June 6, 2011
Last week, we observed a significant deterioration of market internals. On the slightly brighter side, from a valuation perspective, the pullback in the market has modestly increased our estimate of likely 10-year S&P 500 total returns from about 3.4% at the market's peak to about 3.9% presently. That's an improvement, but the muted extent of that improvement should provide some indication of the extent of market losses that would be required to restore meaningfully attractive prospective returns.
From the standpoint of market action, we presently see two lines of critical support. The first is right here at current levels. A week ago, I noted that "one or two more reasonably sloppy weeks would significantly damage market internals." Last week's market action was more than sloppy, with the result that even another modest down week would signal a measurable shift of investors toward risk aversion - and if history demonstrates one thing, the worst periods for the market are those where risk premiums are thin and risk aversion is increasing. A second line of support corresponds to the March lows, where a deterioration would throw a great number of technical trend-following methods simultaneously into sell mode. Whatever one thinks of those methods, investors should probably not ignore the prospect of a speculative liquidation in a market too overvalued for fundamentalists to be interested.
My guess (which we don't trade on and neither should you) is that after several weeks of declines, the market has a good chance of stabilizing and possibly advancing from the present line of support, as investors try to "buy the dip" despite weakening economic data, divergent market internals, and limited prospects for further government stimulus. This is also the general picture for various ensembles of market conditions we examine - relatively neutral short-term (improved from quite negative a few weeks ago), but still with a negative average return/risk profile looking out more than a few weeks. For our part, our overall range of flexibility remains between a tight hedge and about 10-20% exposure to market fluctuations, with a strong line of downside protection still essential in any event. Again, this is because a break of various nearby support levels here would likely prompt an exodus by a large trend-following contingent of speculators, in an environment where value-conscious investors would not have much interest except at substantially discounted valuations.
In recent weeks, and particularly in last week's ISM, employment claims and unemployment reports, we've observed a substantial weakening in measures of economic growth. At present, the evidence of economic deterioration is not severe - as I noted in 2000, 2007 and last summer, recession evidence is best obtained from a syndrome of conditions, including the behavior of the yield curve, credit spreads, stock prices, production, and employment growth. While all of these components have weakened, they have not deteriorated to the extent that has (always) accompanied the onset of recessions.
To a large extent, the current softening of economic conditions is really nothing more than the recrudescence of the deterioration we saw last summer. Basically, we're coming up on the can that the Fed kicked down the road when it initiated QE2. While the Fed was successful in releasing a modest amount of pent-up demand, and was certainly successful in provoking speculative activity, there was never a realistic prospect of creating a beneficial "wealth effect" for the economy as a whole. The historical evidence is emphatic that people consume off of perceived "permanent income" - not off of volatile dollars. Wealth is driven by the creation of long-term cash flows through productive investment, not by boosting the valuation of existing cash flows by encouraging speculation. There was no reason for people to take much of a permanent signal from fluctuations in a stock market that has lost more than half of its value twice in a decade (and is likely to lose a good chunk of its value again if history is of any indication).
So while the Fed has been successful in fostering speculation, further impoverishing the world's poor through commodity price increases, and subsidizing banks by driving funding costs to zero (at the expense of the risk averse and the elderly), QE2 has clearly failed from an economic standpoint. This failure is not because we haven't given it enough time, or because monetary policy works with a lag. Rather, the policy has failed because it focused on easing constraints (bank reserves, short-term interest rates) that weren't binding in the first place. Very simply, neither the Fed's policy, nor the fiscal policy initiatives to date, address the central challenge that the U.S. economy faces, which is the debt burden on households.
The salient problem in the U.S. economy isn't the precise level of already low mortgage rates. It isn't "uncertainty" about taxes or health care. The problem is that people aren't spending as they did in recent decades, because that spending was largely debt-financed, and the pressures now run in the opposite direction. We still haven't restructured mortgage debt on millions of homes that are underwater. Property values are hitting new lows. Hundreds of thousands of properties are delinquent and yet the mortgages are being carried by the banking system at face value. Banks, knowing this, are clearly reluctant to extend their balance sheets further. Government deficits of nearly 10% of GDP are presently required to cover the gap in private incomes and spending. Indeed, most of what we observe as personal income growth is attributable to transfer payments from government.
