June 27, 2016
Brexit and the Bubble in Search of A Pin
First things first. While the full attention of financial market participants is focused on “Brexit” - last week’s British referendum to exit the European Union - the singular factor to recognize here is that the vulnerability of the financial markets to steep losses has very little to do with Brexit per se. Rather, years of yield-seeking speculation, encouraged by central banks, had already brought the financial markets to a precipice prior to last week’s vote. It’s not entirely clear whether Brexit is a sufficient catalyst to burst the bubble, as we recall that the failure of Bear Stearns in early-2008 was followed by a period of calm before the crisis was sealed by Lehman's failure, and numerous dot-com stocks had already been obliterated by September 2000, when the tech bubble began its collapse in earnest. We’ll take the evidence as it comes, but we’re certainly defensive at present, for reasons that have little to do with Brexit at all.
The high-level churning in global financial markets since late-2014 represents what we view as the top formation of the third speculative bubble in 16 years. For the U.S. market, valuation measures most reliably correlated with actual subsequent market returns pushed to the third most offensive extreme in history at the May 2015 market high, eclipsed only by the 2000 and 1929 peaks (see Choose Your Weapon for a ranking of various measures, and the chart series in Imagine for a current perspective). Because this speculative episode has infected nearly every asset class, rather than favoring tech stocks or mortgage securities as in previous bubbles, the median price/revenue ratio across individual U.S. stocks actually pushed to the most extreme level on record in recent weeks, before promptly retreating on Friday.
As I noted a month ago in Latent Risks and Critical Points:
“My impression is that the best way to understand the next stage of the current market cycle is to recognize the difference between observed conditions and latent risks. This distinction will be most helpful before, not after, the S&P 500 drops hundreds of points in a handful of sessions. That essentially describes how a coordinated attempt by trend-followers to exit this steeply overvalued market could unfold, since value-conscious investors may have little interest in absorbing those shares at nearby prices, and in equilibrium, every seller requires a buyer.
“Imagine the error of skating on thin ice and plunging through. While we might examine the hole in the ice in hindsight, and find some particular fracture that contributed to the collapse, this is much like looking for the particular pebble of sand that triggers an avalanche, or the specific vibration that triggers an earthquake. In each case, the collapse actually reflects the expression of sub-surface conditions that were already in place long before the collapse - the realization of previously latent risks.
“Finding the specific trigger that causes the skaters to plunge through the ice isn’t particularly informative. The fact is that catastrophe is inevitable the moment the skaters ignore the latent risk, or rely on faulty evidence to conclude that the ice is stable. The fracture in some particular span of ice is just one of numerous other spots that might have otherwise given way if the skaters had chosen a different course. Hitting that spot creates the specific occasion for the underlying risk to be expressed, but an unfortunate outcome was already inevitable much earlier.”
As I’ve regularly emphasized over time, particularly since mid-2014, valuations are the primary determinant of market returns on horizons of 7-12 years, but have a much weaker relationship with returns over shorter horizons. Over shorter segments of the market cycle, the hinge that distinguishes an overvalued market that continues to advance from an overvalued market that drops like a rock is psychological - the attitude of investors toward risk-seeking or risk-aversion. Because risk-seeking tends to be indiscriminate, we find that the most reliable measure to distinguish risk-seeking from risk-aversion is the uniformity or divergence of market internals across a wide range of individual stocks, industries, and security types, including debt securities of varying creditworthiness. Those measures deteriorated materially in late-2014, as investors finally began a subtle shift toward risk aversion that has persisted during the recent top-formation.
For those inclined to dismiss the dangerous combination of extreme valuations and unfavorable market internals here, on the basis of our own struggle with QE-driven speculation during the advancing half-cycle since 2009, see the Box in The Next Big Short for the full narrative. Given that our measures of market internals are unfavorable here, and our valuation measures didn’t miss a beat even at the 2009 lows, the bulk of our present concerns are based on factors that had no part in that struggle.
