Posts Tagged ‘Risk Profile’
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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Sunday, May 13th, 2012
In recent weeks, I’ve emphasized that our estimate of prospective market return/risk in stocks has slipped into the most negative 0.5% of historical data (reflecting a range of horizons from 2 weeks to 18 months). Last week that estimate actually deteriorated, but I am reluctant to make comments on such a small sample, as the only more negative estimate in post-Depression history was on September 16, 2000. Even in the conditions that match the worst 2% of our return/risk estimates (which is the part of the tail we have been in since late-February), the market has lost an average of 20-25% just in the following 6-month period. As much as I try to maintain equanimity – focusing on the average outcome of a particular set of market conditions rather than the specific instance at hand – it is very difficult to do so at present.
The green bands in the chart below depict all of the points since 1980 in the neighborhood of present conditions – having a nearly similar prospective return/risk profile, coupled with a particularly hostile “exhaustion syndrome” that has been a hallmark of the worst market outcomes in recent decades. The blue line shows the S&P 500 Index. As I noted in Goat Rodeo, “what this combination picks up is an already fragile set of market internals that has enjoyed an ‘exhaustion rally’ that both exceeds earnings growth and is met with overbullish sentiment.”
I usually show longer-term charts, but there are no green bands prior to 1987. Before that point, valuations were never been as extended as they are today – on the basis of normalized earnings – except in the quarters leading up to the 1929 crash. Exhaustion syndromes prior to 1987, while still very hostile to stocks, didn’t occur in valuation conditions as rich as we have today. It’s worth noting that there is a very narrow band in 2006 that was followed by a decline of only a few percent, but even the seemingly benign instances in 1998 and early 2000 represented losses exceeding 10%. I suspect we’re at risk of something far more significant. Importantly, the drivers of our market risk estimates are largely independent of our measures of recession risk. This may provide some insight into why my concerns have become so strident in recent weeks.
Present market risks involve a confluence of factors. First, valuations remain unusually rich. Though prospective returns are better than at the 2000 and 2007 peaks, valuations remain more elevated than at any point prior to the late-1990′s bubble, save for the period before the 1929 plunge. Notably, valuations only seem “reasonable” on the basis of “forward operating earnings” if one ignores the fact that profit margins are 50-70% above historical norms, and are dependent on unsustainably large fiscal deficits and depressed household saving in order for that to continue (see Too Little to Lock In).
Second, market internals have deteriorated, with an uncomfortably familiar “two-tier” profile developing between a handful of speculative momentum stocks and the broader market. Coupled with an active new issues calendar, near-panic levels of selling by corporate insiders, heavy beta exposure among mutual funds and institutional managers, record-low mutual fund cash levels, and advisory bearishness at just 20.5% (a level last seen before the steep 2011 decline), there appears to be a lopsided exposure to risk among speculators, and a divestment among issuers.
Third, as I’ve frequently noted, the best way to extract meaningful signals and reduce noise in volatile data is to draw those signals from the joint behavior of several indicators. While these methods range from the simple to the complex, we’ve frequently presented variously defined sets of indicators (see An Angry Army of Aunt Minnies) that capture some particular investment environment (such as an overvalued, overbought, overbullish market where favorable drivers have begun to drop away). In recent weeks, we’ve seen several of these hostile syndromes emerge, as I’ve detailed in prior weekly comments.
Tags: Earnings Growth, Equanimity, Exhaustion, Goat, Hallmark, Horizons, Hussman, Instances, Market Internals, Market Outcomes, Present Conditions, Quarters, Risk Estimates, Risk Profile, Rodeo, Sentiment, September 16, Term Charts, Valuations, Worth Noting That
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Monday, May 7th, 2012
In recent weeks, I’ve noted that our estimate of the prospective market return/risk profile has shifted to the most negative 1% of instances we’ve observed in the historical data. Most of the time, a given set of market conditions is associated with some mix of positive and negative outcomes, so we focus on the average of those outcomes in the expectation that doing so will produce good results over the complete market cycle even if we are incorrect in specific instances. With regard to current conditions, there is an absence of redeeming instances where things worked out well, coupled with an abundance of starkly negative market outcomes that have accompanied similar conditions. This uniformity of bad outcomes is why I keep using the word “warning” lately. The market’s prospective return/risk tradeoff here is highly unbalanced toward the risk side.
This isn’t just a matter of advisory bullishness being high in one week or another, or even valuations being rich, or just economic risks appearing high. Rather, what concerns us most is the syndrome of evidence: the fact that we observe so many red flags at the same time – rich valuations, overbullish sentiment, heavy institutional saturation in “risk-on” trades, near-panic levels of insider selling, a burst of new stock issuance, overbought conditions (focusing on intermediate-term horizons), a two-tiered market that couples speculation in a handful of momentum stocks with broadly deteriorating market internals, a variety of historically hostile syndromes (see An Angry Army of Aunt Minnies), and increasing likelihood of oncoming recession.
Various observers will undoubtedly take issue with each of these measures. One can look at the Investors Intelligence bullish sentiment figure, which has eased back to 43% from over 50% in early April, but ignore that bearish sentiment is down to 20.4%, less than half of the bullish sentiment figure, and the lowest level since just before the 2011 market rout. One can look the market’s price-to-forward-operating earnings multiple, which seems to be in an acceptable range, but ignore the stratospheric profit margins baked into earnings estimates. One can take issue with our recession concerns, choosing one rule-of-thumb or another that has gone “quiet” out of the broad ensemble of measures that we’ve presented over time, but ignore everything else we’ve written on the subject.
For example, our Recession Warning Composite is “quiet” here, as it usually becomes active only after a market loss of about 10-15%, yet still generally well before a recession is obvious to all (as was true both in late-2000 and late-2007). Strictly defined, the composite would require the manufacturing PMI to decline by a fraction of a point, year-over-year payroll growth to slow another 0.08%, and credit spreads to widen by about 0.25% here. The composite is generally a useful and early signal of recession, and it’s clear that the signal last August was either false or more likely just deferred by monetary interventions. Still, we’ve always advised against focusing on any single indicator, and there’s certainly no lack of additional evidence that I’ve presented on the subject of recession risk in recent months, so that shareholders can see the same things that I’m looking at. The value of research is that it constantly gives you better tools. Our research in areas like ensemble methods and noise reduction (including what we developed through our work in autism genetics) contributes firepower to that arsenal, and we try to approach economic and market issues with everything we’ve got.
Investors wishing to wait for a fresh negative signal from our Recession Warning Composite can do so, but should again recognize that it typically goes negative only after the market has lost some significant ground already. More often than not, stock market weakness continues well beyond those signals, but it’s not a “market timing” tool and isn’t intended for that purpose. It’s worth noting that aside from the S&P 500 – which has benefited from monetary-driven risk-on speculation, the other components of that composite are still fluctuating within a hair of their respective trigger points. Meanwhile, however, it isn’t helpful to ignore that we’ve never seen the components of economic activity as uniformly weak as they are today on a year-over-year basis except in association with recession (e.g. real final sales, real personal income, real personal consumption, employment growth, etc).
Just an analytical sidenote while we’re on the subject: when evaluating economic risk, it isn’t enough to show that some indicator has a high correlation with GDP growth. You also have to test that the indicator leads that growth rather than lags it. Otherwise it’s not a suitable way to identify a turn. We’ve seen a lot of charts lately that fail to make that distinction.
The chart below updates our estimate of the most leading “unobserved” component based on a broad ensemble of economic data (see the note on extracting economic signals in Do I Feel Lucky? for more on this approach). Back in March, we already saw a clear downturn in the extracted signal, which tends to lead coincident economic measures by several months. This signal shows no sign of improvement, while the observed data is now characteristically rolling over.
Interestingly, the most leading component that we infer in U.S. data looks a great deal like what we are already observing globally, particularly in Europe. The path traced out by the Eurozone PMI however, does suggest that we should take any upward bump in first quarter GDP figures in the Eurozone with a grain of salt, being largely “old news” from a predictive standpoint.
As for U.S. data, the broad aggregate continues to come in weaker than expected, with a recent downturn in a broad basket of national and regional economic surveys, and of course, a disappointing April unemployment report (avoiding a negative print, however, which I suspect will come in the May report). From our standpoint, this stream of data is largely as expected, with gradual deterioration likely to accelerate as we move into mid-year. While the stock market enjoyed a brief surge of speculation following a modest positive surprise in the manufacturing Purchasing Managers Index for April, this was an outlier in the context of fairly relentless downward surprises both domestically and all across Europe. Note the concerted downturn in the overall indices, backlogs and new orders in the latest U.S. readings. Again, we would expect this deterioration to accelerate as we move into mid-year.
While I remain concerned about the high risk of a “blindside recession,” the broad consensus of economists and Wall Street analysts remains confidently optimistic. So recession risk is admittedly a “fringe” view – though a fringe view backed by the data. Still, it’s notable that many of our concerns are joined by observers with respectable records and no hesitation about taking fringe views, including Lakshman Achuthan at the Economic Cycle Research Institute and Martin Feldstein at the National Bureau of Economic Research.
It’s no secret that when Alan Greenspan stepped down from the Federal Reserve, I had hoped that Martin Feldstein would be chosen as Fed Chairman, instead of appointing Ben Bernanke to that role. In early 2008 (see Round Two – Home Price Erosion), while Bernanke was still downplaying mortgage risks, and the economy was already quietly in a recession that began nearly 6 months earlier, Feldstein was openly warning about housing and economic risks. He continued to advocate for proactive policies to blunt the oncoming damage, and criticized Bernanke’s willingness to hit CTRL+P, saying “They’ve used up half their balance sheet setting up credit lines to take on questionable credits from the banks and the securities firms.” Since then, the Fed has remained on exactly the same course, only with bigger numbers. This has encouraged needless speculation and sporadic bursts of pent-up demand, but has done nothing to address the underlying debt issues or the continued need for broad restructuring of bad credit both domestically and globally.
Notably, Feldstein is not just any Harvard economist, but is a member of the business cycle dating committee of the National Bureau of Economic Research (the official body that dates U.S. recessions), the president emeritus of the NBER, and the former head of the Council of Economic Advisors. In an interview last week on CNBC, Feldstein provided a good summary of present conditions:
“We are not doing very well. The economy is just coming along at a snail’s pace. The first quarter numbers that we just got last week were not very good at all. The GDP number was 2.2%. That was a disappointment, but you know, it was all automobiles. 1.6 out of the 2.2 was motor vehicle production. So, people were catching up after not being able to buy them the year before. So, this is a very weak economy… I think the real danger is that this is a bubble in the stock market created by low long-term interest rates that the Fed has engineered. The danger is, like all bubbles, it bursts at some point. Remember, Ben Bernanke told us in the summer of 2010 that he was going to do QE2 and then ultimately they did Operation Twist. The purpose of that was to make long-term bonds less attractive so that investors would buy into the stock market. That would raise wealth and higher wealth would lead to more consumption. It helped in the fourth quarter of 2010 and maybe that is what is helping to drive consumption during the first quarter of this year. But the danger is you get a market that is not with the reality of what is happening in the economy, which is, as I said a moment ago, is really not very good at all.”
