No Such Thing as Risk?

30 juillet 2012

John P. Hussman, Ph.D.

The enthusiasm of investors about central-bank interventions has reached a pitch that is already well-reflected in market prices, and a level of confidence that with little doubt, investors will ultimately regret. In the face of this enthusiasm, one almost wonders why nations across the world and throughout recorded history have ever had to deal with economic recessions or fluctuations in the financial markets. The current, widely-embraced message is that there is no such thing as an economic problem, and no such thing as risk. Bernanke, Draghi and other central bankers have finally figured it out, and now, as a result, economic recessions and market downturns never have to happen again. Lire la suite »

A Brief Primer on the European Crisis

20 juin 2012

John P. Hussman, Ph.D.

With Greek elections resulting in a fairly benign outcome that promises to hold the euro together in the near-term, the market may enjoy some amount of relief. The extent and duration of that relief will be informative. Based on broader factors, we don’t expect that relief to survive very long, but we are willing to respond more constructively if our own return/risk measures become more favorable. Lire la suite »

Australia: Mine, all mine

18 juin 2012

Financial Times

Profiting from Asia’s rise and dependence on mineral exports is hurting competitiveness

Steve Sargent, the head of General Electric’s operations in Australia, says people are often surprised to learn that a nation of 22m is now one of GE’s biggest markets – bigger than China in fact. The secret lies in a resources boom that allows the conglomerate to sell locomotives, turbines and underwater technology for the massive mining and energy projects that abound across the island continent. But it is misleading to see this purely as an Australian success story. Lire la suite »

Spain and the final battle for the euro

7 juin 2012

Financial Times

Luis de Guindos, Spanish finance minister, said last month that the battle for the euro was going to be waged in Spain. But while the outcome of the struggle is still unknown, the final showdown may well be approaching fast. The latest warning sign came this week, when Madrid made its most explicit plea to date for European help to its banking sector. Although the comments by Cristóbal Montoro, budget minister, were quickly qualified to say that no formal request had been made, they struck a chord with the markets. With at least €40bn of capital shortfall in its credit institutions and facing high borrowing costs, Spain is now widely expected to seek European help. Lire la suite »

Run of the Mill

6 juin 2012

John P. Hussman, Ph.D.

Since late-February, our estimates of the market’s prospective return/risk tradeoff (over a set of horizons from 2 weeks to 18 months) have persistently held in the worst 0.5% of all historical observations. It’s always important to emphasize that we try to align ourselves with the average return/risk profile that has historically accompanied the particular set of investment conditions we observe at each point in time, but that the outcome in any specific instance may not reflect the average return, and may even fall outside of what we view as the likely range of outcomes. That said, the awful behavior of the market in recent weeks is very run-of-the-mill in terms of how similarly unfavorable conditions have usually been resolved historically, and there is no evidence that this awful prospective course has changed much. The chart I included three weeks ago in Dancing at the Edge of a Cliff presents similar periods for historical perspective. Lire la suite »

The Reality of the Situation

31 mai 2012

John P. Hussman, Ph.D.

For nearly two years, the massive interventions of central banks have repeatedly pulled a fundamentally weak and debt-burdened global economy from the brink of resumed recession. The Federal Reserve’s balance sheet is now leveraged 52-to-1, with assets having an average duration of over 5 years, suggesting that if those assets were marked-to-market, an interest rate increase of less than 50 basis points would wipe out the Fed’s entire capital base. Of course, the Fed takes no marks on its assets when it reports its balance sheet, though it does occasionally take down the value of the securities in the Maiden Lane shell companies that it illegally set up to bail out Bear Stearns and other entities (in violation of Section 13(3) of the Federal Reserve Act, which Congress had to amend and spell out like a See-Spot-Run book as a result). Lire la suite »

Liquidation Syndrome

23 mai 2012

John P. Hussman, Ph.D.

Over the past two weeks, the S&P 500 has lost months of upside progress in a handful of sessions. This is the very characteristic initial outcome of the overvalued, overbought, overbullish syndrome that has been in place until recently (the decline has cleared the overbought component). The good news here is that we now estimate the 10-year prospective total return on the S&P 500 to be about 5.2% annually as a result of the recent decline. As a rule of thumb, a 1% market decline in a short period of time tends to increase the prospective 10-year return, not surprisingly, by about 0.1%. However, that approximation is less accurate over large movements or over extended periods of time, where growth in fundamentals and compounding effects become important. Lire la suite »

The eurozone must shrink to survive

15 mai 2012

Financial Times – Mohamed El-Erian

Extreme political dysfunction is now undermining a Greek economy already hobbled by imploding consumption, explosive joblessness, accelerating capital outflows and debt insolvency. The consequences are multi-faceted and extend well beyond the country’s borders. For the longer-term stability of Europe and the global economy, European leaders need to urgently redefine their historical unity project rather than leave it in the hands of increasingly disorderly conditions on the ground. Lire la suite »

Dancing at the Edge of a Cliff

14 mai 2012

John P. Hussman, Ph.D.

