September 24, 2012
Eating the Future
Imagine there’s a $100 bill taped to the far corner of the room, near the ceiling and way above your head. You will receive that $100 bill ten years from today. Suppose that you reach your hand out directly in front of you and pay $46.31 today for that future $100. Assuming no credit risk, you have now bargained for an 8% annual return.
Now reach higher, about eye-level, and offer $67.56 for that future $100. You have now bargained for a 4% annual return.
Now reach far above your head, jump as high as you can, and offer $84.49 today for $100 ten years from today. You are now an investor in 10-year Treasury securities, which presently yield 1.7% annually.
Every security on Earth works like this. The higher the price you pay for a given set of expected future cash flows, the lower your prospective future rate of return. Higher prices essentially take from future prospective returns and add to past returns. Conversely, lower prices take from past returns and add to future prospective returns.
At the top of your jump, as you hover like Michael Jordan in mid-air, let’s ask all of the other investors who already hold Treasury securities whether they are “wealthier” because of the elevated price you are paying. At first glance, the obvious answer seems to be yes: each of those investors, individually, could sell their Treasury bond at a price that would enable them to command a greater amount of current output than they could before.
But if you think carefully, you’ll realize that regardless of today's price, someone will have to hold that security until it delivers $100 a decade from now - no more, no less. So the price change itself does not create aggregate wealth. Unless something happens to materially change that future cash flow, it is not at all clear that elevating current prices makes investors - in aggregate - any wealthier in terms of consumption. While any individual investor could sell the bond in order to consume today (abandoning the reason they had saved in the first place, which was to provide for their future consumption a decade from now), some other investor now has to defer consumption to purchase the bond and hold it to maturity.
An increase in price alters the profile of investment returns by turning prospective future returns into past returns (and vice versa when prices fall), but economic wealth is only created by the generation of additional goods and services (and cash flows from an investment standpoint) that actually emerge in the future. Security prices are a place-holder until the expected future goods, services and cash flows actually arrive. Raising the price that investors pay today for in return for some fixed payment in the future does not create wealth in aggregate.
Any one investor can realize what they count as “wealth” by selling, but only if someone else buys that claim on future goods, services and cash flows. If those things ultimately never arrive, the perceived wealth simply vanishes. In that case, the people who cash out at rich prices certainly get a transfer of wealth from the people who buy at those same rich prices and see their investments vanish, but that does not mean that new wealth was created. Despite the transfer of wealth between sellers who cash out and buyers who hold the bag, security price changes don't create new aggregate wealth in and of themselves - only increases in goods and services do.
That’s why, when security prices plunge, the lost money doesn’t “go” anywhere or to anyone. It’s air until the goods show up. If a dentist in Poughkeepsie buys a single share of Apple a dime higher than the last guy did, nearly $100 million of market capitalization is suddenly created. Nobody suddenly pumped $100 million into the stock market. One person just paid up a little. All of that is the reason we insist on valuing securities based on the long-term stream of cash flows that we actually expect to be delivered into the hands of investors over time, not based on ephemeral measures like Wall Street’s estimates of next year’s earnings.
Now consider the effect of monetary policy. Suppose that every central bank on Earth is printing money. This may seem like a fine thing when there is so much economic difficulty and credit risk that zero-interest money is willingly absorbed in whatever quantity is produced, but is likely to be inflationary in the back-half of this decade when those cash-seeking motives ease. Alternatively, it will likely lead to significant upward pressure on long-term rates later, as central banks are forced to slash their balance sheets by selling long-term Treasury debt and other assets in order to mop up the liquidity.
Now ask again, if the future cash flows are still the same in nominal terms, and the prospective future price level of goods and services is higher, and the point of saving is to provide for future consumption, are bond market investors actually “wealthier” as a result of all of the manipulation of asset prices? No. To the contrary, they are poorer. In aggregate, the real wealth of fixed-income investors has been assaulted.
One would like to believe that stock market investors will at least be no worse off if inflation eventually emerges in the back half of this decade. After all, inflation would have a tendency to raise future revenues. This is generally true, but historically, inflation has been very hostile to stock prices – particularly during the transition from lower to higher inflation rates – because inflation also raises wages and interest costs, and produces significantly more conservative valuations. Moreover, assuming that government deficits and private savings do not remain in their dismal state indefinitely, we are likely to observe significantly narrower profit margins in the future, compared with present margins, which are about 70% above historical norms (see Too Little to Lock In for the accounting relationships here).
