April 18, 2011
Approaching the Eraser
Market conditions in stocks continue to be characterized by a hostile syndrome of overvaluation, overbought conditions, overbullish sentiment, and rising interest rates, which has historically been associated with a poor return/risk profile, on average, across a wide variety of subsets of historical data. Though I question the ability of the economy to "pass the baton" to the private sector as government stimulus effects run off in the coming 8-10 weeks, I should emphasize up front that our present defensive position is not driven by those economic concerns. As I've noted regularly, we expect to quickly establish at least a moderate exposure to market fluctuations if we can clear some component of the foregoing syndrome (probably either the overbought or overbullish component) without a decline severe enough to damage market internals - based on a wide variety of measures relating to breadth, leadership, yield spreads, sector uniformity, and other price/volume factors.
Late last year, we implemented some significant changes to the way we define Market Climates, which I believe increase the "robustness" of those Climates - basing them on an ensemble that examines scores of individual sub-samples of market history. The practical effect is that we expect to take a moderate and less strongly hedged exposure to market fluctuations on a more frequent basis than we have since 2000, while maintaining our defense in conditions that have historically been hostile to stocks. Clearly, conditions that are associated with strong returns per unit of risk, regardless of what historical sub-sample one chooses, warrant greater exposure to market risk. Conditions that would have led to a wider variety of average outcomes, depending on the sample, warrant a more moderate stance. Conditions that are uniformly associated with poor outcomes, on average, almost regardless of the historical sample, imply that market risk taken in those periods is not only speculative, but dangerously so. Presently, we are not willing to take on a dangerous speculation simply because there are a few weeks of quantitative easing left. On the basis of factors that we can measure and test extensively over history, market conditions here warrant a fully hedged investment stance.
On that note, it's a little bit unfortunate that the overvalued, overbought, overbullish, rising-yields syndrome we've observed in recent months has provided us no chance to demonstrate anything different. But that's a short-term phenomenon that will pass. Presently, stock market conditions are hostile based on our prior approach to defining the Market Climate, and also based on the expanded set of Climates we implemented late last year. But while our current defensive position is "observationally equivalent" regardless of which approach we might take, there are significant differences in the positions implied by these approaches in previous years, particularly during the most recent market cycle. Regardless, both approaches would have been defensive since April 2010 around the 1200 level on the S&P 500, and there is not a chance that we would accept risk in the patently hostile set of market conditions we observe here. In short, we've already modified our hedging strategy to expand the set of Market Climates that we define, but because of present conditions, that has not yet resulted in a change to our hedging stance.
Approaching the Eraser
Two months ago, I noted that the surprise resignation of Wells Fargo's Chief Financial Officer had caught the eye of a number of shareholders, who noted my comment several quarters ago that we could observe a wave of fresh risk aversion "at the point where the first bank CFO resigns out of refusal to sharpen his pencil any further." My impression is that the underlying state of mortgage debt is no better than it was quarters ago, and indeed may be worse in the sense that there has been no meaningful decline in the backlog of delinquent and unforeclosed homes. While foreclosure filings certainly fell significantly in the first quarter, the decline was driven by record-keeping problems and legal moratoriums.
As Realty Trac observed, "Weak demand, declining home prices and the lack of credit availability are weighing heavily on the market, which is still facing the dual threat of a looming shadow inventory of distressed properties and the probability that foreclosure activity will begin to increase again as lenders and servicers gradually work their way through the backlog of thousands of foreclosures that have been delayed due to improperly processed paperwork."
It's fascinating to hear JP Morgan's Jamie Dimon complaining "We have homes sitting there for 500 days rotting that we can't do anything about" while at the same time reducing loan loss reserves on those assets. But of course, that's precisely what the FASB has allowed banks to do. Specifically, there is no longer any need to mark to market, and the FASB appears to have dropped any plan to restore it. The standard instead is "amortized cost" (on which basis you can continuously make the mortgages whole simply by tacking the delinquent payments on to the back of the loan). Little wonder half of all mortgage modifications re-default. The modifications themselves don't materially change the present value of the payment stream, and frequently don't reduce the payments themselves beyond the first year. Meanwhile, it's equally fascinating to observe how much bank earnings for the first quarter (thus far) have been driven by trading profits from commodities and fixed income (thanks Ben).
