November 26, 2007
Financial Markets Anticipate Recessions Before They are Obvious
"This month, market action produced a recession warning. Our investment position does not rely on a recession, so we hope that this signal is incorrect. It is quite true that consensus economic forecasts remain relatively upbeat here. Unfortunately, most economists have never fully internalized the "rational expectations" view that market prices convey information. Of course, accepting this view does not require one to believe that prices convey information perfectly (which is what the "efficient markets hypothesis assumes). But where finance economists take this information concept too far, economic forecasters don't take it far enough. As a result, economic forecasts are generally based on coincident indicators such as GDP growth and industrial production, or pathetically lagging indicators. This tendency to gauge economic prospects by looking backward is why economists failed to foresee the Great Depression and every recession since.
- Hussman Investment Research & Insight, October 3, 2000.
A year later, the NBER business cycle dating committee (the body that officially dates - not forecasts - recessions) confirmed that the U.S. was in recession. By then, the S&P 500 had already lost over 35% of its value. Indeed, by March 2001, which the NBER identified as the official recession start-date, the S&P 500 was already down more than 25% from the high it had set just a few months earlier. A large portion of bear market losses occur while investors are still denying the probability of a recession. By the time that a recession is well-recognized, significant damage has already been inflicted.
Two weeks ago, for the first time since the 2001-2002 downturn, our measures again signaled an oncoming U.S. recession. This signal is based on four general conditions. They are all well-known to be related to economic weakness (not the result of spurious data-mining), but they do not have great usefulness individually. They become powerful when they are unanimous - these conditions have always occurred together during or just prior to recessions, and they have only occurred together during or just prior to recessions. Apart from the survey measures in the fourth condition (the ISM Purchasing Managers Index and U.S. employment), the most reliable evidence for an oncoming recession is based on financial market indicators. It is the forward-looking aspect of market action that produces a timely risk signal. I've added specific criteria and levels that produce a perfect classifier, but less specific cutoffs can be used as well, at the cost of adding a few outlier signals (still in the vicinity of economic downturns). These measures are:
1: Widening credit spreads: An increase over the past 6 months in either the spread between commercial paper and 3-month Treasury yields, or between the Dow Corporate Bond Index yield and 10-year Treasury yields.
2: Moderate or flat yield curve: 10-year Treasury yield no more than 2.5% above 3-month Treasury yields (this doesn't create a strong risk of recession in and of itself).
3: Falling stock prices: S&P 500 below its level of 6 months earlier. Again, this is not terribly unusual by itself, which is why people say that market declines have called 11 of the past 6 recessions, but falling stock prices are very important as part of the broader syndrome.
4: Moderating ISM and employment growth: PMI in the low 50's or worse (below 54), coupled with sluggish employment - either total nonfarm employment growth below 1.3% over the preceding year, or an unemployment rate up 0.4% or more from its 12-month low.
For ease of reference, I've reproduced the chart I presented two weeks ago. The recession signals based on the foregoing criteria are depicted in blue in the chart below. Actual recessions are depicted in red.
Allow for "clearing rallies" without speculating on them
It is crucial to recognize that the market downturns associated with recessions are never one-way movements. The basic feature of bear markets is that they maintain the hope of investors all the way down. The stock market often "rides the Bollinger band" lower, becoming more and more oversold, but will then unpredictably clear those oversold conditions by producing explosive advances that are "fast, furious, and prone-to-failure." The 2000-2002 bear market, which took the S&P 500 down by half and the Nasdaq down by more than three-quarters, included three separate 20% trough-to-peak advances in the S&P 500, and many more 5-7% rallies. We did capture a portion of those, but "clearing rallies" are always prone to failure, so we could remove only a fraction of our hedges. Unless we observe a very broad improvement in market action, that sort of trade would require more modest valuations than we see at present. Generally speaking, when valuations are stretched (on normalized earnings) and both market action and economic measures have turned negative (as they have now), you can expect that "buying-the-dip" will result in a brief feeling of genius and success followed by profound regret.
The other factor to remember is that is extremely difficult to make up large losses in the stock market. Despite a 5-year bull market in stocks, the S&P 500 is currently 5% below its 2000 high. Including dividends, the average annual total return of the S&P 500 over the past 7 years has been just 1%. Risk taken when valuations are rich and market action is poor can produce losses that entirely cancel the successful investment actions of other periods. Though periods of unfavorable valuation and market action can occasionally produce positive returns as well, they don't produce positive returns reliably enough to justify the risk.