In short, there is no question that at least on the surface, there is a lot of contradictory data available to support differing views about market valuation and economic prospects. However, once we make distinctions that have clearly been relevant in the historical data – normalizing earnings, recognizing the difference between leading, coincident and lagging indicators, weighting indicators based on their relationship to outcomes they purport to measure – much of the noise drops away, and we infer clearly negative risk for both stocks and the economy.
All of these conditions will change, and it’s certain that our return/risk estimates will not remain in such an extreme condition for very long. Maybe our present concerns won’t amount to as much downside as we expect. But if investors were to choose a point to test the hypothesis that this time will be different and risk will be well-rewarded, I hardly think a worse moment could be found.
Last week, Michael Wilson of Morgan Stanley noted (via ZeroHedge), “Make no mistake, institutional investors are all in.” Confirming our own observations about the elevated betas of the largest mutual funds, Wilson reported that the monthly rolling beta of mutual funds (their sensitivity to market fluctuations) now exceeds 1.10 and is the highest since the previous record, just before the wicked market plunge in 2011. Meanwhile, examining the sectors in which institutions hold their largest “overweight” relative to the S&P 500, institutions are more concentrated in high-beta sectors than at any time since the start of Morgan Stanley’s data, and long-short funds are also near their most leveraged long positions in history. Of course, mutual fund cash levels also remain at record low levels.
Still, one feature of the iron law of equilibrium is that if institutions are heavily overweight high-risk sectors, other classes of investors must be underweight. The question is then which class of investors is most likely to shift positions. In my view, the two classes of “risk-off” investors are individual investors and value-driven, risk-conscious investors like us. On the individual side, we observe depressed home equity, plunging levels of labor force participation (except for workers over the age of 65, where labor force participation is hitting new highs), weakening employment growth, expiring unemployment compensation, repressively low interest rates on savings, and a coming fiscal drag. These investors already perceive sufficient risk in their overall portfolio of investment assets, home equity, and human capital that we doubt they will suddenly decide to take a flier in high-beta stocks to see if they can speculate themselves into financial security.
For our part, despite our 2009-early 2010 suspension of risk-taking on the hedging side (see Notes on Risk Management for a broad review of that period), the fact is that our stock selections have significantly outperformed the major indices over time, without the need to drink the Kool-Aid by buying low-quality garbage stocks or chasing the overvalued speculative momentum darlings of the moment. We have no plans to take high-beta stocks off the hands of existing holders at even richer valuations and even lower expected returns than they already have.
To some degree, those who are willing to establish very high beta portfolios may be doing it because they are speculating with “Muppets” money, with little of their own skin in the game. In any event, those assets are “all in,” and as a result, my impression is that institutions are likely to have unusual difficulty shifting out of their high-beta positions if the need arises. Investors who want high risk already own it, and the ones who don’t are likely to have far lower reservation prices and far higher required returns than are presently available to compensate for that risk.
Valuations are also a problem. While we continue to hear that the market is “cheap on forward operating earnings”, analysts who worship at the altar of forward operating earnings seem to overlook two factors, in my view. First, profit margins are more than 50% above historical norms, and profits to GDP are nearly 70% above historical norms. There is a strong accounting relationship between those profit shares and the combined savings of households and government (see Too Little to Lock In). To rely on permanently high profit margins, one must rely on the permanence of unsustainably large fiscal deficits and unusually low savings rates.
Our concern about operating earnings is not just that earnings are likely to dip in a recession, but that these elevated earnings are being used as the entire basis for stock valuation. That is, expected operating earnings are essentially being treated as a “sufficient statistic” for the whole long-term stream of cash flows that investors can expect. Failing to adjust for the cyclicality of profit margins isn’t just a transitory issue of “oh, well then we might have next year’s earnings estimates a bit high.” No, failing to adjust for the cyclicality of profit margins means that the entire estimate of fair value is off by something on the order of 50-70% from where it would be on the basis of normalized margins (somewhere in the range of 850-950 on the S&P 500).
This leads to the second factor that analysts seem to ignore. Specifically, major market downturns are not driven by a simple downturn in earnings over a year or two, but instead invariably reflect a change in the valuation of the entire long-term stream of cash flows (either because expected long-term cash flows are revised, or because investors require greater long-term prospective returns). We often hear analysts talk as if the change in the S&P 500 should simply track the change in earnings over the same period. But the historical correlation between the two – for example, the year-over-year change in earnings versus the year-over-year change in the S&P 500 – is close to zero. Major stock price fluctuations nearly always reflect a shift in expected long-term cash flows or in required long-term prospective returns.
To illustrate this, suppose you have a company that is expected to earn $2 per share next year, pays half of earnings out as dividends, and grows at 5% annually each year, ad infinitum. In order to expect a 10% return from this stock over the long-term, you would pay $20 a share today (essentially giving you 5% from expected price growth and 5% from dividend yield). In order to expect a 6% return on this stock, you would pay $100 [5% growth + 1% yield: P = D/(k-g)]. Now let’s wipe out all of the earnings and dividends in the coming year, but leave the long-term flows unchanged. If you do the math, you’ll find that in each case, the value of the stock drops by only about 90 cents. The only way you’ll get a huge change in the price of the stock is if you’ve misjudged the whole stream of long-term cash flows (which is what I believe analysts are doing by failing to adjust for profit margins and using a single year of earnings as the whole basis for valuation), or if you change the long-term prospective return that the stock is priced to achieve.
My view on this is simple – if you’ve overestimated the long-term stream of cash flows by failing to adjust for elevated profit margins, if the prospective return on stocks is unusually low even on the basis of normalized earnings (as it is today), and if you’ve set your portfolio up in a crowded trade that takes record-high beta exposure to market fluctuations (as many institutions have now done), you just might be in for some trouble.
As of last week, our estimates of prospective return/risk in the stock market remained in the most negative 1% of historical observations. That overall assessment reflects a variety of horizons from 2 weeks to as much as 18 months (on a longer horizon that purely reflects valuations, we estimate 5-year S&P 500 total returns of roughly zero, and 10-year prospective returns at about 4.7% after last week’s market decline). All of this can comfortably be dismissed as the ranting of a perma-bear by those who disregard our record through 2009, disagree with my insistence in 2009 to stress-test every method against Depression-era data, and doubt that we will remove our hedges in more favorable conditions (as we did in 2003, and which our ensemble methods would have supported in much of 2009-early 2010). For those who are not so easily dismissive, I appreciate your trust. Very simply, I remain concerned about a blindside recession, significant market losses, and overconfidence in the ability of the Fed to create anything but temporary psychological lifts in the face of real structural economic problems.
Strategic Growth and Strategic International remain fully hedged, Strategic Dividend Value is hedged at 50% of the value of its stockholdings (its most defensive stance), and Strategic Total Return continues to carry a duration of about 2.8 years, precious metals shares amounting to about 12% of net assets, and a few percent of assets in utilities and foreign currency shares.
Tags: Aunt Minnies, Bearish Sentiment, Bullish Sentiment, Current Conditions, Economic Risks, Hussman, Investors Intelligence, Market Internals, Market Outcomes, Momentum Stocks, Negative Outcomes, Panic Levels, Red Flags, Risk Profile, Rout One, Saturation, Stock Issuance, Tradeoff, Using The Word, Valuations
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Tuesday, April 10th, 2012
by Michael Nairne, Tacita Capital
“Buy and hold” is not an effective strategy for risk conscious investors. Any portfolio’s asset mix will drift from its strategic target as asset prices move differentially in response to changing economic and market forces. Over time, the higher return assets will comprise a larger proportion of the portfolio and distort its return and risk dimensions from those originally constructed.
Sound portfolio management is founded on “buy and rebalance”. Rebalancing involves selling the asset classes that have done relatively well to buy those assets that have lagged in order to restore the portfolio’s target mix. Rebalancing is vital in risk management since it ensures that a portfolio’s risk dimensions stay within an investor’s defined tolerance limits. This is illustrated in the following graph which compares the return and risk of a portfolio comprised of 40% US bonds and 60% US stocks which was rebalanced annually (in red) to those of the same portfolio that was never rebalanced (in orange).
The rebalanced portfolio experienced much lower risk while the never rebalanced portfolio drifted into a much riskier asset weighting dominated by stocks. Its return was lower but that is because it avoided the escalating risk of the never rebalanced portfolio. Critically, the rebalanced portfolio had better risk-adjusted performance .
Rebalancing has a second vital role in a portfolio. Rebalancing is a source of diversification return that arises from the contrarian act of selling assets that have appreciated on a relative basis and buying the lagging assets in order to restore the weights of the target asset mix of a particular investment strategy.
A return premium is created by the disciplined act of regularly “selling high and buying low” while maintaining the risk profile of the portfolio. It can be calculated by comparing the return of a rebalanced portfolio to the weighted average geometric return of the assets which comprise the portfolio . An example of the rebalancing premium is illustrated in the following table which sets out the returns of the individual assets in the 40% bond/60% stock portfolio, the weighted average return of the two assets, the return of the rebalanced portfolio and the rebalancing premium.
The rebalanced portfolio had an annualized return of 8.60% compared to the weighted average return of 8.06% for the two assets that comprise the portfolio. Rebalancing resulted in an annualized return premium of 0.54%.
The rebalancing premium can be increased by adding more assets when they exhibit the right blend of volatility and covariance (i.e. tendency to move in tandem) with the overall portfolio – the more volatile the assets added and the lower their covariance, the higher the rebalancing premium. This is illustrated in the following graph which portrays the annualized rebalancing premium for the period January 1972 to January 2012 that resulted from sequentially adding asset classes to a two asset portfolio comprised initially of 40% US bonds and 60% US stocks. The assets added in order are: international stocks, US small value stocks, Canadian stocks, US REITs, and finally gold .
The rebalancing premium more than doubled – from 0.44% to 0.99% – as assets were added. It increased initially as international stocks increased rebalancing opportunities. Then, the addition of volatile small cap value stocks had a large premium as its wide return swings created an even greater rebalancing effect. Adding real estate and commodity-biased Canadian stocks also increased the premium. Finally, adding gold which is very volatile and has a low covariance to other assets had a particularly large premium as there were frequent opportunities for substantive rebalancing.
