November 7, 2011
A quick note on Greece - as of Friday, the yield on 1-year Greek debt has soared to 212%, up from 144% a week ago, just after the grand "solution" to the crisis was announced. Over the past week, the price of 1-year Greek debt has plunged by 20%, to 38.4 (bid 35.81, ask 40.97 to be exact). Which begs the question - if everyone has agreed that Greek debt will only be written down by 50%, why is the 1-year note trading at just 38% of face value, with longer maturities trading below 30% of face? This sort of incongruence isn't inspiring.
Much of the reason Greece is seeking a voluntary exchange of debt from its bondholders is that an "involuntary" exchange would be a default event, which would trigger payments on credit default swaps. But across the global financial system, there are only about $3.7 billion in credit default swaps outstanding against Greek debt, and even in the event of an "involuntary" exchange, the actual amount of payouts would be less than that notional value.
One of the greatest advantages Greece has is that about 90% of its debt is governed by Greek law. The terms of any debt exchange, voluntary or involuntary, are more than simply technical details, as any restructuring should significantly reduce the discounted value of the new debt, and I suspect that the next stumbling block is that Greece will change its laws to impose "collective action clauses" on its debt, sufficient to restructure the debt more easily, given the consent of some supermajority of its bondholders. That would help to avoid any holdouts to "voluntary" restructuring, but it would also allow the possibility of a larger haircut. Little of this has been worked out, so even widely publicized "final" deals are not final until the details are settled. In any event, a 50% haircut still puts the Greek debt/GDP ratio above 100% by the end of the decade, so it's possible that Greece will pursue a further haircut, even if it triggers CDS payments. We'll see soon enough whether the widely accepted 50% figure actually holds up.
Here in the U.S., our broadest models (both ensembles and probit models) continue to imply a probability of oncoming recession near 100%. It's important to recognize, though, that there is such a uniformity of recession warnings here (in ECRI head Lakshman Achuthan's words, a "contagion") that even an unsophisticated, unweighted average of evidence indicates a very high likelihood of recession. The following chart presents an unweighted average of 20 binary (1/0) recession flags we follow (e.g. credit spreads widening versus 6 months earlier, S&P 500 lower than 6 months earlier, PMI below 54, ECRI weekly leading index below -5, consumer confidence more than 20 points below its 12-month average, etc, etc). The black brackets represent official recessions. The simple fact is that we've never seen a plurality (>50%) of these measures unfavorable except during or immediately prior to U.S. recessions. Maybe this time is different? We hope so, but we certainly wouldn't invest on that hope.
Consider the menu of traditional investment opportunities here. The yield on 10-year Treasury notes is just 2%, 30-year yields are at 3%, the Dow Jones Corporate Bond Index is yielding just 3.5%, our estimate for 10-year nominal S&P 500 total returns is now at just 4.5%, and our 10-year total return estimate for higher-yielding utilities is still at just 5.5% annually (a figure that, while higher than our estimate for the S&P 500, is still among the lowest 15% of historical observations). So Ben Bernanke has done his job well, given that he believes his job is to drive investors into higher-risk assets by starving them of yield on safer investments. The end result is that investors face a perfect storm - risky assets priced to achieve dismal long-term returns (except in comparison to equally dismal alternatives), coupled with the risk of an oncoming global recession.
In our view, investors should presently hold risky assets only in the amount they would be willing to hold through the duration of significant downturn, without abandoning them in the interim. For buy-and-hold investors, that amount may be exactly the same as they are holding at present, but the choice should be a conscious and deliberate one.
It's easy to dismiss the probability of a recession because "you can't see it in the data." To some extent, that's true, provided that you restrict the data to coincident and lagging indicators - our recession concerns are driven by leading indicators that are tightly related to subsequent economic outcomes, and are broad enough not to be influenced by any one or two components. (In contrast, the Conference Board index of leading economic indicators actually places most of its weight on M2 and the yield curve, resulting in curious "improvements" in the LEI that stem from safe-haven demand for U.S. bank CDs and U.S. Treasuries).
