spain and Portugal (which have high debt ratios, heavily socialized economies, and very fragile banks) seem to be the furthest apart. The real question is who will get the Euro if the wish-bone snaps – the stronger more solvent states, or the weaker more inflation-prone states. Until the answer is clear, it will be difficult to anticipate the future direction of the Euro’s value. I would expect the least amount of systemic disruption in the event of an exit from the Euro by the stronger European countries, but that would also be associated with the maximum amount of Euro depreciation as the remaining members are left to inflate as they (and the ECB) please. All of this will be extraordinarily interesting, but it will not be easy.

Market Climate

As of last week, the Market Climate for stocks remained among the most negative 0.6% of historical observations, holding us to a tightly defensive stance. Strategic Growth remains fully hedged, with a staggered-strike position that raises the strike prices of the put option side of our hedge within a few percent of prevailing levels, at a cost of less than 2% of assets in time premium looking out to very late-2012. The Fund’s day-to-day returns can be expected to primarily reflect changes in the value of this time premium and day-to-day performance differences between the stocks held by the Fund and the indices we use to hedge. Strategic International also remains fully hedged. Strategic Dividend Value remains hedged at about 50% of the value of its stock holdings. Strategic Total Return continues to carry a duration of about one year in Treasury securities, with about 10% of assets in precious metals shares, and a small percentage of assets in utility shares and foreign currencies.

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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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Extraordinary Strains (Hussman)

Sunday, July 22nd, 2012

by John Hussman, Hussman Funds

Just weeks after the enthusiasm over Europe’s plan to plan for the possibility of using the European Stability Mechanism to bail out Spanish banks, the subtle technicality – that direct bailouts would make all of Europe’s citizens subordinate to even the unsecured bondholders of Spain’s banks – has predictably deflated that enthusiasm. On the growing recognition that addressing Spain’s banking problem will mean taking those banks into receivership, wiping out unsecured debt (much of which unfortunately was sold to unknowing Spanish savers as secure “savings” vehicles), and having the Spanish government sort out the damage, Spanish 10-year debt plunged to new lows last week (see chart below), and Spanish yields hit fresh Euro-crisis highs. At the same time, interest rates in Germany, Finland, Holland, Denmark and Switzerland all moved to negative levels looking 2-5 years out. The world is paying these governments to lend money to them, because the only way to acquire other default-free, non-commodity assets is to hire armored trucks and secure vaults to take delivery of physical currency. This set of conditions is not normal or sustainable, and indicates extreme credit market strains in Europe.

The Euro also hit a fresh 2-year low last week at 1.21, just a shade above its 2010 crisis low of 1.20. Likewise, the yield on 10-year U.S. Treasury bonds dropped to 1.45%, matching the historic low it reached a few weeks ago. Yields were higher even in the depths of the Great Depression, when the S&P 500 was trading at less than 2 times the pre-Depression level of earnings, the Shiller P/E on 10-year normalized earnings was less than 5, and the S&P 500 was yielding 16%. As a side note, many analysts seem almost woozy at the “incredible value” that supposedly exists in stocks because the 2.3% yield on the S&P 500 exceeds the 1.45% yield on 10-year Treasuries. It’s worth pointing out that prior to the point that inflation took off after 1960, the yield on the S&P 500 exceeded the yield on Treasury bonds in fully 93% of the data.

Keep in mind that once you subtract out the necessary compensation for default risk (which is rapidly increasing in Spain, for example), interest rates represent the value that the economy places on time. Long-term interest rates have plunged to record lows, and real interest rates are negative after inflation. What interest rates are telling you; what the Federal Reserve is telling you; what the equilibrium created by lenders and borrowers is telling you – is that time is economically worthless and that economic malaise will extend for years.

This does not reflect a well-functioning economy. To the contrary, if you look across history and across nations, strong prospects for sustained economic growth are typically accompanied by high real interest rates, because the demand for capital is robust and good ideas have to compete for funding. Interest rates are an indication of both the demand for loans and the incentive to save. It is not “stimulative” to depress interest rates in an environment where households, businesses and governments are desperately trying to reduce debt. That policy may insult the value of time enough to deter people from saving, and to reduce the immediate penalty for assuming even larger amounts of debt (as the U.S. government continues to do), but it should be clear that these actions move the economy further from a sustainable equilibrium, not closer to it.

I do expect that it will be possible to navigate the coming years well, but it will not be by locking in negligible yields and depressed risk premiums in the futile hope that one plus one will end up being something other than two. Prospective returns vary a great deal over the course of the market cycle, and the strategy of varying risk exposure in proportion to the prospective compensation for that risk will be essential.

On the economic front, as we expected based on leading economic evidence, new orders and order backlogs have dropped abruptly in recent reports. These indices are short-leading indicators of production, which is likely to show a striking decline beginning in the July data. Note carefully whether any positive surprises are in May and June data, because these reports will still be mixed. I continue to expect negative employment changes in the coming months, though as I’ve noted before, we may only find this out later on revisions rather than the initial prints in real-time. In any event, I am convinced that we will ultimately learn that the U.S. economy, slightly trailing the global economy, entered a new recession in June.

While July components are still coming in, the chart below shows the most recent condition of coincident U.S. economic data, reflecting a variety of Fed surveys and Purchasing Managers surveys.

The key question – in view of extreme credit market strains in Europe, and accelerating economic deterioration in the U.S. – is why the S&P 500 continues to trade within a few percent of its April bull market high. The answer is simple: investors are scared to death of missing the widely anticipated market advance that they expect to follow a widely anticipated third round of quantitative easing. Good economic news may be a relief for investors, but bad economic news in this context is just as much of a relief because it brings forward the anticipated delivery date of the sugar. The follow-up question, however, is that if more QE is widely anticipated, and a market advance is widely anticipated to result, isn’t that the precise definition of an event that is already priced into the market?

