John P. Hussman, Ph.D.
With the exception of extreme market conditions (see Warning- Examine All Risk Exposures , and Extreme Conditions and Typical Outcomes ), I try not to wave my arms around about near-term market risks, but I think it’s important to cut straight to the chase here. The present market environment warrants unusual concern, in my view. Based on a wide variety of evidence and its typical market implications over an ensemble of dozens of subsets of historical data, the expected return/risk profile of the stock market has shifted to hard-negative. This places us in a tightly defensive position. This isn’t really a forecast in the sense that shifts in the evidence even over a period of a few weeks could move us to adjust our investment stance, but here and now we observe conditions that have often produced abrupt crash-like plunges. This combination of evidence includes elevated valuations, overbullish sentiment, market internals best characterized as a « whipsaw trap » on the basis of typical follow-through, heightened credit strains, and clear evidence (on reliable forward-looking indicators) of oncoming recession, among other factors.
As always, we try to align our investment positions with the evidence we observe. If the evidence softens, our hedges will soften. While the quickest route to a modest exposure to market fluctuations (perhaps 20-30%) would be a clear improvement in market internals – which could justify a less defensive stance even in the face of recession risks and rich valuations – the most likely route to a significant investment exposure would be a decline to much lower prices and correspondingly higher prospective returns. Presently, avoidance of major market losses takes precedence in our analysis.
On a valuation front, we estimate that the S&P 500 is likely to achieve an average total return over the coming decade of about 4.8% annually. This is certainly better than the projected returns that we have observed over much of the past decade, but then, the past decade has produced virtually no total return for equity investors at all. An expected total return of 4.8% is also clearly better than is presently available on Treasury bills, which are priced to return a single basis point of interest annually, and is also better than the sub-2% yield available on 10-year Treasury debt.
The problem is that the duration of a 10-year Treasury bond is only about 7 years, which is not only the weighted average time it takes to receive the future stream of payments, but also conveniently measures the expected percentage change in the bond price for a 1% change in long-term return. For stocks, the « duration » mathematically works out to be roughly the price/dividend ratio, which is about 45 for the S&P 500. Put simply, in order to achieve a given increase in long-term expected return, stocks would have to suffer about 6 times the price decline that bonds would experience. Stocks may very well outperform Treasury bonds over the coming decade, but for investors who have any sensitivity to price volatility, that is likely to be a small comfort in the next few years. We estimate that the S&P 500 would have to trade at about the 800 level in order to achieve 10-year prospective returns of 10% annually. Importantly, even a magical « fix » out of Europe would do nothing to change that algebra.
On the sentiment front, Investors Intelligence reports that the percentage of advisory bears dropped below 30% last week, which has historically resulted in unrewarding market outcomes when valuations have been elevated even to a lesser extent than they are today. Thomson Reuters reports that negative earnings pre-announcements are exceeding positive ones by the largest ratio since mid-2001. Investors have eagerly accepted forward operating earnings as a basis for valuation assessments, without accounting for the fact that those earnings expectations assume profit margins about 50% above their historical norms. Unfortunately, profit margins are highly vulnerable to economic weakness, and we are beginning to observe that regularity here.
As noted last week, we continue to estimate a very high probability of oncoming recession. While the economic outlook seems fairly benign based on a « flow of anecdotes » approach (judging economic prospects on the basis of positive or negative surprises in individual reports as they arrive), the outlook is actually very unfavorable based on a more reliable ensemble of leading indicators of economic activity (see Have We Avoided a Recession? ).
That view is clearly shared by the Economic Cycle Research Institute, where Lakshman Achuthan noted on Bloomberg last week that « forward looking data since two months ago has remained weak, it’s getting weaker, it’s not turning up. So, to my fellow forecasters out there, I’d say they’re roughly in two camps. There are those who say that the economy is firming and will continue to firm into next year. We reject that. There’s nothing there that suggests that at all. I think there’s a larger camp that says we’re going to muddle through; we’re going to get this kind of slow growth, ‘I’m not terribly optimistic, but we’re going to muddle through.’ I would point out that that’s never happened. We never muddle through. A market economy does not want to have a static state. It either accelerates or it decelerates, and these forward looking indicators say decelerate. »
Achuthan also noted that « the other half of the GDP report, » gross domestic income or GDI (which tends to be the more accurate measure of GDP) was up just 0.3% in the most recent quarter. The Federal Reserve has observed that when GDP and GDI differ, the GDP figure tends to be revised toward GDI, not the other way around. Achuthan warned that the GDI figures are « a big red recession signal. » In response to the question « You had a recession call, what happened?, » Achuthan simply answered « It’s happening. »
It’s important to be clear that the hard-negative condition of our ensembles here is based on observable data, and our expectation for returns is based on market outcomes that have accompanied past observations that fall into the same classification « bucket » or « cluster » as we see today. The negative average return/risk profile associated with present conditions is, of course, an average, and this specific instance might turn out differently. The problem is that the average is dominated by poor outcomes, some very steeply negative, with a much smaller set of positive outcomes. In any case, our market expectations here are driven by observable data, not by our views about what may or may not happen in Europe. Of course, our concern about high recession risk here is also driven by observable data.
