June 28, 2010
Based on evidence that has always and only been observed during or immediately prior to U.S. recessions, the U.S. economy appears headed into a second leg of an unusually challenging downturn.
A few weeks ago, I noted that our recession warning composite was on the brink of a signal that has always and only occurred during or immediately prior to U.S. recessions, the last signal being the warning I reported in the November 12, 2007 weekly comment Expecting A Recession (the instance before that was the recession warning I reported in October 2000). While the set of criteria I outlined in 2007 would still require a decline in the ISM Purchasing Managers Index to 54 or less to complete a recession warning, what prompts my immediate concern is that the growth rate of the ECRI Weekly Leading Index has now declined to -6.9%. The WLI growth rate has historically demonstrated a strong correlation with the ISM Purchasing Managers Index, with the correlation being highest at a lead time of 13 weeks.
Taking the growth rate of the WLI as a single indicator, the only instance when a level of -6.9% was not associated with an actual recession was a single observation in 1988. But as I've long noted, recession evidence is best taken as a syndrome of multiple conditions, including the behavior of the yield curve, credit spreads, stock prices, and employment growth. Given that the WLI growth rate leads the PMI by about 13 weeks, I substituted the WLI growth rate for the PMI criterion in condition 4 of our recession warning composite. As you can see, the results are nearly identical, and not surprisingly, are slightly more timely than using the PMI. The blue line indicates recession warning signals from the composite of indicators, while the red blocks indicate official U.S. recessions as identified by the National Bureau of Economic Research.
The blue spike at the right of the graph indicates that the U.S. economy is most probably either in, or immediately entering a second phase of contraction. Of course, the evidence could be incorrect in this instance, but the broader economic context provides no strong basis for ignoring the present warning in the hope of a contrary outcome. Indeed, if anything, credit conditions suggest that we should allow for outcomes that are more challenging than we have typically observed in the post-war period.
Unthinkability is Not Evidence
One of the greatest risks to investors here is the temptation to form investment expectations based on the behavior of the U.S. stock market and economy over the past three or four decades. The credit strains and deleveraging risks we currently observe are, from that context, wildly "out of sample." To form valid expectations of how the economic and financial situation is likely to resolve, it's necessary to consider data sets that share similar characteristics. Fortunately, the U.S. has not observed a systemic banking crisis of the recent magnitude since the Great Depression. Unfortunately, that also means that we have to broaden our data set in ways that investors currently don't seem to be contemplating.
On this front, perhaps the best single reference is a somewhat academic book on economic history with the intentionally sardonic title, This Time Is Different, by economists Kenneth Rogoff (Harvard) and Carmen Reinhart (University of Maryland). The book presents lessons from a massive analysis of world economic history, including recent data from industrialized nations, as well as evidence dating to twelfth-century China and medieval Europe. Reinhart and Rogoff observe that the outcomes of systemic credit crises have shown an astonishing similarity both across different countries and across different centuries. These lessons are not available to investors who restrict their attention to the past three or four decades of U.S. data.
Reinhart and Rogoff observe that following systemic banking crises, the duration of housing price declines has averaged roughly six years, while the downturn in equity prices has averaged about 3.4 years. On average, unemployment rises for almost 5 years. If we mark the beginning of this crisis in early 2008 with the collapse of Bear Stearns, it seems rather hopeful to view the March 2009 market low as a durable "V" bottom for the stock market, and to expect a sustained economic expansion to happily pick up where last year's massive dose of "stimulus" spending now trails off. The average adjustment periods following major credit strains would place a stock market low closer to mid-2011, a peak in unemployment near the end of 2012 and a trough in housing perhaps by 2014. Given currently elevated equity valuations, widening credit spreads, deteriorating market internals, and the rapidly increasing risk of fresh economic weakness, there is little in the current data to rule out these extended time frames.
In recent months, I have finessed this issue by encouraging investors to carefully examine their risk exposures. I'm not sure that finesse is helpful any longer. The probabilities are becoming too high to use gentle wording. Though I usually confine my views to statements about probability and "average" behavior, this becomes fruitless when every outcome associated with the data is negative, with no counterexamples. Put bluntly, I believe that the economy is again turning lower, and that there is a reasonable likelihood that the U.S. stock market will ultimately violate its March 2009 lows before the current adjustment cycle is complete. At present, the best argument against this outcome is that it is unthinkable. Unfortunately, once policy makers have squandered public confidence, the market does not care whether the outcomes it produces are unthinkable. Unthinkability is not evidence.
