October 1, 2012
Leap of Faith
In the context of historical evidence and outcomes, present market conditions give us no choice but to remain highly defensive. Valuations remain rich on the basis of normalized earnings (which are better correlated with subsequent returns than numerous popular alternatives based on forward operating earnings, the Fed Model and the like). Investor sentiment is overcrowded on the bullish side even as corporate insiders are liquidating at a rate of eight shares sold for every share purchased – a surge that Investors Intelligence describes as a “panic.” Market conditions remain steeply overbought on an intermediate and long-term basis, with the S&P 500 still near its upper Bollinger bands (two standard deviations above the 20-period moving average) on weekly and monthly resolutions. We continue to observe wide divergences in market action, from century-old criteria such as the weakness in transports versus industrials (which suggests an unwanted buildup of inventories) to more subtle divergences and signs of exhaustion in market internals.
Overall, we continue to estimate a steeply negative return/risk for stocks on horizons from 2-weeks to 18 months. I recognize that this is easy to treat as disposable news, given that the ensemble methods we developed to capture both post-war and Depression-era data have indicated a negative return/risk profile for stocks since April 2010, yet the S&P 500 is 18% higher today than it was at that time. Central bank interventions have certainly played a role in that gain. But then, our prospective return/risk estimates have been in the lowest 1% of historical data only since March, and the market loss that would erase the intervening gain since April 2010 is one that we would consider small from the perspective of present market conditions. The average cyclical bear market has historically wiped out more than half of the preceding bull market advance, and stocks have typically surrendered closer to 80% of their preceding bull market gains when the cyclical bear is part of a “secular” bear period such as the one we’ve experienced since 2000 (see the discussion of cyclical and secular fluctuations in A False Sense of Security). I remain convinced that we will observe numerous points in the market cycle ahead where the evidence will support a significant and even aggressive exposure to market fluctuations. Now is not one of those points.
While our estimates of prospective return/risk in stocks remain among the most negative instances we’ve observed in a century of market history, it is important to note that these estimates are largely independent of our conviction that the U.S. economy has already entered a recession. They are also independent of our concerns about instability in the European banking system. With regard to Europe’s banking strains, the capital needs of Spanish banks were estimated at modest levels last week only due to the heroic assumption that distressed banks would be able to massively deleverage their balance sheets without amplifying their losses – an assumption that ZeroHedge refers to as deus ex-fudge while begging the question “just who will these banks sell said debt to?”
Both in the U.S. and in Europe, investors seem to believe that the most important challenges are political, which shows up in analyst after analyst spouting the relentless, vague, milk-toast analysis that “at the end of the day, the U.S. Congress and European leaders will do the right thing.” The trouble is that the U.S. and Europe face deep-seated economic problems, not just political ones. Even if the capital needs of Spanish banks are somehow not as wildly underestimated as Greece’s were, or as Spain itself asserted only months ago, half of the continent still carries debt loads that are incongruous with a common currency. Nearly the entire continent is already in recession, which means that those debt loads are likely to increase quickly over the coming year, despite austerity efforts.
Here in the U.S., the federal government is running a deficit approaching 10% of GDP despite suppressed interest costs. If addressing that deficit was just a political issue of doing the “right thing,” what would that right thing be? With total federal revenues at $2.3 trillion last year, and spending at $3.7 trillion, the gap itself represents more than half of total revenues and more than a third of total spending. That gap will not be closed even if lawmakers were to agree to an immediate repeal of the Bush tax cuts in their entirety. Assuming that all of the desired revenue actually showed up, the bump to revenues would only be about $100 billion a year - reducing the deficit by less than one-tenth. In the event of a recession (which we believe is already in progress), the increase in government debt - merely as a passive cyclical response to economic weakness – would swamp that effect even if all the tax cuts were repealed. Likewise, even in the current budget, less than $1.3 trillion represents discretionary spending that is negotiated between the President and Congress. The other spending represents mandatory outlays for Social Security, Medicare, military retirement, and so forth. Well over half of discretionary spending represents military spending. To balance the budget with spending cuts, Congress would have to wipe out discretionary spending altogether, including military outlays. Observers who believe that the fiscal cliff is simply a matter of political disagreement have vastly underestimated the depth of the challenges here.
Economic weakness makes it extremely difficult to reduce budget deficits, which is why deficit reduction plans invariably assume that the economy will grow at nominal rates of 5-6% annually or more. As for spending reductions, we’ve seen the impact of austerity measures in deepening European recessions. Does anyone believe that the U.S. experience would be different and that spending cuts would not suppress economic activity and thereby impact revenues? None of this is to say that deficit reduction efforts should be abandoned, but aggressive timing would worsen an economic downturn, and even in a recovery, progress is likely to be painstakingly slow.
Meanwhile, the Federal Reserve now holds $2 trillion more on its balance sheet than it did three years ago. If it ever has to disgorge this debt, even over time, the sale would crowd out 20% of U.S. gross private domestic investment for 5 years running. These problems are more than a simple political issue of “doing the right thing.” While central banks have successfully created an environment of blissful ignorance of deeper economic realities, they have also encouraged policymakers to waste time that should not have been wasted.
Economists know that there are three ways to deleverage an economy: austerity – where debt growth is held below the rate of economic growth; restructuring – where bad debts are written down or renegotiated; and monetization – where money is printed to make lenders whole at broader expense. In this regard, Ray Dalio of Bridgewater has good-naturedly called the recent experience a “beautiful deleveraging” because it has involved some mix of all three. But it is precisely that beauty that has made it so ineffective, as the global economy and the global banking system have hardly deleveraged at all in the wake of the last credit crisis. The insufficiency of restructuring measures and the excessiveness of monetary interventions have combined to create an environment of moral hazard where increasing debt burdens have been tolerated without durable concern. The hard decisions have been put off to the point where the size of the problem is likely to overwhelm the ability of hard decisions to address it without a crisis.
