January 27, 2014
Increasing Concerns and Systemic Instability
Just a note - I'll be speaking at the Wine Country Conference in Sonoma, CA on May 1st & 2nd, 2014, along with Mike "Mish" Shedlock, David Stockman, Stephanie Pomboy, Steen Jakobsen, Chris Martenson, Mebane Faber, Jim Bruce and others. This year's conference will benefit high-impact programming for individuals on the autism spectrum and their families, primarily local efforts through the Autism Society of America. As many of you know, my 19-year old son JP has autism, so the cause is very close to my heart. Last year's conference benefited the Les Turner ALS Foundation. It's a great event in a beautiful location. Hope to see you there. For more information, please visit www.winecountryconference.com. Thanks - John
With the S&P 500 just 3% below its all-time high, there’s very little change our views here. Last week’s mild retreat only looks something other than mild when viewed in the context of a late-stage parabolic advance that has not seen a single 2.5% weekly decline since June of 2012. At the typical historical frequency, we would have had eight of them.
The ratio of nonfinancial equity market capitalization to nominal GDP is presently about 120%, compared with a historical average prior to the late-1990’s bubble of just 55%. The comparison - about double the historical norm - is about the same if one uses the Wilshire 5000, which includes financials, and for Tobin’s Q (price to replacement cost of assets). The price/revenue multiple of the S&P 500 is presently 1.6, versus a pre-bubble norm of just 0.8. All of these measures have a correlation of about 90% with subsequent 10-year S&P 500 returns, even including recent bubbles and subsequent busts.
The reason we generally don’t include late-90’s bubble data in the calculation of historical norms (though one should always be explicit about it), is that the S&P 500 has achieved total returns of hardly more than 3% annually for almost 14 years since the 2000 peak as the result of those valuations, and those historical extremes remain only partially corrected. We currently estimate nominal total returns for the S&P 500 averaging just 2.7% annually over the coming decade - no more than the present yield on 10-year Treasury bonds (though stocks are likely to experience far greater volatility and interim losses). These estimates incorporate a broad variety of fundamentals, including properly normalized forward operating earnings (see Valuing the S&P 500 Using Forward Operating Earnings).
Disagreements between valuation methods can be quickly resolved by examining the data. In every case, measures suggesting stocks as fairly valued or undervalued are those that take current profit margins at face value, and assume that current earnings are a sufficient statistic for corporate profitability over the next five decades (which is roughly the duration over which discounting must occur – see Superstition Ain’t the Way).
There's really no need to focus on the Shiller P/E, as it doesn't particularly underlie our views. But it's broadly followed so I often discuss it as a useful "shorthand" for other valuation measures. As it happens, the Shiller P/E at 25, versus a pre-bubble norm of just 15, is among the more optimistic valuation measures we track (at least those that have reliable historical records). This is because even the Shiller P/E is moderately biased by variations in profit margins. Its explanatory relationship to subsequent returns can be significantly improved by taking that margin variation into account (See the final chart in Does the CAPE Still Work?). Think of it this way. The ratio of Shiller earnings (the 10-year average of inflation adjusted earnings) to S&P 500 current revenues is 6.4% here, versus a historical norm of 5.3%. At normal profit margins, the Shiller P/E would presently be 30 – right in line with other more reliable measures at about double its pre-bubble norm. Even at 25, however, the Shiller P/E exceeds every pre-bubble observation since 1871, except for a few weeks leading up to the 1929 peak.
It’s tempting to look at the 2000 valuation peak as if it’s some sort of goal to be achieved again, rather than a point that has already resulted in 14 years of 3% total returns with the likelihood of another 10 years of similar returns. One hastens to respond (and hastens for reasons below) that the success of the S&P 500 in reaching that pinnacle of valuation was followed by a decline that wiped out the entire total return of the S&P 500, in excess of Treasury bills, all the way back to May 1996, and yet another decline a few years later that wiped out the entire excess return all the way back to June 1995. Taking all of the instances for which data is available, even including the late-1990’s bubble, S&P 500 nominal total returns have averaged less than 1% annually in the 5-year period following Shiller multiples similar to the present. Taking a broader set of historically reliable measures into account, our actual estimates of S&P 500 total returns are negative at all horizons shorter than 7 years.
Of course, valuation isn’t a timing tool, and elevated valuations can persist for some time. Increasing our concern is the emergence in recent months of an extreme syndrome of overvalued, overbought, overbullish, rising-yield conditions exclusively seen at the 1929, 1972, 1987, 2000 and 2007 market peaks. We’ve seen even extreme variants of this syndrome emerge in February and May of last year without consequence, but we doubt that moving further along the edge of the cliff has diminished the likelihood of a fall.
Increasing our concern is also a very well-defined log-periodic bubble running from 2010 to the beginning of this year, which we estimate is now past its “finite-time singularity” (see A Textbook Pre-Crash Bubble). Increasing our concern is the shift to increased short-interval volatility just at the point of that singularity (which we estimate as January 13 – when 2-10 minute fluctuations began looking like the p-wave on a seismogram). Increasing our concern is the highest level of option “skewness” in history as option prices reflect extreme "tail risk" as they did prior to the 1987 crash (the 30-day average of skewness reached a record high on Friday - see Estimating the Risk of a Market Crash).