If you look at the Federal Reserve’s own research on quantitative easing – large scale asset purchases (LSAPs) – nearly every paper emphasizes the “portfolio balance” effect. Put simply, as the Fed removes longer-term Treasury securities from the menu of portfolio choices available to investors, it forces investors to consider alternative securities, raising their prices and lowering their yields – with a particular impact in driving down the risk premiums of risky securities. Indeed, as we’ve noted, QE has generally been effective in helping stocks to recover the peak-to-trough loss that they have suffered in the prior 6-month period (though the most recent LSAPs in the UK and Europe have been failures in that regard).

Still, once risk premiums are already deeply depressed (we estimate the likely 10-year prospective total nominal return for the S&P 500 to be only 4.8% annually), once stocks are trading near their bull market highs, and once Treasury debt already sports the lowest yield in history, should investors really expect much of a portfolio-balance effect from further attempts at QE? Frankly, I doubt it, but in the eventuality of a third round of QE, we’ll focus on our own measures of market action – not on any blind faith in the Fed.

The more troubling issue is that Fed papers on the effectiveness of QE focus almost singularly on the effect of QE on interest rates and risk premiums in the financial markets, with the notable absence of any analysis of the resulting effect on the real economy. This is like showing that squirting gas into an engine will make the engine run faster, without any concern for the fact that there is no transmission that connects the engine to the wheels. In a nutshell, the problem with QE is the lack of any material transmission mechanism from monetary interventions to real economic activity. This is a problem that the Fed should have recognized years ago, because there is strong and consistent historical evidence that real economic activity has very weak “elasticity” with respect to financial market fluctuations, particularly in equity values. Invariably, a 1% change in the value of the stock market is associated with a change of just 0.03-0.05% in GDP, and even that change is transitory. What the Fed has been doing is little but bubble-blowing, while at the same time driving the global financial system further from equilibrium rather than toward it.

Unfortunately, I expect these efforts to continue, but I also expect that it will be useless in averting an unfolding global recession. If the Fed was to initiate a third round of QE near present levels, it would likely be disappointing in the sense that it would fail to reverse economic weakness and at the same time would fail to drive equity prices higher than they already are, or interest rates materially lower than they already are. This would damage confidence in the Federal Reserve and force it to resort to language about monetary policy working with “long and variable lags.” Moreover, at a 1.45% yield and an 8-year duration on a 10-year bond, any interest rate increase of more than about 18 basis points a year will now produce a negative total return for the Federal Reserve over the period that the bonds are held, which comes at public expense (reducing the amount of interest that the Fed would otherwise turn over to the Treasury). As a result, talk is presently much cheaper than action. It seems likely that another round of QE will await obvious economic weakness and a significant spike in risk premiums – probably best measured by the depth of the drawdown in the S&P 500 from its most recent 6-month peak. Still, given that the rationale for much higher risk premiums is very real, it’s not clear that QE will have durable effects on stocks even in that event.

In short, a broad array of observable evidence suggests extraordinary strains in Europe, and abrupt though expected deterioration in U.S. economic activity. The Federal Reserve certainly has policy options, but those options have no material transmission mechanism to the real economy. We’ve always viewed the Federal Reserve as having an important and legitimate role in providing liquidity to the banking system in the event of heavy withdrawals; creating new reserves in return for high-quality, default-free securities backed by the full faith and credit of the U.S. government. This remains an important role, but the Fed’s actions have gone far beyond this role into areas that distort financial markets without transmission to economic activity. That’s just a reality we have to accept, and we’ll respond to further interventions with particular attention to trend-following measures of market action.

Here and now, we remain defensive in the face of accelerating strains the global economy – new highs in Spanish yields, negative interest rates across more stable European countries, new lows in the Euro and U.S. Treasury yields, collapsing new orders and backlogs, a sudden plunge in the employment component of the Philly Fed index, collapsing M2 velocity, and other factors. Due to some modest interest-rate considerations, our estimates of prospective return/risk have improved negligibly from the most negative 0.5% of historical observations, and are now among the most negative 0.8% of historical data. This rare extreme keeps us on red alert for now.

Market Climate

As noted above, accelerating strains are evident both in the global economy – particularly Europe – and in the U.S. economy. Stock valuations remain stretched on the basis of normalized earnings. Profit margins are nearly 70% above their historical norms at present, but these margins reflect very high deficit spending and very weak savings rates – something that can be related to corporate profit margins through accounting identities. Unless one anticipates continued deficits indefinitely, either revenues will revert closer to the level of labor compensation, or less likely, labor compensation will increase toward the level of revenues, but in any event the gap will tend to narrow. This may not be an immediate outcome, but stocks are instruments with an effective duration of over 40 years (mathematically, the duration of stocks is essentially equal to the price-dividend ratio, regardless of growth rates or repurchases). The very long-term stream of cash flows matters enormously in asset valuation.

One of the immediate issues I have with stocks here is the “exhaustion syndrome” (see Goat Rodeo) that has re-emerged in recent weeks. Examining the rare past instances of this syndrome, in 1961, 1987, 2000, and early-2008 among others, the key feature is a breakdown in measures of market action from an overvalued, overbought extreme, followed by a recovery rally toward the prior high and accompanied by earnings yields below their level of 6-months earlier. Normally, the recovery carries the market back to the prior “line” of support that surrounds the peak. The emergence of this exhaustion syndrome may seem benign or unimportant, but it has historically been an important precursor of major market declines. Given what are already significant challenges for both the economy and for the prospective return/risk tradeoff in stocks, my concerns about the potential for deep market losses remain elevated.

Investors often have the impression that the market simply collapses once a bull market peak is set, but this isn’t typical. What is typical is exactly the sort of exhaustion pattern we’ve observed since April. To illustrate this, the chart below presents market behavior around several market peaks that were also followed by an exhaustion syndrome as we observe today. The bull market peaks are aligned at 1.0. The remaining scale is set as a fraction of that peak. Time is measured in trading days before and after the bull market peak. Note that after a quick initial decline from the bull market peak, it’s typical for the market to recover much of the lost ground before the downside progress continues, in some cases producing the “exhaustion syndrome” that we presently observe. Exhaustion syndromes can go on for several weeks, but have historically been very dangerous advances to trade, because more often than not, there is a bear market just behind them. This was not the case in three instances: the July 1998 instance – followed by a decline of only 18%, the July 1999 instance – down only 12% over the next several months, and of course the instance in late January of this year, which occurred at about 1326 on the S&P 500 and still hasn’t yet resolved into losses beyond the weakness we saw in May. It’s possible that the market outcome will be benign in this case, and that the market will go on to set further bull market highs. We have no intention of taking that improbable gamble in the face of present headwinds.