While the S&P 500 is slightly lower than it was when Wells Fargo's CFO resigned, it's probably worth noting that the CFO of Bank of America also resigned last week. The press releases focused on personal reasons in both cases, but then, those press releases on CFO departures invariably have a positive spin. We're reminded of how Citigroup reported that it had "promoted" its CFO to Vice Chairman in 2009, which the Financial Times later reported was part of an agreement with regulators that included the provision "Citigroup will initiate a process that will result in a decision on (a) whether the CFO for Citigroup ... can be more effectively utilized in other Citigroup responsibilities, and (b) if so, on replacements by a person ... with relevant financial, accounting or other experience acceptable to the agencies, with the results publicly announced by ... publication of Citigroup's third quarter 2009 earnings."
Maybe it's nothing. In any event, given that the FASB has moved in the direction of permanently disabling transparency, it's not clear that problems with bank balance sheets - even if significant - need to actually work their way through to regulatory events. What is more likely, though, is that credit conditions may be more sluggish to normalize than the upbeat bank reports of recent quarters may suggest. So my concern isn't so much a replay of the banking crisis and customer runs of early 2009, as much as it is with the headwinds for the banking system and the economy as a whole from continuing debt burdens that have not been materially restructured.
As noted above, the Market Climate in stocks last week remained characterized by a hostile syndrome of overvalued, overbought, overbullish, rising interest rate condition. Both Strategic Growth and Strategic International Equity are fully hedged. Our 10-year projection for total returns on the S&P 500 remains at about 3.4% annually based on our standard methodology, which has continued to perform well over time. It's worth repeating that our challenge in 2009 and early 2010 had nothing to do with the valuation aspect of our methodology, but instead with the "two data sets" problem that emerged when it became clear that economic conditions were wholly out-of-sample from the standpoint of post-war data that had been the primary basis of our analysis. The conclusion that stocks are richly valued and priced to achieve poor long-term returns is, on the basis of evidence and track record, difficult to get around without heroic and historically inconsistent assumptions.
The issue most open to question, in my view, is the length of time that stocks can hold up without clearing any aspect of the overvalued, overbought, overbullish, rising-yields syndrome we observe. Given that there are several weeks of quantitative easing left, and a small but non-zero probability that the FOMC could embark on yet another program of QE, there is really no way to eliminate that source of uncertainty. It depends far more on the caprice of speculators and policy-makers than on hard analysis or data. But regardless of that source of near-term uncertainty, the evidence implying a poor average return-risk profile in response to the syndrome of conditions we presently observe is clear.
The bottom line then, is that the market appears clearly overvalued, and the evidence for a defensive position in the present syndrome of conditions is strong. But unfortunately, there is no evidence that requires stocks to clear these conditions within a narrow time frame. Still, I strongly believe that a defensive stance remains appropriate here.
In bonds, the Market Climate last week was characterized by relatively neutral yield levels and moderately hostile yield pressures. Strategic Total Return presently has a duration of about 1.5 years, with about 6% of assets in precious metals shares. Generally speaking, precious metals shares have been a good proxy for foreign currency exposure in recent years, in that they have performed well on dollar weakness. As we look at the global economy, however, there are clear pockets of weakness in Europe and potential for slowing in emerging economies. Though precious metals and oil have remained generally strong, numerous other commodities are beginning to back off, and as I've noted in recent weeks, gold and other precious metals are showing characteristics consistent with a late-phase bubble. This is important from the standpoint of our investment choices.
When gold prices are constant or rising in terms of the Euro or other currencies, dollar weakness clearly translates to a rising dollar price of gold. However, given the pattern of economic and commodity price behavior we presently observe, it's not clear that commodity prices will remain firm as measured in foreign currencies. This means, in turn, that dollar gold prices (or oil prices for that matter) may not advance even in the event of further dollar weakness. As a consequence, gold may not be a very good hedge against dollar depreciation going forward. For that reason, I expect that we'll increasingly establish direct foreign-currency based positions in Strategic Total Return, in lieu of 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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