To be clear, I believe that about 90% of the economy is functioning reasonably well (in the typical range of what is experienced over an economic cycle), but 10% of it is in extreme difficulty well outside what is seen in the normal cycle, and is only floating thanks to deficit spending that is unsustainable in the long-term and increasingly under pressure in the short-term. The problem is that we measure severe recessions as declines in GDP on the order of 2% or so. Without addressing the central problem of household indebtedness and underwater mortgages, the economic growth we get may not be robust enough to avoid more frequent recessions and near-recessions.
As disappointing economic news mounted last week, the attention of market participants immediately turned to policy responses, the most obvious one being - will the Fed embark on QE3?
In my view, there are three central questions relevant to this issue. The first is simply this: Has QE2 been successful in a way that the economy should desire more of it?
When the Fed initially embarked on QE2, there was at least some amount of hope that it would provoke a strong economic response (despite the lack of historical evidence that stock market fluctuations have more than a minuscule wealth effect). If the Fed were to embark on a version of QE3, it would probably be much more difficult to convince an increasingly skeptical public of the potential benefits, and not insignificant risk of political and international criticism, as well as moves to restrict the Fed's independence.
The second question is this: How much scope for intervention does the Fed have left? As of June 1, according to the Fed's consolidated balance sheet, the Fed is now leveraged 53-to-1 ($2.79 trillion in assets / $52.6 billion in total capital). This is more extended than Bear Stearns and Lehman were just prior to their failure. The principal difference being that the U.S. Treasury, and by extension, the U.S. public, is on the hook for any losses incurred by the Fed.
Also as of June 1, the Fed's SOMA portfolio stood at $2.561 trillion (with an explicit QE2 target of $2.6 trillion), leaving $39 billion of purchases remaining under QE2. Given the pace of the Fed's purchases, this amount should be completed by the end of the coming week. We already have nearly 18 cents of monetary base outstanding per dollar of nominal GDP. In order to absorb this amount of base money without provoking inflation, short-term interest rates have to be held at literally 2 or 3 basis points. Higher interest rates would provide too much competition, discouraging anyone from willingly holding the stuff, because base money doesn't bear interest except to the extent the Fed actually pays banks to hold it (and when you're leveraged 53-to-1, you don't have much room to do so).
Even a "moderate" program of $200 billion more Fed purchases would simply create even greater extremes, and would compound the already enormous difficulty that the Fed will face at the point that it attempts to normalize Fed policy in the least. Below, I've updated the liquidity preference schedule, reflecting nearly 70 years of monthly U.S. data. Notice that the willingness to hold base money is tightly related to the level of interest rates. More importantly, notice the non-linearity of the relationship. In order to achieve a non-inflationary increase in short-term interest rates to even 0.25%, the Fed would effectively have to reverse the entire amount of purchases it executed as part of QE2. Extending this policy to QE3 would only amplify the disruptive effect of any future Fed unwinding.
The third consideration relevant to a possible QE3 is this: Is Ben Bernanke so invested in this attempt at balance-sheet expansion that he will push forward an extension of the policy despite its economic ineffectiveness and speculative distortions? It is on this question that the prospect for QE3 ultimately turns. Given Bernanke's disregard for the statutory restrictions of the Federal Reserve Act (which I've detailed elsewhere) and his clear willingness to expand the Fed's balance sheet to breathtaking leverage ratios, it may not be helpful to judge the prospects for Fed policy on the basis of what would be reasonable, empirically sound, or even legal. Moreover, the objections of various Fed governors to QE2 have been based more on the idea that "we've done enough," rather than any recognition that the policy itself is ill-advised, and would be so even in a further economic downturn because it doesn't act on any binding economic constraint in the first place.
