John P. Hussman, Ph.D.
Last week, the estimated return/risk profile of the S&P 500 fell to the worst 2.5% of all observations in history on our measures. This is not a runaway bull market. Rather, it is a market that again stands near the highs of an extended but volatile trading range. I am convinced that the breakdown of the market from this range has been deferred only through repeated and extraordinary central bank actions.
Importantly, the market is again characterized by an extreme set of conditions that we’ve previously associated with a « Who’s Who of Awful Times to Invest. » The rare instances we’ve seen this syndrome historically are reviewed in that previous weekly comment. They include the 1972-73 and 1987 market peaks, and several instances since 1998. The more recent instances of this syndrome are shown by the blue bands on the chart below. Note that each of the separate instances in the 1999-2000 period were followed in short order by intermediate market declines of between 10-18%, and of course, ultimately by a plunge of more than 50% in 2000-2002. Likewise, the 2007 instance was followed in short order by a correction of nearly 10%, and a few months later by a plunge of more than 50% in 2007-2009. The more recent instances in 2010 and 2011 have also been followed by substantial market selloffs in each case, though with a longer lag in 2011 (due to ongoing QE2 operations). Aggressive monetary policy did not prevent the ultimate declines, though massive central bank interventions have undoubtedly helped to short-circuit the more violent follow-through that occurred in 1973-1974, 1987, 2000-2002, and 2007-2009, at least to-date.
A word of caution. While a few of the highlighted instances were followed by immediate weakness, it is more typical for these conditions to persist for several weeks and even longer in some cases (for example, the wide blue strip in late-2010 and early 2011). When we look at longer-term charts like the one above, it’s easy to see how fleeting the intervening gains turned out to be in hindsight. However, it’s easy to underestimate how utterly excruciating it is to remain hedged during these periods when you actually have to live through day-after-day of advances and small incremental new highs that are repeatedly greeted with enthusiastic headlines and arguments that « this time it’s different. » For us, it’s particularly uncomfortable on days when our stocks don’t perform in line with the overall market, or when the « implied volatility » declines on our option hedges.
We can narrow the blue bands to a range within a few weeks of the exact peaks in 1999, 2000, 2007, 2010 and 2011 by further restricting to periods where the Shiller multiple was above 22 and advisory bullishness was above 50. While that restriction is so tight that it excludes several critical market peaks in history, such as August 1987, it actually still retains the present environment.
Even so, my greatest concern as an investment manager is the possibility that some number of our shareholders will grow so exasperated with remaining defensive during these periods that they capitulate and take a significant position in the market at the worst possible point. In a market that has now underperformed Treasury bills for more than 13 years, with two plunges of more than 50% in the interim (all of which we anticipated), my hope is that shareholders recognize our record in identifying major downside risks, and understand – if not fully agree with – my insistence on stress-testing our methods against Depression-era data in 2009 in response to the credit crisis (see the semi-annual report for more on that subject).
The S&P 500 has experienced repeated bouts of volatility since early 2010, when even our existing ensemble approach would have moved to a defensive stance, but it is notable that the S&P 500 would have to decline all of 11% to return to its April 2010 level. The completion of the present bull-bear market cycle (and it will be completed) will undoubtedly present strong opportunities to play offense, but today stands among a Who’s Who of the worst historical times to do so. Particularly for investors who do not have a large number of future cycles between now and the point they will need to draw significantly on their assets, a defensive stance is crucial here.
While our defensive stance may seem interminable, it is important to keep in mind exactly where we are in terms of valuations, and exactly where we have been over the past decade. Since we can easily examine the investment positions that would have been supported by our ensemble analysis throughout market history, a few benchmarks may be helpful.
In market history prior to 1998, the ensemble methods that we presently use in practice would have supported a mostly or completely unhedged investment stance about two-thirds of the time. In contrast, since 1998, they would have supported such a position less than 20% of the time – periods which included 2003 (when in fact we lifted about 70% of our hedges), as well as much of 2009 and early 2010. Conversely, a tightly hedged investment stance was appropriate in pre-1998 data well under than one-third of the time, while a full hedge has been appropriate the majority of the time since then. As for « hard negative » periods where we find ourselves openly using the word « warning, » we find only 3% of pre-1998 periods that justified such a view, but fully 23% of periods since 1998 – including today – where our market views would have been so unfavorable. As noted at the outset of this comment, the present situation is actually somewhat worse than that, standing in the bottom 2.5% of all historical periods in terms of the prospective tradeoff between return and risk.