The upshot is simple. The elevated prices of financial assets have already eaten the future. At present, a 10-year investment in U.S. Treasury debt is associated with a prospective total return of just 1.7% annually over the whole of that investment horizon. A 30-year investment will achieve a 2.9% annual total return over three decades. An investment in bonds comprising the Dow Jones Corporate Bond Index will achieve an annual total return of 2.8% annually. We estimate that the S&P 500 is likely to achieve a 10-year average annual total (nominal) return of about 4.1% annually. What has happened here is that the prospect for meaningful future returns has been removed, in order to elevate prices in the present.
Unfortunately, this does not mean that real output will be more plentiful in the future, or that savers who are hoping to provide for the future will be prompted into consuming much more today. Historically, a 1% increase in the value of the stock market is associated with a transitory increase of just 0.03-0.05% in GDP over the following year, quite to the contrary of what Mr. Bernanke wishes the public to believe. As former Fed Chairman Paul Volcker said last week “Another round of QE is understandable, but it will fail to fix the problem. There is so much liquidity in the market that adding more is not going to change the economy.”
That’s particularly important given that we continue to infer that the economy has already entered a recession – something that will probably take several more months to be broadly recognized. We’re seeing fresh lows on the most leading economic component that we infer using unobserved components methods (see the note on extracting economic signals in Do I Feel Lucky?), matching weakness that emerged in late 2000 and late 2007. On a slightly positive note, we don’t yet see the near free-fall in these measures that occurred later in 2001 and 2008 as economic weakness rapidly gained momentum.
As for the financial markets, any single investor interested in present consumption can reasonably count himself or herself as wealthier at this moment, in that higher-risk securities can be sold at elevated prices to others reaching their hands far above their heads, in the belief that they will later find someone who is willing and able to jump higher still. Unfortunately, the tragedy of the commons is that behavior that can be followed by a single individual is not always behavior that can be followed by all individuals taken together.
My impression is that we may not be far off from finding out (once again) what happens when they try.
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. Only comments in the Fund Notes section relate specifically to the Hussman Funds and the investment positions of the Funds.
Our estimates of prospective stock market return/risk were unchanged last week, after reaching the single lowest estimate we’ve observed in a century of market data. As I noted last week, this is not because any single data point is beyond its own historical extremes – valuations were far richer in 2000; overbought conditions were more extensive in 1929 and the late-1990’s; the most extreme bullish sentiment was in January 1977 (immediately rolling into a bear market). The problem is that the combinations of indicators – the syndromes – that we presently identify have repeatedly appeared in subset after subset of historical data, and are uniformly associated with negative market outcomes. Think of it this way – if you throw together a pile of saltpeter, a pile of sulfur, and a pile of charcoal, neither item by itself may be of particular concern, but what you may not realize is that you’re sitting on dynamite.
So we have a strongly negative average outcome on the basis of dozens of individual models or “learners” that comprise our ensemble methods, and at the same time, the disagreement or dispersion between those learners is unusually small. The result is a steeply negative return/risk estimate. As always, this particular instance might turn out differently than the average. Presently, though, we have little basis for that expectation.Strategic Growth Fund remains fully hedged, and while we continue to carry a staggered-strike put position (which raises the strike price of the put side of our hedges closer to the prevailing level of the market), we have not aggressively raised strikes, and with option volatility (VIX) at just under 14%, the cost and time-decay of that position is just over 1% of assets looking out to next year. Given that we expect an unusually high risk of “tail events” given the extreme negative return/risk estimates we observe, put option premium at a 14% VIX seems strikingly inexpensive. Strategic International remains fully hedged. Strategic Dividend Value remains hedged at about 50% of the value of its stock holdings. Strategic Total Return carries a duration of about 1.4 years (meaning that a 100 basis point move in Treasury yields would be expected to impact the Fund by about 1.4% on the basis of bond price fluctuations), and on the recent surge in precious metals shares, we have cut our exposure to less than 4% of assets – inflation is likely to be a significant problem in the back-half of this decade, but not without a significant recession, weakness in key commodity consumers like China, credit strains, and other challenges to the “money printing = buy gold” hypothesis first. The Fund also holds a few percent of assets in utility shares, and we closed our foreign currency holdings on the recent surge in the FX markets.
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