With little doubt, the most likely effect of further economic deterioration will be a commitment by the Fed to sustain "extraordinarily low interest rates" for an even more extended period of time. But this is something that market participants are well aware of. Despite our view that any further extension of quantitative easing would be both misguided and reckless, we simply can't rule it out because frankly, we believe that Bernanke himself is misguided and reckless. The real issue for investors is how the prospect affects the potential return/risk profile of the markets.
On that note, it seems unlikely that we will observe a push toward QE3 unless we observe substantially more economic weakness than we've observed to date. Moreover, much of the strength of the market's response to QE2 appears to have been conditioned by the fact that stocks were down substantially from their prior highs when Bernanke began discussing the policy. The upshot is that we view the likelihood of QE3 as fairly remote, but we can't rule it out. Even so, the prospects of QE3 and further Fed-induced speculation are probably not worth contemplating until we first observe significant economic and market weakness.
On the mechanics of Property Appreciation Rights (PARs)
Last week, the Case-Shiller home price index hit a new low, dropping below its April 2009 trough. As I've argued throughout the recent financial crisis, the most important policy initiative to help the economy forward in a durable way (aside from expanding bank capital requirements, including contingent capital such as convertible debt), is to restructure debt burdens. This does not mean debt forgiveness, and it does not mean massive government bailouts. It means using government as a coordination mechanism to change the structure of payment obligations in a way that allows the debt to be serviced. Below is an extension of my early 2009 views on property appreciation rights as a mechanism to achieve this end without the need for widespread foreclosures, but also without the dangerous prospect of running the U.S. banking system as a Ponzi scheme (which is largely what FASB rules allow at present). Two years later, and it is not evident that we need this sort of approach any less. Here are the details of my proposal to establish property appreciation rights ("PARs"), which engage the Treasury to coordinate (but not subsidize) the restructuring of mortgage debt:
Suppose a $300,000 mortgage is in foreclosure (or the homeowner and lender can agree to the following arrangement outside of foreclosure court). One possible mortgage restructuring might be to cut the principal of the mortgage to $200,000, and to create a $100,000 PAR. The homeowner would agree to pay off the PAR to the Treasury (and administered through the IRS) out of future price appreciation on the existing home or subsequent property. Ideally, the actual restructuring would involve a PAR obligation of less than $100,000 - possibly half the amount of principal reduction, but some mutually acceptable proportion could likely be negotiated.
The homeowner would be excluded from taking on any home equity loans or executing any "cash out" refinancings until the PAR was satisfied. The maximum PAR obligation accepted by the Treasury would be based on the value of the home and the income of the homeowner. The program would only be available for mortgages restructured to the point that they were no longer underwater. The lender would receive not a direct claim on that homeowner, but a participation in the Treasury's "PAR fund" which would pay out proportionately out of all PAR proceeds received by the Treasury by homeowners over time.
There could be, say, five PAR tranches, each corresponding to mortgages in a given quintile of loan/value ratios. This would keep mortgages of generally like-quality in the same tranche. The "nonparametric" use of quintiles would be helpful in preventing a version of "bracket creep" in assigning mortgages to different tranches as the housing market fluctuates.
Some technical details: New shares in the PAR fund would be assigned based on a ratio reflecting the extent to which existing shareholders have already been paid off, so earlier shareholders don't receive more than they have coming to them. The number of shares per dollar of unpaid PAR face value would vary accordingly. For example, suppose the first lender participating in the program claims $100,000 in face value. That first lender would get 100,000 PAR "shares." Now suppose that $50,000 of that obligation is repaid by the homeowner, which flows through to the existing PAR shares. Now another lender comes in and submits $100,000 of face value to the Treasury for PAR shares. Clearly, you don't want to issue another 100,000 shares, because that puts the first lender - who has already received partial recovery - in a better position than the second. Instead, you want the ratio of new shares to existing shares to be equal to the ratio of new obligations to existing unpaid obligations. Stated equivalently, the "Issuance Ratio" - the number of PAR shares a newly participating lender gets, per dollar of new obligations, would be equal to the ratio of existing shares to existing unpaid obligations. So the second lender gets 200,000 PAR shares. This works out, because if all of the $150,000 unpaid claims were eventually received, $50,000 would go to the first lender (who already received $50K), and $100,000 to the second.