Strategic Growth and Strategic International continue to be fully hedged, with a staggered-strike option position in Strategic Growth (which raises the strike prices of the put side of our hedge). We presently estimate the time-decay or “theta” of the staggered-strike position at about 0.25% of assets monthly – which we are willing to accept based on the extremely negative outcomes that are typical of the current climate, and the expectation that we will not remain in this position for a long time. Strategic Dividend Value is hedged at about 50% of the value of its stock holdings, and Strategic Total Return continues to carry a duration of just over one year, with about 10% of assets in precious metals shares and a few percent of assets in utility shares and foreign currencies.

Copyright © Hussman Funds

Tags: 10 Year Treasury, Armored Trucks, Bondholders, Commodity, European Stability, Great Depression, Hussman, Hussman Funds, John Hussman, Lows, Receivership, Shiller, Spanish Banks, Spanish Government, Strains, Technicality, Time Interest, U S Treasury, U S Treasury Bonds, Unsecured Debt, Vaults
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Anatomy of a Bear (Hussman)

Monday, July 2nd, 2012

by John Hussman, Hussman Funds

In the first week of March, the U.S. stock market established a set of conditions placing it among the most negative 2.5% of historical observations (see Warning: A New Who’s Who of Awful Times to Invest) – a short list that includes the major peaks of 1972-73, 1987, 2000, and 2007. Since then, we’ve seen an increasing set of indicator syndromes that are associated with historically hostile market outcomes, maintaining us in a hard-defensive stance that is as rare as it is imperative. Last week, the market reconfirmed the “exhaustion syndrome” that I discussed several months ago (see Goat Rodeo). Prior to 2012, there were 112 weeks in post-war U.S. data where our investment strategy would have encouraged a similarly defensive position with that syndrome in place. Following those instances, the S&P 500 plunged at an average annual rate of -47.5%.

The trend-following components of our market action measures remain negative here, but it is important to note that those components are moderately – probably a small number of positive weeks – away from an improvement that could shift us from such a tightly defensive stance. While our outlook would not become bullish by any means, this shift would rein in the “staggered strike” put option hedges we presently hold in Strategic Growth. These positions (which raise the strike prices on the long-put portion of our hedges) substantially improve performance during market plunges, but make us vulnerable to the loss of put option premium during “risk on” advances such as we saw last week. That is uncomfortable even if the puts only represent a very small percentage of assets (as they do here).

Suffice it to say that we are most likely a single number of weeks away from either substantial market losses, or enough stabilization in market action to ease our defensiveness. In any event, we will not maintain our present stance indefinitely.

So far, hopes for massive bailouts and monetary interventions have allowed the market to forestall the more violent follow-through that it experienced in 1973-74, 1987, 2000-2002 and 2007-2009 from similar conditions. Yet the market impact from various monetary actions has become progressively weaker, and the exuberance from various “agreements” out of Europe has become progressively shorter. More importantly, in data spanning more than a century, including Depression, two world wars, rapid inflation, credit crisis, and numerous bubbles and crashes, we’ve seen that relevant global events show up in observable data such as market action, credit spreads, valuations, economic indicators, sentiment, and specific syndromes of conditions. As a result, we don’t need a “Euro breaks up” indicator, or a “Bernanke bubble factor” in our data set, nor do we need a live feed showing constantly refreshed CT-scans of Angela Merkel’s spine.

When the observable data shifts, so will our investment stance. We certainly struggled in 2009 and early 2010 to ensure that our methods were robust to Depression-era data, and the repeated bouts of monetary intervention have narrowed our criteria for establishing staggered-strike hedges, becoming more sensitive to trend-following factors than was necessary prior to 2009. The past few years would have been more comfortable if these adaptations had not been necessary, but they also leave us well-prepared to weather a broad range of potential outcomes, in the expectation of returns that resemble what we’ve achieved in other complete market cycles (e.g. peak-to-peak 2000-2007, trough-to-trough 2002-2009). Both the internet bubble and the housing and credit bubble offered plenty of temptation to believe in a “new era” where historically important market factors were irrelevant. The same temptation exists today despite accelerating global economic challenges. We remain just as unwilling to shift our investment discipline away from testable evidence, or to rely on a blind faith in policymakers to make risk simply go away.

Anatomy of a Bear

Last week, the market re-established the “exhaustion syndrome” that we observed several months ago. The associated rally was uncomfortable, not only because banks and financials advanced (where we hold very little exposure), but also because the advance took our staggered strike put option hedges from in-the-money to out-of-the-money while the CBOE volatility index dropped to just 17. It is easy to forget that we experienced much the same thing near the 2000 and 2007 market peaks. As I noted in the March Who’s Who piece: “A word of caution… When we look at longer-term charts like the one above, it’s easy to see how fleeting the intervening gains turned out to be in hindsight. However, it’s easy to underestimate how utterly excruciating it is to remain hedged during these periods when you actually have to live through day-after-day of advances and small incremental new highs that are repeatedly greeted with enthusiastic headlines and arguments that ‘this time it’s different.’ For us, it’s particularly uncomfortable on days when our stocks don’t perform in line with the overall market, or when the ‘implied volatility’ declines on our option hedges.”

Though our level of defensiveness will remain sensitive to any improvement in our measures of market action, my opinion remains that the global economy is entering a new recession, and that stocks are already in the beginning of a bear market. Because bull and bear markets can only be confirmed in hindsight, we prefer in practice to focus on the broad set of observable evidence at every point in time. Our investment stance is based on that evidence, not my views about recession or bear market status.

