July 5, 2011
Chutes and Ladders
In 1943, Milton Bradley introduced a board game called Chutes and Ladders, inspired by an 18th century game from India. The object is to make your way step-by-step from the bottom of the game board to the top, while you periodically come upon ladders that help you advance more quickly, or fall into chutes that set you back, sometimes a great distance. In the Indian game, ladders represent the good karma from following the path of virtue (faith, reliability, generosity, knowledge), while the numerous chutes represent the bad karma that follows from taking the path of vice (disobedience, debt, vanity, greed). In the Milton Bradley (now Hasbro) version, there are illustrations of children doing good or helpful actions at the bottom of each ladder, and illustrations of the happy consequences at the top. In contrast, the top of each chute depicts children doing irresponsible things, with an illustration of the unfortunate consequences at the bottom.
On October 9, 2007, the S&P 500 reached a bull market peak, which was followed over the next 18 months by a stunning market plunge which wiped out more than half of the market capitalization of U.S. stocks. As any number of weekly comments at the time should demonstrate, the crisis was the fairly predictable result, albeit of uncertain timing, of reckless speculation in the housing market, irresponsible yield-seeking among lenders, exuberant overvaluation in the equity market, overbullish sentiment, failure of investors to consider the cyclicality of profit margins, and a variety of other factors. Investors plunged down a terribly deep chute. While we avoided a great deal of damage, even our fairly cautious response to improved valuations and periodic improvements in market action in late-2008 was punished, but we slipped down a comparatively smaller chute.
Since early 2009, assisted by the largest fiscal and monetary intervention in U.S. history, coupled with changes in U.S. accounting rules, investors have essentially climbed back to rejoin us. The S&P 500 is now about even with the Strategic Growth Fund (within a fraction of 1%) since the 2007 peak. It is not clear that the policies contributing to this recovery have been particularly virtuous, driving the U.S. debt/GDP ratio toward 100%, leaving the Federal Reserve leveraged over 54-to-1, and bringing the valuation of the S&P 500 to the point where we estimate prospective total returns of just 3.8% annually for the index over the coming decade. Given the assumptions required to justify further risk-seeking and elevated valuations (permanently wide profit margins, sustained monetary distortions, further sovereign bailouts, avoidance of state and municipal strains, and other factors), there's a good chance that investors have simply clawed their way to the top of another chute, but that remains to be seen.
Nevertheless, the average investor plunged down a steep chute in the first part of the present market cycle, and has rejoined us after the recent advance. Meanwhile, we initially slipped down a more modest chute, and have more or less stayed put since 2009.
But why? Was staying put during this advance a standard feature of our investment approach? Has this period been representative of the hedging strategy in Strategic Growth Fund? Should investors expect us to respond to future advances the same way? For long-term shareholders, and frequent readers of these weekly comments, our ongoing and hopefully transparent discussion of our concerns and research efforts since 2009 should make it clear that the answer is "no."
Recall that we entered this crisis with a hedging approach that was essentially suited to the Chutes and Ladders of post-war data. While we anticipated that a significant amount of debt would have to be restructured, I expected what I called a "writeoff recession" that would not necessitate major economic disruptions, provided that bondholders accepted losses from bad loans that they knowingly made at a spread. As the crisis unfolded, policy makers chose a course far different than we viewed as appropriate (defending private debt and distressed sovereign debt with public funds, altering accounting rules to effectively allow insolvency, and aggressively damaging public confidence with catastrophic "either-or" rhetoric in order to frame the bailouts as the only option).
As the crisis unfolded, were forced to contemplate data and outcomes from prior credit crises, including the Great Depression. Those game boards were strikingly different. Conditions that would reasonably be associated with ladders in post-war data were instead associated with deep chutes in Depression-era data. Taking average outcomes of any small number of models (post-war, post credit-crisis) still led to negative expected returns, because the outcomes in Depression-era data were so hostile. So we remained defensive, choosing first to do no harm. At the same time, we responded by modifying our hedging approach, in order to broaden our ability to deal with these uncertainties in a more nuanced way. I expect that this will be of benefit in the coming years, because I do not believe that underlying credit issues facing the economy have receded to nearly the extent that investors imagine.
A side note - we make an important distinction between "risk" and "uncertainty." As I've noted before, risk describes the "spread" of a known probability distribution - for example, the chance that you'll roll something other than a 7 given that you know you're throwing two six-sided dice. Uncertainty emerges when you don't even know whether the dice have six sides, so you are forced to entertain the possibility that your entire model of the world is incorrect. In the past two years, our research efforts have been singularly directed at measuring uncertainty and dealing with it in a very disciplined way.