While Wall Street continues to celebrate the fact that coincident indicators such as the ISM survey and weekly unemployment claims have not worsened from a dead-stall, the global economy is already showing overt signs of a new downturn. For instance, German factory orders dropped by 4.3% in the latest report, with demand from other euro-area countries plunging by 12.1%. The Markit Eurozone manufacturing PMI weakened again to 47.1 in October (which isn't a "lock" on recession in and of itself, but certainly isn't helpful). The number of unemployed workers in Europe rose to 16.2 million - the highest number since the euro was created. Canada also unexpectedly reported job losses last month. Even China's PMI dropped to borderline 50.4 reading - the lowest level in 3 years. We can understand that investors are inclined to hold off any concerns until an economic downturn can be seen and touched in actual (not just leading) U.S. data, but that inclination comes with the prospect of trying to reduce risk when a hundred million other investors suddenly become interested in doing the same thing.
As Pimco's Mohammad El Erian said last week, "The big exposure to Americans is the general exposure to the equity market. You cannot be a good house in a bad neighborhood, that's just a fact. The equity market is the house, and the global economy is the neighborhood. So if the global economy takes a leg down, the equity market is going to take a leg down too."
All of that said, we have no intrinsic desire to remain defensive, except to get through the present set of risks intact, and to get us to the point where we can act on opportunities to establish a constructive position (even fractionally - in proportion to the expected return/risk profile). As my friend Richard Belton, a former football player, reminds me - "The job of the defense is to get off the field." The problem, unfortunately, is that can sometimes take a while. I'm the last guy who should ever talk about football, since I've never caught a pass without dislocating a finger, but Richard's analogy was interesting: "We used to call third down 'money down.' Fourth down, they're going to punt, so if we could hold them back at third down, we knew our defense could get off the field. But sometimes they'd just keep converting, and you'd keep having to go three more plays. You just have to stick to your game."
The financial markets are different from football in the sense that there is an elastic cord on the ball that eventually yanks things back when they've gone too far. Though that cord is terribly stretched already, every time we've reached "money down," we've seen some increasingly large government intervention to move the ball down the field by just enough to maintain possession (the football equivalent of "kicking the can down the road"). While that has helped to dampen one crises after another, it just makes them more frequent, and it doesn't change the outcome of the game. We're very eager to get the defense off the field, but we'll take things one play at a time.
As of last week, the Market Climate for stocks was characterized by a clearly negative expected return/risk profile, based on an ensemble of factors including rich valuations, oncoming recession risks, and an overall technical condition that has historically been very prone to "whipsaw" reversals. We saw some of that early last week, as the stock market dropped sharply from above its 200-day moving average to below that level. The fact that the market is dabbling with widely-followed technical levels does create some potential for some amount of speculation if we happen to get a reprieve in day-to-day news, despite persistent underlying valuation and economic negatives. In that event, there would be enough flattening in the return/risk profile to allow a slight loosening of our still tight hedges, but moving to a largely unhedged or aggressive investment stance would require a much broader set of shifts in the data (most probably involving a significant improvement in valuations as a result of a significant market decline). Strategic Growth and Strategic International remain tightly hedged. Strategic Total Return continues to have a duration of about 3 years in Treasury securities, with about 2% of assets in utility shares, and a 20% exposure to precious metals shares driving most of the day-to-day fluctuation in the Fund.
A final note. The overvaluation, misguided policy, and misallocation of capital that has produced more than a decade of dismal returns for the S&P 500 has also forced us to take a regularly hedged investment stance in response (though we know that the ensemble methods presently in use would have done things differently in several periods, particularly 2009 and early 2010). While our investment approach is by construction risk-managed, it is not by construction hard-defensive or fully-hedged. These are positions that have been thrust on us by conditions that have, predictably, led to a decade of stock market returns far below the historical norm. Though the present menu of prospective investment returns remains unappealing, those conditions can change quickly, particularly in a crisis-prone environment. This is important to mention here, because I strongly expect that we will begin seeing opportunities - probably not immediately but also not in the distant future - to significantly and perhaps sustainably reduce the extent of our hedging.
We emphatically don't need to wait for the world to solve its problems before being willing to accept risk. What we do need is for those risks to be more appropriately priced in view of those problems. We're not there by any means, but a significant change in the market's return/risk profile could come quickly. To quote MIT economist Rudiger Dornbusch (who was a professor to the new head of the ECB, Mario Draghi), "The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought."
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
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