In recent weeks, I’ve emphasized that our estimate of prospective market return/risk in stocks has slipped into the most negative 0.5% of historical data (reflecting a range of horizons from 2 weeks to 18 months). Last week that estimate actually deteriorated, but I am reluctant to make comments on such a small sample, as the only more negative estimate in post-Depression history was on September 16, 2000. Even in the conditions that match the worst 2% of our return/risk estimates (which is the part of the tail we have been in since late-February), the market has lost an average of 20-25% just in the following 6-month period. As much as I try to maintain equanimity – focusing on the average outcome of a particular set of market conditions rather than the specific instance at hand – it is very difficult to do so at present. Lire la suite »

Black Scholes and the formula of doom

9 mai 2012

Financial Times

It has been argued that one formula known as Black-Scholes, along with its descendants, helped to blow up the financial world.

Well, that got FT Alphaville’s attention this weekend! For a good part of Saturday, the article with the above sentence was among the Most Read on the BBC News website. Not bad for an article about option pricing. Lire la suite »

Release the Kraken

30 avril 2012

John P. Hussman, Ph.D.

Over the past 13 years, and including the recent market advance, the S&P 500 has underperformed even the minuscule return on risk-free Treasury bills, while experiencing two market plunges in excess of 50%. I am concerned that we are about to continue this journey. At present, we estimate that the S&P 500 will likely underperform Treasury bills (essentially achieving zero total returns) over the coming 5 year period, with a probable intervening loss in the range of 30-40% peak-to-trough.

Why? Lire la suite »

Run, Don’t Walk

23 avril 2012

John Hussman

We currently estimate the prospective 10-year total return on the S&P 500 at about 4.5% annually, in nominal terms, based on our standard valuation methodology. This may not seem bad, relative to 2% yields on the 10-year Treasury bond, provided that investors actually consider either figure to be an adequate 10-year investment return, and provided that they view 4.5% annual returns as adequate compensation for securities that have several times the volatility of a 10-year Treasury bond (especially when yields are low), and provided that investors ignore the fact that prospective market returns tend to enjoy a significant range over the course of the market cycle, so that "locking in" present prospective returns must necessarily forego any higher prospective return that might be observed in the coming decade. Even given robust growth in GDP and corporate revenues, a move to prospective returns of just 6% at some point in the next two years would likely leave investors with no return (including dividends) in the interim (see Too Little to Lock In).

Wall Street continues to focus on the idea that stocks are "cheap" on the basis of forward price/earnings multiples. I can’t emphasize enough how badly standard P/E metrics are being distorted by record (but reliably cyclical) profit margins, which remain about 50-70% above historical norms. Our attention to profit margins and the use of normalized valuation measures is nothing new, nor is our view that record profit margins have corrupted many widely-followed valuation measures. As I noted in our September 8, 2008 comment Deja Vu (Again), which happened to be a week before Lehman failed and the market collapsed, "Currently, the S&P 500 is trading at about 15 times prior peak earnings, but that multiple is somewhat misleading because those prior peak earnings reflected extremely elevated profit margins on a historical basis. On normalized profit margins, the market’s current valuation remains well above the level established at any prior bear market low, including 2002 (in fact, it is closer to levels established at most historical bull market peaks). Based on our standard methodology, the S&P 500 Index is priced to achieve expected total returns over the coming decade in the range of 4-6% annually." Present valuations are of course more elevated today than they were before that plunge.

Suffice it to say that every P/E multiple is simply a shorthand for proper discounted cash-flow methods, because there are countless assumptions about growth, margins, return on invested capital and other factors quietly baked inside. Like price-to-forward operating earnings multiples, even our old price-to-peak earnings metric has been rendered misleading due to historically high profit margins. Of course, we knew that was happening even before the credit crisis began, and believe that numerous widely-followed valuation measures remain distorted by record profit margins here.