In short, the period since 2008 has been extraordinary in terms of how often a hedged investment stance has been appropriate. The validation for such a defensive stance should be obvious given the fact that stocks have underperformed Treasury bills since that time, including two separate market plunges in excess of 50%. While much more frequent hedging has been required, even the past decade supports the expectation that the completion of the present bull-bear cycle will produce substantial opportunities to accept market risk. Our present defensiveness is unlikely to persist a great while longer, but my hope is that the basis for our current position is clear.
A Menu of Bitter Pills
« Over the past 30 years, an offensively minded Federal Reserve and their global counterparts were printing money, lowering yields and bringing forward a false sense of monetary wealth. Successful investing in a deleveraging, low interest rate environment will require defensive in addition to offensive skills. Interest rates have a mathematical bottom and when they get there, the washing of the financial market’s hair produces a lot less lather when it’s wet, and a lot less body after the blow dry. At the zero bound, not only are yields rendered impotent to elevate P/E ratios and lower real estate cap rates, but they begin to poison the financial well. Low yields, instead of fostering capital gains for investors via the magic of present value discounting and lower credit spreads, begin to reduce household incomes, lower corporate profit margins and wreak havoc on historical business models connected to banking, money market funds and the pension industry. The offensively oriented investment world that we have grown so used to over the past three decades is being stonewalled by a zero bound goal line stand. Investment defense is coming of age. »
– Bill Gross, PIMCO March 2012 Letter
« You simply cannot create investment opportunities when they’re not there. When prices are high, it’s inescapable that prospective returns are low. That single sentence provides a great deal of guidance as to appropriate portfolio actions. Investment risk comes primarily from too-high prices, and too-high prices often come from excessive optimism and inadequate skepticism and risk aversion. Contributing underlying factors can include low prospective returns on safer investments, recent good performance by risky ones, strong inflows of capital, and easy availability of credit. That same pattern of taking new and bigger risks in order to perpetuate return often repeats in a cyclical pattern. The motto of those who reach for return seems to be: ‘If you can’t get the return you need from safe investments, pursue it via risky investments.’ It takes a lot of hard work or a lot of luck to turn something bought at a too-high price into a successful investment. Patient opportunism – waiting for bargains – is often your best strategy. »
– Howard Marks, Oaktree Capital, The Most Important Thing (2011)
The present menu of investment opportunities continues to be among the worst in history. Treasury bill yields stand at only a few basis points. The 10-year Treasury yield is just 2%. The 30-year Treasury yield is just 3.1% to maturity. Corporate bond yields are at 3.2%, the lowest level since 1955. Meanwhile, we presently estimate that the S&P 500 is likely to achieve an average (nominal) total return of just 4.3% annually over the coming decade.
With respect to projected stock market returns, our standard valuation methodology has provided an extremely accurate guide, both historically and even over the decade through last week. The only notable exception was the result of the late-1990’s bubble, which was so unusual that we have now seen 13 years of sub-Treasury-bill total returns for the S&P 500. We did observe a brief period of undervaluation in early 2009, but at present market levels, valuations continue to be challenging. Better valuations will emerge as the present market cycle is completed. Arguments that stocks are « cheap on the basis of forward operating earnings » fail to adjust for the record high level of profit margins (about 50% above their historical norms), and also apply bubble-era norms for price-to-forward earnings multiples. This is the same argument that analysts made in 2007, and it is dangerously wrong.
Now, just because stocks are likely to achieve a total return of only 4.3% over the coming decade, we can’t conclude that it is impossible for prices to move higher and prospective returns to move lower (as they did during the late 1990’s tech bubble and the housing bubble ending in 2007). It’s just that with market conditions now extremely overvalued, overbought, and overbullish, the declines that generally follow have easily wiped out the speculative « tails » of already mature advances. Indeed, the typical bear market wipes out more than half of the preceding bull market gain.
Even assuming that reasonably positive economic growth is more than enough to offset any tendency for record profit margins to normalize, a further 10% market advance over a period of a year would reduce the prospective 10-year return for the S&P 500 to somewhere between 3.3% and 3.6%. Nothing in the evidence suggests that outcome, but should we speculate on that hope, given that previous ventures to such low prospective returns were ultimately followed by violent losses that wiped any temporary speculative gains? For our part, the answer is simply no.
