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May 10, 2010

Greek Debt and Backward Induction

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

John Kenneth Galbraith, 1955, The Great Crash

"I started accumulating stocks in December of '74 and January of '75. One stock that I wanted to buy was General Cinema, which was selling at a low of 10. On a whim I told my broker to put in an order for 500 GCN at 5. My broker said, 'Look, Dick, the price is 10, you're putting in a crazy bid.' I said 'Try it.' Evidently, some frightened investor put in an order to 'sell GCN at the market' and my bid was the only bid. I got the stock at 5."

Richard Russell, 1999, Dow Theory Letters

In March, I noted that in addition to overvalued, overbought and overbullish market conditions, we had begun to observe "a subtle shift in yield pressures, which has historically been associated with fairly abrupt 'air pockets' in which stocks have typically lost 10% or more within the span of about 6 weeks... Based on the current overbought status of the market, there are only three similar periods that we can identify in post-war data: August-October 1999 (which was followed by an abrupt air pocket of greater than 10%), September-October 1987 (no comment required), and September-December 1955 (which was followed by a 10% correction, a brief recovery, and a secondary decline to re-test the initial low)."

If the decline we've seen to date is the entire resolution of the recent overvalued, overbought, overbullish, rising-yields syndrome, investors will be fortunate. Given that last week's decline was just enough to clear the "overbought" component of this condition at least on short-term basis, we lowered our S&P 500 put strikes closer to current market levels and "re-set" our staggered strike hedge in the Strategic Growth Fund enough to put us in a more constructive position if the market advances more than a few percent, while maintaining a strong defense against a further market loss. Our overall position is much like a fully hedged stance with a couple of percent of assets in out-of-the-money index calls. We're in no hurry to "buy the dip." We don't rule out much larger, and possibly profoundly larger market losses, but again, last week gave us a nice opportunity to re-set our strikes in a way that allows us to be comfortable in the event that the market recovers.

Thursday was a fascinating day in the market, featuring a 20-minute span in which the Dow moved from a loss of about 300 points to a loss of nearly 1000 points and then back again within a span of about 15-20 minutes. While the decline and recovery was interesting, the fascinating part was the eagerness of investors to view the decline as a "glitch" in trading. My hope is that the opening quotations in this weekly comment are sufficient reminders that illiquidity is not a "glitch," but a typical feature of panicked markets. In a market where active market makers have increasingly been replaced by "high frequency" trading algorithms that can be switched off at will, it is important for investors to avoid the assumption that there will be a willing buyer close at hand if risk concerns begin to escalate.

If you spend a good portion of your time studying price-volume behavior, "air pockets" of the type we observed last week become familiar parts of the landscape (though they are typically not so distilled into a single intra-day move). Robust demand is the only thing that holds prices from falling vertically in the face of eager selling. Overvalued, overbought, overbullish markets are often already spent of that demand. As investors suddenly became aware of that reality on Thursday, all I could think was "welcome to my world."

Again, the market decline we've observed is certainly not material from anything but a very short-term perspective, but we got enough of a short-term oversold condition to allow us to reset our strike prices in a way that would allow us to benefit moderately from a recovery of more than a few percent, while maintaining a tight downside hedge against further losses. Stocks remain broadly overvalued, and are still quite extended on an intermediate-term basis. Investors Intelligence reported on Wednesday that bullish advisory sentiment had advanced to 56% - the highest level since the 2007 market peak. Meanwhile, yield pressures have eased moderately in a flight to the perceived safety of default-free Treasuries. That reduction in Treasury yield pressures is helpful, but as credit spreads are moving quickly in the opposite direction, the overall profile of yield pressures is not yet inviting.

I think the best way to characterize the market here is to view the area between 1080 and about 1130 on the S&P 500 as something of an "inflection point." A clear decline below about 1080 on the S&P 500 would most likely put market internals in a clearly negative position, leaving the market with a coupling of overvaluation and negative market internals that has historically been very hostile. We're not yet to that point, however, so it's reasonable to allow for the potential for a recovery from these levels while still maintaining a tight hedge against further weakness.