As veteran market analyst Richard Russell has noted, investors often equate the concept of a bear market with the expectation that prices will continuously fall. Indeed, if you think back to the 2000-2002 bear, or the 2007-2009 bear, that is probably the memory that those bear markets invoke. In fact, however, those bear markets can be seen on a smaller scale as a constant process of hope and disappointment, with periods of risk-seeking abruptly punished by fresh waves of risk-aversion. This can make it very difficult to live through a bear market day-after-day with a clear sense of the larger picture.

In an attempt to reinforce this picture, the following charts present the initial the 1973-74, 1987, 2000-2002, and 2007-2009 bear markets, respectively. For each period, the initial portion of the bear market is on the left side, while the complete decline is on the right side. Those complete declines represented market losses of about 50% from the highs, except for 1987 which was more abrupt but somewhat less extensive. The final chart shows the S&P 500 from early March through last week. Notably, each of those previous bears started from conditions that match the “Who’s Who” syndrome we observed in March of this year. The feature to notice about these early bear markets is that in each case, despite a hard initial decline, the market recovered within a few percent its bull market high at some point between 2-9 months after the bear market had already started. In effect, investors mounted an “exhaustion rally” despite already deteriorating market internals and rich valuations.

The unusually bad outcomes of similar historical precedents help to convey why we retain such a durable sense of doom, even after last week’s scorching “risk on” advance. Again, a moderate continuation of constructive market action would likely be sufficient to move us to soften our presently hard defense by retreating from a “staggered strike” option hedge. At present, conditions remain aligned with those that have preceded some of the most negative consequences in market history.

On Europe’s Plan to Have a Plan to Have a Memo of Understanding

The following is Friday’s statement from the EU (emphasis added):

“We affirm that it is imperative to break the vicious circle between banks and sovereigns. The Commission will present Proposals on the basis of Article 127(6) for a single supervisory mechanism shortly. We ask the Council to consider these Proposals as a matter of urgency by the end of 2012. When an effective single supervisory mechanism is established, involving the ECB, for banks in the euro area the ESM could, following a regular decision, have the possibility to recapitalize banks directly. This would rely on appropriate conditionality, including compliance with state aid rules, which should be institution-specific, sector-specific or economy-wide and would be formalised in a Memorandum of Understanding. The Eurogroup will examine the situation of the Irish financial sector with the view of further improving the sustainability of the well-performing adjustment programme. Similar cases will be treated equally.

“We urge the rapid conclusion of the Memorandum of Understanding attached to the financial support to Spain for recapitalisation of its banking sector. We reaffirm that the financial assistance will be provided by the EFSF until the ESM becomes available, and that it will then be transferred to the ESM, without gaining seniority status.

“We affirm our strong commitment to do what is necessary to ensure the financial stability of the euro area, in particular by using the existing EFSF/ESM instruments in a flexible and efficient manner in order to stabilise markets for Member States respecting their Country Specific Recommendations and their other commitments including their respective timelines, under the European Semester, the Stability and Growth Pact and the Macroeconomic Imbalances Procedure. These conditions should be reflected in a Memorandum of Understanding. We welcome that the ECB has agreed to serve as an agent to EFSF/ESM in conducting market operations in an effective and efficient manner.

“We task the Eurogroup to implement these decisions by 9 July 2012.”

The upshot here is that Spain’s banks are undercapitalized and insolvent, but rather than take them over and appropriately restructure them in a way that requires bondholders to take losses instead of the public, Spain hopes to tap European bailout funds so that it can provide capital directly to its banks through the European Stability Mechanism (ESM), and put all of Europe’s citizens on the hook for the losses. Spain has been trying to get bailout funds without actually having the government borrow the money, because adding new debt to its books would drive the country further toward sovereign default. Moreover, institutions like the ESM, the ECB, and the IMF generally enjoy senior status on their loans, so that citizens and taxpayers are protected. Spain’s existing bondholders have objected to this, since a bailout for the banks would make their Spanish debt subordinate to the ESM.

As a side note, the statement suggests that Ireland, which already bailed its banks out the old-fashioned way, will demand whatever deal Spain gets.

So the hope is that Europe will agree to establish a single bank supervisor for all of Europe’s banks. After that, the ESM – Europe’s bailout fund – would have the “possibility” to provide capital directly to banks. Of course, since we’re talking about capital – the first buffer against losses – the bailout funds could not simply be lent to the banks, since debt is not capital. Instead, it would have to be provided by directly purchasing stock (though one can imagine the Orwellian possibility of the ESM lending to bank A to buy shares of bank B, and lending to bank B to buy shares of bank A). On the question of whether this is a good idea, as opposed to the alternative of properly restructuring banks, ask Spain how the purchase of Bankia stock has been working out for Spanish citizens (Bankia’s bondholders should at least send a thank-you note). In any event, if this plan for a plan actually goes through, the bailout funds – provided largely by German citizens – would not only lose senior status to Spain’s government debt; the funds would be subordinate even to the unsecured debt held by the bondholders of Spanish banks, since equity is the first thing you wipe out when a bank is insolvent.

It will be interesting to see how long it takes for the German people to figure this out.

Market Climate

It bears repeating that our present defensiveness is not a reflection of European concerns or even our view that the U.S. economy is entering a recession. We try to align our investment position with the prospective return/risk profile that we estimate on the basis of prevailing market conditions, and those conditions are what keep us tightly hedged here. As noted earlier, a moderate further recovery in market internals would move us to reduce the tightness of our hedge, though it’s fair to say that the required improvement is not simply a stone’s throw away and would likely require at least a small number of positive weeks. Here and now, present conditions remain among the most negative in history from a prospective return/risk standpoint. Strategic Growth Fund remains tightly hedged, with a staggered strike position where the additional put option premium at risk represents about 1.8% of total assets. Strategic International also remains fully hedged, and Strategic Dividend has nearly 50% of its stock holdings hedged (its most defensive stance). Strategic Total Return continues to carry a duration of about one year, with about 14% of assets in precious metals shares, and a small percentage of assets in utility shares and foreign currencies.