On the economic front, the recent uptick in new unemployment claims is consistent with the leading economic measures and "unobserved components" estimates that we obtain from the broad economic data here (see the note on extracting economic signals in Do I Feel Lucky?). Indeed, it will be difficult to get the expected flat or negative April employment print if weekly new claims don’t rise toward about 400,000 in the next few weeks. We’ve seen "surprising" weakness in some of the more recent regional surveys such as Empire Manufacturing and Philly Fed. A continuation of that trend would also be informative.

As I noted a few months ago, "examining the past 10 U.S. recessions, it turns out that payroll employment growth was positive in 8 of those 10 recessions in the very month that the recession began. These were not small numbers. The average payroll growth (scaled to the present labor force) translates to 200,000 new jobs in the month of the recession turn, and about 500,000 jobs during the preceding 3-month period. Indeed, of the 80% of these points that were positive, the average rate of payroll growth in the month of the turn was 0.20%, which presently translates to a payroll gain of 264,000 jobs. Notably however, the month following entry into a recession typically featured a sharp dropoff in job growth, with only 30% of those months featuring job gains, and employment losses that work out to about 150,000 jobs based on the present size of the job force. So while robust job creation is no evidence at all that a recession is not directly ahead, a significant negative print on jobs is a fairly useful confirmation of the turning point, provided that leading recession indicators are already in place." (see Leading Indicators and the Risk of a Blindside Recession).

The upshot is that while I expect a weak April jobs report, we should hesitate to take leading information from what remains largely a short-lagging indicator. We’re already seeing deterioration in economic data, but it remains largely dismissed as noise. An acceleration of economic deterioration as we move toward midyear would be more difficult to ignore. My impression is that investors and analysts don’t recognize that we’ve never seen the ensemble of broad economic drivers and aggregate output (real personal income, real personal consumption, real final sales, global output, real GDP, and even employment growth) jointly as weak as they are now on a year-over-year basis, except in association with recession. All of these measures have negative standardized values here. My guess is that we’ll eventually mark a new recession as beginning in April or May 2012.

Emphatically, however, our concerns about the stock market continue to be independent of these economic expectations, as the hostile investment syndromes we’ve seen in recent months have historically been sufficient to produce very negative market outcomes, on average, even in the absence of economic strains (see Goat Rodeo and An Angry Army of Aunt Minnies). As always, I strongly encourage investors to adhere to their disciplines – including those following a buy-and-hold approach – provided that they have carefully contemplated the full-cycle risk and their ability to stick to their strategy through the worst parts of the investment cycle. What I am adamantly against is the idea that speculators can successfully "game" overvalued, overbought, overbullish markets – particularly in the face of numerous hostile syndromes, near-panic insider selling, speculation in new issues, and broad divergences in market internals, all of which we are now observing.

In the absence of hostile syndromes like we observe today, we generally have more equanimity about market prospects – recognizing the average outcome, but also emphasizing the wide range of individual outcomes associated with a given set of market conditions. The majority of our past market comments are filled with reminders that our expectations are based on average return and risk characteristics, and should not be taken as forecasts about any specific instance. At present, the outcomes that have historically emerged from similar conditions are so uniformly negative that too much equanimity would be misleading.

One way to gauge your speculative exposure is to ask the simple question – what portion of your portfolio do you expect (or even hope) to sell before the next major market downturn ensues? Almost by definition, that portion of your portfolio is speculative in the sense that you do not intend to carry it through the full market cycle, and instead expect to sell it to someone else at a better price before the cycle completes. With respect to those speculative holdings, and when to part with them, my own view is straightforward. Run, don’t walk.

Notes on banking and monetary policy

Banks continue to report seemingly pleasant earnings, as long as one doesn’t look under the hood at the drivers of those reports. Two drivers have been particularly important this quarter. One is the further reduction of reserves against future loan losses, which shows up as a positive contribution to bank earnings. For example, a decline in loan loss reserves was the source of about one-third of the earnings reported by Citigroup. The other driver is something called a "debt valuation adjustment" or DVA. You might recall that as a result of European credit strains last year, investors sold off the bonds of major banks. In the world of bank accounting, the debt was therefore cheaper to retire, so – I am not making this up – the decline in the value of the bonds was booked as earnings. Of course, the value of bank debt has recovered somewhat since then, as investors have set aside concerns about Europe (which we doubt is a good idea). One might expect that since banks booked DVA as a contribution to earnings last year, we would see the opposite effect this quarter. But one would be wrong. As Peter Tchir noted last week, "Morgan Stanley no longer includes DVA in its ‘continuing operations’ headline number. It was a loss of $2 billion this quarter. With 2 billion shares outstanding, that would have wiped out the gain. What bothers me, is that in Q3, when it was a gain of $3 billion, it was part of continuing ops." It was the same story at Bank of America, prompting one analyst to observe "one-time items are to be ignored when negative, and praised when providing a ‘one-time benefit.'"