Greek Debt and Backward Induction

On Sunday, the IMF approved its 30 billion portion of the 110 billion euro bailout package for Greece - the remaining funds to come from the European Union. The reason for all of this cooperation, of course, is that Greece has enormous debt that is owed in the euro, a currency that it cannot devalue. For many years, Greece has allowed government spending and wage agreements to grow rapidly, thanks to ability to borrow in euros as if it were little different from Germany or France. Unfortunately, the Greek economy faces a debt burden that its economy is now unable to service. If Greece were not part of the European Monetary Union and its debt was denominated in drachmas, it would be able to satisfy its debts by devaluing its currency, essentially making Greek goods, services and wages worth less in terms of foreign goods, services, wages and currencies. In other words, it could alter the relative price of Greek labor and output, without imposing extreme cuts in government spending, and without inducing what amounts to an internal deflation. Since this is not possible, keeping Greece as part of the European Monetary Union requires it to impose extreme austerity toward its own citizens, which has predictably led to strikes and rioting. Greek debt problems also predictably imply problems for the European banks that have lent to the country.

The bailout package for Greece should keep it from having to tap the open market for capital for about 18 months. Yet it is hard to look at the possible trajectories of Greek output, deficits and debt without concluding that a debt restructuring will ultimately be necessary - meaning that owners of Greek debt are likely to receive only a portion of face value. What European leaders seem to be attempting is to buy Greece more time, essentially to smooth the potential amount of this restructuring and its impact on the banking system, perhaps three or four years from today when, hopefully, Greece has smaller deficits and the ability to operate without new borrowing.

While this is a hopeful scenario, backward induction is not kind to it. In Game Theory, there's a technique called "backward induction" that is often used to identify the likely outcome of a game that is repeated again and again for multiple periods. Essentially, you evaluate what would be the best move for each player that would be optimal in the very last period, then assuming those moves, you evaluate what the optimal moves would be in the next-to-last period, and so on to the beginning of the game.

Put yourself in the position of a holder of Greek government debt a few years out, just prior to a probable default. Anticipating a default, you would liquidate the bonds to a level that reflects the likelihood of incomplete recovery. Working backward, and given the anticipated recovery projected by a variety of ratings services and economists, one would require an estimated annual coupon approaching 20% in order to accept the default risk. For European governments and the IMF to accept a yield of only 5% is to implicitly provide the remainder as a non-recourse subsidy. Even then, investors are unlikely to be willing to roll over existing debt when it matures - the May 19th roll-over is the first date Europe hopes to get past using bailout funds. In the event Greece fails to bring its budget significantly into balance, ongoing membership as one of the euro-zone countries implies ongoing subsidies from other countries, many of which are also running substantial deficits. This would eventually be intolerable. If investors are at all forward looking, the window of relief about Greece (and the euro more generally) is likely to be much shorter than 18 months.

Still, for Greece, it appears that the IMF and EU will provide the funding for the May 19th rollover of Greece's debt, so there's some legitimate potential for short-term relief. The larger problem is that Portugal and Spain are also running untenable deficits (think of Greece as the Bear Stearns of Euro-area countries). European officials deny the possibility of contagion that might call for additional bailouts, but my impression is that Greece is the focus because its debt is the closest to rollover. The attempt to cast Greece as unique is a bit strained - Christine LaGarde, the French finance minister suggested last week "Greece was a special case because it reported special numbers, provided funny statistics." In other words, Greece gets the bailout because it had the most misleading accounting?

The bottom line is that 1) aid from other European nations is the only thing that may prevent the markets from provoking an immediate default through an unwillingness to roll-over existing debt; 2) the aid to Greece is likely to turn out to be a non-recourse subsidy, throwing good money after bad and inducing higher inflationary pressures several years out than are already likely; 3) Greece appears unlikely to remain among euro-zone countries over the long-term; and 4) the backward induction of investors about these concerns may provoke weakened confidence about sovereign debt in the euro-area more generally.

Despite the potential for a short burst of relief, the broader concern about deficits in the euro-area make it unlikely that global investors will be appeased by a large bailout of Greece, or will go forward on the assumption that all is back to normal once that happens.

