June 17, 2013
The Price of Distortion
"Today, an economic forecast is more like the analysis of a criminal mind than the evaluation of economic data."
Tyler Durden (pen name) at ZeroHedge
The central issue in the current financial markets, in my estimation, is distortion. Because monetary distortion dominates the financial markets here (helped by fiscal distortions that have temporarily elevated profit margins about 70% above their historical norms), the only certainty is that short-term market fluctuations will be dominated by the vagaries of the near-criminal mind that dictates how far those distortions will be pushed. Investors cannot control that decision. Still, I don’t have a single doubt that over the full course of the present market cycle, investors will be better served by adhering to informed discipline than by tying their destiny to predictions about what the Fed will or will not do next.
To fully understand that confidence in discipline, one needs to fully understand the market cycle. Since 1940, the market has experienced 13 bull market advances of at least 25% from a bear market low, and 13 bear market declines of at least 20% from a bull market high. Bull market advances during this period have averaged a 123% price gain, a 162% total return, and a duration of 4.4 years. Bear market declines during this period have averaged a 35% price loss, a 32% loss including dividends, and a duration of 1.3 years. So dividends have helped to boost the bull market gains and mute the bear market losses to some extent, but with a dividend yield of just over 2% on the S&P 500, this effect is not very strong at present. Combining bull and bear markets, the average market cycle has averaged a 45% price gain, a 79% total return, and a duration of 5.6 years. This works out to an annualized total return of 10.9%, and an annualized capital gain of 6.9%, that gap being bridged by dividends, which have represented nearly 40% of total returns over time.
Pre-war market cycles tended to be shorter and more violent. Taking market history since the early 1920’s, the market has experienced 23 bull market advances of at least 25% from a bear market low, and 23 bear market declines of at least 20% from a bull market high. Taken together, bull market advances during this period have averaged a 102% price gain, a 129% total return, and a duration of 2.9 years. Bear market declines during this period have averaged a 37% price loss, a 35% loss including dividends, and a duration of 1 year. Combining the two, the average market cycle has averaged a 27% price gain, a 50% total return, and a duration of 3.9 years (which is why market historians used to think in terms of a standard “4-year cycle”). All of this works out to an annualized total return of 10.9%, and an annualized capital gain of 6.3%.
There is a great deal of variation across individual cycles, and the precise averages here depend on exactly where the historical analysis starts, whether one uses price changes or total returns, and whether one uses geometric or arithmetic averages, but the overall profile of the typical market cycle should be clear. It's also worth reiterating that returns over any extended number of years have been highly dependent on initial valuations, and that we presently estimate a nominal total return for the S&P 500 averaging just slightly over 3% annually during the coming decade.
The most important feature of market cycles, in my view, is the impact of compounding. It is an important but easily forgotten fact of arithmetic that, for example, a 30% loss reduces a 140% gain to a 68% gain, while a 40% loss reduces a 140% gain to a 44% gain. Because of that compounding effect, it’s a simple fact that most bear market declines wipe out more than half of the preceding bull market advance. This effect tends to be more pronounced when the decline occurs from a point of rich valuations in the context of a “secular” bear market – a period where valuations begin at very high levels and gradually correct to more typical levels over the course of several market cycles.
The most richly valued bull market peaks in history, using the Shiller P/E* as a shorthand measure, were: 2000 with a Shiller P/E of 46, 1929 with a Shiller P/E of 39, 2007 with a Shiller P/E of 28, the post-crash rally peak of 1930 with a Shiller P/E of 26 (a temporary reprieve from the 1929 low, followed by the true collapse), and the recent peak in May 2013, with a Shiller P/E above 24 – not that it’s certain that the May peak was a bull market high. Each of those prior peaks was followed by a bear market loss of well over 40%. This time may be different, but as a far more general proposition, once a bull market advance reaches mature, overvalued, overbought, overbullish conditions, with deterioration in interest-sensitive securities and a broadening dispersion in market internals (advances vs. declines, new highs vs. new lows), any incremental bull market gains have always been surrendered over the completion of the cycle.