The simple fact is that we are all playing a game of Chutes and Ladders where it is not at all clear which game-board is applicable. To believe strongly in a certain investment outcome is to imagine that there is only one correct model of the world, and that the correct model is in hand. Investors appear very eager to apply post-war norms to the economy, and to apply the elevated valuation norms of the past two decades to the stock market. I doubt that these models represent the correct view of the world, but our approach is to allow for these possibilities and dozens of alternate ones.
As I've noted in several recent weekly comments, our eventual resolution of the "two-data sets problem," as I described it in 2009, is to discard the belief that one model, or any small number of models, is the correct way to view the world, and to instead proliferate dozens of models each estimated over different subsets of historical data and different subsets of indicators. These still emphasize measures of valuation, market action, credit spreads, interest rates, sentiment and other factors with strong theoretical and historical support, but there is no single "master" among them. The performance of the ensemble is typically much stronger (and generalizes better to new "out-of-sample" data) than any of the components.
If the conditions we observe at a given date have been associated with positive market returns in a significant plurality of models and data-samples, we have positive expected returns and low uncertainty - a reasonable basis to accept market risk. If the average expected return is positive, but with a great deal of variability and many negative outcomes among individual models, we have positive expected returns but high uncertainty - which warrants a positive but more restrained exposure to market risk. If the average expected return is negative, and particularly if the ensemble of models is uniformly negative, accepting market risk is not supported by the evidence.
In hindsight, the points where the ensemble suggests significantly different positions than we took in practice were late-2008, when they were even more defensive than the limited exposures we accepted, and in 2009 through about April 2010, when the ensembles were generally more constructive. Frankly, this approach would still have rejected a material market exposure during the recent period of quantitative easing - the historical tendency of the market to generate poor average returns in overvalued, overbought, overbullish, rising-yields conditions is simply too strong. So with minor exceptions, our experience over the past year would have been about what it has been. But then, had our present approach been in hand since 2008, I doubt that we would be as uncomfortable with the modest net loss that we've experienced since early 2010 in Strategic Growth.
While the S&P 500 remains below its 2007 market peak, it is clear that investors are excited at the amount of ground that they have recovered thanks to extraordinary government interventions. With regard to the future course of the market, we don't get the luxury of certainty. The best we can do is to estimate probable returns, and the likely range of uncertainty. When we look over the past two decades, the highest points of measured uncertainty were in 1998 during the Asian crisis and the collapse of Long Term Capital Management, late 2001 just after 9/11, 2008 following the Lehman collapse, and summer 2010 just before the Fed launched QE2. Presently, the expected return estimates are negative on average, and are nearly uniformly negative across dozens of ensemble components. So we expect negative returns, with little uncertainty about it. A further improvement in market action, without a surge in bullish sentiment, would introduce more dispersion into expected outcomes and could move us to a moderate, if transitory market exposure. Here and now, we are defensive.
The past few years have been excruciating for investors. For buy-and-hold investors, the discomfort was concentrated at the front-end. For us, the discomfort has been on the back half. None of us gets a do-over, so the real question is how well we are prepared to deal with future market opportunities and uncertainties. I believe that we are well equipped.
The benefit of controlled risk and the avoidance of deep drawdowns is that it is often possible to recover lost ground rapidly, particularly relative to a passive buy-and-hold. Regardless of the course of the market in the coming months, my expectation is that we will see steep chutes in the coming years, and that there will be much greater success to be had from taking a future ladder at a low rung than attempting to climb the present one at elevated levels. From the simplistic level of discourse we observe in the investment markets, and the lack of concern for disciplined process and effective risk control, it is not clear that investors are broadly prepared to navigate the landscape ahead comfortably.
A few observations on present market conditions. A week ago, I noted "we expect that enthusiasm about Greece may provoke short-lived market spikes and short-squeezes, but little of durable effect for the stock market." Indeed, last week's advance off of the recent correction trough had very common features of a short-squeeze, particularly weak trading volume. A panic to cover shorts coupled with sellers backing off is typical behavior that produces price jumps on low volume. While my impression remains that last week represented a short-squeeze, we are not tied to that view, and a further improvement in market internals (without a surge in bullish sentiment) could provide a basis for some limited exposure. That said, the type of short-squeeze behavior we saw last week has a nasty tendency to be whacked within a fairly short window, so market action in the next few weeks could have more than the usual amount of information content. On the valuation front, last week's advance brought our 10-year projection for S&P 500 total returns back down to 3.8% annually - and it will remain important to monitor prospective returns from a longer-term perspective.
As a further note on valuation - we continue to hear valuation comments from Wall Street analysts that amount to "forward operating earnings times arbitrary P/E." In selecting the appropriate P/E to apply to forward operating earnings, two factors are important. One is the level of profit margins embedded into the forward operating earnings, since the subsequent multi-year growth of earnings (however measured) has an inverse relationship with the level of profit margins. Profit margins mean-revert over any extended period of time, and if we care about stocks as a claim on a stream of future cash flows (not just a multiple of current ones), the assumed level of profit margins is an essential consideration.