Restructure, Restructure

Looking at the current state of the world economy, the underlying reality remains little changed: there is more debt outstanding than is capable of being properly serviced. It's certainly possible to issue government debt in order to bail out one borrower or another (and prevent their bondholders from taking a loss). However, this means that for every dollar of bad debt that should have been wiped off the books, the world economy is left with two - the initial dollar of debt that has been bailed out and must continue to be serviced, and an additional dollar of government debt that was issued to execute the bailout.

Notice also that the capital that is used to provide the bailout goes from the hands of savers into the hands of bondholders who made bad investments. We are not only allocating global savings to governments. We are further allocating global savings precisely to those who were the worst stewards of the world's capital. From a productivity standpoint, this is a nightmare. New investment capital, properly allocated, is almost invariably more productive than existing investment, and is undoubtedly more productive than past bad investment. By effectively re-capitalizing bad stewards of capital, at the expense of good investments that could otherwise occur, the policy of bailouts does violence to long-term prospects for growth. Looking out to a future population that will increasingly rely on the productivity of a smaller set of younger workers (and foreign labor) in order to provide for an aging demographic, this is not a luxury that our nation or the world can afford.

"Failure" and "restructuring" mean only that bondholders don't get 100 cents on the dollar. We can continue to bail out the poor stewards of capital who voluntarily made bad, unproductive investments, and waste our future productivity in order to make those lenders whole, or we can turn the debate toward deciding the best strategies for restructuring existing debt.

Market Climate

As of last week, the Market Climate for stocks was characterized by unfavorable valuations, mixed market action, overbullish sentiment, and mixed yield pressures (easing Treasury yields, but widening credit spreads). Overall, the market appears to be at an inflection point. While there is not a great deal of upside that we could observe before the market is again characterized by an overvalued, overbought, overbullish syndrome, we cleared the overbought conditions enough last week to reset the strike prices of our hedges in the Strategic Growth Fund. As noted above, the overall position is much like a fully hedged stance with a couple of percent of assets in out-of-the-money index calls.

In bonds, the Market Climate last week was characterized by slightly unfavorable yield levels and mixed yield pressures. Presently, there is still well enough risk of additional credit strains to warrant a modest duration exposure here. In the Strategic Total Return Fund, our current duration is just under 4 years (meaning that a 100 basis point move in interest rates would be expected to affect the Fund by less than 4% on the basis of bond price fluctuations).

With regard to credit issues, some remarks by Meredith Whitney from a Bloomberg hedge fund conference last week are notable (if familiar):

"If you look at what happened last year, I would say a vast majority of the banking sector's profits and capital creation was government induced. In the first quarter, it's highly arguable that certain companies wrote up assets. People lowered their provisions on losses.

"What has kept home prices stable - and make note that politicians and banks are eating their own cooking because they really believe home prices are stable - they're stable because there's been a ton of inventory kept from the market. So if you control the supply, you can control the price without controlling the demand.

"Here's a statistic that I find fascinating. This is just for the top four banks. If you look at nonperforming assets - that's loans that haven't paid over 120 days - the size of that is 1.5 times all of the chargeoffs that banks have incurred since 2005. So you think credit has stabilized, mortgages have stabilized? Non-performs have ballooned so they've more than doubled since the beginning of 2009, and that's just stuff that has to start going on to the market, and interestingly, this quarter you're starting to see housing supply reach the market. That to me triggers another down leg in housing, so to me, I'm steadfast in my belief that there's going to be another double-dip in housing

"There's huge growth in non-performing assets. These are numbers, apples-to-apples, on the four big banks. The issue is when does that stuff that's not paying come to market, and when do banks recognize the chargeoffs? I think you're going to see more of that in the second quarter and the third quarter. Does the supply move in the second quarter and then you report it in the third quarter? The timing may be weighted more to the third quarter. I just don't know. I think you see a huge leg down in asset prices when you see the supply reach the market. So no, it's not factored into valuations. No, it's not factored into bank guidance. And yes, I think it's going to be a big problem for the banks."

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