Earning the rebalancing premium is easier in theory than in practice. Selling winners to buy losers seems to go against human nature. In fact, the vast majority of investors either don’t rebalance or don’t rebalance as frequently as they should .
That’s too bad. Rebalancing earns a return premium while maintaining the risk profile of a portfolio – to paraphrase Scott Willenbrock, rebalancing adds a “free dessert” to the “free lunch” served by diversification. Serious investors need to stay seated long enough at the investing table to enjoy both.
1. Bond and stock returns are from Ibbotson’s intermediate-term government bond and large company stock series. Rebalancing is undertaken on an annual basis.
2. Although not shown, the rebalanced portfolio had a higher Sharpe Ratio, Sortino Ratio and M-Squared Ratio.
3. Booth, D.G., Fama, E.F., Diversification Returns and Asset Contributions, Financial Analysts Journal, Vol. 48, No.3, p. 26–32, May/June 1992. Booth and Fama define the incremental return from a rebalanced portfolio compared to the weighted average asset compound return as the “diversification return”.
4. Willenbrock, Scott, Diversification Return, Portfolio Rebalancing, and the Commodity Return Puzzle, Financial Analysts Journal, Vol. 67, No. 4, pp. 42-49, July/August 2011. Willenbrock states that “the diversification return is the difference between the geometric average returns of both a rebalanced portfolio of volatile assets and a balanced portfolio of hypothetical assets with the same weights and geometric average returns as the true assets but zero volatility.” Practically, the latter term is the weighted average geometric return of the assets comprising the portfolio.
5. All return data is from Morningstar Encorr. The asset classes are based on the following indices: international stocks – MSCI EAFE; US small value stocks – Fama-French Small Value; Canadian stocks – S&P/TSX Capped Composite in US$; US REITs – FTSE NAREIT All Equity REIT; and gold – London Fix Gold PM US$. Proportions added vary but are based on practical weighting considerations. Rebalancing is undertaken on an annual basis.
6. AllianceBernstein Investment Research and Management Asset Allocation Research 2005. Findings of a nationwide telephone survey of 1000 investors.
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Sunday, March 4th, 2012
by John P. Hussman, Ph.D.
Last week, the estimated return/risk profile of the S&P 500 fell to the worst 2.5% of all observations in history on our measures. This is not a runaway bull market. Rather, it is a market that again stands near the highs of an extended but volatile trading range. I am convinced that the breakdown of the market from this range has been deferred only through repeated and extraordinary central bank actions.
Importantly, the market is again characterized by an extreme set of conditions that we’ve previously associated with a “Who’s Who of Awful Times to Invest.” The rare instances we’ve seen this syndrome historically are reviewed in that previous weekly comment. They include the 1972-73 and 1987 market peaks, and several instances since 1998. The more recent instances of this syndrome are shown by the blue bands on the chart below. Note that each of the separate instances in the 1999-2000 period were followed in short order by intermediate market declines of between 10-18%, and of course, ultimately by a plunge of more than 50% in 2000-2002. Likewise, the 2007 instance was followed in short order by a correction of nearly 10%, and a few months later by a plunge of more than 50% in 2007-2009. The more recent instances in 2010 and 2011 have also been followed by substantial market selloffs in each case, though with a longer lag in 2011 (due to ongoing QE2 operations). Aggressive monetary policy did not prevent the ultimate declines, though massive central bank interventions have undoubtedly helped to short-circuit the more violent follow-through that occurred in 1973-1974, 1987, 2000-2002, and 2007-2009, at least to-date.
A word of caution. While a few of the highlighted instances were followed by immediate weakness, it is more typical for these conditions to persist for several weeks and even longer in some cases (for example, the wide blue strip in late-2010 and early 2011). 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.
We can narrow the blue bands to a range within a few weeks of the exact peaks in 1999, 2000, 2007, 2010 and 2011 by further restricting to periods where the Shiller multiple was above 22 and advisory bullishness was above 50. While that restriction is so tight that it excludes several critical market peaks in history, such as August 1987, it actually still retains the present environment.
Even so, my greatest concern as an investment manager is the possibility that some number of our shareholders will grow so exasperated with remaining defensive during these periods that they capitulate and take a significant position in the market at the worst possible point. In a market that has now underperformed Treasury bills for more than 13 years, with two plunges of more than 50% in the interim (all of which we anticipated), my hope is that shareholders recognize our record in identifying major downside risks, and understand – if not fully agree with – my insistence on stress-testing our methods against Depression-era data in 2009 in response to the credit crisis (see the semi-annual report for more on that subject).
The S&P 500 has experienced repeated bouts of volatility since early 2010, when even our existing ensemble approach would have moved to a defensive stance, but it is notable that the S&P 500 would have to decline all of 11% to return to its April 2010 level. The completion of the present bull-bear market cycle (and it will be completed) will undoubtedly present strong opportunities to play offense, but today stands among a Who’s Who of the worst historical times to do so. Particularly for investors who do not have a large number of future cycles between now and the point they will need to draw significantly on their assets, a defensive stance is crucial here.
While our defensive stance may seem interminable, it is important to keep in mind exactly where we are in terms of valuations, and exactly where we have been over the past decade. Since we can easily examine the investment positions that would have been supported by our ensemble analysis throughout market history, a few benchmarks may be helpful.
In market history prior to 1998, the ensemble methods that we presently use in practice would have supported a mostly or completely unhedged investment stance about two-thirds of the time. In contrast, since 1998, they would have supported such a position less than 20% of the time – periods which included 2003 (when in fact we lifted about 70% of our hedges), as well as much of 2009 and early 2010. Conversely, a tightly hedged investment stance was appropriate in pre-1998 data well under than one-third of the time, while a full hedge has been appropriate the majority of the time since then. As for “hard negative” periods where we find ourselves openly using the word “warning,” we find only 3% of pre-1998 periods that justified such a view, but fully 23% of periods since 1998 – including today – where our market views would have been so unfavorable. As noted at the outset of this comment, the present situation is actually somewhat worse than that, standing in the bottom 2.5% of all historical periods in terms of the prospective tradeoff between return and risk.
In short, the period since 2008 has been extraordinary in terms of how often a hedged investment stance has been appropriate. The validation for such a defensive stance should be obvious given the fact that stocks have underperformed Treasury bills since that time, including two separate market plunges in excess of 50%. While much more frequent hedging has been required, even the past decade supports the expectation that the completion of the present bull-bear cycle will produce substantial opportunities to accept market risk. Our present defensiveness is unlikely to persist a great while longer, but my hope is that the basis for our current position is clear.
A Menu of Bitter Pills
“Over the past 30 years, an offensively minded Federal Reserve and their global counterparts were printing money, lowering yields and bringing forward a false sense of monetary wealth. Successful investing in a deleveraging, low interest rate environment will require defensive in addition to offensive skills. Interest rates have a mathematical bottom and when they get there, the washing of the financial market’s hair produces a lot less lather when it’s wet, and a lot less body after the blow dry. At the zero bound, not only are yields rendered impotent to elevate P/E ratios and lower real estate cap rates, but they begin to poison the financial well. Low yields, instead of fostering capital gains for investors via the magic of present value discounting and lower credit spreads, begin to reduce household incomes, lower corporate profit margins and wreak havoc on historical business models connected to banking, money market funds and the pension industry. The offensively oriented investment world that we have grown so used to over the past three decades is being stonewalled by a zero bound goal line stand. Investment defense is coming of age.”
- Bill Gross, PIMCO March 2012 Letter
“You simply cannot create investment opportunities when they’re not there. When prices are high, it’s inescapable that prospective returns are low. That single sentence provides a great deal of guidance as to appropriate portfolio actions. Investment risk comes primarily from too-high prices, and too-high prices often come from excessive optimism and inadequate skepticism and risk aversion. Contributing underlying factors can include low prospective returns on safer investments, recent good performance by risky ones, strong inflows of capital, and easy availability of credit. That same pattern of taking new and bigger risks in order to perpetuate return often repeats in a cyclical pattern. The motto of those who reach for return seems to be: ‘If you can’t get the return you need from safe investments, pursue it via risky investments.’ It takes a lot of hard work or a lot of luck to turn something bought at a too-high price into a successful investment. Patient opportunism – waiting for bargains – is often your best strategy.”
- Howard Marks, Oaktree Capital, The Most Important Thing (2011)
The present menu of investment opportunities continues to be among the worst in history. Treasury bill yields stand at only a few basis points. The 10-year Treasury yield is just 2%. The 30-year Treasury yield is just 3.1% to maturity. Corporate bond yields are at 3.2%, the lowest level since 1955. Meanwhile, we presently estimate that the S&P 500 is likely to achieve an average (nominal) total return of just 4.3% annually over the coming decade.
With respect to projected stock market returns, our standard valuation methodology has provided an extremely accurate guide, both historically and even over the decade through last week. The only notable exception was the result of the late-1990′s bubble, which was so unusual that we have now seen 13 years of sub-Treasury-bill total returns for the S&P 500. We did observe a brief period of undervaluation in early 2009, but at present market levels, valuations continue to be challenging. Better valuations will emerge as the present market cycle is completed. Arguments that stocks are “cheap on the basis of forward operating earnings” fail to adjust for the record high level of profit margins (about 50% above their historical norms), and also apply bubble-era norms for price-to-forward earnings multiples. This is the same argument that analysts made in 2007, and it is dangerously wrong.
Now, just because stocks are likely to achieve a total return of only 4.3% over the coming decade, we can’t conclude that it is impossible for prices to move higher and prospective returns to move lower (as they did during the late 1990′s tech bubble and the housing bubble ending in 2007). It’s just that with market conditions now extremely overvalued, overbought, and overbullish, the declines that generally follow have easily wiped out the speculative “tails” of already mature advances. Indeed, the typical bear market wipes out more than half of the preceding bull market gain.
Even assuming that reasonably positive economic growth is more than enough to offset any tendency for record profit margins to normalize, a further 10% market advance over a period of a year would reduce the prospective 10-year return for the S&P 500 to somewhere between 3.3% and 3.6%. Nothing in the evidence suggests that outcome, but should we speculate on that hope, given that previous ventures to such low prospective returns were ultimately followed by violent losses that wiped any temporary speculative gains? For our part, the answer is simply no.