Increasing our concern is a 10-week average of advisory bulls at 57.7% versus just 14.8% bears – the most lopsided bullish sentiment in decades. Add the record pace of speculation on borrowed money, with NYSE margin debt now at 2.5% of GDP – an amount equivalent to 26% of all commercial and industrial loans in the U.S. banking system. Add the currency collapses in Argentina and Venezuela, as well as fresh credit strains and industrial shortfall in China, and one has any number of factors that could be viewed in hindsight as a “catalyst” (as the German trade gap was viewed after the 1987 crash, in the absence of other observable triggers).
Against all of these concerns is the recognition that the market doesn’t move in a straight line, and that the risks that concern us here have concerned us – though at less extreme levels – too long for many investors to give them much immediate credibility. Immediacy wasn’t really our strong suit in 2000 or 2007 either, but by the time our concerns played out, we still found ourselves far ahead over the complete cycle, with far less pain than speculators endured. Despite the challenges of an unusual but also unfinished half-cycle, and despite our awkward stress-testing transition, I'm comfortable that the tools we've developed and the benefits of discipline will be evident enough over the completion of this cycle and throughout future ones. But as Kierkegaard wrote, “patience is necessary, and one cannot reap immediately where one has sown.”
In any event, however, the objective evidence speaks well enough for itself across history. If accuracy in projecting actual subsequent market returns is a standard by which alternative valuation metrics should be judged, then the U.S. equity market is trading about double its historical norms, and double the level at which investors should expect historically normal returns. Presently, we estimate 10-year total returns of averaging about 2.7% annually for the S&P 500, with negative returns at horizons of 7 years or less. With a very mature bull market advance and major indices still near their upper Bollinger bands at a monthly resolution (2 standard deviations above the 20-perod average), conditions remain strenuously overbought.
Though the subject of log-periodic bubbles is more arcane, the advance of the past few years has perhaps the greatest fidelity to that trajectory than nearly any prior bubble (and as Didier Sornette demonstrated more than a decade ago in Why Stock Markets Crash, that dynamic has described quite a few). Likewise, the singularity of that process is well-centered about January 2014. The potential collapse of a now-complete log-periodic bubble is best considered something of a physics experiment, and it’s not what drives our investment stance. Still, the backdrop of steep overvaluation, extreme bullish sentiment, record margin debt, and international dislocations could hardly provide a more fitting context for a disruptive completion to the present market cycle. To quote Didier Sornette:
“The underlying cause of the crash will be found in the preceding months and years, in the progressively increasing build-up of market cooperativity, or effective interactions between investors, often translated into accelerating ascent of the market price (the bubble). According to this ‘critical’ point of view, the specific manner by which prices collapsed is not the most important problem: a crash occurs because the market has entered an unstable phase and any small disturbance or process may have triggered the instability. The collapse is fundamentally due to the unstable position; the instantaneous cause of the collapse is secondary. In this sense, the true cause of a crash could be termed a systemic instability.”
My overall impression of the global economy here couples disruptions in developing economies with year-over-year growth in U.S. real GDP, real final sales, payroll employment and household employment all close to the border that has historically delineated expansions from recessions. The Wall Street Journal reported last week that “The China Beige Book, a quarterly survey of Chinese businesses and banks, concluded that the country’s ‘credit transmission is broken.’” The same appears to be true in the U.S., where there are $2.4 trillion of excess reserves already in the U.S. banking system. Additional quantitative easing does little but ease a constraint that is not at all binding in the first place. The Fed is correct to conclude that it has done enough.
We view economic weakness as the dominant risk, but given that the correlation between leading measures (purchasing managers surveys, regional Fed surveys) and subsequent economic activity has largely collapsed in the past two years (see When Economic Data is Worse than Useless), it’s quite difficult to get a good near-term read on economic direction here. That said, we don’t expect upward pressure on short-term yields in the foreseeable future, and given the relatively wide spread between Treasury bond yields and Treasury bill rates, we continue to view Treasury debt constructively overall. In effect, deflationary risks, yield spreads, and the prospect of a flight-to-safety dominate the risk of positive economic surprises the effect of Fed tapering, in our view.
In contrast, corporate credit spreads appear dangerously narrow, and we view corporate debt with concern. Likewise, despite the popular belief that equity yields and bond yields should move closely together over time, this doesn’t hold well at all in the data. In fact, equity yields and bond yields were weakly or negatively correlated in historical data prior to 1970, and have been weakly or negatively correlated since the late-1990’s. The strongest positive correlation between the two was when 10-year yields were above 7%, reflecting the inflation-disinflation cycle from the 1970’s to the late-1990’s. Moreover, stocks are 50-year duration instruments from a present-value standpoint, while the benchmark 10-year Treasury has a duration of about 9 years. In short, there is little evidence that contained Treasury yields are a compelling argument for equities here.
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.
The Hussman Funds continue to be defensively positioned in U.S. and international equities, with a moderately constructive view of Treasury debt and a slightly constructive view of precious metals shares. Strategic Growth continues to carry a “staggered strike” hedge that raises the strike prices of its index put options closer to market levels. Last week’s equity market decline brought many of those positions “in the money.” Depending on the frequency of opportunities to shift strike prices and expirations, we can expect some “give and take” from those index put options on a day-to-day basis as the indices fluctuate. Suffice it to say that we remain defensive here, and our investment stance will change in response to shifts in the return/risk profile we estimate.
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