Moreover, from a valuation standpoint, a further market trough would not even be "out of sample" in post-war data. Based on our standard valuation methods, the S&P 500 Index would have to drop to about 500 to match historical post-war points of secular undervaluation, such as June 1950, September 1974, and July 1982. We do not have to contemplate outcomes such as April 1932 (when the S&P 500 dropped to just 2.8 times its pre-Depression earnings peak) to allow for the possibility of further market difficulty in the coming years. Even strictly post-war data is sufficient to establish that the lows we observed in March 2009 did not represent anything close to generational undervaluation. We face real, structural economic problems that will not go away easily, and it is important to avoid the delusion that the average valuations typical of the recent bubble period represent sustainable norms.
Our policy makers have spent their ammunition in the attempt to bail out bondholders and to create an entirely deficit-financed appearance of economic strength. It would be better to allow insolvent, non-sovereign debt to default (including long-term Fannie and Freddie obligations, and obligations to bank bondholders), and to instead use public funds to take receivership of failing institutions and to defend customers and depositors from the effects. Restructuring is probably a more useful word, but in any case, the key element is that those who actually made the loans, not the public, should absorb the loss. Restructuring means simply that the payment terms are rewritten to reflect the lower amount that will delivered over time. I can't emphasize this point often enough - "failure" of a financial institution means only that the bondholders don't receive 100 cents on the dollar plus interest. Failure is only a problem when it requires piecemeal liquidation, as occurred in the case of Lehman. This is not necessary when appropriate regulators can take receivership of insolvent bank and non-bank institutions (as the new financial regulatory bill now provides).
My greatest concern is that these new receivership powers will not be implemented because the Fed and the Treasury are both in bed with major Wall Street and banking institutions. Yet there is no effective alternative. Having squandered trillions in an empty confidence-building exercise, it will be nearly impossible for those same policies to build confidence again in the increasingly likely event that the economy turns lower and defaults pick up again. The best approach will still be to allow bad debt to go bad, let the bondholders lose, and defend the customers by taking whole-bank receivership (as the FDIC does seamlessly nearly every week with failing institutions). Almost undoubtedly, however, our policy makers will choose to defend bondholders again, pushing our government debt to a level that is so untenably high that little recourse will remain but to suppress the real obligation through long-term inflation (though as noted below, the near-term effects of credit crises are almost invariably deflationary at first).
Though Reinhart and Rogoff published This Time is Different in early 2009, extending the analysis they provided in a January 2008 NBER working paper (13761), the book accurately foreshadowed the recent debt crisis in European countries, noting "As of this writing, it remains to be seen whether the global surge in financial sector turbulence will lead to a similar outcome in the sovereign default cycle. The precedent, however, appears discouraging on that score. A sharp rise in sovereign defaults in the current global financial environment would hardly be surprising."
It is interesting that despite the apparent stabilization of the Euro in recent weeks, the stabilization more reflects sudden concerns about the U.S. dollar than improvement of European debt conditions. Notice that relative to the Swiss Franc, for example, the Euro continues to plunge to fresh lows.
Reinhart and Rogoff observe that "the aftermath of systemic banking crises involves a protracted and pronounced contraction in economic activity and puts significant strains on government resources. Banking crises almost invariably lead to sharp declines in tax revenues as well as significant increases in government spending. On average, government debt rises by 86 percent during the three years following a banking crisis.
"Banking crises in advanced economies significantly drag down world growth. The slowing, or outright contraction, of economic activity tends to hit exports especially hard. Weakening global growth has historically been associated with declining world commodity prices. These reduce the export earnings of primary commodity producers and, accordingly, their ability to service debt."