Economic concerns remain difficult to escape
It’s worth emphasizing that our concerns about the financial markets here are distinct from our economic views, in the sense that the present syndrome of overvalued, overbought, overbullish conditions would be hostile even if we were more optimistic about economic prospects. But it is also worth emphasizing that many aspects of recent economic data have been more favorable than we observed last summer.
For my part, I have no interest in overstating the case for recession risk, but I am also convinced that these concerns have been abandoned much more vigorously by investors than is really warranted by the evidence.
In terms of coincident indicators, we can get a good overall picture of the improvement in the recent data by taking the average standardized value of multiple regional and national surveys. The recent bounce is clear, but we are still very close to the zero line, and of course, we observed a similar bounce in the lead-up to the 2007-2009 recession. So the recent coincident data certainly feels better, but we know from historical correlation profiles that there is not a great deal of leading usefulness in this data (see Leading Indicators and the Risk of a Blindside Recession ).
A week ago, Lakshman Achuthan of the Economic Cycle Research Institute (ECRI) reiterated his own case for an oncoming recession saying “Consider it reaffirmed.” Achuthan observed that given a broad aggregate of GDP growth, real sales, personal disposable income, industrial production, and other measures, we’ve never observed a similar decline in year-over-year growth without seeing a recession. Note that Achuthan does not simply consider the extent of the decline from a growth peak, but instead defines a downturn based on what he calls the “three P’s” – pronounced, persistent, and pervasive. On this feature of the data, we are in agreement with ECRI – we’ve observed a uniformity of recession warnings in a broad set of leading data that we simply haven’t observed across history except in association with recession.
At the same time, we’ve also seen an improvement in some measures – particularly new claims for unemployment – where the extent of positive progress we’ve seen is not at all typical of pre-recession periods. Similarly, while year-over-year employment growth remains quite tepid, that growth rate has been rising rather than falling (though we also saw that just before the 1981-1982 recession). While we know that payrolls and new claims for unemployment are actually lagging indicators, not leading ones, we still generally see new claims for unemployment creeping higher before recessions, unlike today.
So from our standpoint, the essential question is whether the improvement in job growth negates the evidence from leading indicators, and from coincident indicators that are now at year-over-year growth rates also associated with oncoming recessions. As uncomfortable as it is to contemplate a renewed economic downturn, the weight of the evidence still leans to the leading indicators and coincident growth rates. Achuthan made this point very precisely, noting that “downturns in job growth lag downturns in consumer spending growth, which is very clearly in a downturn. That’s the sequence: jobs growth follows consumer spending growth, not the other way around.”
Tags: Amp, Blue Strip, Caution, Hussman, Interventions, Invest, Market Declines, Measures, Monetary Policy, Plunge, Rare Instances, Risk Profile, Selloffs, Short Circuit, Substantial Market, Term Charts
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Monday, December 12th, 2011
John P. Hussman, Ph.D., Hussman Funds
With the exception of extreme market conditions (see Warning- Examine All Risk Exposures , and Extreme Conditions and Typical Outcomes ), I try not to wave my arms around about near-term market risks, but I think it’s important to cut straight to the chase here. The present market environment warrants unusual concern, in my view. Based on a wide variety of evidence and its typical market implications over an ensemble of dozens of subsets of historical data, the expected return/risk profile of the stock market has shifted to hard-negative. This places us in a tightly defensive position. This isn’t really a forecast in the sense that shifts in the evidence even over a period of a few weeks could move us to adjust our investment stance, but here and now we observe conditions that have often produced abrupt crash-like plunges. This combination of evidence includes elevated valuations, overbullish sentiment, market internals best characterized as a “whipsaw trap” on the basis of typical follow-through, heightened credit strains, and clear evidence (on reliable forward-looking indicators) of oncoming recession, among other factors.
As always, we try to align our investment positions with the evidence we observe. If the evidence softens, our hedges will soften. While the quickest route to a modest exposure to market fluctuations (perhaps 20-30%) would be a clear improvement in market internals – which could justify a less defensive stance even in the face of recession risks and rich valuations – the most likely route to a significant investment exposure would be a decline to much lower prices and correspondingly higher prospective returns. Presently, avoidance of major market losses takes precedence in our analysis.
On a valuation front, we estimate that the S&P 500 is likely to achieve an average total return over the coming decade of about 4.8% annually. This is certainly better than the projected returns that we have observed over much of the past decade, but then, the past decade has produced virtually no total return for equity investors at all. An expected total return of 4.8% is also clearly better than is presently available on Treasury bills, which are priced to return a single basis point of interest annually, and is also better than the sub-2% yield available on 10-year Treasury debt.
The problem is that the duration of a 10-year Treasury bond is only about 7 years, which is not only the weighted average time it takes to receive the future stream of payments, but also conveniently measures the expected percentage change in the bond price for a 1% change in long-term return. For stocks, the “duration” mathematically works out to be roughly the price/dividend ratio, which is about 45 for the S&P 500. Put simply, in order to achieve a given increase in long-term expected return, stocks would have to suffer about 6 times the price decline that bonds would experience. Stocks may very well outperform Treasury bonds over the coming decade, but for investors who have any sensitivity to price volatility, that is likely to be a small comfort in the next few years. We estimate that the S&P 500 would have to trade at about the 800 level in order to achieve 10-year prospective returns of 10% annually. Importantly, even a magical “fix” out of Europe would do nothing to change that algebra.
On the sentiment front, Investors Intelligence reports that the percentage of advisory bears dropped below 30% last week, which has historically resulted in unrewarding market outcomes when valuations have been elevated even to a lesser extent than they are today. Thomson Reuters reports that negative earnings pre-announcements are exceeding positive ones by the largest ratio since mid-2001. Investors have eagerly accepted forward operating earnings as a basis for valuation assessments, without accounting for the fact that those earnings expectations assume profit margins about 50% above their historical norms. Unfortunately, profit margins are highly vulnerable to economic weakness, and we are beginning to observe that regularity here.
As noted last week, we continue to estimate a very high probability of oncoming recession. While the economic outlook seems fairly benign based on a “flow of anecdotes” approach (judging economic prospects on the basis of positive or negative surprises in individual reports as they arrive), the outlook is actually very unfavorable based on a more reliable ensemble of leading indicators of economic activity (see Have We Avoided a Recession? ).
That view is clearly shared by the Economic Cycle Research Institute, where Lakshman Achuthan noted on Bloomberg last week that “forward looking data since two months ago has remained weak, it’s getting weaker, it’s not turning up. So, to my fellow forecasters out there, I’d say they’re roughly in two camps. There are those who say that the economy is firming and will continue to firm into next year. We reject that. There’s nothing there that suggests that at all. I think there’s a larger camp that says we’re going to muddle through; we’re going to get this kind of slow growth, ‘I’m not terribly optimistic, but we’re going to muddle through.’ I would point out that that’s never happened. We never muddle through. A market economy does not want to have a static state. It either accelerates or it decelerates, and these forward looking indicators say decelerate.”
Achuthan also noted that “the other half of the GDP report,” gross domestic income or GDI (which tends to be the more accurate measure of GDP) was up just 0.3% in the most recent quarter. The Federal Reserve has observed that when GDP and GDI differ, the GDP figure tends to be revised toward GDI, not the other way around. Achuthan warned that the GDI figures are “a big red recession signal.” In response to the question “You had a recession call, what happened?,” Achuthan simply answered “It’s happening.”
It’s important to be clear that the hard-negative condition of our ensembles here is based on observable data, and our expectation for returns is based on market outcomes that have accompanied past observations that fall into the same classification “bucket” or “cluster” as we see today. The negative average return/risk profile associated with present conditions is, of course, an average, and this specific instance might turn out differently. The problem is that the average is dominated by poor outcomes, some very steeply negative, with a much smaller set of positive outcomes. In any case, our market expectations here are driven by observable data, not by our views about what may or may not happen in Europe. Of course, our concern about high recession risk here is also driven by observable data.
No Sugar Tonight
As for Europe, last week was essentially a confirmation of our impressions on a variety of fronts. First, and probably most important from (the standpoint of investor perceptions) is that the new head of the ECB, Mario Draghi, is as committed to the constraints imposed by EU Treaties as clear-headed observers should expect (see Why the ECB Won’t, and Shouldn’t, Just Print ). Far from looking for clever “political cover” that would allow the ECB to initiate massive purchases of distressed European debt, Draghi said that he was “kind of surprised” that that others misinterpreted his phrase “other measures might follow” as a suggestion that massive ECB bond-buying would be allowed once a fiscal union was more clearly established. To the contrary, he rejected any sort of “grand bargain,” saying “We have a Treaty, and Article 123 prohibits financing of governments. It embodies the best tradition of the Bundesbank. We shouldn’t try to circumvent the spirit of the treaty.” He specifically warned against attempts to use “legal tricks” to circumvent the EU Treaties.
Notably, the restriction in Article 123 specifically prohibits the ECB from “any financing of the public sector’s obligations vis-a-vis third parties” – this does not simply restrict the ECB from buying debt directly (which could be circumvented by buying distressed debt on the open market). Rather, it is a restriction against using the ECB as a funding mechanism for public sector obligations. Read Draghi’s lips: the ECB will not be initiating massive purchases of distressed European debt unless and until the EU Treaties themselves are explicitly changed.
It is still a good thing that 26 of the 27 EU members appear willing to agree to greater fiscal union, but that sort of pact, outside of EU Treaty changes, will not be sufficient to trigger ECB bond buying in any event. Britain vetoed the idea of an EU Treaty change, with Prime Minister David Cameron saying “We’re not in the euro and I’m glad we’re not in the euro. We’re never going to join the euro. We’re never going to give up this kind of sovereignty that these countries are having to give up in order to have a fiscal union.”
The key point here is that the ECB should not be expected to buy distressed European debt anytime in the near future. In order to achieve that end, particularly with Germany’s consent, Europe requires not only an agreement on fiscal union among euro-area members, but explicit EU Treaty amendments including changes in the ECB’s restrictions and mandate. Moreover, an agreement on fiscal union isn’t just a matter of putting nice words on paper – it has to be credible in order for Germany to go along. Otherwise, massive ECB buying of distressed European debt would effectively constitute a permanent creation of new euros that would never be undone. While open market operations that temporarily create new currency are often not inflationary, permanent creation of new currency to finance government deficit spending is entirely a different matter.
On the question of credibility, there is also a problem in creating an effective enforcement mechanism for the fiscal union. Suppose a government is, in fact, running actual deficits greater than 3% of GDP, or “structural” deficits greater than 0.5%, which is the desired maximum. It will be impossible, at that point, to credibly say, “Uh oh, you’re running larger deficits than are allowed – therefore, you’re going to have to pay a penalty, which will effectively drive you into larger deficits. Otherwise, you’re going to lose your vote in the EU, which will accelerate the risk of your disorderly departure from the union.”
