John P. Hussman, Ph.D.
Last week was a scorching « risk-on » week for the markets, as a putative « solution » to Europe’s debt problems and a positive print for third-quarter GDP convinced investors that all pressing economic concerns have vanished. We observed very little expansion of trading volume, which is characteristic of markets where short sellers are forced to cover while existing holders raise their offers and reduce their size. For our part, Thursday was difficult, as our largely defensive holdings were clearly out-of-favor, bank stocks (which we continue to avoid) shot higher on short covering, and option volatility declined as investors abandoned the desire to defend against losses.
I suppose it’s needless to say that we shared neither the market’s enthusiasm nor its confidence in the sudden view that everything has been fixed (more on that below). At the same time, as I noted last week, speculation can take on a life of its own when there is a pause in fresh concerns, so we’re not inclined to « fight » the recent advance by raising our line of defense (which would expend option premium on higher-strike put options). The benefit of holding the existing line is that we won’t get another crush in near-the-money option premium if the market advances further (which has contributed to a few percent of discomfort in recent weeks). The downside is that a sharp reversal lower won’t benefit us much until the market loss exceeds about 3-5%. So we remain defensive here, but as a concession to the speculative inclinations of investors, we are not putting up a contrarian fight.
Beyond that, however, we don’t have the evidence here to establish a material positive exposure or « go long » – at least not at present. Current market conditions cluster among a set of historical observations that might best be characterized as a « whipsaw trap. » Though last week’s rally triggered several widely-followed trend-following signals (for example, a break through the 200-day moving average on the S&P 500), the broader ensemble of data suggests a high likelihood of a failed rally. In this particular bucket of historical observations, less than 30% of them enjoyed an upside follow-through over the next 6 weeks. Some recent examples from this bucket include the weeks ended 11/3/00, 12/7/01 and 2/1/08. These were points that followed snap-back rallies that were actually good selling opportunities in what turned out to be violent bear market declines.
That said, about 30% of the observations in the current bucket did enjoy a positive follow-through. So while the expected return/risk profile of the market remains negative here, we have to be somewhat more tentative about taking a « hard » defensive position. As always, we’ll respond to new evidence as it arrives.
On the questionable benefits of a leveraged EFSF
With respect to Europe’s perceived « solution » to its debt crisis, the 50% write-down of Greek debt is appropriate, but it’s not clear that this includes a writedown of Greek obligations to « official » holders such as other European governments and agencies. If not, it’s unclear whether the writedown is really deep enough to allow Greece to avoid further debt problems several years out.
Likewise, I suspect that investors are celebrating various « headline » figures (such as « 1 trillion euros ») without much understanding of what they are cheering about. The European Financial Stability Facility (EFSF) is a Luxembourg corporation to which European states have committed 440 billion euros of backing, beyond which the EFSF must issue its own bonds to investors in order to make loans (not grants) to recipient countries or banks. There are two basic options that the EFSF contemplates for « leveraging » its 440 billion euros (which will actually probably be closer to 250 billion for all of Europe after amounts needed for Greece and bank recapitalizations). One is to issue « credit enhancements » or « partial protection certificates » that would be sold along with the new debt of European governments, where the certificates would provide first-loss protection of say, 20% of face value. Alternatively, the EFSF could construct a « special purpose vehicle » or SPV in each given country – basically an investment company formed to buy European debt – where the EFSF would « provide the equity tranche of the vehicle and hence absorb the first proportion of losses incurred by the vehicle. »
So to start with, the EFSF is not actually an operating « bailout fund » at present – it’s a shell corporation with a business plan and a certain amount of promised capital – not yet in hand – from European governments, in search of additional funding from private investors. Its intended business is to a) partially insure European debt, using capital from European governments, which these governments will obtain by issuing debt to investors, or b) to purchase European debt outright, by issuing EFSF debt to investors, leveraging capital obtained from European governments, which these governments will obtain by issuing debt to investors.
In effect, European leaders have announced « We have agreed to solve our debt problem, leveraging money we do not have, to create a fund, which will then borrow several times that amount, in order to buy enormous amounts of new debt that we will need to issue. »
As Jens Weidmann, the President of the German Bundesbank objected about this plan last week, « It is tied to higher risks of losses and to increased sharing of risks. The way they are constructed, the leveraging instruments are not too different from those which were partly responsible for creating the crisis, because they concealed risks. »
Moreover, the benefit to private investors is suspect. The basic idea of leveraging the EFSF is to provide enough « credit enhancement » to make European debt attractive. What is the value of that credit enhancement? Well, if the expected recovery rate is 80% or more, and the probability of default is fairly low, then the insurance (a promise to take « first loss » of 20%) isn’t really needed in the first place. If you do the math, the expected effect on yields is something on the order of 1-2% on 1 year debt, and a fraction of a percent for longer dated debt. Unfortunately, when the insurance really is needed (assuming more typical recovery rates around 50% and default probabilities higher than 15% or so), a 20% first-loss provision does little but reduce an extremely high interest rate to a lower, but still intolerably high interest rate. Given debt-to-GDP ratios of 100% or more, that protection does nothing to avoid certain default except to delay it for a small number of years.
On that note, don’t look now, but even if you were to assume an optimistic 80% recovery rate, Portugese yields already imply certain default within less than 2 years. Assuming a more typical 60% recovery rate, the probability of a Portugese default within 2 years was 68% as of Friday (that same recovery rate produces an implied default probability of 88% within 3 years, and 100% within 5 years).