From an inflation standpoint, is important to recognize the distinction between what occurs during a credit crisis and what occurs afterward. Credit strains typically create a nearly frantic demand for government liabilities that are considered default-free (even if they are subject to inflation risk). This raises the marginal utility of government liabilities relative to the marginal utility of goods and services. That's an economist's way of saying that interest rates drop and deflation pressures take hold. Commodity price declines are also common, which is a word of caution to investors accumulating gold here, who may experience a roller-coaster shortly. Over the short-term, very large quantities of money and government debt can be created with seemingly no ill effects. It's typically several years after the crisis that those liabilities lose value, ultimately at a very rapid pace.
Reinhart and Rogoff continue, "Episodes of treacherously high inflation are another recurrent theme. Indeed, there is a very strong parallel between our proposition that few countries have avoided serial default on external debt and the proposition that few countries have avoided serial bouts of high inflation. Even the United States has a checkered history. Governments can default on domestic debt through high and unanticipated inflation, as the United States and many European countries famously did in the 1970's.
"Early on across the world, the main device for defaulting on government obligations was that of debasing the content of the coinage. Modern currency presses are just a technologically advanced and more efficient approach to achieving the same end. In many important episodes, domestic debt has been a major factor in a government's incentive to allow inflation, if not indeed the dominant one. If a global surge in banking crises indicates a likely rise in sovereign defaults, it may also signal a potential rise in the share of countries experiencing high inflation. Inflation has long been the weapon of choice in sovereign defaults on domestic debt and, where possible, on international debt."
Commenting on why last year's massive interventions may not have addressed global problems, economist David Rosenberg of Gluskin-Sheff aptly observes - "It's about bad short-term decisions over good long-term solutions, which is burying the world. While U.S. banks have recapitalized themselves and written off debt, this cycle has been dominated by governments socializing the losses and taking the bad debts from the private sector and transferring the liabilities to the public sector balance sheets. We now have a global debt problem and in order to deal with it we must understand the magnitude. Even with low interest rates, the massive debt bulge in the U.S. has become so large that interest charges on the public debt are within a decade of absorbing over 30% of the revenue base, which then makes it that much tougher to reverse course. When you add up the entitlement programs, what we have is 65% of total government spending that can't be touched. In the next few years, under status quo policies, this 'mandatory' share of the spending pie goes to 72%."
In short, my concerns about the economy and financial markets are escalating quickly. Given the already vulnerable condition of the U.S. economy, a second phase of weakness would most likely contribute to already troubling levels of mortgage delinquency and foreclosure, and could be expected to push the unemployment rate toward 12%. It is not useful to rule out unfavorable outcomes simply because they seem unpleasant or unthinkable. It is also not useful to place superstitious hope in the Fed and the Treasury to fix the consequences of irresponsible lending without any ill effect. In the coming quarters, remember that every time you hear an incomprehensibly large bailout commitment from government, it will equate to an unconscionably large extraction of public resources, possibly through overt taxation, but more likely through the long-term destruction of purchasing power.
Fannie, Freddie, and the delusion of uniform quality
While the Treasury's quiet extension of 3-year bailout funding for the GSEs was not part of Congressional intent, the word I've received is that representatives believe it was legal, but only because of a loophole that would have required explicit Congressional approval had the Treasury made the same announcement a week later. Fannie Mae and Freddie Mac remain responsible for about 3 out of 4 outstanding U.S. mortgages. The way the bailout money is being used is that, for example, Fannie Mae is purchasing all mortgage loans in its MBS pools that are delinquent by more than four months. It effectively pays off the full mortgage balance on those homes, retires a portion of outstanding mortgage backed securities, and takes ownership of the collateral. Of course, none of those homes can be liquidated at anything close to their outstanding mortgage balances, but that's the deal that Fannie and Freddie made in return for a negligible insurance premium (G-fee), and that Tim Geithner graciously stands behind on behalf of the public. Accordingly, Fannie and Freddie are already sitting on 160,000 foreclosed homes, with losses escalating at public expense. Edward DeMarco, who oversees the government's conservation of Fannie and Freddie, observes "we cannot do this indefinitely."
While our Treasury's magnanimous generosity ensures that Fannie and Freddie obligations maturing through 2012 will be paid in full, if at public expense, it is clear that longer-term GSE obligations should not be viewed as sovereign debt. GSE obligations with maturities beyond 2012 are the obligations of insolvent institutions, not of the U.S. government. As such, the collateral behind these obligations should emphatically not be considered of uniform credit quality. It follows that many of Fannie and Freddie's long-term securities should carry junk status. The disastrously misleading rating of subprime debt pales in comparison to the current practice of rating longer-term GSE debt as investment grade.