If the markets want more flexible bond buying from the ECB, the best route would be for EU members to agree to explicit changes to EU Treaties, and to restrict various provisions that Britain finds objectionable, so that they apply only to the 17 EU members whose currency is the euro. That said, while an explicit fiscal union would give the ECB greater flexibility, my impression is that we will still never see the ECB embarking on “big bazooka” purchases of distressed European debt, precisely because the very fact that the debt is distressed would introduce a question about whether the debt would be repaid; therefore a question about the ECB’s ability to reverse the purchases; therefore a question about the credibility of the ECB; and therefore a question about the credibility of the euro itself.
We’ve seen some theories that Europe intends to address the problem through ECB lending to banks, taking distressed debt as collateral, with the banks turning around and buying more distressed debt. Apart from the fact that this would be the sort of “legal trick” that the ECB would be unwilling to facilitate, this would imply an increase in bank leverage ratios far beyond the 30-40 multiples that already exist (which would be a disaster when tighter Basel III capital requirements kick in). In practice, depositors would flee, and you would end up with a European banking system where bank bondholders, not the ECB, would be subject to the losses, since the ECB’s collateral claims would be senior. Likewise, IMF loans are always highly conditional, and are always senior claims.
As I noted last week, what investors really want isn’t just for someone to buy distressed European debt, but for someone to buy that debt and willingly take a loss on it so the money doesn’t ever actually have to be repaid. This is a solvency issue – a shortfall between money owed and the resources to credibly repay it. There is no legal trick to get around that. Ultimately, you either have to restore credibility, or you have to restructure the claims through default or devaluation.
As for the knee-jerk enthusiasm of some analysts over the prospect of not just one European bailout fund, but two, it is helpful to recognize that the European Stability Mechanism (ESM) is simply the permanent, Treaty-blessed version of the European Financial Stability Facility (EFSF). These are not two separate pools of money, but are instead the presently operating facility and its eventual permanent home, as the EFSF expires in 2013. There is a 1-year overlap in the life of these two vehicles in order to facilitate that transfer of responsibility. The guarantee commitment of European member states to the EFSF is 440 billion euros (about one-third of that from Italy and Spain, which is ironic), which increases to 500 billion euros in guarantee commitments once the ESM is established. Again, these facilities are really one in the same.
I want to be clear – it is critically important for the EU to establish some sort of fiscal unity, to pull European member states off of the road toward insolvency. In my view, an oncoming global recession will be very hostile to the effort to balance government budgets, but greater fiscal coordination is an important objective if Europe’s common currency is to survive.
The bottom line is that last week’s events took a great deal more off the table than sugar-addicted investors may immediately appreciate. In effect, if a fiscal union is achieved without treaty changes, the ECB is unlikely to act. But even if treaty changes are achieved, the ECB is unlikely to act forcefully unless those changes are credible. Of course, if the changes are credible, then forceful actions will not be needed anyway. In any event, the problem for bailout-hungry investors is that they will be deeply disappointed if they expect Mario Draghi to turn into Ben Bernanke.
A credible solution for Europe: convertible debt
So what can Europe do to credibly address its credit strains, in a way that reduces the risk of a collapse of the European monetary union? In my view, the most viable approach is for European member states (particularly the distressed ones) to begin writing convertibility clauses into their debt as it rolls over. Those convertibility clauses would provide that the debt could be converted, at the option of the issuing government, into an equivalent amount of that country’s legacy currency (lira, pesetas, etc).
Undoubtedly, this would tack a “conversion premium” onto the bond yields of highly indebted countries, essentially substituting for the default premiums that investors tack on today. If a country follows (or adopts) a credible fiscal policy, the conversion premium would be relatively low, because investors would be confident that the country would remain in the euro-zone, and that no future conversion would occur. But if a country pursues an unsound fiscal course, the conversion premium would rise, creating an incentive for that country to correct its own fiscal policies, without the need for external pressure from other EU member countries, and with far less fear of disorderly default. If those efforts fail, the country would convert the debt to its legacy currency. Investors would reasonably expect that in the event of conversion, the newly converted currencies would most probably depreciate, and they would reflect that risk in the prices they pay and yields they demand.
Keep in mind that the average maturity of Euro-area debt is less than 7 years. Gradually introducing debt with convertibility clauses could provide a substantial “release-valve” for Europe within a fairly small number of years. Rather than perpetuating a system of moral hazard, where indebted countries become more indebted on the expectation of eventual bailouts by stronger EU members, introducing convertible debt would place the costs and incentives for fiscal reform squarely on each individual country.
Ideally, all of the present euro-zone members would achieve sufficient fiscal credibility to remain in the euro. Clearly, each country would have an incentive to do so, without the need for questionable enforcement mechanisms by other EU members. In this way, if the system can be saved, the system will be saved. Yet unlike the present arrangement, the entire EU will not be brought to its knees in the event that individual countries fail to solve their budget difficulties.
As of last week, the Market Climate for stocks was characterized by an extremely unfavorable ensemble of conditions across valuations, sentiment, economic factors, and other conditions. Current conditions cluster with periods such as May 1962, October 1973, July 2001, and December 2007, all which produced 10-20% market losses in extremely short-order. Strategic Growth and Strategic International are tightly hedged here. Strategic Total Return continues to carry an average duration of about 3 years, with about 20% of assets in precious metals shares (where conditions remain quite positive on our measures), and small single-digit positions in utility shares and (non-euro) foreign currencies.
That said, our investment strategy is not based on forecasting specific near-term market movements, but instead on accepting market risk in proportion to the expected return that has historically accompanied similar observable conditions, on average. As that evidence changes, our investment stance will also change.
Importantly, we don’t look to “time” short-term movements or “catch” various trends. My heightened concerns here should not be taken as a specific “prediction” of coming market movements, but rather as a response to conditions that have typically been hostile. We are responding to this observable data defensively, in a way that is most consistent with our long-term, full-cycle investment objective.
Finally, I recognize that it is common for investment managers to position their portfolios near year-end in hopes of window-dressing their portfolios or betting on a “Santa Claus” rally or other mild seasonal tendencies. In general, these seasonal tendencies are too weak to counter the other factors that enter into our analysis, but in any case, we manage the Funds with a focus on a specific full-cycle investment discipline, not with a focus on tweaking our end-of-year holdings. So while year-end window-dressing activity may or may not defer the unfavorable pressures that we see in the data, we have no intention of ignoring that evidence in hopes of catching a wholly uncertain ride on Santa’s sleigh. We’ll continue to follow our discipline. For now, we remain broadly defensive.
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Tags: Clear Evidence, Defensive Position, Defensive Stance, Extreme Conditions, Hedges, Hussman Funds, Investment Positions, Market Environment, Market Fluctuations, Market Implications, Market Internals, Market Losses, Plunges, Quickest Route, Risk Exposures, Risk Profile, Typical Market, Typical Outcomes, Valuations, Whipsaw
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Monday, August 29th, 2011
A Reprieve from Misguided Recklessness
by John P. Hussman, Ph.D., Hussman Funds
An immediate note on market conditions. Last week’s market advance cleared out the “predictable” expectation for constructive returns that briefly emerged from the recent market selloff. That doesn’t mean that the market can’t advance further, but given that the expected return/risk profile of stocks has now shifted hard negative again, any such advance would be a random fluctuation rather than a predictable one. Strategic Growth and Strategic International Equity have shifted from a briefly constructive position back to a full hedge. Our principal investment position in Strategic Total Return remains a 20% allocation to precious metals shares, where the ensemble of conditions remains very favorable on our measures, despite what we view as a welcome correction in the spot price of physical gold. The Fund has a duration of only about 1.5 years in Treasury securities, mostly driven by a modest exposure in 3-5 year maturities.
It is now urgent for investors to recognize that the set of economic evidence we observe reflects a unique signature of recessions comprising deterioration in financial and economic measures that is always and only observed during or immediately prior to U.S. recessions. These include a widening of credit spreads on corporate debt versus 6 months prior, the S&P 500 below its level of 6 months prior, the Treasury yield curve flatter than 2.5% (10-year minus 3-month), year-over-year GDP growth below 2%, ISM Purchasing Managers Index below 54, year-over-year growth in total nonfarm payrolls below 1%, as well as important corroborating indicators such as plunging consumer confidence. There are certainly a great number of opinions about the prospect of recession, but the evidence we observe at present has 100% sensitivity (these conditions have always been observed during or just prior to each U.S. recession) and 100% specificity (the only time we observe the full set of these conditions is during or just prior to U.S. recessions). This doesn’t mean that the U.S. economy cannot possibly avoid a recession, but to expect that outcome relies on the hope that “this time is different.”
While the reduced set of options for monetary policy action may seem unfortunate, it is important to observe that each time the Fed has attempted to “backstop” the financial markets by distorting the set of investment opportunities that are available, the Fed has bought a temporary reprieve only at the cost of amplifying the later fallout.
Recall how the housing bubble started. Back in 2002-2003, Alan Greenspan held short term interest rates at such low levels that investors felt forced to “reach for yield” – and they found that extra yield in mortgage securities, which up until then had never experienced major credit difficulties. Wall Street quickly got a whiff of that, and realized that it could earn enormous fees by cranking out more “product” to satisfy investor demand. Soon, a flood of mortgage securities was created featuring increasingly complex structures (in order to maintain “AAA” status) while the proceeds from issuing these securities were offered to borrowers who were less and less creditworthy. As long as a willing borrower could be found – however unable to actually pay off the mortgage, and as long as a willing lender could be found – pressed to reach for yield by the Fed’s distortive low interest rate policies, Wall Street and the banking system got them together, and obscured the gaping chasm between actual and perceived credit risk through “financial engineering” that created slice-and-dice securities with mind-numbing complexity.
Once the housing bubble collapsed, the Fed again responded with policies aimed primarily at distorting the set of investment opportunities through zero interest rates, preserving the misallocation of capital toward speculative investments (on Bernanke’s misguided and empirically unsupported belief that consumers spend out of speculative gains). Yet the underlying debt burdens have not been restructured, so consumers – particularly homeowners – continue to pare back spending in order to reduce those debt burdens. As a result, there is little expectation of significant growth in demand, and companies therefore have little reason to hire new employees – all of which reinforces a “low level equilibrium” in the economy.
The way to get out of this is to abandon the misguided belief that economic prosperity can be obtained by encouraging speculation and distorting the set of investment opportunities. Rather, we will eventually find, as was eventually also discovered in the post-Depression stagnation of the 1930′s, that the way to get the economy moving again is to restructure hopelessly burdensome debt obligations.