Second, Wall Street gets away with a great deal when talking about forward operating earnings, because the concept is not even defined under generally accepted accounting principles (GAAP), and was essentially created by Wall Street itself in the early 1980's. This has the lovely benefit of depriving forward operating earnings of any tie to long-term historical evidence. As a result, the "norms" that analysts apply to forward operating earnings are largely reflective of recent bubble valuations, and as such, are also norms that have been associated with more than a decade of near-zero net market returns.
Still, if investors are going to use forward operating earnings, it is essential to put them into a more complete context. Below, we've charted the S&P 500 price/forward-operating-earnings multiple against the Shiller P/E (10-year average reported TTM earnings with an inflation adjustment). By and large, and even with periodic distortion from profit margins, the two line up fairly well despite the shorter history of forward operating earnings. The relationship, of course, is not one-to-one. Since forward operating earnings are invariably far higher than the 10-year average of past net earnings, the price/forward-operating-earnings multiple generally runs at about 60% of the Shiller P/E.
Given over a century of data demonstrating that Shiller P/E's much above 20 have been hostile for long-term investors, we have to recognize that the corresponding multiple on forward operating earnings is only about 12. Moreover, even in post-war data, the deep-value points such as 1950, 1974 and 1982 map to forward operating multiples of about 5 or 6. What Wall Street analysts don't really think to mention is that the S&P 500 price/forward operating earnings multiple was identical to present levels the week before the 1987 market crash. For our part, we prefer to approach valuation from a "stream of deliverable cash flows" perspective that considers profit margins, dilution, reinvestment of earnings, and other factors, but investors who prefer to use simple price/fundamental multiples would be well-advised to at least seek out robust historical norms.
Turning to the subject of monetary policy, according to the Fed's consolidated balance sheet , the Fed now holds assets $2.87 trillion, versus $52.87 billion in capital, putting it just north of 54-to-1 leverage. Now, given that the average duration of the Fed's holdings works out to something in the neighborhood of 6 years, an increase in interest rates of roughly 30 basis points is now enough to completely wipe out the Fed's capital. Needless to say, given the recent spike in Treasury yields, we would have observed a huge hit to the Fed's reported capital in recent weeks if the Fed was to allow such losses to actually flow through to the capital line of the balance sheet. Of course, that's why the Fed changed its accounting a few months ago to allow such losses to show up as a "negative liability" - basically consuming interest that the Fed receives on the Treasury debt it holds, which would normally be remitted back to the Treasury for public benefit (yet another example of altering accounting rules to effectively allow insolvency).
There's also a creepy line item that recently reappeared on the liability side of the Fed's balance sheet, called "U.S. Treasury, supplementary financing account" which basically represents proceeds of government borrowing that the Treasury transmits directly to the Federal Reserve. That account had its origins during the height of the financial crisis, where it grew to about $300 billion before it was unwound. As economist James Hamilton noted at the time, the novel line item on the Fed's balance sheet was accompanied by a "rather obscure" press release by the Treasury, noting:
" The Treasury Department announced today the initiation of a temporary Supplementary Financing Program at the request of the Federal Reserve. The program will consist of a series of Treasury bills, apart from Treasury's current borrowing program, which will provide cash for use in the Federal Reserve initiatives."
Needless to say, the Treasury probably cannot do much more with this until the debt ceiling is raised, but we wonder to what extent the public, or even most members of Congress, are aware of this provision at all.
As of last week, the Market Climate for stocks was characterized by unfavorable valuations, and still mixed market action. As noted above, if market internals improve somewhat further without a quick increase in bullish sentiment (though bearish sentiment is still fairly low), we would expect somewhat more dispersion in expected returns, which could allow for a modest, if transitory exposure to market risk. At present, we are defensive in both Strategic Growth and Strategic International Equity, and will shift our exposures as the evidence changes.
In bonds, the Market Climate remains characterized by unfavorable yield levels and now hostile yield pressures. Most of our roughly 2.5 year duration is in fairly short duration Treasury debt, where we don't anticipate strong yield pressures. Still, we don't have sufficient evidence here to respond to the recent uptick in yields by increasing our long-maturity holdings. The clear area where we are observing strong expected return/risk profile is in the area of precious metals shares. Note that the specific market is the equities, and not necessarily physical gold. While they are of course related, the ratio of gold prices to gold shares is exceptionally high here, which provides something of a margin of safety in the event of a commodity price decline, while allowing the potential for a disproportionate advance in the stocks if precious metals prices advance. Strategic Total Return presently holds about 18% of assets in precious metals shares. This is the primary source of day-to-day fluctuations in the Fund at present, though of course those fluctuations may be positive or negative. Still, our response is proportional to the expected return/risk profile we estimate, and at least in this sector, we observe a clear basis for exposure to market fluctuations.
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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