No Sugar Tonight
As for Europe, last week was essentially a confirmation of our impressions on a variety of fronts. First, and probably most important from (the standpoint of investor perceptions) is that the new head of the ECB, Mario Draghi, is as committed to the constraints imposed by EU Treaties as clear-headed observers should expect (see Why the ECB Won’t, and Shouldn’t, Just Print ). Far from looking for clever « political cover » that would allow the ECB to initiate massive purchases of distressed European debt, Draghi said that he was « kind of surprised » that that others misinterpreted his phrase « other measures might follow » as a suggestion that massive ECB bond-buying would be allowed once a fiscal union was more clearly established. To the contrary, he rejected any sort of « grand bargain, » saying « We have a Treaty, and Article 123 prohibits financing of governments. It embodies the best tradition of the Bundesbank. We shouldn’t try to circumvent the spirit of the treaty. » He specifically warned against attempts to use « legal tricks » to circumvent the EU Treaties.
Notably, the restriction in Article 123 specifically prohibits the ECB from « any financing of the public sector’s obligations vis-a-vis third parties » – this does not simply restrict the ECB from buying debt directly (which could be circumvented by buying distressed debt on the open market). Rather, it is a restriction against using the ECB as a funding mechanism for public sector obligations. Read Draghi’s lips: the ECB will not be initiating massive purchases of distressed European debt unless and until the EU Treaties themselves are explicitly changed.
It is still a good thing that 26 of the 27 EU members appear willing to agree to greater fiscal union, but that sort of pact, outside of EU Treaty changes, will not be sufficient to trigger ECB bond buying in any event. Britain vetoed the idea of an EU Treaty change, with Prime Minister David Cameron saying « We’re not in the euro and I’m glad we’re not in the euro. We’re never going to join the euro. We’re never going to give up this kind of sovereignty that these countries are having to give up in order to have a fiscal union. »
The key point here is that the ECB should not be expected to buy distressed European debt anytime in the near future. In order to achieve that end, particularly with Germany’s consent, Europe requires not only an agreement on fiscal union among euro-area members, but explicit EU Treaty amendments including changes in the ECB’s restrictions and mandate. Moreover, an agreement on fiscal union isn’t just a matter of putting nice words on paper – it has to be credible in order for Germany to go along. Otherwise, massive ECB buying of distressed European debt would effectively constitute a permanent creation of new euros that would never be undone. While open market operations that temporarily create new currency are often not inflationary, permanent creation of new currency to finance government deficit spending is entirely a different matter.
On the question of credibility, there is also a problem in creating an effective enforcement mechanism for the fiscal union. Suppose a government is, in fact, running actual deficits greater than 3% of GDP, or « structural » deficits greater than 0.5%, which is the desired maximum. It will be impossible, at that point, to credibly say, « Uh oh, you’re running larger deficits than are allowed – therefore, you’re going to have to pay a penalty, which will effectively drive you into larger deficits. Otherwise, you’re going to lose your vote in the EU, which will accelerate the risk of your disorderly departure from the union. »
If the markets want more flexible bond buying from the ECB, the best route would be for EU members to agree to explicit changes to EU Treaties, and to restrict various provisions that Britain finds objectionable, so that they apply only to the 17 EU members whose currency is the euro. That said, while an explicit fiscal union would give the ECB greater flexibility, my impression is that we will still never see the ECB embarking on « big bazooka » purchases of distressed European debt, precisely because the very fact that the debt is distressed would introduce a question about whether the debt would be repaid; therefore a question about the ECB’s ability to reverse the purchases; therefore a question about the credibility of the ECB; and therefore a question about the credibility of the euro itself.
We’ve seen some theories that Europe intends to address the problem through ECB lending to banks, taking distressed debt as collateral, with the banks turning around and buying more distressed debt. Apart from the fact that this would be the sort of « legal trick » that the ECB would be unwilling to facilitate, this would imply an increase in bank leverage ratios far beyond the 30-40 multiples that already exist (which would be a disaster when tighter Basel III capital requirements kick in). In practice, depositors would flee, and you would end up with a European banking system where bank bondholders, not the ECB, would be subject to the losses, since the ECB’s collateral claims would be senior. Likewise, IMF loans are always highly conditional, and are always senior claims.
As I noted last week, what investors really want isn’t just for someone to buy distressed European debt, but for someone to buy that debt and willingly take a loss on it so the money doesn’t ever actually have to be repaid. This is a solvency issue – a shortfall between money owed and the resources to credibly repay it. There is no legal trick to get around that. Ultimately, you either have to restore credibility, or you have to restructure the claims through default or devaluation.