Of course, this same story is playing out on a global scale. It is worth noting that the yield on 1-year Greek government debt surged to 55% last week. At present, the global bond market is expressing a 100% expectation that this debt will default. The only question now is what the recovery rate will be.
Over the past three years, Wall Street and the banking system have enjoyed enormous fiscal and monetary concessions on the self-serving assertion that the global financial system will “implode” if anyone who made a bad loan might actually experience a loss. Because reversing this mantra is so difficult, policy makers are likely to continue fitful efforts to “rescue” this debt for the sake of bondholders, through mechanisms that are increasingly distasteful to the broader population. The justification for those policies will therefore have to be coupled with rhetoric that institutions holding these securities are too “systemically important” to suffer losses.
On this note, it is critical to remember that nearly all financial institutions have enough capital and obligations to their own bondholders to completely absorb restructuring losses without customers or counterparties bearing any loss at all. So keep in mind that the debate here is not about protecting customers or counterparties – it is really about whether the stockholders and bondholders of banks and other financial institutions should bear a loss. The “failure” of a bank only means that existing stockholders and bondholders are disenfranchised – the company simply takes on a new life under new ownership. Existing stockholders lose everything, unsecured bondholders typically lose something, and senior bondholders get any residual obtained as a result of the sale or transfer of the company. If the global economy is fortunate, the financial system two or three years from now will look much the same as it does today, but the ownership and capital structure will have changed almost entirely. A major restructuring of debt is the clearest path to long-term economic recovery, and the accompanying losses to those who recklessly made bad loans would be the highest realization of Schumpeter’s idea of “creative destruction.”
From that perspective, Warren Buffett’s $5 billion investment in Bank of America preferred stock last week was essentially a defense of the old guard. Buffet observed, “It’s a vote of confidence, not only in Bank of America, but also in the country.”
Yes – to be specific, it’s a vote of confidence that the country will bail out Bank of America in any future crisis. We should all hope that Buffett’s investment is successful – provided there is no future crisis – and we should equally hope that Buffett loses the entire investment otherwise.
A reprieve from misguided recklessness
On Friday, Ben Bernanke gave his long-awaited speech at Jackson Hole, which notably did not include any pronouncement about a third round of quantitative easing. The stock market advanced anyway, largely because investors seemed to take Bernanke’s comments as a cue that the Fed will revisit the prospect of QE3 in September. Specifically, analysts focused on Bernanke’s observation that “the Federal Reserve has a range of tools that could be used to provide additional monetary stimulus. We discussed the relative merits and costs of such tools at our August meeting. We will continue to consider those and other pertinent issues, including the course of economic and financial developments, at our meeting in September, which has been scheduled for two days (the 20th and the 21st) instead of one to allow a fuller discussion.”
Part of the reason for the expanded discussion, of course, is that three FOMC members have already declared mutiny, opposing even the Fed’s promise to hold interest rates near zero through mid-2013 (which is the most resistance to a Fed decision in two decades). Still, this opposition unfortunately seems to be for the wrong reason – not because they recognize that QE2 didn’t actually work, nor because they understand that consumers don’t spend out of speculative gains – particularly in stocks and commodities, nor that they recognize that QE isn’t effective in relieving any constraints on the economy – given that interest rates are already low and banks are already awash in liquidity (though not necessarily capital – and there is a difference). Rather, the reason for their opposition seems to be that they don’t believe that economic conditions warrant further “stimulus.”
Look. Imagine that Ben Bernanke announced that he is going to stop spitting watermelon seeds into a can. Should we all become concerned that he is suddenly not doing enough to stimulate the economy? Well, only if you think that spitting watermelon seeds into a can is stimulative to the economy. And this is precisely the point. The successes of QE2 included a brief boost to pent-up demand which has already reversed, a boost to speculation in the stock market that has already reversed, a plunge in the value of the U.S. dollar that has persisted because the increased stock of U.S. dollars has persisted, and a wave of commodity hoarding that injured the world’s poor by raising prices of food and energy – because commodities are viewed as currency substitutes when governments are debasing purchasing power through money creation.
Moreover, this failure was predictable even before the Fed launched QE2, because with near-zero interest rates, depressed long-term rates, and already massive bank reserves, the policy could not hope to relieve any constraints that were actually relevant to the economy (see The Recklessness of Quantitative Easing ); because consumers don’t spend out of volatile forms of “wealth” (see Bubble, Crash, Bubble, Crash, Bubble… ); and because a monetary easing that creates inflation expectations while pressing down interest rates invariably leads to an “overshooting” depreciation in that currency and a surge in commodity prices that are quoted in that currency (see Why Quantitative Easing is Likely to Trigger a Collapse of the U.S. Dollar ). Of course, given that other central banks have also attempted to keep pace through competitive devaluations, the most spectacular collapse of the dollar has been against the currency substitute that cannot be printed by fiat – namely gold.
Even Bernanke seemed to acknowledge that further attempts at monetary intervention could only provide short-term juice, saying “most of the economic policies that support robust economic growth in the long run are outside the province of the central bank.”
On that subject, Bernanke offered some of the only sound words of his tenure, stressing that “U.S. fiscal policy must be placed on a sustainable path that ensures that debt relative to national income is at least stable, or, preferably, declining over time,” and warning against excessive austerity by observing “Although the issue of fiscal sustainability must urgently be addressed, fiscal policymakers should not, as a consequence, disregard the fragility of the current economic recovery.
Somewhat surprisingly, Bernanke also outlined several elements of a more promising policy response, which were very consistent with our own views: “To the fullest extent possible, our nation’s tax and spending policies should increase incentives to work and save, encourage investments in the skills of our workforce, stimulate private capital formation, promote research and development, and provide necessary public infrastructure. We cannot expect our economy to grow its way out of our fiscal imbalances, but a more productive economy will ease the tradeoffs that we face,” adding that “Good, proactive housing policies could help speed that process.”
The upshot is that it remains unclear whether the Fed will revert to reckless policy in September, or whether the growing disagreement within the FOMC will result in a more enlightened approach – abandoning the “activist Fed” role, and passing the baton to public policies that encourage objectives such as productive investment, R&D, broad-benefit infrastructure, and mortgage restructuring – rather than continuing reckless monetary interventions that defend and encourage the continued misallocation of resources and the repeated emergence of speculative bubbles.
As of last week, we estimate that the prospective 10-year total return for the S&P 500 is back down to about 5.1% annually. To put this expected return in perspective, the chart below reviews the prospective return estimates from our standard methodology, going back to just before the Great Depression. The chart also presents the actual subsequent 10-year total returns achieved by the S&P 500. Note that a 5.1% prospective return is certainly not the worst level we’ve observed in history, but it is far from the 7.5-13% range of prospective returns that has characterized the bulk of historical data (and of course nowhere near the 20% prospective returns that have marked “secular” market lows).
Notice that the historical data is not particularly sympathetic to the idea that low Treasury bill yields should be accompanied by high market valuations and low prospective returns on stocks. While it is true that very high interest rates and inflation rates seem to be accompanied with depressed prices and accordingly high prospective market returns, it is clear that history contains long periods of near-zero interest rates coupled with depressed valuations and very high prospective market returns. As investors, we should hope for such opportunities, and I expect that we will eventually see them. Unfortunately, the transition from here to there would not be pretty.
There are certainly alternative methods of valuation embraced by Wall Street analysts. In particular, many analysts view the market as “cheap” based on forward operating earnings, without any consideration for the fact that stocks are a claim on a very long-duration stream of deliverable cash flows (not a single year’s results), and even less consideration for the fact that those forward operating earnings incorporate the assumption that profit margins will achieve and sustain the highest level of profit margins in U.S. history.
Before accepting conclusions based on a given valuation model, investors should demand similar evidence of its historical reliability. That evidence should be easy to produce, of course, and yet analysts typically don’t produce it. Hint – for many of these approaches, this is because evidence linking those methods to subsequent market returns does not exist.
The chart below provides a more comprehensive view of the prospective returns that would be associated with various levels of the S&P 500, based on the fundamentals we presently observe. As a rule-of-thumb, this curve shifts to the right at a rate of about 6% annually, which is the approximate growth rate of long-term normalized fundamentals (earnings, dividends, book values, revenues, and even nominal GDP).
I recognize that after a decade of bubble valuations (which has predictably resulted in near-zero total returns for the market), the implications of this chart may seem preposterous. Considering the historical accuracy of this approach in projecting subsequent market returns, however, we have to remember that unthinkability is not evidence. It seemed equally unthinkable in 1999 that stocks might underperform Treasury bills for more than a decade (see The Importance of Measuring Returns Peak-to-Peak ), and that valuations in 2000 could actually imply a decade of negative total returns, as our models were then projecting (see the August 2000 Hussman Funds investment letter). Yet that’s precisely what we observed.
Historically, the typical bull-bear market cycle has produced a range of 10-year prospective returns in a band between about 7.5% and 13%. That band presently corresponds to a range for the S&P 500 index between 600 and 1000. A 10% prospective return is right in the middle, at about 800 on the S&P. Once you recognize that profit margins are in fact cyclical, that range is about right, as uncomfortable as it may be to contemplate. Jeremy Grantham of GMO estimates that fair value is “no higher than 950.” A tighter norm for prospective return between 9-11% maps to an S&P 500 between 750 and 850.
Finally, while I certainly would not expect it in the absence of extreme macroeconomic upheaval, major secular undervaluation as we observed in 1950, 1974 and 1982 would presently map to about 400 on the S&P 500. When you think of “once in a generation” valuations and “secular bear market lows” – that number, not anything near present levels, should be what crosses your mind. I am well aware that even discussing numbers like these, given the present mindset of investors, is likely to be dismissed as utterly ridiculous. Frankly, I would rather risk the ridicule of those who pay lip-service to research, cash flows, fundamentals, and value than to pretend these outcomes are impossible, when the historical record (and even the experience of the past decade) strongly indicates otherwise.
As Howard Marks of Oaktree Capital has noted, “We hear a lot about ‘worst-case’ projections, but they often turn out to be not negative enough.. most people view risk taking primarily as a way to make money. Bearing higher risk generally produces higher returns. The market has to set things up to look like that’ll be the case; if it didn’t, people wouldn’t make risky investments. But it can’t always work that way, or else risky investments wouldn’t be risky. And when risk bearing doesn’t work, it really doesn’t work, and people are reminded what risk’s all about.”