As of Friday, the S&P 500 has lagged Treasury bills year-to-date. Longer-term, the S&P 500 has lagged Treasury bills for what is now nine full years. The recent bull market that started at the turn of 2002-2003 was unusual, in that it started at the highest valuation of any bull market in history. While 2003 presented reasonable conditions in which to accept risk, rich valuations also returned rather quickly. The predictable consequence of this is that even a minimal 20% bear market decline from the bull market high would leave the total return on the S&P 500 since the end of 2003 at less than 5%. As I've noted before, I expect that by the time that the current market cycle is completed, 2003 will be the only bull market year for which the market's returns (in excess of Treasury bills) will have been retained.
For us, the only good reason to accept risk is to achieve gains (in excess of risk-free Treasury bill yields) that we can reasonably expect to retain. This is a much different perspective than the one held by many speculators, who seem to believe that it is unacceptable to miss any rally. The problem is that it's futile to chase a rally unless you also have a reliable exit strategy. It's likely that most investors who "caught" the rally in the stock market earlier this year never got out, because the features that would have prompted them to reduce risk (overvaluation, overbought conditions, overbullish sentiment) were the same conditions that would have prevented them from taking risk in the first place. As often happens when the market is strenuously overbought, trend-following signals were not helpful in retaining the gains either. Many of the better trend-following measures (particularly Richard Russell's Primary Trend Index and Dow Theory) are only now turning negative.
Although the market will almost certainly enjoy powerful "clearing rallies" from time to time, the expected return of the current Market Climate (unfavorable valuations and unfavorable market action) is negative. Over the complete market cycle, there are typically many excellent opportunities to accept risk on the expectation of strong returns, so there is no need to speculate on short-term, high-risk rallies during unfavorable Climates. I strongly expect opportunities to accept substantial market exposure in the years ahead, despite presently unfavorable conditions.
Meanwhile, we'll take our evidence as it arrives. My main concern continues to be that investors accept an overall profile of risk that they can maintain regardless of market action, particularly allowing for the possibility of a substantially deeper market decline than we've observed to date. I do not encourage net short positions and I do not encourage abandoning carefully planned long-term investment strategies (including buy-and-hold exposures in index funds and the like). The real issue is to consider now how you would react to a 20%-30% overall loss in the stock market. If that sort of event would produce unacceptable harm or would prompt you to abandon your investment strategy, it is better to adjust your exposure sooner rather than later. As usual, make larger adjustments on favorable prices and smaller adjustment on unfavorable prices, but act immediately and consistently, in steps, until you are comfortable that you can maintain your investment discipline over the full course of a market cycle.
Needless to say, investors having an investment horizon shorter than a complete market cycle are encouraged to allocate their assets away from the Hussman Funds, which are not suitable for such investors.
As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully-hedged investment stance. Short-term conditions remain oversold, and it tends to be the case that the market often rallies up to "prior support" following a significant break. That leads us to allow for the possibility of a larger "clearing rally" than we saw on Friday, but is not sufficiently strong a likelihood to warrant speculation. Suffice it to say that despite the likelihood of an oncoming recession, and a clearly unfavorable Market Climate, investors should never expect the market to move in only one direction.
I should emphasize again that most of the returns in the Strategic Growth Fund over time have come from the gradual accrual of a performance difference between the stocks we hold and the indices we use to hedge. The dollar value of our shorts never materially exceeds our long holdings. If our investment discipline is performing well, you will not observe it simply by looking for the Fund to gain on days when the market loses. Rather, you'll observe it by the tendency for the Fund to pick up a few cents more here and there than it gives back - sometimes during advances, sometimes during declines, without any well-defined pattern. During the 2000-2002 bear market, the Fund achieved strong returns, but those returns were not well-correlated with market declines. On average, the Fund gained less than a penny a day, and would often lose a bit of value on both advancing days and declining days before recovering to a fresh high.
Given our current position, the Fund will tend to be somewhat stronger on days when technology, energy, health care and consumer stocks are strong while financials are weak, and to pull back when the opposite is true. If the Fund has a particularly strong or weak day, the first place to look is for dispersion in the market that day (e.g. between financials and technology, between large cap and small cap, etc). When there is a great deal of dispersion in the market, there will naturally be a wider amount of dispersion between the stocks we hold long and the indices we use to hedge.
In bonds, the Market Climate remains characterized by unfavorable yield levels and favorable yield trends. With 10-year Treasury yields close to 4% while corporate yields move higher, credit spreads have spiked in recent weeks (as they typically do prior to recessions). It's clear that the bond market is caught in a flight to safety, but the combination of low long-term yields and a relatively flat yield curve invites yield spikes that can erase several weeks of declining yields in a matter of days. I don't expect any sustained upward pressure on bond yields here, but I do view some of the recent decline in bond yields as having a speculative component (even allowing for the likelihood of an oncoming recession). As usual, we'll tend to increase our durations on short-term increases in yield, and to clip our durations a bit when yields become unusually depressed. In precious metals, the Market Climate continues to be generally favorable. Accordingly, the Strategic Total Return Fund holds about 12% of assets in precious metals shares.
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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