In my opinion, Congress should make this distinction clear sooner rather than later, and let the market price this debt accordingly. The problem, of course, is that the Fed also owns $1.5 trillion of these obligations, which is a travesty of judgment and an abuse of public trust. Regardless, to the extent that the Fed takes losses, it will provide useful discipline on the Fed itself, which it profoundly lacks. At this point, the public will take a loss on Fed-held GSE debt in any event, either through direct default or equivalent bailout cost to the Treasury. Actual losses in market value would be more transparent, and might even prompt the appropriate resignation of Ben Bernanke.
If the public has an interest in promoting home ownership, it should not be by slapping cheap insurance on wildly heterogeneous credit risks, with no residual risk to the mortgage originator. It certainly should not be through Fannie Mae and Freddie Mac, both of which have been disastrously managed. This is not a surprise - it has been clear for nearly a decade that these institutions have operated with far too much risk and far too generous assumptions about the impossibility of default and risk mismatches. Even in 2002, the GSEs were producing large duration mismatches that threatened their solvency to a much greater extent that investors understood, which is one of the reasons I noted in January of that year " I don't even understand why Fannie Mae trades at all." Except for a note or two suggesting that my view was preposterous, nobody cared. But one can only play balance sheet roulette for so long. Fannie and Freddie became penny stocks about a week ago as it was announced that they would be delisted.
It may grease the skids of capitalism for investors to treat all GSE securities as homogeneous, and all credit risk as being perfectly described by a letter of the alphabet. The wheels of Wall Street are constantly churning to create credit default swaps and payment guarantees to make investors believe that no thought is required of them other than to hand over their money. But this belief in uniform quality is a delusion. The institutions that provided these guarantees were at far more risk than investors understood, which is why AIG, Fannie Mae and Freddie Mac were the first to go down, and why the U.S. public is paying hundreds of billions to make sure that bondholders get a good deal despite the failure of the underlying collateral.
As Bill Hester notes in his latest research piece The Great Divergence (additional link below), it is also a mistake to view international debt and equity to be of uniform quality. Distinctions and selectivity among investments will most probably be increasingly important as we move through the coming years.
As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action - a combination that has been unfortunately frequent over the past decade, but has historically occurred only about 25% of the time. A natural consequence of the frequency of this particular Climate over the past decade is that the S&P 500 has delivered a negative total return over this period. This outcome underscores the fact that market outcomes on average do vary with valuations and market action. But it also reflects an economy that has constantly misallocated resources because we have embraced quick fixes, bailouts, speculation, cheap money, and quarterly operating earnings, rather than careful risk assessment and a focus on long-term solvency and properly discounted cash flows. Frankly, if one good thing comes out of the recent (and likely continuing) trouble, it will be revulsion toward "playing" the market as if it is some sort of carnival.
The Strategic Growth Fund is fully hedged here. In this position, the primary source of day-to-day fluctuations in Fund value is the difference between the stocks owned by the Fund and the indices we use to hedge.
In bonds, the Market Climate last week was characterized by moderately unfavorable yield levels and favorable yield pressures. Credit spreads continue to widen, and we've observed a flattening of the yield curve due to a flight-to-safety in default free instruments. This may seem like an odd outcome, given that the growing issuance of Treasury and Fed liabilities is gradually setting us up for a difficult inflationary period beginning in the second half of this decade, but it is a strong regularity that "default-free" beats "inflation prone" during periods of crisis. For that same reason, we have to be careful about concluding that the growth of government liabilities will quickly translate into continued appreciation in precious metals and other commodities. Again, the historical regularity is for commodities to decline, though with a lag, once credit difficulties emerge. My weekly comments on this front might be less redundant if there were more subtlety to the issue, but it is subtle enough to recognize that the long-term inflationary implications of current monetary and fiscal policies will not necessarily translate into negative short-term outcomes for the Treasury market, nor persistently positive short-term outcomes for commodities.
NEW from Bill Hester: The Great Divergence
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