As I noted at the outset, the Market Climate for stocks shifted from a briefly positive constructive stance back to hard negative last week. Accordingly, we closed our modest constructive position in Strategic Growth and Strategic International Equity. Both are fully hedged at present. In Strategic Total Return, the primary source of day-to-day fluctuations continues to be our allocation to precious metals shares, at about 20% of assets. The Fund also holds just over 4% of assets in utility shares, and has a duration of about 1.5 years in Treasury securities of short- and intermediate-maturity.
Among the important factors to watch here, yields shot above 50% on 1-year Greek government debt, suggesting an acceleration of liquidity and default concerns there. IMF chief Christine Lagarde spoke at Jackson Hole, saying that European banks “need urgent recapitalization. They must be strong enough to withstand the risks of sovereigns and weak growth. This is key to cutting the risks of contagion… we risk seeing the fragile recovery derailed.”
Meanwhile, the corporate bond market, which has held up until recently, saw a sharp but very initial selloff of about 2% early last week. Junk bonds have also dropped by about 5% so far this month. As Jeffrey Gundlach of DoubleLine Capital observed, “something funny is going on in the world of corporate bonds now. Something looks broken. It seems there’s less willingness all of a sudden to be lending money to corporations, maybe because the absolute yields are so low.” Even so, he argued against reaching for yield too early into this emerging weakness in corporate and speculative-grade debt, saying “I want fear. I want to buy things when people are afraid of it, not when they think that it’s a gift being handed to them.” Suffice it to say that in nearly every asset class, we are not there yet.
Tags: Bonds, Commodities, Consumer Confidence, Corporate Debt, Credit Spreads, Economic Evidence, Economic Measures, GDP Growth, Gold, Hussman Funds, Infrastructure, Investment Position, Market Advance, Nonfarm Payrolls, physical gold, precious metals, Principal Investment, Purchasing Managers Index, Random Fluctuation, Recklessness, Risk Profile, Treasury Securities, Treasury Yield Curve, Welcome Correction
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Tuesday, August 2nd, 2011
More Than Meets the Eye
by John P. Hussman, Ph.D., Hussman Funds
On the surface, the agreement on the U.S. debt ceiling can be expected to produce a significant relief rally in the financial markets, particularly if one views uncertainty on that front to be the reason for last week’s market weakness. That prospect, coupled with the predictable support that investors gave the S&P 500 precisely at its 200-day moving average, prompted us to cover just over 10% of our short calls, but retaining full hedge on the remainder of our holdings, and keeping a strong line of protection about 2% below Friday’s closing levels using index put options (near that 200-day). That’s still a fairly tight hedge, because unfortunately, the ensemble of observable data continues to indicate negative expected returns. So while we’ve modified our position slightly to allow for reduced uncertainty on the deficit front, and the likelihood of “knee jerk” technical support at the widely-followed 200-day average, the expected return/risk profile in stocks remains negative in our estimation. Of course, our precise hedge will change from day-to-day as market conditions change.
Part of the problem here is that market internals have deteriorated badly, particularly last week, where breadth was nearly 10-to-1 in favor of declining issues, and downside leadership exerted itself with more stocks hitting new 52-week lows than new highs. Meanwhile, though new claims for unemployment dipped just below 400,000 last week, we would be more encouraged if the margin was greater, and sustained over a period of many weeks. At present, the 4-week average is running at about 414,000, a level which has historically been associated with growth of only about 30,000-50,000 in monthly non-farm payrolls on average (see the July 11 comment), though there’s certainly month-to-month noise around those averages.
The overall impression from the data suggests the possibility that there is more information in the recent breakdown in market internals than can be explained by debt ceiling concerns alone. On that note, there are emerging economic signals whose leading tendencies are strong enough to make a review worthwhile.
We’ll begin with our own recession warning composite, which accurately signaled oncoming recessions in 2000 and 2007 (see the November 12, 2007 comment Expecting A Recession ). That particular conformation of indicators never deteriorated sufficiently in 2010 to provoke a recession warning, though the deterioration in the ECRI leading index and other measures clearly indicated serious concern. In any event, QE2 effectively forestalled incipient economic weakness in 2010. Given that second quarter GDP came in at just 1.3% annually, and first quarter GDP growth was revised down to just 0.4% (from a prior estimate of 1.9%), it is wholly unclear that the Fed’s extraordinary actions have been worth the market distortions, predictable commodity hoarding, injury and social unrest among the world’s poor (resulting from food and energy price increases) and significant “unwinding” risks that this policy has produced.
The components of our recession warning composite might be called “weak learners” in that none of them, individually, has a particularly notable record in anticipating recessions. The full syndrome of conditions, however, captures a critical “signature” of recessions. That signature of “early warning” conditions is based on financial market indicators including credit spreads, equity prices and yield curve behavior, coupled with slowing in measures of employment and business activity. Every historical instance of this full syndrome has been associated with an ongoing or immediately impending recession.
The components (which I’ve reordered for simplicity) are:
1: Widening credit spreads: An increase over the past 6 months in either the spread between commercial paper and 3-month Treasury yields, or between the Dow Corporate Bond Index yield and 10-year Treasury yields.
2: Falling stock prices: S&P 500 below its level of 6 months earlier. This is not terribly unusual by itself, which is why people say that market declines have called 11 of the past 6 recessions, but falling stock prices are very important as part of the broader syndrome.
3: Weak ISM Purchasing Managers Index: PMI below 50, or,
3: (alternate): Moderating ISM and employment growth: PMI below 54, coupled with slowing employment growth: either total nonfarm employment growth below 1.3% over the preceding year (this is a figure that Marty Zweig noted in a Barron’s piece many years ago), or an unemployment rate up 0.4% or more from its 12-month low.
4: Moderate or flat yield curve: 10-year Treasury yield no more than 2.5% above 3-month Treasury yields if condition 3 is in effect, or any difference of less than 3.1% if 3(alternate) is in effect (again, this criterion doesn’t create a strong risk of recession in and of itself).
At present, both measures of credit spreads in condition 1 are widening, the S&P 500 is within about one percent of its level 6 months ago, the Purchasing Managers Index is at 55.3%, total nonfarm payrolls have grown by only 0.8% over the past year, the unemployment rate is up 0.4% from its March 2011 low, and the Treasury yield spread is just 2.7%. From the standpoint of this composite, we would require only modest deterioration in stock prices and the ISM index to produce serious recession concerns.
This impression is supported by a number of other observations. First, the year-over-year growth in U.S. real GDP is now just 1.6%. As David Rosenberg notes (via John Mauldin), this level of growth has historically been slow enough to anticipate an oncoming recession.
Wells Fargo’s senior economist Mark Vitner reiterated the point last week, noting that since 1950, year-over-year growth in real GDP has dipped below 2% on 12 occasions. In 10 of those instances, the economy was already in recession or quickly entered one. The exceptions were 1956 and 2003.
For our part, we’ve always believed that the strongest evidence is obtained by combining multiple data points into a single “gestalt.” So I have difficulty concluding that the U.S. is on the verge of recession simply because the year-over-year growth rate has stalled. At the same time, we are closely monitoring a much broader set of data, because the deterioration has been very rapid. I should be clear – the evidence is not yet convincing that a recession is imminent, but it is also important to recognize that the developing risks are greater than most investors seem to assume at present.
I should also note that while our recession warning composite uses the ISM Purchasing Managers Index as a component, we believe it is important to monitor a much broader set of survey-based data, including the ISM (National, Chicago, Cincinnati, Milwaukee) and Federal Reserve (Empire Manufacturing, Philadelphia, Richmond, Dallas) indices. As you can see from the chart below, the combined evidence from these measures collapsed sharply during the summer of 2010, and enjoyed a brief bounce as the Fed embarked on its second round of quantitative easing. The deterioration in recent months is of significant concern, though again, we would need to see further weakness in a number of measures before attaching a significant probability to an oncoming recession.
Notably, the full effect of QE2 on economic activity was to provide transitory bump to short-term growth. Of course, that’s not a surprise, as we knew (and the Fed should have known) that there is virtually no “wealth effect” from stock market values to real GDP (specifically, the historical impact has been an increase of just 0.03-0.05% in GDP for every 1% increase in stock market capitalization). Yet, in order to achieve this pitiful amount of can-kicking, the Fed has now leveraged its balance sheet to 55-to-1, driving the monetary base to 18 cents for every dollar of nominal GDP. Notably, we’ve never observed Treasury bill yields at even 2% when the base has been anything greater than 10 cents per dollar of nominal GDP. Given the non-linear relationship between short-term interest rates and the amount of base money per dollar of GDP, a non-inflationary increase in interest rates to just 0.50% would presently require approximately $1 trillion in Treasury bond sales by the Fed, more than reversing its entire volume of purchases under QE2 (see Charles Plosser and the 50% Contraction in the Fed’s Balance Sheet ).
Tags: 52 Week Lows, Breadth, Debt Ceiling, Downside, Estimation, Financial Markets, Hussman Funds, Likelihood, Market Weakness, Moving Average, New 52 Week Lows, New Highs, Non Farm Payrolls, Observable Data, Rally, Remainder, Risk Profile, S Market, Uncertainty, Unemployment
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Monday, July 18th, 2011
Very little change in market conditions this week; stock valuations imply expected 10-year S&P 500 total returns of about 3.8% annually, based on our standard estimation methodology, market action remains mixed, and advisory bearishness remains too low for comfort in the context of current valuations. The overall set of conditions implies a slightly negative expected return/risk profile for stocks, which would turn sharply negative on a broad decline much below about 1280 on the S&P 500 (particularly if that sort of decline had broad participation from industries, sectors, and security types). By contrast, a further pullback toward that level, sufficient to generate oversold conditions and more bearish sentiment, but not much deeper and not coupled with broad further deterioration in market internals, might be associated with a brief improvement in the expected return/risk profile.
The overall market picture continues to have the look of a broad topping process, in which it’s very common to see the market confined to a trading range of about 5-7% for 6-8 months. Still, our investment position isn’t driven by the expectation of an oncoming bear market, and we’ll remain flexible to changes in the ensemble of market conditions. Near-term, tests of widely-recognized “support” are often met by a bout of short-covering, similar to what we observed two weeks ago. Given the moderate improvement in market internals produced by that rally, a retest of those lows that isn’t overly hostile to market internals might provide some latitude for modest market exposure. Suffice it to say that constructive opportunities are likely to be limited, moderate, but not impossible to achieve, and the downside risks below roughly 1280 on the S&P 500 (about where the popular 200-day moving average is running these days) could be fairly violent if internals weaken again.