The “buy-and-hold” approach tends to recruit an increasing following near market peaks, because that’s where it has performed best in hindsight. I certainly don’t intend to discourage investors who follow a passive but disciplined approach using a balanced and well-diversified portfolio of investment classes. My concern is with investors who repeatedly “discover” buy-and-hold at peaks, and abandon other disciplines, only to abandon a buy-and-hold strategy after it experiences a major loss.
The tendency to chase approaches that have worked in the latest cycle is how investors get trapped into some “concept” by the end of every bull run; dot-com stocks, technology, financials, housing, the “conglomerates” and “tronics” stocks of the late-60’s go-go market, the Nifty-Fifty of the early 70’s, and so forth. The problem isn’t so much with the concepts themselves, and there’s nothing wrong with having some piece of one’s portfolio tied to some particular concept. The danger is in repeatedly shifting between disciplines, which is the hallmark of having no discipline at all. That’s why I’ve always begged readers not to listen to a word I say unless they are committed to our discipline over the course of a complete market cycle.
The dominant concept today, of course, is “Don’t fight the Fed.” Proof of success is easy to find in the period since 2009, but the evidence is far weaker in the historical record (see Following the Fed to 50% Flops). For that reason, my impression is that the appearance of success in this instance is an artifact of a cycle that is only half-finished, and that the unquestioned faith in Fed easing and “Bernanke puts” will be faced with yet another devastating counterexample before too long – though not necessarily in the immediate future. One might argue that the unconventional nature of quantitative easing means that this time is different, and that stocks will advance until QE ends, at which point everybody can safely take their profits. But this belief rests on the hope that tens of millions of investors can ultimately get out at prices that rely on all of them being in. Equilibrium is a tricky thing.
It’s notable that among a score of trend-following and fundamental strategies we track that have outstanding long-term and risk-adjusted records (some that serve as “base learners” in our ensembles), virtually none has outperformed the S&P 500 since about mid-2010. I certainly complicated matters with my insistence on stress-testing in 2009-early 2010, but the larger issue is whether investors should be abandoning disciplined long-term approaches for those that have performed best in the present cycle. Unless the new approach can also be demonstrated across numerous market cycles over a century of market history, and the “meta-strategy” of switching between approaches based on their recent performance has also been tested, the answer should be no.
To the greatest extent possible, when you’re switching from a security or strategy you believe is “lower ranked” to one that you view as “higher ranked,” it’s best to exit the lower ranked one on strength and to enter the higher ranked one on weakness (ideally absolute, but at least relative to each other). The tendency to repeatedly sell strategies that are down and buy ones that are up is among the main reasons for poor long-term investment performance. Even if you’re using trend-following methods, it’s best to act on longer-horizon trend-following signals by using short-term noise (e.g. retracements) opportunistically. Again, not that any of this has very helpful for a score of good strategies since mid-2010.
With regard to our own discipline, there are certainly periods since 2010 where a material retreat in valuations was followed by early improvement in market internals and the absence of an overvalued, overbought, overbullish syndrome of conditions. Based on much of the “exclusion analysis” we’ve applied over the recent cycle and have validated over a century of market history, that combination appears sufficient to override other considerations, encouraging a constructive investment stance even when our more general return/risk estimates for the market are negative. If the present bull market has more life to it, this sort of opportunity is likely to emerge again.
I admittedly arrived at that subtlety too late to benefit us in the most recent cycle, and it’s quite a source of frustration that we haven’t observed a similar opportunity in the past year. Still, we can interpret the absence of such opportunities in one of two ways. One might be that overvalued, overbought, overbullish conditions in mature bull market advances no longer matter as they have historically, and that we should abandon our concern about this syndrome because it has led us to miss out on some very successful speculation. The alternate interpretation is that the recent advance is a symptom of euphoria featuring increasingly immediate impulses to buy the dip; that in the context of what have historically been hostile conditions with terrible consequences, the uncorrected ascent is little more than the setup to an accident waiting to happen; and that speculators will not – in aggregate – be able to realize their recent paper gains. It will not take much reflection to guess which interpretation I believe is correct.