The amount of total unpaid principal per share (say, "UPS" - basically, the reciprocal of the Issuance Ratio) would be reported daily by the Treasury. In this case, it would now be $150,000 / 300,000 shares = $0.50/share. Notice that this figure doesn't mean that loans are selling at 50 cents on the dollar. Rather, the UPS is simply the amount of principal claimed by a par share. The "cents on the dollar" calculation would be the market price of the PAR shares divided by the UPS. So if investors were willing to pay $0.50 for a PAR share with a UPS of $0.50, it would reflect full confidence in repayment, whereas a market price of $0.40 would mean that investors expected "80 cents on the dollar." The entry of new lenders into the program wouldn't reflect hostile dilution, because all new share issuance would come with new claims on the same terms as existing claims. The only time the UPS figure drops is when a payment is made to PAR shareholders, much like an "ex-dividend" adjustment.
Lenders could sell their PAR shares on the open market, much as closed-end mutual fund shares are sold. Likewise, homeowners could buy PAR shares on the open market and tender them to the Treasury at the prevailing UPS rate, in lieu of monetary payment (at least for some portion of their obligation). Of course, it's unlikely that market participants would buy them for the full amount of unpaid principal per share, so the PAR shares would generally trade at a discount. That discount would reflect the general confidence of market participants in the housing market, and the open market prices of the PAR securities would fluctuate like any other investment class. The key to creating a market for these, of course, would be the centralized coordination of payments through the Treasury.
Importantly, the Treasury would not guarantee repayment, but would simply serve as a conduit. There would be no "free lunch" at taxpayer expense. If the homeowner was to eventually sell the home and not purchase another, the obligation would become a low-interest loan obligation (possibly even one that decays over time) and would eventually be a claim on the estate of the homeowner, possibly with an initial exclusion at low income and a progressive recovery rate based on the size of the estate. While one can imagine linking the PAR to the property itself rather than to the homeowner, nobody would buy those homes except at a discount to their open market value, and in most cases, at a discount to the remaining mortgage balance, which would require the original homeowner to make up the difference with cash that is probably not available. As long as the Treasury provided details on the broad distribution of properties, mortgage balances, income statistics and so forth, markets could value the PARs just like any other security where uncertain cash flows must be estimated.
The PARs would be tradeable, since each tranche would be based on a single pool of cash flows, though again, they would almost certainly trade at a discount to face value. Assuming that the PAR obligations are fixed and don't increase at some rate of interest, then even if home prices were expected to take about 15 years to recover, the PARs would still trade at a market price of well over 50% of UPS. Given that recovery rates in foreclosure are running at only about 50% of the entire loan, it is clear that this sort of approach would be preferable to foreclosure. If it were available, lenders might agree to outright principal reductions as well in preference a costly foreclosure process.
The housing market does not need government bailouts nearly as much as it needs government coordination. The use of PARs would reduce foreclosures without relying on free money from the government, or violating contract law. The PARs would provide a legally enforceable, diversified stream of cash flows at far lower cost than individual lenders would have to spend to collect from individual homeowners. Since home sales are taxable events, the IRS would be in an ideal position to enforce these obligations.
As of last week, the Market Climate for stocks was characterized by unfavorable valuations, tenuous market action, and abruptly deteriorating economic indicators. In Strategic Growth, about 35% of our hedge represents put options only, with an overall strike price distribution that provides a relatively tight hedge locally in the event of further market weakness, but with a somewhat softer effect in the event of market strength. We've had good opportunities to vary our exposure modestly in recent weeks, though still in a relatively limited range, and consistently with a line of defense against any extended weakness. Strategic International Equity also remains well-hedged at present. Strategic Total Return continues to carry a moderate but positive duration, which has benefited from the downward pressure on Treasury yields, and we have been gradually accumulating precious metals shares on weakness, given a variety of factors including a high gold/XAU ratio, downward pressure on Treasury yields, ISM weakness, and negative real interest rates, all which have historically been supportive for that asset class.
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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