Despite the potential for Brexit to act as a trigger to express latent risks that have been steeply elevated for some time now, my strong view is that investors should not be misled into thinking that the specifics of this particular trigger matter all that much. We could write pages on the potential renegotiation points that Britain and the EU will need to hash out as Article 50 of the Lisbon Treaty is invoked. But for investors, the main objects of focus should be the condition of valuations and market action, particularly the status of market internals, and the position of the major indices relative to various trigger points that might result in concerted selling attempts by trend-followers. That’s particularly important since value-conscious investors will likely have little interest in absorbing shares at nearby prices.
Brexit and the untenable structure of the EU
Having emphasized that Brexit is only one of many possible disruptions to a bubble in search of a pin, some aspects of Brexit are certainly worthy of discussion.
As long-time followers know, I’ve often expressed concern over what I see as an untenable structure underlying the European Union. There’s certainly merit in promoting flexible trade among European nations, and in the ideal of a common European identity. But the additional fact is that Europe is virtually unequalled in its economic and cultural dispersion. It includes some of the strongest but also weakest economies in the developed world, with diverse languages and deeply-held cultural identities that are immediately invoked by the names of each country - the United Kingdom, France, Italy, Germany, Greece, Sweden, Ireland, Poland, Spain, and many others. These individual national identities are not unanimously seen as insignificant relics, and it is a source of greater discord, not less, to imagine that they don’t exist. Nor is it reasonable to assume that the same fiscal and monetary policies are appropriate to all of them.
Probably the most poorly structured element of the EU in this regard is the euro, which binds many (though not all) of these members together under a common currency. A stable common currency requires that its member states pursue common fiscal policies, and presumes that a common monetary policy is appropriate for all of them. This has been a disaster for Europe. The clearest symptom of this untenable structure is the European Central Bank under Mario Draghi. The blindly frantic “anything it takes” monetary dysfunction promoted by the ECB has enabled the development of massive sovereign debt burdens, Humpty Dumpty banks (with Deutsche Bank being the most leveraged among major institutions, and Credit Suisse not far behind), and negative interest rates across Europe, with the ECB now buying the bonds of even private corporations.
Given that Britain has its own currency, part of the support behind the Brexit vote relates to the relatively free migration of workers under the Common Market. While I do believe that every country has the right to immigration policies that contribute to the relative stability of its own culture, I don’t defend the ugly leap to intolerance that some have demonstrated in Britain, and that has also become an unfortunate and offensive element in the U.S. political debate. My own concern with the structure of the EU is primarily focused on the misguided structure of the common currency, and the underlying requirement for fiscal and monetary harmony that it imposes on countries that desperately need the flexibility to pursue substantially divergent policies. Those constraints have brought Greece close to a depression, while at the same time shoveling default-prone sovereign debt onto the balance sheets of European banks and the ECB.
Compared with what might result from the exit of another major EU member, Britain actually has a relatively easy course over the next two years (which is the period over which existing agreements with the EU will be renegotiated, and can be extended by the EU if necessary). There is every reason to expect provisions that are mutually beneficial to each side to be preserved. The transition will be substantially eased by the fact that many of these provisions have broad public support in Britain across a wide range of sectors. Despite protests that “everything has gone back to square one,” it’s not as if all of those mutually beneficial provisions have suddenly gone up in flames and have to be redrafted from scratch. The discord will be among provisions that have “political” features; those that might benefit one group within Britain versus another.
Any country that shares the euro as a common currency would have a more difficult exit course, because currency uncertainties would suddenly be introduced, disrupting a wide range of securities and private contracts. That’s not to say that Brexit will be easy, but the main risk of Brexit is actually the risk of a domino effect that might encourage defection of other EU members, particularly those that share the euro. Also, some EU members, particularly Germany, look at the unrestrained behavior of the European Central Bank with increasing dismay. If Europe experiences another round of economic weakness, there may be increasing strains on this passive acceptance by Germany, which is currently required to preserve the euro.