Tyler Durden of ZeroHedge has started referring to the Federal Reserve as simply "CTRL+P" – which is brilliant, because it really captures the full intellectual content of Fed policy in recent years. Keep in mind that when the Fed engages in quantitative easing, it purchases Treasury securities and pays for them by creating new base money. From an equilibrium perspective, the U.S. government has financed its deficit in recent years partly by issuing new Treasury debt that was bought by the public, and partly by printing money that is now held by the public (corresponding to the Treasuries bought by the Fed). Of course, the Fed can "unprint" the money, so to speak, by reversing its transactions, and selling those Treasury securities back to the public. But the Fed’s ability to do such massive selling without disruption is unproved, to say the least.

Some have asked why the Fed will ever need to reverse its transactions. Couldn’t the Fed just leave the monetary base out there and perpetually roll the Treasury portfolio forward? The answer depends on what sort of inflation we would like to observe, particularly in the back-half of this decade.

To put some structure on this question, I’ve updated our Liquidity Preference chart (1947-present), which illustrates the close relationship between nominal interest rates and monetary base per dollar of nominal GDP. Currently, the U.S. monetary base amounts to 17 cents per dollar of GDP – a level that is consistent with contained inflation only if short-term (3-month Treasury) yields are held below about 10 basis points. For more on the relationship between the monetary base, interest rates, nominal GDP and inflation, see Sixteen Cents – Pushing the Unstable Limits of Monetary Policy, and Charles Plosser and the 50% Contraction in the Fed’s Balance Sheet.


Think of it this way. The willingness of people to hold a given amount of base money, per dollar of nominal GDP, is intimately tied to the rate of return that they could get on an interest-bearing security. Higher interest rates reduce the demand for zero-interest cash. So if there is upward pressure on interest rates, and the Fed leaves the money supply alone, how do you reach equilibrium? Simple – nominal GDP becomes the adjustment variable. If there’s not enough real GDP growth to absorb the excess base money, prices rise to do the job.

Likewise, expanding the amount of base money per dollar of nominal GDP puts downward pressure on Treasury bill yields and short-term interest rates, but really only if there are no inflationary pressures in the system. Clearly, if inflationary pressures are present (suggesting that the monetary base is already too large), an expansion in the monetary base won’t produce lower interest rates. Rather, it will accelerate those inflationary pressures as nominal GDP is forced to keep up with the monetary base – even if real GDP isn’t growing at all. All hyperinflations are built on this dynamic. That said, it’s worth emphasizing that untethered money growth is invariably a reflection of untethered fiscal deficits (the central bank just buys the government debt and replaces it with money). So significant inflation is ultimately not a monetary phenomenon as much as it is a fiscal one.

In any event, the simple fact is that the Fed can sustain the current size of its balance sheet, without inflationary pressures, only to the extent that people (and banks) are willing to sit on idle, low or zero-interest money balances. In an environment of credit concerns and an increasingly likely implosion of the European banking system (where the fresh leverage taken to pursue the "Sarkozy trade" is now turning into leveraged losses), the short-term willingness to hold idle but "safe" cash balances is quite high. So in the event of additional credit strains, the ability of the Fed to go further out to the right on the Liquidity Preference curve is nearly unconstrained.

The problem is that this policy is inconsistent with any economic environment except one where credit is imploding and the Fed is running the whole show in setting short-term interest rates. As the Fed increases the monetary base, it becomes a greater and greater challenge to reverse those actions in the future. Getting into the position may be as easy as hitting CTRL+P, but getting out of the position promises to be a disruptive nightmare – not to mention the effect that these policies have in distorting financial markets, rewarding reckless lenders, punishing savers, and misallocating capital.

Notably, any exogenous pressure on short term interest rates to even 0.25% (on the 3-month Treasury yield), would effectively require the Fed to move back to the pre-QE2 monetary base in order to forestall incipient inflation pressures. Of course, the Fed could delay that outcome by boosting the interest it pays to the banking system for holding idle reserves. Then again, the Fed already has a balance sheet leveraged more than 50-to-1 against its own capital. So upward interest rate pressure would begin to induce capital losses on the Treasury securities the Fed has accumulated at low yields. Raising interest payments to banks would further strain the Fed’s balance sheet, producing an insolvent Fed while providing a fiscal subsidy to the banking system at taxpayer expense.

