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November 23, 2009

Alert for Tanks

John P. Hussman, Ph.D.
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Last week, the Mortgage Bankers Association released the most comprehensive report available on third quarter delinquencies. Here is a summary of points from that report:

"The delinquency rate for mortgage loans on one-to-four residential properties rose to a seasonally adjusted rate of 9.64% percent of all loans outstanding as of the end of the third quarter of 2009. The delinquency rate breaks the record set last quarter. The records are based on MBA data dating back to 1972. The combined percentage of loans in foreclosure or at least one payment past due was 14.41% on a non-seasonally adjusted basis, the highest ever recorded in the MBA delinquency survey.

"Job losses continue to increase and drive up delinquencies and foreclosures because mortgages are paid with paychecks, not percentage point increases in GDP. Over the last year, we have seen the ranks of the unemployed increase by about 5.5 million people, increasing the number of seriously delinquent loans by almost 2 million loans and increasing the rate of new foreclosures (on a quarterly basis) from 1.07 percent to 1.42 percent," said Jay Brinkmann, MBA's Chief Economist.

"Prime fixed-rate loans continue to represent the largest share of foreclosures started and the biggest driver of the increase in foreclosures. The foreclosure numbers for prime fixed-rate loans will get worse because those loans represented 54 percent of the quarterly increase in loans 90 days or more past due but not yet in foreclosure. The performance of prime adjustable rate loans, which include pay-option ARMs in the MBA survey, continue to deteriorate with the foreclosure rate on those loans for the first time exceeding the rate for subprime fixed-rate loans.

"The outlook is that delinquency rates and foreclosure rates will continue to worsen before they improve. The seriously delinquent rate, the non-seasonally adjusted percentage of loans that are 90 days or more delinquent, or in the process of foreclosure, was up from both last quarter and from last year. Compared with last quarter, the rate increased 82 basis points for prime loans (from 5.44 percent to 6.26 percent), and 216 basis points for subprime loans (from 26.52 percent to 28.68 percent)."

As I noted a couple of weeks ago in The Second Wave Begins, we are now largely beyond the peak of the sub-prime mortgage crisis, and have just begun the second wave of Alt-A and Option-ARM resets. That's important, because what we saw in the third quarter, then, was still part of the relatively tame and predictable March-November 2009 lull in the reset schedule. In that context, the surge in delinquencies and foreclosures on prime fixed-rate loans is disturbing, because that wasn't even part of the reset equation, and represents a relatively pure effect of the weakness in employment conditions.

Now, we face a coupling of those weak employment conditions with a mountain of adjustable resets, on mortgages that have to-date been subject to low teaser rates, interest-only payments, and other optional payment features (hence the "Option" in Option-ARM). These are precisely the mortgages that were written at the height of the housing bubble, and therefore undoubtedly carry the highest loan-to-value ratios.

The inevitability of profound credit losses here is unnervingly similar to the inevitability of profound losses following the dot-com bubble. In that event, it wasn't just that people were excited about dot-com stocks in a way that might or might not have worked out depending on how fast the economy grew. Rather, it was a structural issue that related to the dot-com industry itself - those bubble investments couldn't have worked out in a competitive economy, because market capitalizations were completely out of line with what could possibly be sustained in an industry that had virtually no cost to competitive entry. If you understood how profits evolve in a perfectly competitive market with low product differentiation, you understood that profits would not accrue to the majority of those companies even if the economy and the internet itself grew exponentially.

In the current situation, the assumption that the credit crisis is behind us is completely out of line with what possibly could result from the marriage of deep employment losses and an onerous reset schedule on mortgages that have extremely high loan-to-value ratios. A major second wave of mortgage losses isn't a question of whether the economy will post a positive GDP print this quarter or next. Rather, it is a structural feature of the debt market that is baked into the cake because of how the mortgages were designed and issued in the first place.