Copyright © Hussman Funds

Tags: Action Measures, Anatomy, Defensive Position, Defensive Stance, Defensiveness, Exhaustion, Goat, Hedges, Hussman, Hussman Funds, Investment Strategy, John Hussman, Market Losses, Market Outcomes, Market Plunges, Post War, Put Portion, Rodeo, Substantial Market, Syndromes, U S Stock Market
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The Heart of the Matter (Hussman)

Sunday, June 10th, 2012

by John Hussman, Hussman Funds

Over the past 13 years, the S&P 500 has underperformed even the depressed return on risk-free Treasury bills. Real U.S. gross domestic investment has not grown at all since 1999, and even as a share of GDP, real investment remains weak.

The ongoing debate about the economy continues along largely partisan lines, with conservatives arguing that taxes just aren’t low enough, and the economy should be freed of regulations, while liberals argue that the economy needs larger government programs and grand stimulus initiatives.

Lost in this debate is any recognition of the problem that lies at the heart of the matter: a warped financial system, both in the U.S. and globally, that directs scarce capital to speculative and unproductive uses, and refuses to restructure debt once that debt has gone bad.

Specifically, over the past 15 years, the global financial system – encouraged by misguided policy and short-sighted monetary interventions – has lost its function of directing scarce capital toward projects that enhance the world’s standard of living. Instead, the financial system has been transformed into a self-serving, grotesque casino that misallocates scarce savings, begs for and encourages speculative bubbles, refuses to restructure bad debt, and demands that the most reckless stewards of capital should be rewarded through bailouts that transfer bad debt from private balance sheets to the public balance sheet.

What is central here is that the government policy environment has encouraged this result. This environment includes financial sector deregulation that was coupled with a government backstop, repeated monetary distortions, refusal to restructure bad debt, and a preference for policy cowardice that included bailouts and opaque accounting. Deregulation and lower taxes will not fix this problem, nor will larger “stimulus packages.” The right solutions are to encourage debt restructuring (and to impose it when necessary), to strengthen capital requirements and regulation of risk taken by traditional lending institutions that benefit from fiscal and monetary backstops, to remove fiscal and monetary backstops and ensure resolution authority over institutions engaging in more speculative financial activities, and to discontinue reckless monetary interventions that encourage financial speculation and transitory “wealth” effects without any meaningful link to lending or economic activity.

By our analysis, the U.S. economy is presently entering a recession. Not next year; not later this year; but now. We expect this to become increasingly evident in the coming months, but through a constant process of denial in which every deterioration is dismissed as transitory, and every positive outlier is celebrated as a resumption of growth. To a large extent, this downturn is a “boomerang” from the credit crisis we experienced several years ago. The chain of events is as follows:

Financial deregulation and monetary negligence -> Housing bubble -> Credit crisis marked by failure to restructure bad debt -> Global recession -> Government deficits in U.S. and globally -> Conflict between single currency and disparate fiscal policies in Europe -> Austerity -> European recession and credit strains -> Global recession.

In effect, we’re going into another recession because we never effectively addressed the problems that produced the first one, leaving us unusually vulnerable to aftershocks. Our economic malaise is the result of a whole chain of bad decisions that have distorted the financial markets in ways that make recurring crisis inevitable.

Once we abandoned Glass-Steagall, removing the firewall between traditional banking and more speculative activities, and allowing those activities to have the effective protection of the U.S. government, it was only a matter of time until a credit crisis would unfold. My 2003 piece Freight Trains and Steep Curves detailed the problem: “So the real question is this: why is anybody willing to hold this low interest rate paper if the borrowers issuing it are so vulnerable to default risk? That’s the secret. The borrowers don’t actually issue it directly. Instead, much of the worst credit risk in the U.S. financial system is actually swapped into instruments that end up being partially backed by the U.S. government. These are held by investors precisely because they piggyback on the good faith and credit of Uncle Sam.”

The ability to use the Federal government as a backstop for risk-taking was the central element in creating the housing bubble. As long as a borrower was physically breathing, you could make a mortgage loan without really worrying about whether the loan could be paid back. By the time it was packaged up, tranched out, and securitized either by a bank or by Fannie and Freddie, all of which had the government backstop, the loan was somebody else’s problem. When the bubble crashed, our policy makers made their crucial mistake – first through the Bush Administration, and then continued by the Obama Administration – they failed to require bondholders to take losses on bad loans.

Every major bank is funded partially by depositors, but those deposits typically represent only about 60% of the funding. The rest is debt to the bank’s own bondholders, and equity of its stockholders. When a country like Spain goes in to save a failing bank like Bankia – and does so by buying stock in the bank – the government is putting its citizens in a “first loss” position that protects the bondholders at public expense. This has been called “nationalization” because Spain now owns most of the stock, but the rescue has no element of restructuring at all. All of the bank’s liabilities – even to its own bondholders – are protected at public expense. So in order to defend bank bondholders, Spain is increasing the public debt burden of its own citizens. This approach is madness, because Spain’s citizens will ultimately suffer the consequences by eventual budget austerity or risk of government debt default.

The way to restructure a bank is to take it into receivership, write down the bad assets, wipe out the stockholders and much of the subordinated debt, and then recapitalize the remaining entity by selling it back into the private market. Depositors don’t lose a dime. While the U.S. appropriately restructured General Motors – wiping out stock, renegotiating contracts, and subjecting bondholders to haircuts – the banking system was largely untouched.

The failure of our policy makers to restructure debt resulted in the worst of both worlds – an economy where banks were relieved of the need for transparency (thanks to accounting changes by the FASB), and yet homeowners strapped with bubble-sized mortgage obligations saw very little in terms of debt restructuring. The reason we never got any economic traction in this “recovery” is that these debt burdens remain in place. While we certainly don’t advocate “freebie” principal writedowns – which would almost surely result in a tsunami of strategic defaults, we’ve long proposed what we’ve called Property Appreciation Rights as a way to partially substitute mortgage premium for a marketable claim on future appreciation. Failing any meaningful debt restructuring, however, we’ve got a financial system that continues to operate with a confident government backstop for risk taking, while aggregate demand remains suppressed by a burden of existing debt.