The dignity of a united European identity can survive without forcing each member country into an inappropriately identical fiscal, monetary and political shoe. Think of the EU, in its current ill-structured form, as a kind of Ponzi scheme, and Britain as the guy who just asked for his money back. There are undoubtedly greater prospects for near-term disruption after last week’s vote, but the hallmark of a Ponzi scheme is the attempt to use progressively greater distortions in order to preserve a structure that is fundamentally unsound and increasingly bankrupt. Of any large country that could leave the EU, Britain was the best first mover. I have no immediate concerns about a domino effect, but if one was to emerge, my view is that the exit of Germany, France, and the Nordic countries would be preferable to the exit of Greece, Italy, Spain, or Portugal. It would be better to leave the euro intact and capable of steep devaluation among the weaker members than to sustain a system where the stronger and larger members of the euro become even more deeply entrenched in its flaws.
As for the prospects for Britain itself, given that recessions are generally periods where the mix of goods demanded by an economy becomes misaligned with the mix of goods being supplied, a recession in Britain appears likely. The decline in the British pound may serve as something of an automatic stabilizer, reducing imports and increasing demand for exports, but that still requires some adjustment in the relative composition of demand and supply, so some amount of disruption is inevitable.
From a currency standpoint, I observed in March 2015 that both the Japanese yen (then at about $0.0082/yen or 122 yen/$) and the euro (then at about $1.05/euro) had become substantially undervalued relative to the U.S. dollar based on our “joint parity” estimates (see Extremes in Every Pendulum). As of Friday, the yen has advanced by nearly 20%, to about $0.0098/yen or 102 yen/$), which I view as fully valued, though not rich.
In contrast, as of Friday, both the euro and the British pound appear modestly undervalued relative to the U.S. dollar, by about the same amount. While the euro has advanced nearly 6%, the move to negative rates across Europe has reduced our fair value estimates, which we peg at just under $1.20/euro, narrowing our expectation for much appreciation. Given the choice of a poorly structured and crisis-prone euro and the British pound, I’d much rather hold the pound over time. Our joint parity estimate for the pound currently stands at about $1.50, though that value would be degraded somewhat in the event of an ill-advised move toward negative rates by the Bank of England. While near-term pressures may drive the pound well below the current exchange rate of $1.37, my impression is that this would improve an already modestly favorable valuation.
Late note - over the weekend, the foreign ministers of Germany, France, Belgium, Italy, Luxembourg and the Netherlands released a statement of willingness to work toward an orderly departure of Britain from the EU, and observed “we shall also recognize different levels of ambition amongst Member States when it comes to the project of European Integration. While not stepping back from what we have achieved, we have to find better ways of dealing with those different levels of ambition so as to ensure that Europe delivers better on the expectations of all European citizens.”
One wishes that those “different levels of ambition” had originally included flexibility for member countries to pursue reasonable, if constrained, differences in their monetary, fiscal, and immigration policies, scrapping the notion of a common currency. The ideal of workable integration would be much easier to achieve, the European economy would be struggling less, and the ECB would not be able to engineer an increasingly extreme choice between monetary dysfunction and financial crisis. That choice has already become a double bind; either option is ultimately likely to bring the same end. Unfortunately, financial and monetary extremes have already been taken too far to allow a return to long-term stability along anything other than a difficult road.Still, even in a highly repressed financial system, volatility also brings opportunity. Though Japanese interest rates have been pegged near zero for two decades, the Nikkei has experienced multiple bull and bear markets, including two losses in excess of -60%, even after the -60% loss that followed the 1990 peak. As long as investors focus on the joint condition of valuations and market action (particularly the uniformity or divergence of market internals as they change over time), and as long as they avoid the mistake of equating zero interest rates with stock market stability, I expect that a patient, flexible, value-conscious discipline will serve investors well in the market cycles ahead.
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. Please see periodic remarks on the Fund Notes and Commentary page for discussion relating specifically to the Hussman Funds and the investment positions of the Funds.
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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