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August 13, 2012

Begging for Trouble

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

We presently estimate a projected 10-year total (nominal) return for the S&P 500 of less than 4.6% annually, based on our standard methodology (see the notes at the end of this comment). I continue to believe that fundamentals such as earnings (normalized for the variability of profit margins over the economic cycle), dividends, revenues and other measures are useful in evaluating prospective market returns, and the behavior of the market over the past decade has certainly not changed that view. Indeed, the 5.1% total return of the S&P 500 over the most recent 10-year period has been as expected (see also my July 7, 2002 comment). It’s notable that even without compelling valuations a decade ago, we lifted 70% of our hedges several months later in early 2003, at what turned out to be the start of the next bull market – something to remember for those who misunderstand our two-data sets issue of 2009-early 2010 and assume that we’ll never lift our hedges until the market is deeply undervalued.

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

Of course, with the yield on the 10-year Treasury bond at just 1.6%, one might argue that a prospective 10-year return - by our estimates, though certainly not assured - of nearly 4.6% on stocks is still very good by comparison, and should be enough to prevent any substantial adjustment to lower prices and higher prospective returns. To inform that argument, I’ve added the 10-year Treasury bond yield to our standard chart above. Note that the correlation between 10-year S&P 500 returns and 10-year Treasury bond yields (which reflect both expected and actual 10-year returns, provided no default occurs) is just 0.1. There is virtually no relationship at all, with the exception of the early-1980’s, when the prospective and actual returns were quite high for both as a result of inflation shocks.

While the simultaneous rally in both stocks and bonds from the early 1980’s through the late-1990’s gave the illusion that the 10-year bond yields and forward operating earnings yields had a precise point-for-point relationship, spawning an unfortunate little cottage industry of adherents to the “Fed Model”, this model is based entirely on the relationship between stock yields and bond yields during a specific 16-year period of sustained disinflation, and there is no evidence – or even sound theory – supporting that spurious one-to-one correlation more generally. Of course, past performance is not indicative of subsequent returns, and the relationship between stock and bond returns may be different in the future.

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

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

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

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

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

Begging for Trouble

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

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

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

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

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

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

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

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

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

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

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

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

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

Market Climate

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

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Prospectuses for the Hussman Strategic Growth Fund, the Hussman Strategic Total Return Fund, the Hussman Strategic International Fund, and the Hussman Strategic Dividend Value Fund, as well as Fund reports and other information, are available by clicking "The Funds" menu button from any page of this website.

Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 reflect our standard valuation methodology, focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle (see for example The Likely Range of Market Returns in the Coming Decade and Valuing the S&P 500 Using Forward Operating Earnings ).


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