The bottom line is that a 20% first-loss provision is irrelevant until you need it, and then it suddenly is not nearly enough. Consider also that the IMF just raised its estimate of required European bank recapitalization to 300 billion euros. Even if regulators demand less, enormous amounts of capital must quickly be raised either directly by issuing stock (which would require banks to issue shares in nearly the same amount as their existing float), or failing that, by depleting the committed funds of the EFSF. It is an open question how much of the EFSF commitment will actually be available for use beyond mopping up the Greek writedown, especially if the economy fails to avoid a recession. In any event, it appears very unlikely that Europe has achieved a durable solution.
Leading Data, Lagging Data
Accompanying the news of the « grand and comprehensive » European solution on Thursday was the news that GDP rose at an annual rate of 2.5% in the third quarter. There was already coincident data that the U.S. was not yet in contraction in August or September, so this was no surprise. Still, investors continued the habit of confusing lagging and coincident indicators for leading ones, so the positive GDP figure was taken as evidence that an oncoming economic downturn was « off the table. »
I can’t emphasize enough that leading evidence is in fact leading evidence. Take, for example, the ECRI Weekly Leading Index. It’s certainly not a perfect indicator in itself, but its leading properties are instructive. If you look at the historical points where the WLI growth rate fell below zero, you’ll find that weekly unemployment claims (a coincident indicator) were generally still about 3% below their 5-year average. It generally took about 13-16 weeks for unemployment claims to climb above that 5-year average, and even longer for the unemployment rate (a lagging indicator) to rise sharply. That’s not much of a lag in the grand scheme of the full economic cycle, but allows a great deal of intervening and often contradictory action in the financial markets.
The tendency to demand predictable outcomes to also be immediate is a dangerous one, because it allows investors to be sucked in by temporary reprieves during what are, in fact, very negative conditions. As I noted in May (see Extreme Conditions and Typical Outcomes ), « It’s clear that overvalued, overbought, overbullish, rising-yields syndromes as extreme as we observe today are even more important for their extended implications than they are for market prospects over say, 3-6 months. Though there is a tendency toward abrupt market plunges, the initial market losses in 1972 and 2007 were recovered over a period of several months before second signal emerged, followed by a major market decline. Despite the variability in short-term outcomes, and even the tendency for the market to advance by several percent after the syndrome emerges, the overall implications are clearly negative on the basis of average return/risk outcomes.«
The same can be said here of economic prospects. Investors have almost entirely abandoned any concern about recession risk based on a few weeks of benign economic figures. Yet on the basis of indicators that have strong leading characteristics, a broad ensemble of evidence continues to suggest very high recession risks, and even sparse combinations of indicators provide a major basis for concern.
For example, since 1963, when the ECRI Weekly Leading Index growth rate has been below -5 and the ISM Purchasing Managers Index has been below 54, the economy has already been in recession 81% of the time, and the probability of recession within the next 13 weeks was 86%.
If in addition, the S&P 500 was below its level of 6 months earlier, the economy was already in recession 87% of the time, and the probability of recession within the next 13 weeks climbed to 93% (and then to 96% within 26 weeks). Under these conditions, once the PMI fell below 52, the probability of recession within 13 weeks climbed to 97%.
That simple set of conditions (WLI < -5, PMI < 52, SPX < 6 months earlier) has been seen in every postwar recession for which the data is available. Though we’ve seen recessions without a drop in the WLI much below -5, when a WLI below -7 has been coupled with a PMI below 52 and an S&P 500 below its level of 6 months earlier, the economy has been in recession within 13 weeks, 100% of the time. This is the combination, incidentally, that we observe today.
We certainly don’t base our economic expectations solely on these data points, as a broad ensemble of other data continues to present high risk of an oncoming recession. Still, we view the virtual abandonment of recession concerns to be remarkably naive, and lacking of any real basis in historical evidence. Wall Street eagerly points to 2010, when the ECRI’s WLI dropped below -10 without a subsequent recession, largely thanks to the brief can-kick produced by QE2. But even in that instance, a smaller set of negatives was in place (the ECRI itself did not observe enough deterioration in its indicators to project a recession). In the present instance, a much broader range of evidence has turned down, both in the U.S. and internationally.
Given that nothing in economics is entirely certain, it’s possible that this time will be different. But that possibility is not one that has support in the data. To avoid a recession, we have to hope for an outcome other than the one that has historically occurred 100% of the time that similar data has been in hand.
As of last week, the Market Climate for stocks was characterized by unfavorable valuations (we estimate a 10-year S&P 500 return of about 4.8% annually), overbought conditions, and mixed market internals. The overall ensemble of evidence places the current market among a set of historical counterparts that is best characterized as a « whipsaw trap » – an overbought rally in an unfavorable overall Market Climate, about 70% of instances which fail to follow through. Even so, we’re mindful of trend-following factors (e.g. the 200-day moving average crossing) that could contribute to a speculative mood, so we’re not inclined to fight, for example, by raising our put strikes. We remain defensive in both Strategic Growth and Strategic International Equity, but also remain open to taking a more constructive position – despite specific features such as overvaluation and economic risks – if the broad ensemble of evidence shifts to a more constructive mix.
In Strategic Total Return, we slightly increased our bond market duration to about 3 years on the spike in Treasury yields last week. We also clipped some of our foreign currency exposure as investors abandoned the dollar as a safe-haven (at least temporarily). Most of the day-to-day fluctuation in the Fund remains driven by our holdings of precious metals shares, which remain slightly below 20% of net assets.