Economists define a standard of living as the amount of goods and services that people in the economy can consume as a result of the work they do. They define productivity as the amount of goods and services that people in the economy can produce as the result of the work they do. In the long run, a rising standard of living requires rising productivity, which in turn requires the economy to accumulate a stock of productive investments – factories, machines, inventions, education, and so forth. In the short run, the benefits of productivity growth can be retained through profits in a way that prevents those benefits from being enjoyed by workers, but even then, redistributing wealth can only achieve limited improvements in living standards. Over time, an economy that squanders its scarce savings will predictably suffer for it.

Tragically, nobody seems to have learned a thing from the dot-com crash, or the tech crash, or the housing crash. Wall Street continues to beg for monetary interventions to reward speculative trading, even though these rewards have repeatedly proved to be short-lived. What investors don’t seem to appreciate is how much of our nation’s scarce savings have been burned to ashes as a result.

I really don’t mean to pick on Facebook. It’s a neat company, a neat platform, and I respect Mark Zuckerberg’s charitable initiatives. But the example is too instructive to miss, so let’s think about it as a recipient of investment capital. If you go on Amazon or Ebay, you want to stay in order to buy something. That’s a fine business model, and network effects work in your favor because there are a lot of sellers on the other side. If you go on Google, you want to find what you’re looking for and then leave, which is a situation where advertising is welcome, and also works as a business model. But consider Facebook. If you go on Facebook, your whole intention is to stay on Facebook for a while, but not to buy something. Here, network effects work against advertising because responding to the ad pulls you away from the network.

Tags: Backstop, Bad Debt, Cowardice, Debt Restructuring, Deregulation, Financial Sector, Global Financial System, Government Programs, Gross Domestic Investment, Heart Of The Matter, Hussman Funds, John Hussman, Lower Taxes, Partisan Lines, Policy Environment, Public Balance, Right Solutions, Scarce Capital, Speculative Bubbles, Treasury Bills
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Run of the Mill (Hussman)

Monday, June 4th, 2012

by John Hussman, Hussman Funds

Since late-February, our estimates of the market’s prospective return/risk tradeoff (over a set of horizons from 2 weeks to 18 months) have persistently held in the worst 0.5% of all historical observations. It’s always important to emphasize that we try to align ourselves with the average return/risk profile that has historically accompanied the particular set of investment conditions we observe at each point in time, but that the outcome in any specific instance may not reflect the average return, and may even fall outside of what we view as the likely range of outcomes. That said, the awful behavior of the market in recent weeks is very run-of-the-mill in terms of how similarly unfavorable conditions have usually been resolved historically, and there is no evidence that this awful prospective course has changed much. The chart I included three weeks ago in Dancing at the Edge of a Cliff presents similar periods for historical perspective.

It’s probably needless to say that last week’s decline improved valuations modestly – we presently estimate prospective 10-year total returns (nominal) for the S&P 500 about 5.5% annually, based on our standard methodology. Most bear markets have historically ended only after prospective returns moved above 10% (including bear markets in periods of very low interest rates, and also including 2009). Moreover, regardless of whether interest rates have been high or low, extended secular bear markets have ended – and secular bull market advances have begun – only when prospective 10-year returns have reached about 20% annually (see Too Little To Lock In for a chart on this). So it won’t come as a surprise that we don’t view a 5.5% annual prospective total return as having much investment merit. You don’t “lock in” prospective stock market returns – you ride them out, and holding on for the expectation of a 5.5% prospective annual return is likely to involve a very bumpy 10-year ride.

Investors with most of their assets already invested and unhedged should hope that prospective market returns move no higher than about 8% through the completion of the present cycle, since even touching a prospective return of 10% in the interim would require an S&P 500 in the mid-800′s. Though I think it’s plausible that we’ll establish prospective returns consistent with the start of a secular bull market at some point in the next few years, actually quoting the associated level for the S&P 500 would only strain credibility here. Investors have forgotten so much after just 3 years time that it seems fruitless to talk about secular lows that only occur every 30-35 years (even if the last secular low was all the way back in 1982).

At this point, the S&P 500 has achieved a cumulative total return of less than 10% since April 2010. Meanwhile, of course, there remains a great deal of faith in the “Bernanke put,” because even though it’s fairly obvious that QE has done nothing durable for the economy or the financial markets over the last couple of years, a hit of QE might at least be good for a few months of “risk on” delirium. If the American public can’t get thoughtful economic leadership, at least Wall Street’s speculative junkies can hope for a little taste of Q from Sugar Daddy.

One of the problems with QE here, however, is that it would essentially represent fiscal policy for the benefit of speculators, at taxpayer expense. To see this, note that the 10-year Treasury yield is now down to less than 1.5%. One wonders how Bernanke would be able to argue, with a straight face, that this is not low enough. Nevertheless, a 10-year bond has a duration of 8 years – meaning that each 100 basis point fluctuation in interest rates is associated with a change of about 8% in the price of the bond. So if you buy the bond and hold it for a full year, an interest rate change of of 1.5/8 = .1875, or less than 20 basis points, is enough to wipe out the annual interest and leave you with a negative total return.

So at this point, if the Fed buys Treasury bonds, it will predictably lose money – after interest – unless interest rates rise less than 20 basis points a year during the period that the Fed holds those bonds. Over the past year, the standard deviation of week-to-week changes in the 10-year Treasury yield has been about 13 basis points, so 20 bips over the course of a full year is nothing. Whether or not a speculator is willing to take a bet on lower yields, it’s highly unlikely that the Fed could buy Treasury bonds here at a yield of 1.5% and ever expect to unload its portfolio later at even lower yields, because yields would shoot higher merely on the anticipation of Fed liquidation.

As a result, Treasury debt purchased by the Fed here would almost certainly result in capital losses, at taxpayer expense, and those capital losses would be an implicit subsidy to speculators who sold those bonds to the Fed at elevated prices. Of course, “sterilized QE” – where the Fed would buy bonds, and then pay banks 0.25% interest to keep the balances on reserve – would involve an even larger subsidy, and would then require only a 15 basis point move to put the Fed into loss mode.

“QE3 – subsidizing banks and bond speculators at taxpayer expense” – there’s a pithy slogan. That doesn’t mean the Fed will refrain from more of its recklessness (which will be nearly impossible to reverse when it becomes necessary to do so), but does anyone actually believe by now that QE would improve the economy, durably elevate risky assets beyond a few months, or materially relieve global debt strains?