If one wishes to monitor the markets for emerging signs of risk, several areas are worth watching. First, the FDIC should release its most current Quarterly Banking Profile later this week. That report will be an interesting gauge of emerging credit stress. Yet even here, a lot of the pressure to properly account for losses on off-balance sheet entities and so forth won't start until next year. In the meantime, credit spreads in general, and credit-default swaps on individual companies may bear closer attention in the weeks ahead. Finally, given the enormous pressure there may be to put a good face on increasingly bad assets, the departure of the chief financial officer of at least one major banking institution, which would not surprise me early next year, might be a sign that all hell could break loose.

The past decade has been largely the experience of watching tanks rolling over a hilltop to attack the villagers celebrating below. Repeatedly, one could observe these huge objects rolling over the horizon, with an ominous knowledge that things would not work out well. But repeatedly, nobody cared as long as it looked like there might be a little punch left in the bowl. As a result, long-term investors in the S&P 500 have achieved negative total returns over a full decade. These negative returns, of course, were also predictable at the time, based on our standard methodology of applying a range of terminal multiples to an S&P 500 earnings profile that has - aside from the recent collapse - maintained a well-behaved growth channel for the better part of a century.

From my perspective, we are again at the point where we should be alert for tanks. We already know that stocks are priced to deliver a 10-year total return in the area of 6.1% annually - among the lowest levels observed in history except for the period since the late-1990's (which despite periodic advances has ultimately not worked out well for investors). We are already observing evidence of weak sponsorship from a volume perspective and growing non-confirmations of recent highs from the standpoint of market internals. The cumulative tally of surprises in economic reports (a metric we credit to Bridgewater, which Bill Hester adapted here), has also turned down decidedly. Though the historical correlation is not always as strong as it has been during the recent downturn, shifts in economic surprises have tended to lead market turns in recent years.

Still, with market internals mixed but not clearly collapsing, prices strenuously overbought but still achieving marginal new highs, and valuations unfavorable but not as extreme as they were in 2000 or 2007, investors may be convinced that there is still a little bit of punch in the bowl. We can't argue with that too strongly, and have been trading in (on market weakness) and out (on market strength) of a modest positive market exposure in recent weeks (to diversify our position and allow for two very different potential states of the world). We're just keeping our risk very close to the vest.

In short, we have to allow for the potential for further speculation, and we can't ignore the day-to-day charts showing several market indices near 52-week highs. But we are also at the point where we can look right over the top of the monitor, and see the tanks a-coming.

Market Climate

As noted above, the Market Climate for stocks last week was characterized by unfavorable valuations and mixed market action - with several major indices achieving new 52-week highs, but weak volume sponsorship, lack of confirmation from several indices and market breadth, and still strenuous overbought conditions from an intermediate-term perspective. The Strategic Growth Fund remains largely hedged, though we are allowing for a small amount of positive exposure on weakness, and clipping that exposure on strength. Most of the day-to-day fluctuation in the Fund here is driven by variation in the performance of the stocks owned by the Fund versus the indices (the S&P 500, Russell 2000 and Nasdaq 100) we use to hedge. That fluctuation can be positive or negative day-to-day, but the performance differential from our stock selection has been a net contributor to Fund returns both this year and since inception.

In bonds, the Market Climate last week was characterized by modestly unfavorable yield levels and modestly favorable yield pressures. The Fund made a very distinct move away from TIPS on the strength of recent weeks, as real yields on many issues moved to negative levels. The Fund is also flat foreign currencies, having closed those positions out on recent strength, and has only about 1% of assets in precious metals shares and about 4% of assets in utility shares. The primary risk carried by the Fund currently is a modest amount of interest rate exposure, where the Fund carries an average duration of about 3 years, mostly in intermediate-term Treasury securities. As usual, we tend to be opportunistic in establishing investment positions, so to the extent that we observe decided weakness in foreign currencies, precious metals or TIPS (all of which would most probably be driven by a shift toward risk-aversion in response to fresh credit concerns), I would expect that we would re-establish exposure in these areas. For now, we are maintaining a comfortable but limited amount of interest rate exposure, and are prepared to respond to opportunities as they arise.

New from Bill Hester: Three Observations on Third Quarter Earnings


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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