The way to make the most in a bull market is to take the greatest risk. That’s also the way to lose the most in a bear market. The distinction is particularly important to remember once an advance is mature, overbought, overvalued, and overbullish. It’s easy to forget how the “wealth” from dot-com, tech, commodities and housing speculation entirely vanished over the completion of those cycles. The primary, observable, testable conditions that preceded those meltdowns are also present here, though we can’t rule out the potential for short-term factors – and monetary enthusiasm in particular – to maintain the suspense for a bit. As the old saying goes – be careful not to confuse a bull market for genius.
*The Shiller P/E is the ratio of the S&P 500 to the 10-year average of inflation-adjusted earnings. While I often use the Shiller P/E as a shorthand valuation metric because of its popularity, numerous other valuation measures have an equal or stronger relationship with subsequent market returns. See Investment, Speculation, Valuation and Tinker Bell for several reliable measures and related calculations.
The Price of Distortion
An update on the effect of monetary and fiscal distortions here. First, with respect to monetary policy, the Fed has now pushed the size of the monetary base to over 20 cents per dollar of nominal GDP. We know from a century of data that short-term interest rates are tightly linked to the monetary base. Last week, a piece by Jon Hilsenrath of the Wall Street Journal triggered a great deal of excitement, underscoring that the Fed had no intention of raising its policy rates at any point in the near future. It’s difficult to see how this news was surprising.
Below, it should be evident that the Fed would have to dramatically reduce its portfolio simply to raise interest rates by a fraction of one percent. The chart is the real-world version of what economists know as the "liquidity preference" curve. Essentially, as the Fed creates more zero-interest money (relative to nominal GDP), cash becomes a "hot potato" and holders of cash seek alternatives, which drives down competing yields, particularly on "near-money" like Treasury bills. At present, the Fed is pushing on a string, and the entire force of Fed policy is based on the attempt to drive investors to hold securities of greater and greater risk in return for lower and lower prospective returns. All this despite decades of data that reject the notion of a material "wealth effect" from stock values to economic activity. People consume from their view of "permanent income" and do not respond to changes in the value of volatile assets - this is well established in both theory and evidence.
Note how far we have pushed the string. The Fed would have to reduce its portfolio by well over half to raise interest rates to 2%. So even if the Fed was to completely terminate new purchases of Treasury securities, that action would not be expected to raise short-term interest rates. This underscores the fact that reducing the pace of quantitative easing is not the same thing as raising the Fed’s policy rates. But it should also underscore how far the Fed’s policy has already gone, and how difficult it will be to normalize over time.
I continue to believe that continuing investment discipline will be a more effective approach than trying to second-guess the Federal Reserve, so my own views on this are purely for the sake of discussion. Although the minutes of the May Fed meeting noted that “A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth,” market expectations weigh heavily against the Fed dialing back the pace of quantitative easing at next week’s meeting. I don’t see that as something that investors should completely rule out, but my guess is that the accompanying statement will instead include increased references to “benefits” and “risks.” Taken together, the minutes of the May Fed meeting, coupled with several recent efforts by the Wall Street Journal’s Jon Hilsenrath to clarify Fed policy, implies the following general line of thinking at the Fed:
a) A balanced assessment of risks and benefits of further QE suggests that while the Fed intends to provide "monetary support" for a long time, there’s a reduced need for the acute, emergency intervention reflected in the current pace of QE, coupled with the potential for speculative distortions and longer-term inflation risks if the current pace is maintained;
b) The Fed does not intend a diagonal “taper” but instead will remain open to increasing or decreasing the pace of QE from time to time as it sees appropriate based on incoming data;
c) A reduction in the pace of quantitative easing should not be confused with an imminent hike in policy rates, as increasing the Fed’s policy rates would generally imply a significant reduction in the monetary base, which is not being contemplated at present.
That line of thinking seems likely to be expanded in the next few months. As the architect of quantitative easing, it’s clear that Bernanke leans toward barreling ahead. The real issue seems to be how strongly other Fed members will articulate an opposing view and bring the Fed closer to a middle path. We’ll see.