As for the knee-jerk enthusiasm of some analysts over the prospect of not just one European bailout fund, but two, it is helpful to recognize that the European Stability Mechanism (ESM) is simply the permanent, Treaty-blessed version of the European Financial Stability Facility (EFSF). These are not two separate pools of money, but are instead the presently operating facility and its eventual permanent home, as the EFSF expires in 2013. There is a 1-year overlap in the life of these two vehicles in order to facilitate that transfer of responsibility. The guarantee commitment of European member states to the EFSF is 440 billion euros (about one-third of that from Italy and Spain, which is ironic), which increases to 500 billion euros in guarantee commitments once the ESM is established. Again, these facilities are really one in the same.
I want to be clear – it is critically important for the EU to establish some sort of fiscal unity, to pull European member states off of the road toward insolvency. In my view, an oncoming global recession will be very hostile to the effort to balance government budgets, but greater fiscal coordination is an important objective if Europe’s common currency is to survive.
The bottom line is that last week’s events took a great deal more off the table than sugar-addicted investors may immediately appreciate. In effect, if a fiscal union is achieved without treaty changes, the ECB is unlikely to act. But even if treaty changes are achieved, the ECB is unlikely to act forcefully unless those changes are credible. Of course, if the changes are credible, then forceful actions will not be needed anyway. In any event, the problem for bailout-hungry investors is that they will be deeply disappointed if they expect Mario Draghi to turn into Ben Bernanke.
A credible solution for Europe: convertible debt
So what can Europe do to credibly address its credit strains, in a way that reduces the risk of a collapse of the European monetary union? In my view, the most viable approach is for European member states (particularly the distressed ones) to begin writing convertibility clauses into their debt as it rolls over. Those convertibility clauses would provide that the debt could be converted, at the option of the issuing government, into an equivalent amount of that country’s legacy currency (lira, pesetas, etc).
Undoubtedly, this would tack a « conversion premium » onto the bond yields of highly indebted countries, essentially substituting for the default premiums that investors tack on today. If a country follows (or adopts) a credible fiscal policy, the conversion premium would be relatively low, because investors would be confident that the country would remain in the euro-zone, and that no future conversion would occur. But if a country pursues an unsound fiscal course, the conversion premium would rise, creating an incentive for that country to correct its own fiscal policies, without the need for external pressure from other EU member countries, and with far less fear of disorderly default. If those efforts fail, the country would convert the debt to its legacy currency. Investors would reasonably expect that in the event of conversion, the newly converted currencies would most probably depreciate, and they would reflect that risk in the prices they pay and yields they demand.
Keep in mind that the average maturity of Euro-area debt is less than 7 years. Gradually introducing debt with convertibility clauses could provide a substantial « release-valve » for Europe within a fairly small number of years. Rather than perpetuating a system of moral hazard, where indebted countries become more indebted on the expectation of eventual bailouts by stronger EU members, introducing convertible debt would place the costs and incentives for fiscal reform squarely on each individual country.
Ideally, all of the present euro-zone members would achieve sufficient fiscal credibility to remain in the euro. Clearly, each country would have an incentive to do so, without the need for questionable enforcement mechanisms by other EU members. In this way, if the system can be saved, the system will be saved. Yet unlike the present arrangement, the entire EU will not be brought to its knees in the event that individual countries fail to solve their budget difficulties.
As of last week, the Market Climate for stocks was characterized by an extremely unfavorable ensemble of conditions across valuations, sentiment, economic factors, and other conditions. Current conditions cluster with periods such as May 1962, October 1973, July 2001, and December 2007, all which produced 10-20% market losses in extremely short-order. Strategic Growth and Strategic International are tightly hedged here. Strategic Total Return continues to carry an average duration of about 3 years, with about 20% of assets in precious metals shares (where conditions remain quite positive on our measures), and small single-digit positions in utility shares and (non-euro) foreign currencies.
That said, our investment strategy is not based on forecasting specific near-term market movements, but instead on accepting market risk in proportion to the expected return that has historically accompanied similar observable conditions, on average. As that evidence changes, our investment stance will also change.
Importantly, we don’t look to « time » short-term movements or « catch » various trends. My heightened concerns here should not be taken as a specific « prediction » of coming market movements, but rather as a response to conditions that have typically been hostile. We are responding to this observable data defensively, in a way that is most consistent with our long-term, full-cycle investment objective.
Finally, I recognize that it is common for investment managers to position their portfolios near year-end in hopes of window-dressing their portfolios or betting on a « Santa Claus » rally or other mild seasonal tendencies. In general, these seasonal tendencies are too weak to counter the other factors that enter into our analysis, but in any case, we manage the Funds with a focus on a specific full-cycle investment discipline, not with a focus on tweaking our end-of-year holdings. So while year-end window-dressing activity may or may not defer the unfavorable pressures that we see in the data, we have no intention of ignoring that evidence in hopes of catching a wholly uncertain ride on Santa’s sleigh. We’ll continue to follow our discipline. For now, we remain broadly defensive.