In Strategic Growth and Strategic International Equity, we’re well defended against the impact of general market fluctuations, but continue to be open to moderate exposure if only the average expected return profile implied by the full ensemble of market conditions would peek above zero.
In bonds, conditions are similar in that long-term expected returns (which in this case can be directly observed as yield-to-maturity) remain poor, while near term returns rely on a further flight to safety on debt concerns of other countries, but not our own. Per unit of risk, the present ensemble of conditions is far more sympathetic to accepting exposure in precious metals shares. In the Strategic Total Return Fund, we continue to carry a duration of about 2.5 years, mostly in near- and intermediate-term Treasury securities, with the bulk of the Fund’s day-to-day fluctuations driven by our position in precious metals shares, at just under 20% of assets.
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Tags: Bear Market, Bearish Sentiment, Current Valuations, Deterioration, Downside Risks, Estimation, Hussman, International Equity, Investment Position, Lows, Market Exposure, Market Internals, Moderate Improvement, Moving Average, Pullback, Retest, Risk Profile, Security Types, Stock Valuations, Term Tests
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Sunday, June 12th, 2011
by John P. Hussman, Ph.D., Hussman Funds
Last week did a great deal of damage to our measures of market internals, suggesting that investors have shifted measurably toward risk-aversion in an environment where risk premiums are very thin. Historically, this combination of unfavorable valuations and unfavorable market action is strongly associated with a negative return/risk profile. However, we’ve also reached this point after six consecutive down-weeks, so the short-term condition of the market is fairly compressed and open to a fast, furious rebound to relieve that compression. The prospects for that would admittedly be better if there was less complacency among investors. Even after these consecutive declines, the CBOE volatility index (VIX) is still only about 18% (the VIX tends to spike toward 30% or higher at points where investors can reasonably be viewed as “fearful”). Likewise, though Investors Intelligence reports that the percentage of bullish investment advisors has pulled back modestly, most of them have simply gone to the “correction” camp, suggesting that the confidence in a rebound is still fairly universal. The percentage of bearish investment advisors remains way down at 22.6%.
Overall then, we’re seeing a measurable and potentially dangerous breakdown of market internals in an environment where risk premiums remain very thin. Short-term conditions are fairly compressed, which invites a rebound, but the expectations for that have to be tempered by the still-complacent sentiment of investors. Indeed, about the only areas where we see real concern is in measures where such concern is actually predictive (rather than being a contrary indicator). These include widening interest-rate spreads in peripheral European debt, and surging credit-default swap spreads for major U.S. banks.
A few notes on the banking sector. My view continues to be that the massive interventions of recent years have essentially kicked the can down the road, encouraging a writing-up of assets that are still not performing. The same basic view applies to European interventions to buy time for countries like Greece and Portugal. The problem is that while we have bought time, at great expense, our policy makers continue to waste that time by failing to prepare the markets adequately for debt restructuring.
With fiscal and monetary palliatives stretched to their limits, it is beginning to appear that the global economy is “up the creek without a paddle” – but this really ignores the fact that the boat has a motor, if we only had the courage to use it. That motor, which would be loud and uncomfortable to start, but would actually help to get the economy moving again, is debt restructuring. In some cases, such as Greek debt, this will require actual losses – a form of debt forgiveness. In other cases, such as U.S. housing, it is possible to restructure the payment stream without the need for subsidies or massive losses (though there will be some adjustment). Last week’s comment details my views on property appreciation rights as one avenue to coordinate this and revive a functioning housing market.
Presently, the major issue relating to banks surrounds the question of capital requirements. Late last year, international banking negotiations known as “Basel III” adopted a guideline to require banks to hold capital (equity and retained earnings) in an amount of at least 7% of risk-weighted assets. Technically, the figure is 4.5%, with a 2.5% buffer during periods of “excess credit growth.” Below those thresholds, banks would be required to raise more capital, with regulators expected to exercise resolution authority if bank capital dropped below 4% of assets.
The discussion now is about the additional margin-of-safety that large systemically-important banks should be required to hold – the likely figure being about 3% – which would put the total capital requirement as high as 10% of risk-weighted assets, for major banks during periods of rapid credit growth. That would still allow these banks a 10-to-1 leverage ratio – which given the range of default rates on various classes of bank debt, is appropriate, and not unreasonably restrictive. That’s especially true because debt created at points of rapid credit growth is often of fairly low-quality, as we saw in the aftermath of the housing bubble. Lehman and Bear Stearns ran leverage ratios near 30, with disastrous results. Fannie and Freddie’s leverage multiples were even higher, at about 40. You might recall that Long-Term Capital Management also ran at a leverage multiple of about 40-to-1 before it imploded. It’s probably worth noting that according to the Fed’s consolidated balance sheet as of June 8, Ben Bernanke has now taken the Federal Reserve’s leverage ratio to 53.4. Fortunately or unfortunately, U.S. taxpayers would automatically end up subsidizing any Fed losses, so unlike commercial banks, the Fed could actually go insolvent without major consequences.
After significant price weakness, the banks advanced late Friday when CNBC suggested – without any identified source – that the additional capital buffer for major banks might end up being closer to 2-2.5%. It’s ironic that bank shareholders are cheered-up by anything that makes the banking system more systemically vulnerable and therefore, more likely to require government bailouts. But that’s essentially how option pricing works. If your downside risk is covered, higher volatility actually increases the value of the option. For our part, we’re 100% behind FDIC head Sheila Bair – “On obvious things like higher capital standards, I say full speed ahead and the higher the better.”
From an economic standpoint, the last several weeks have generated more damage than may be readily apparent. Credit spreads are now wider than they were 6 months ago, the ISM Purchasing Managers Index is below 54, total non-farm payroll growth is far below 1.3% over the past year, and the spread between 10-year Treasury yields and 3-month T-bill yields is less than 3.1%. If the S&P 500 was to fall by about 2% further, it would also be lower than it was 6 months ago. The reason I note these particular measures is that they combine to form the “Aunt Minnie” that I noted in our November 2007 comment “Expecting A Recession” – a combination of indicators that has always and only been observed prior to or fairly early into post-war U.S. recessions.
Notably that composite did not signal recession risk in the summer of 2010 – based on the historical tendency of the ECRI weekly leading index (WLI) to deteriorate in advance of the ISM indices with a lead-time of several weeks, my double-dip concerns at the time were driven by the clear plunge in the WLI. But the ISM figures never dropped to 54 or below, and in any case, the Fed’s initiation of QE2 provoked a burst of enthusiasm and pent-up demand sufficient to buy some time. The problem now is that we have bought the time and wasted it, because policy makers have done nothing to either facilitate or reduce the impact of necessary debt restructuring.
My argument here is not that the economy is headed for a fresh recession (though a further loss in the S&P 500, continued weakness in the ISM, widening credit spreads and a flattening yield curve would all contribute to evidence in that direction). Nor do I think that we necessarily need a “day of reckoning” where debt strains again reach crisis levels (though I also remain unconvinced that we should rule it out). Rather, my view is that the economy retains most of the key vulnerabilities it did in 2007, including re-established overvaluation and an overhang of unserviceable debt. Clearly, there are intense efforts underway to reduce the requirement for banks to carry more capital, and the FASB has now effectively abandoned even modified versions of mark-to-market, which could have included reasonable approaches such as 3-year averaging.
From our perspective, the problem in the economy is not that banks are over-regulated, but that they are quietly holding a large amount of non-performing assets, and remain unlikely to expand their risk portfolio further. Either we subsidize these assets for years through interest rate spreads that are hostile to depositors, small savers and the elderly, or we initiate approaches to allow the existing debts – particularly mortgages – to be reasonably restructured. Policy makers seem to be on a fairly strong course in favor of the first option – essentially allowing a zombie banking system like Japan’s. It’s a valid choice, but it comes with the consequence of anemic economic prospects.
As noted above, market internals deteriorated notably last week, suggesting a measurable shift among investors toward risk aversion. The compressed short-term condition of the market invites something of a rebound, particularly given that markets frequently advance toward prior support once they break below it. Still, the relative complacency evidenced by a low volatility index and muted bearish sentiment give us the impression that there are still more potential sellers than willing buyers at nearby prices. Value investors will eventually be interested, but probably at much lower levels (even with the recent decline, our 10-year total return projections for the S&P 500 have barely cracked 4%). Meanwhile, the QE2 trade is essentially unwinding, and our impression is that the Fed’s balance sheet is extended enough to make QE3 a difficult (though not impossible) sell. Further economic and market weakness might modify that possibility, but it’s not clear how much latitude would be possible for a Fed that is now operating at more than 53-to-1 leverage.
For our part, we’ve made every attempt to give the market the benefit of the doubt, by rolling down index put strikes as the market has declined, and holding a put-only hedge against 20-35% of the Strategic Growth Fund’s stock portfolio (varying the effective exposure of the Fund between a tight hedge and 10-20% exposure to market fluctuations). Given that market internals have now broken down significantly on our measures, we require either a recovery of market internals or a large improvement in valuations to warrant a significant exposure to market fluctuations. Accordingly, we’ve slowed our willingness to reduce strike prices and the like, so our hedge should be fairly tight in the event of further market weakness. Strategic International Equity is tightly hedged here as well.
Recovering market internals would be easier than significantly improving valuations, of course, but that also requires some uniformity of improvement across a wide range of measures (breadth, credit spreads, leadership, and numerous industry groups and security types) that are currently going strongly in the wrong direction. That doesn’t make a reversal impossible, or even particularly unlikely, but it does suggest that the “quality” of a rebound – in terms of uniformity across a large range of market internals – will be critical in improving the prospective return/risk profile of the market.
In bonds, the Market Climate remains generally constructive, but not aggressive, with unfavorable yield levels largely offset by favorable downward pressures on yields and now widening credit spreads as well. The Strategic Total Return Fund continues to have a duration of about 3 years, meaning that a 100 basis point change in interest rates would be expected to affect the Fund by about 3% due to bond price fluctuations. Notably, and in contrast to the broad stock and bond markets, our measures of prospective return/risk in gold shares has surged, with falling long-term yields, negative real interest rates, weakening economic statistics and a very high gold/XAU ratio all provoking a distinct jump in our expected return/risk measures for gold stocks (see my 1999 article Going for the Gold for a discussion of some of these factors). Accordingly, we’ve built Strategic Total Return’s exposure to precious metals shares to nearly 18% of assets, which is significant, but far from the most aggressive 30% exposure that the Fund could hold (which would require stronger inflation pressures and a weaker ISM, combining to create severe pressure on the U.S. dollar). Even near 18% of assets, however, fluctuations in gold stocks are likely to be the most important driver of day-to-day fluctuations in the Fund here.
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