Needless to say, I don’t expect that all of this will end very well, but given that the full historical record captures inflation, deflation, recession, expansion, Depression, credit expansion, and credit crisis, we are prepared to respond to a wide range of possible events, without relying on the hope for perpetually high profit margins, endless monetary interventions, absence of major sovereign defaults, stability of the euro-zone, or avoidance of what we view as an oncoming recession. For now, both market and economic evidence remain negative, and we remain accordingly defensive. That will change, but we emphatically view present conditions as being among the most negative subset we’ve observed in the historical record.

Market Climate

As of last week, the Market Climate continued to be characterized by rich valuations and a variety of hostile syndromes (generally related to overvalued, overbought, overbullish conditions, and other variants that capture a general syndrome of "overextended market coupled with a loss of supporting factors"). This places market conditions among the most negative 1% of observations on record, particularly on a 6-18 month horizon, though shorter horizons are clearly negative as well here. Strategic Growth and Strategic International Equity remain tightly hedged. Strategic Dividend Value continues to be about 50% hedged, which is its most defensive position. In Strategic Total Return, we raised our exposure in precious metals shares to about 12% of net assets in response to recent price weakness in that sector. The ratio of gold prices to the XAU is now nearly 10-to-1, which is close to a record high. Historically, gold stocks have been treated as having "insurance" features, and their negative correlation with other stocks was accompanied by premium valuation multiples. At present, many precious metals shares have higher yields than most S&P 500 stocks, and are also significantly depressed relative to gold prices, which suggests a relative margin of defense even if gold prices were to decline substantially. This sector still has substantial volatility, which is why our exposure in terms of net assets is not aggressive (though we would likely increase that exposure on significant economic weakness). Overall, we’re comfortable shifting to a moderately higher exposure in this sector, recognizing that we may observe additional volatility as market conditions change. Strategic Total Return continues to hold a duration of just under 3 years in Treasury securities, and a few percent of assets in utilities and foreign currencies.

No… Stop… Don’t.

16 avril 2012

John P. Hussman, Ph.D

As of Friday, the S&P 500 was at about the same level as at the end of February. I noted then that our estimate of potential market losses over an 18-month window was in the worst 1.5% of historical observations. More recently, we’ve observed a marked deterioration in our measures of market internals. As a result, our estimate of potential market losses over a 6-month window is now in the worst 0.5% of historical observations. In particular, we’re seeing a very broad-based downward shift in market action across nearly every industry group. While the depth of the breakdown is still fairly shallow, the uniformity of the signal suggests significant information content (for more on this distinction, see the note on extracting economic signals from multiple sensors in Do I Feel Lucky?). Though our market concerns are independent of our economic concerns, we see essentially the same downward uniformity in leading economic measures across the industrialized and developing world (for example, see the charts near the end of last week’s comment Is the Fed Promoting Recovery or Desperation?). Lire la suite »

Is the Fed Promoting Recovery or Desperation?

9 avril 2012

John P. Hussman, Ph.D.

On Friday, the Department of Labor reported that March non-farm payrolls increased by 120,000, falling well short of consensus expectations in excess of 200,000. For our part, we continue to expect a deterioration in observable economic variables, with weakness that emerges gradually and then accelerates toward mid-year. On the payroll front, our present expectation is that April job creation will deteriorate toward zero or negative levels.

Immediately after the payroll number was released, CNBC shot out a news story titled "Disappointing Jobs Report Revives Talk of Fed Easing." Of course it does, because this remains a market dependent on sugar. And with little doubt the Fed will eventually deliver it – perhaps following a market plunge of 25% or more – but with little doubt nonetheless, because like the indulgent parent of a spoiled toddler, the FOMC can’t stand to see Wall Street throw a tantrum without reaching for a lollipop. Lire la suite »

Investors hunt strategies in era of ‘repression’

28 mars 2012

Financial Times

It may be little more than a buzz phrase in the markets but a growing number of strategists believe it accurately encapsulates how sovereign debt markets are being distorted by central bank and government policies that keep interest rates at historic lows.

Chart: Click to enlarge

Real bond yields, those adjusted for inflation, are at their lowest since the 1970s in the US and UK. And if the effect of central bank action is to prevent market mechanisms from responding to inflation, an element of the repression, then this poses big questions for investors’ asset allocation strategies. Lire la suite »