Despite the uncertainties, our game plan remains fairly straightforward. As I noted two weeks ago in Liquidation Syndrome, “there may be latitude to take a more constructive stance between the point that any new monetary intervention produces an improvement in our measures of market internals, and the point where we re-establish an overvalued, overbought, overbullish syndrome. Without a material improvement in valuations or market action here, we remain defensive. Undoubtedly, the best outcome would be a strong improvement in valuations, followed by signs of improvement in our measures of market action, which is the typical sequence of events that complete a market cycle and can launch a very favorable investment environment.

Tags: Bear Markets, Decline, Expectation, Historical Perspective, Horizons, Hussman Funds, Investment Conditions, John Hussman, Low Interest Rates, Methodology, Nbsp, Periods, Point In Time, Prospective Course, Risk Profile, Secular Bull Market, Stock Market, Tradeoff, Unfavorable Conditions, Valuations
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Liquidation Syndrome (Hussman)

Monday, May 21st, 2012

by John Hussman, Hussman Funds

May 20, 2012

Over the past two weeks, the S&P 500 has lost months of upside progress in a handful of sessions. This is the very characteristic initial outcome of the overvalued, overbought, overbullish syndrome that has been in place until recently (the decline has cleared the overbought component). The good news here is that we now estimate the 10-year prospective total return on the S&P 500 to be about 5.2% annually as a result of the recent decline. As a rule of thumb, a 1% market decline in a short period of time tends to increase the prospective 10-year return, not surprisingly, by about 0.1%. However, that approximation is less accurate over large movements or over extended periods of time, where growth in fundamentals and compounding effects become important.

The bad news here is that given the sharp deterioration in market internals, and the likelihood of an emerging recession, we have no basis to expect market losses to be contained to such minimal levels. It is important to recognize that the scope of our concerns is on the order of 25-35% market losses over 12-16 months, and those concerns aren’t meaningfully resolved by a 5% decline over the course of a few sessions. A good week in the market is unlikely to change our assessment unless it produces a material improvement in our measures of market internals. The fast, furious, prone-to-failure rallies that often result from short-term oversold conditions aren’t generally enough, and usually reflect short-covering rather than sustainable investment demand. Improved valuations are often supportive of that sort of sustainable demand, but that would require a much larger decline than we’ve seen thus far.

Massive monetary interventions have not done much for the economy, but have proved capable of provoking speculation for several months at a time. As I’ve noted recently, there may be latitude to take a more constructive stance between the point that any new monetary intervention produces an improvement in our measures of market internals, and the point where we re-establish an overvalued, overbought, overbullish syndrome. Without a material improvement in valuations or market action here, we remain defensive. Undoubtedly, the best outcome would be a strong improvement in valuations, followed by signs of improvement in our measures of market action, which is the typical sequence of events that complete a market cycle and can launch a very favorable investment environment.

In the meantime, however, a bad week is unlikely to change our assessment unless that bad week includes a market crash. Last week was not a crash, though a free-fall appears increasingly possible, as the reality of emerging recession (and all that it implies for fresh credit risks, sovereign defaults, fiscal imbalances, banking strains and other problems) will likely smash against the consensus view of economic expansion in next few months.

I continue to view the U.S. economy as most probably entering a recession that will ultimately be marked as beginning in May or June of 2012. We are very much in agreement with the ECRI on this, though our methods are different, and our conclusions are clearly still seen as “fringe” views by the consensus.

For the financial markets, those risks are compounded by the unbalanced “risk-on” exposure that investment managers and institutions adopted early this year, encouraged by a short-lived burst of economic activity, and faith in a central-bank backstop. When heavy “risk-on” positions established in recent months are forced to squeeze out through a narrow exit, large price adjustments may be needed, since investors who are less tolerant of speculative risk seem unlikely to respond with the requisite demand until improved valuations provide a sufficient incentive.

As John Kenneth Galbraith wrote in 1955, “Of all the mysteries of the stock exchange there is none so impenetrable as why there should be a buyer for everyone who seeks to sell. October 24, 1929 showed that what is mysterious is not inevitable. Often there were no buyers, and only after wide vertical declines could anyone be induced to bid … Repeatedly and in many issues there was a plethora of selling orders and no buyers at all. The stock of White Sewing Machine Company, which had reached a high of 48 in the months preceding, had closed at 11 on the night before. During the day someone had the happy idea of entering a bid for a block of stock at a dollar a share. In the absence of any other bid he got it.”

Illiquidity is a very unpleasant thing when you’ve got an inappropriately speculative position and you’re under pressure to close it out. The very high beta exposure taken by managers and institutions lately (see Unbalanced Risk) strikes me as particularly dangerous in an environment where we continue to estimate the market’s return/risk profile among the most negative 0.5% of historical instances.

Will the Federal Reserve come in with QE3 in an attempt to prop up the market? Maybe. It doesn’t matter to Bernanke that the Fed’s interventions are reckless, promote speculation, distort resources, punish savers, produce only temporary economic effects, and will be nearly impossible to unwind. But the Fed will undoubtedly feel compelled to “do something.” Apart from dollar swap lines (which the Fed is likely to reopen to Europe in efforts to reduce banking strains there), more QE is all the Fed can hope to offer. Let’s face it – when your only tool is a hammer, all the world looks like a nail.

Still, we’ve observed diminishing returns from the Fed’s interventions, there is no political tolerance for the Fed to intervene in securities involving any credit risk that would be borne by U.S. citizens (purchasing European sovereign debt, for example), and the yield on the 10-year Treasury bond is already down to 1.7%, which is far below where it stood when prior interventions were initiated. It seems a hard sell to argue that yields aren’t low enough, and that the Fed needs to intervene to drive them down further. Even so, it’s clear that Wall Street responds to Bernanke like a bunch of Pavlov’s dogs. Provided that renewed Fed intervention is sufficient to improve our measures of market action, I expect we would have some latitude to respond with a more constructive position until an overvalued, overbought, overbullish syndrome is re-established.