Economic concerns remain difficult to escape
It’s worth emphasizing that our concerns about the financial markets here are distinct from our economic views, in the sense that the present syndrome of overvalued, overbought, overbullish conditions would be hostile even if we were more optimistic about economic prospects. But it is also worth emphasizing that many aspects of recent economic data have been more favorable than we observed last summer.
For my part, I have no interest in overstating the case for recession risk, but I am also convinced that these concerns have been abandoned much more vigorously by investors than is really warranted by the evidence.
In terms of coincident indicators, we can get a good overall picture of the improvement in the recent data by taking the average standardized value of multiple regional and national surveys. The recent bounce is clear, but we are still very close to the zero line, and of course, we observed a similar bounce in the lead-up to the 2007-2009 recession. So the recent coincident data certainly feels better, but we know from historical correlation profiles that there is not a great deal of leading usefulness in this data (see Leading Indicators and the Risk of a Blindside Recession ).
A week ago, Lakshman Achuthan of the Economic Cycle Research Institute (ECRI) reiterated his own case for an oncoming recession saying « Consider it reaffirmed. » Achuthan observed that given a broad aggregate of GDP growth, real sales, personal disposable income, industrial production, and other measures, we’ve never observed a similar decline in year-over-year growth without seeing a recession. Note that Achuthan does not simply consider the extent of the decline from a growth peak, but instead defines a downturn based on what he calls the « three P’s » – pronounced, persistent, and pervasive. On this feature of the data, we are in agreement with ECRI – we’ve observed a uniformity of recession warnings in a broad set of leading data that we simply haven’t observed across history except in association with recession.
At the same time, we’ve also seen an improvement in some measures – particularly new claims for unemployment – where the extent of positive progress we’ve seen is not at all typical of pre-recession periods. Similarly, while year-over-year employment growth remains quite tepid, that growth rate has been rising rather than falling (though we also saw that just before the 1981-1982 recession). While we know that payrolls and new claims for unemployment are actually lagging indicators, not leading ones, we still generally see new claims for unemployment creeping higher before recessions, unlike today.
So from our standpoint, the essential question is whether the improvement in job growth negates the evidence from leading indicators, and from coincident indicators that are now at year-over-year growth rates also associated with oncoming recessions. As uncomfortable as it is to contemplate a renewed economic downturn, the weight of the evidence still leans to the leading indicators and coincident growth rates. Achuthan made this point very precisely, noting that « downturns in job growth lag downturns in consumer spending growth, which is very clearly in a downturn. That’s the sequence: jobs growth follows consumer spending growth, not the other way around. »
To illustrate this, the following chart shows how growth in disposable income, personal consumption, and payroll employment correlates with recession. Leading up to a recession, and even until about 5 months after a recession starts, the evidence from personal consumption growth swamps the evidence from payroll employment growth. The growth rate of disposable income also provides better leading evidence of recession risk than payroll growth.
Notice that the peak in the correlation profile for personal consumption leads the peak in the profile for payroll employment by about 5 months. This is exactly what Achuthan is talking about. Consumption growth leads payroll growth, not the other way around. Indeed, in order to line up the peaks and troughs of the two, we have to shift payroll growth by a 5-month interval.
Now examine the year-over-year growth rate in personal income and personal consumption. With respect to personal income, we briefly observed slower year-over-year growth without recession in 1987, but recent months have shown a more persistent downturn. Similarly, real personal consumption growth (red) at 1.5% year-over-year growth is at levels that we have simply never observed historically except in connection with recessions.
Will things work out differently in the present case? Possibly, but it’s a challenging argument. Consumption and income both disappointed expectations in the latest report last week, government spending is under pressure, last quarter featured a striking inventory buildup coupled with tepid final sales, we’re seeing divergences between industrial stocks (production) and transport stocks (distribution) that smacks of oncoming inventory accumulation (which is the economic basis behind Dow Theory), and around the world, we’re seeing a sudden dropoff in trade growth. Maybe despite the abominably weak menu of prospective returns available to investors, the Fed can engineer even further financial speculation and drive prospective returns even lower. Probably the best hope is that the recent improvement in job growth will be sustained – that it is a sign of a revival in production that will create its own demand – despite the indications from consumption growth, which suggest deteriorating job growth instead.