In regard to a U.S. recession, keep in mind that the consensus of economic forecasters – not to mention central bankers - has never recognized the start of a recession in real-time, largely because their assessments typically revolve around a “stream of anecdotes” approach that treats each new economic report with equal weight, without distinguishing leading/lagging and upstream/downstream structure. For example, we’ve noted that real consumption growth and real income lead new factory orders, which lead employment. Yet observers have already largely dismissed the soft data on income, consumption and factory orders thanks to last week’s single outlier on new weekly unemployment claims. As for the payroll report this Friday, we fully expect that September payroll growth will ultimately be reported as a significant loss in jobs. The main wrinkle, as I’ve noted frequently, is that the “real-time” employment figures in the early months of a recession are often hundreds of thousands of jobs off from where they are ultimately revised (see the economic notes in Late Stage, High Risk). So while Friday’s employment report seems likely to be disappointing, the data tends to be heavily revised, and even the seasonal adjustments amount to hundreds of thousands of jobs, so our expectations for a negative figure may or may not be realized in the initial report.
Last week, the second quarter GDP growth figure was revised down to 1.3%, from the previous estimate of 1.7%. Durable goods orders plunged at a 13.2% rate in August, largely on reduced transportation orders, but even ex-transportation, new orders dropped at the sharpest rate since 2009. It is also notable that Gross Domestic Income – the theoretically equal “income” companion of gross domestic “production” – grew at an annual rate of just 0.1% in the second quarter. The difference between GDI and GDP is nothing but a statistical discrepancy, so the two series track each other very closely over time despite short-term disparities. Because GDI has often led GDP at recessionary turns, Alan Greenspan was well-known for paying close attention to GDI – though not closely enough to recognize that the economy was already in recession when he was interviewed by Business Week in mid-2008, fully two-quarters after that recession had actually begun.
The chart below presents the 6-quarter growth of real gross domestic product (GDP) and real gross domestic income (GDI) since 1950. A good look at this chart provides some insight into why recession concerns have had a “Chicken Little” quality in recent quarters. Note that by the time the 6-quarter growth in income and production has slowed below 2.3% in the past, the economy was always either approaching or already in recession. It’s also worth observing the weakness in GDI growth approaching the 1990-91 and 2008-2009 recessions.
In the present instance, the 6-quarter average of real GDI and GDP growth has been below 2.3% for nearly a year, with no apparent recession, and in fact has bounced around that threshold since 2010. The monetary interventions of the past few years have helped to kick the recessionary can down the road in short-lived fits and starts. Still, they certainly have not been effective in producing sustained recovery (nor should they be expected to – being largely a manipulation of financial markets with no reliable transmission mechanism to the real economy).
The key question is whether the absence of an obvious recession should be taken as an indication that the deterioration in income and output growth can be ignored – in effect, whether we should assume that this time is different. From our standpoint, the evidence from a wide variety of economic series, including but not limited to broad measures like GDI and GDP, continues to indicate that the U.S. economy most likely entered a recession in the middle of this year.
I want to emphasize that I don’t hope for a recession – that is just the conclusion that I believe the best reading of the evidence supports. Sure – if there is no recession, I clearly would rather not have warned of the risk, but I would still prefer to avoid a recession even though that’s what our analysis indicates. It would be a relief to see the data shift away from a recessionary pattern in a durable way, and I would be happier still for stock market valuations and market conditions to support a significant exposure to market risk. Both of those will arrive, but they are not here at present, and I expect there will be some downside first. Our economic challenges will be addressed in time, but they are likely to involve much greater restructuring and much slower progress on deficit reduction than the capital markets seem to contemplate. Europe will solve its problems, but most likely through a departure of stronger countries from the Euro, followed by a combination of aggressive restructuring and monetization. We will get through all of this, and both the economy and the financial markets will do fine in the longer-term, but to imagine that there will not first be major challenges and disruptions is a leap of faith – and a leap over a century of economic and financial history that screams otherwise.
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.
As of last week our estimates of prospective return/risk in stocks remained strongly negative. Strategic Growth Fund remains fully hedged, with a “staggered strike” position that raises the strike prices of the put option side of its hedge closer to market levels, at a cost of just over 1% of assets looking out to early 2013. Strategic International Fund remains fully hedged. Strategic Dividend Value is hedged at 50% of the value of its stock holdings, its most defensive stance. Strategic Total Return continues to carry a duration of about 1.4 years (meaning that a 100 basis point change in interest rates would be expected to impact the Fund by about 1.4% on the basis of bond price fluctuations), with about 4% of assets in precious metals shares, and a few percent of assets in utility shares.Our unusually defensive stance here, across the menu of financial instruments, reflects the unusually depressed profile of prospective returns in the financial markets, where our estimate of the likely 10-year nominal total return for the S&P 500 remains near 4% annually, 10-year Treasury bonds yield just 1.6%, the Dow Jones Corporate Bond Index yields 2.7%, and even 30-year Treasuries are priced to achieve a nominal yield-to-maturity of just 2.8%. This situation has resulted from ill-conceived monetary policies that force all assets to compete with near-zero interest rates, and have left their prospective returns accordingly diminished. Further quantitative easing seems unlikely to depress these prospective returns materially lower. The compensation for financial risk-taking is likely to improve as a result of ongoing economic, financial and international risks, but that transition from low prospective returns to more meaningful prospective returns is likely to involve significant price declines in the financial markets.
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