Frankly, I doubt that investors will find the third time to be a charm in the event of another round of QE. This is why any willingness to accept risk will far more tied to our longstanding measures of market action and other testable factors than to some novel “Bernanke faith factor” that we have no way of testing historically in any kind of rigorous manner. Yes, the stock market advanced in 2009-2010 when the Fed tripled its balance sheet. But there is no material long-term relationship between the size or growth rate of the monetary base and stock market fluctuations. Rather, QE has had its effect on the markets by essentially starving investors of safe yield and making them feel forced into increasingly speculative corners in search of return. With safe yields already so depressed, I suspect that we will see already diminishing returns become even weaker, because there is little left for the Fed to squeeze.

Liquidation Syndrome

As I’ve  frequently noted in recent weeks, there are numerous ways of defining the basic “syndrome” of a richly valued, overbullish market where favorable internals (breadth, leadership) or other driving factors have fallen away. Presently, the market remains richly valued on normalized earnings, and is coming off of a speculative peak with an abrupt and persistent initial decline. The guys at Nautilus Capital recently noted that just a 5% decline from a nearby peak, coming off of a 25% prior advance, has historically been fairly hostile to forward returns. Bill Hester notes that going back as far as Depression era data, that same behavior coupled with a rich Shiller P/E (anything above the mid-teens) and a preponderance of daily declines in recent data (say down 11 days out of 14) has preceded even worse outcomes – particularly in the context of a weak economic backdrop. I should note that we also saw a “leadership reversal” last week – a shift from a preponderance of new weekly highs to a preponderance of new weekly lows. All of this reflects what might be called a “liquidation syndrome” that is selective for awful drops that began in 1969, 1972, 1987, 2000, 2007, and the more moderate but still steep losses in 1998, 2010, and 2011.

The chart below captures a fairly simple filter of instances when the market lost 5% or more over a 2-week period, from a market peak in the prior 6 weeks (within 5% of the prior 52-week high) that was characterized by a Shiller P/E over 19, more than 50% advisory bulls, and fewer than 25% advisory bears. So the bars simply identify quick initial declines from overvalued, overbullish peaks. But the fact that they coincide with so many important cyclical bull market peaks says something about how those peaks are formed.

It’s important to note that on long-term charts like this one, small distances actually represent weeks of data, including many days where stocks advanced and everything looked just fine on a near-term basis, so we certainly shouldn’t rule out the typical “fast, furious, prone-to-failure” rallies that usually punctuate extended market slides. 

Tags: Approximation, Bad News, Deterioration, Handful, Hussman Funds, Interventions, Investment Demand, John Hussman, Likelihood, Market Decline, Market Internals, Market Losses, Minimal Levels, Rallies, Recession, Rule Of Thumb, Short Period, Speculation, Sustainable Investment, Valuations
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“Release the Kraken” (Hussman)

Monday, April 30th, 2012

by John P. Hussman, Ph.D., Hussman Funds

Over the past 13 years, and including the recent market advance, the S&P 500 has underperformed even the minuscule return on risk-free Treasury bills, while experiencing two market plunges in excess of 50%. I am concerned that we are about to continue this journey. At present, we estimate that the S&P 500 will likely underperform Treasury bills (essentially achieving zero total returns) over the coming 5 year period, with a probable intervening loss in the range of 30-40% peak-to-trough.

Why? First, with respect to 5-year prospective returns, it’s important to recognize that returns at that horizon are primarily driven by valuations – not the “Fed Model” kind, but the normalized earnings and discounted cash flow kind. Stocks remain strenuously overvalued here, and only appear “fairly priced” relative to recent and near-term earnings estimates because corporate profit margins are more than 50% above their long-term norm. Meanwhile, corporate profits as a share of GDP are about 70% above the long-term average. As I detailed in Too Little To Lock In, these abnormally high margins are tightly related (via accounting identity) to massive fiscal deficits and depressed household savings rates, neither which are sustainable.

Our projection for 10-year S&P 500 total returns – nominal – is about 4.4% annually, which is far better than the 2000 peak, far inferior to the 2009 trough, and save for the period before the 1929 crash, worse than any prospective return observed prior to the late-1990′s bubble – even in periods having similarly depressed interest rates.

Of course, rich valuations can persist for some time – predictably resulting in poor long-term returns, but often doing little to prevent short-run speculation and temporary gains. The issue is then to identify the point at which overvalued conditions are joined by sufficiently overextended conditions, and a sufficient loss of speculative drivers, to make rich valuations “bite” even in the shorter-term. This is where additional criteria come in, such as overbought technical conditions and extreme optimism in the form of low bearish sentiment, depressed mutual fund cash levels, and heavy insider selling. Presently, it doesn’t help that T-bill yields and long-term bond yields remain higher than 6 months ago, and we have signs of oncoming recession. This is particularly evidenced by collapsing economic measures in Europe, softening economic performance in developing economies including China and India, and jointly weak year-over-year growth in key U.S. economic measures such as real personal income, real personal consumption, real final sales, and reliable leading indicators from the OECD and ECRI, as well as our own measures.

The combination of rich valuations, overbought conditions, overbullish sentiment, and deteriorating leading economic evidence can still unfortunately persist for months before being resolved. But once the hostile syndromes we’ve seen recently have emerged in the data, attempts at continued speculation have amounted to playing with fire. Similar conditions have repeatedly resulted in disastrous outcomes for investors. It would be nice to be able to “time” these outcomes better. We haven’t found a reliable way to do so, and would still be concerned about robustness – sensitivity to small errors – even if we did. Yet even when unfortunate outcomes are not immediate, the fact that the S&P 500 has underperformed T-bills for 13 years is not very sympathetic to arguments that stock market risk has been worth taking overall, except in confined doses.

Tags: Corporate Profit, Corporate Profits, Discounted Cash Flow, Earnings Estimates, Fed Model, Fiscal Deficits, GDP, Household Savings, Hussman Funds, Kraken, Market Advance, Market Plunges, Model Kind, Profit Margins, Speculation, Term Earnings, Treasury Bills, Trough, Valuations
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