We’ve seen arguments that recession concerns can be discarded because GDP growth has increased over the past three quarters. But we often see this prior to recessions, just as we often see a burst of job growth in the months prior to a recession. That’s exactly what keeps those periods in the « recovery » camp. Looking at the year before a recession starts, the general pattern is for GDP growth to stall to a fairly slow but positive growth rate 3 to 4 quarters ahead of the recession, followed by a strong but brief acceleration in GDP growth about 2 quarters before a recession begins, a modest positive quarter, and finally a drop to negative GDP growth. You rarely see a nice stair-step to lower and lower quarterly growth rates. The lowest quarterly GDP print in the year before a recession begins is usually about 3 quarters ahead. As a result of that stall, coupled with new quarters that are slower than the year earlier, we often see a slowdown in the overall year-over-year GDP growth rate as a recession approaches. On that note, the rate of GDP growth over the past three quarters is already lower than in the three quarters prior to 7 of the past 10 recessions, and the year-over-year growth rate is slower than it was just before 9 of them.
The FDIC Quarterly Banking Profile for the fourth quarter of 2011 was released last week. The headline: « Banks earned $26.3 billion in the fourth quarter, an increase of $4.9 billion (23.1%) from the same period in 2010. » This FDIC report was quickly picked up by news articles as a sign of clear recovery in the banking sector.
The details: « Earnings benefited further from lower provisions for loan losses. Insured institutions set aside $19.5 billion in provisions for loan losses during the fourth quarter. » The amount set aside for loan losses declined $13.1 billion (40.1%) from the fourth quarter of 2010. Actual net charge-offs of $25.4 billion exceeded loss provisions of $19.5 billion. As a result, total loan loss reserves declined by $6.3 billion (3.2%), falling for the 7th consecutive quarter. Meanwhile, full-year net operating revenue declined for only the second time since 1938 (the only other decline occurred in 2008).
In another widely reported sign of recovery, the number of insured institutions on the FDIC’s « problem list » fell from 844 to 813 during the quarter. Of course, 18 insured institutions actually failed last quarter, and so are no longer on the list. Nearly 1% of insured institutions were merged into other institutions during the quarter, likely accounting for much of the remainder.
Similarly, banks enjoyed their largest quarterly increase in lending since 2008, which was hailed as a sign of resurgence in economic activity. But recall that nearly two thirds of the GDP growth posted in the 4th quarter represented inventory buildup, not final sales (accounting for 1.88% of the revised 3% annualized GDP growth last quarter). Between the time inventories are produced and the point that they are sold, inventories are typically financed by drawing on lines of credit.
That said, two clear sources of improvement in the banking sector since 2009 have undoubtedly been wider interest spreads, and the removal of any need to report loans at market value. Essentially, the Fed has starved savers of any meaningful yield on deposits, while banks have been very slow to refinance their loan portfolios from existing, higher long-term interest rates. I remain convinced that the 2009 accounting changes have allowed periodic bouts of insolvency and near-insolvency from making their way onto balance sheets or requiring regulatory action. Along with reduced loan loss provisions (and more troubling, reduced loan loss reserves), all of this has allowed banks to report enough earnings to justify paying dividends.
A good amount of bad debt has been written down, but the remaining bad debt still needs restructuring. Notably, non-current assets and bank-owned non-foreclosed property (« other real estate owned » or OREO) is actually a larger percentage of bank assets today than in 2008. Restructuring generally means reducing the interest spread or writing down a portion of the principal, and this process is likely to siphon off earnings in the financial sector for years. Despite their preferred status as « risk on » speculative assets, I continue to view financials as a minefield.
As noted above, we presently view the menu of investment opportunities to be one of the most unfavorable in history. For equities, much of the bubble period since the late-1990’s has been worse in terms of valuations (predictably generating near-zero total returns during this span of time), but in terms of the overall overvalued, overbought, overbullish profile of the market, present conditions fall into a Who’s Who of awful times to invest. Both Strategic Growth and Strategic International remain fully hedged. Strategic Dividend Value is nearly 50% hedged. In Strategic Total Return, we clipped our duration back to about 3.5 years, and added a few percent in precious metals shares on price weakness last week, but our overall tendency is toward defensiveness here.