Frankly, I view the present course of monetary policy as reckless - not because it threatens inflation (which I don't think it will for several years), but because it diverts scarce capital away from productive investment and toward speculative activities; because it fails to act on any economic constraint that is actually binding here, so has little hope of providing the economic "support" that it purports to offer; because decades of historical evidence provide no basis to expect a material "wealth effect" from stock values to the economy; because the policy lowers hurdle rates and encourages borrowing for unproductive purposes - including stock buybacks at record highs (and there is no evidence that buybacks are a good indication of value); because it punishes the elderly on fixed incomes; because it perpetuates a bubble-bust cycle created by Fed intervention, which is not the medicine but the very poison itself; and because moving to the left on the liquidity preference curve will likely be as painful as moving to the right has been pleasant. Meanwhile, we’ll continue along a studied, disciplined course over the remainder of this market cycle, considering a broad ensemble of evidence that has been validated across market cycles throughout history. Our views will change as that evidence does.
As for fiscal policy, I’ve published a chart on several occasions showing the tight mirror-image relationship between combined government and household deficits, and corporate profits as a share of GDP. It’s worth pointing out that this relationship is not just in levels, but also in changes. Importantly, corporate profit growth has slowed dramatically. In the most recent quarterly GDP report, U.S. corporate profits quietly declined by more than $30 billion.
The chart below should make it fairly evident that an elevated share of profits to GDP is tightly related to weak subsequent profit growth (the right scale is inverted), and one does not need to make particularly “long run” assertions about this process. I continue to expect corporate profits to contract significantly over the next few years.
The following chart should also make it clear that the primary driver of variation in corporate profits is variation in the combined deficit of the government and household sectors. Simply put, the deficits of one sector must emerge as the surplus of another. There’s no debate that corporations are “leaner” and that rising international sales have been beneficial. If one doesn’t believe that competition will erode that benefit, we might even get a durable lift to profits, perhaps a point or two above 6% of GDP. Still, the debate is about relative magnitudes. The government deficit alone recently blew out to 10% of GDP. Where did it go? Well, total U.S. corporate profits are normally only about 6% of GDP, but they recently blew out to 11% of GDP. It should be obvious that the impact of deficit spending was not just a tiny second-order effect. To the contrary, it’s been the primary driver of margin variations in recent years, and that driver is coming off. Changes in the combined government and household savings have a tight historical relationship with changes in profits as a share of GDP. This should not even be the subject of serious debate.
Of course, one might explain elevated profits by observing that wage payments as a fraction of GDP have fallen to the lowest share in history, that high government transfer payments have supported consumption, and that companies took a year’s worth of benefit from investment tax credits in the first quarter, which also contributed to profits. All of these are true, but they are operationally identical to saying that the household and government sectors are running a large combined deficit.
The bottom line is simple. Corporate profits have benefited in recent years from enormous fiscal distortions that have bloated margins 70% above their historical norms. Stock prices have benefited in recent years from enormous monetary distortions that have suppressed interest rates and encouraged investors to “reach for yield.” Combining those effects, investors have been encouraged to chase stocks, placing elevated price/earnings multiples on already elevated earnings. Investors who value stocks on the basis of these distortions are likely to discover in hindsight that they have paid a very dear price.
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. Only comments in the Fund Notes section relate specifically to the Hussman Funds and the investment positions of the Funds.
As of last week, market conditions remained characterized by overvalued, overbought, overbullish conditions, though sentiment has eased somewhat from recent extremes. Strategic Growth remains fully hedged, with a “staggered strike” position that raises the index put option side of its hedge within a few percent of present market levels. Given the potential for Wednesday’s Fed statement to have a “binary” impact on the market, coupled with the slight easing of sentiment last week, we did pick up a small contingent call option position representing a small fraction of 1% of assets, which could help to offset the impact of nearly 25% of our hedges if the Fed signals a still-open throttle next week (which I doubt, but can’t rule out). Strategic International remains fully hedged. Strategic Dividend Value remains hedged at about 50% of the value of its stock holdings. Strategic Total Return presently has a duration of about 3 years (meaning that a 100 basis point move in interest rates would be expected to impact Fund value by about 3% on the basis of interest rate fluctuations), with less than 10% of assets in precious metals shares, as we view valuations as favorable here, but real interest rate pressures are clearly upward, which create a headwind for precious metals in the near term.
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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