Where are we?

From John Hussman of Hussman Funds, who has been right about everything, thus far. A ten minute read that offers rational perspective in an irrational world. Enjoy!

Reckless Myopia

John P. Hussman, Ph.D.
All rights reserved and actively enforced.
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I was wrong.

Not about the implosion of the credit markets, which I urgently warned about in 2007 and early 2008. Not about the recession, which we shifted to anticipating in November 2007. Not about the plunge in the stock market, which erased the entire 2002-2007 market gain, which was no surprise. Not about the “ebb and flow” of short-term data, which I frequently noted could produce a powerful (though perhaps abruptly terminated) market advance even in the face of dangerous longer-term cross-currents. I expect not even about the “surprising” second wave of credit distress that we can expect as we move into 2010.

From a long-term perspective, my record is very comfortable. But clearly, I was wrong about the extent to which Wall Street would respond to the ebb-and-flow in the economic data – particularly the obvious and temporary lull in the mortgage reset schedule between March and November 2009 – and drive stocks to the point where they are not only overvalued again, but strikingly dependent on a sustained economic recovery and the achievement and maintenance of record profit margins in the years ahead.

I should have assumed that Wall Street's tendency toward reckless myopia – ingrained over the past decade – would return at the first sign of even temporary stability. The eagerness of investors to chase prevailing trends, and their unwillingness to concern themselves with predictable longer-term risks, drove a successive series of speculative advances and crashes during the past decade – the dot-com bubble, the tech bubble, the mortgage bubble, the private-equity bubble, and the commodities bubble. And here we are again.

We face two possible states of the world. One is a world in which our economic problems are largely solved, profits are on the mend, and things will soon be back to normal, except for a lot of unemployed people whose fate is, let's face it, of no concern to Wall Street. The other is a world that has enjoyed a brief intermission prior to a terrific second act in which an even larger share of credit losses will be taken, and in which the range of policy choices will be more restricted because we've already issued more government liabilities than a banana republic, and will steeply debase our currency if we do it again. It is not at all clear that the recent data have removed any uncertainty as to which world we are in.

Taking the weighted average outcome for the two states of the world still produces a poor average return/risk tradeoff. Taking the weighted average investment position for the two states of the world is somewhat more constructive. As I noted several weeks ago, I have adapted our weightings accordingly. As a result, we have been trading around a modest positive net exposure, increasing it slightly on market weakness, and clipping it on strength, as is our discipline. Currently, the Strategic Growth Fund has a net exposure to market fluctuations of less than 10%, but enough “curvature” (through index options) that our exposure to market risk will automatically become more muted on market weakness and more positive on market advances, allowing us to buy weakness and sell strength without material concern about the (increasing) risk of a market collapse.

There is no chance, even in hindsight (“could have, would have, should have” stuff) that I would have responded to the existing evidence in recent months with more than a moderate exposure to market risk during some portion of the advance since March. But our year-to-date returns might now be into a second digit had I recognized that investors have learned utterly nothing from the bubbles and collapses of the past decade. That recognition might have encouraged a greater weight on trend-following measures versus fundamentals, valuations, price-volume sponsorship, and other factors.

Still, our stock selections continue to perform well relative to the market, our risks remain well-managed through a substantial (though not full) hedge, and our investment approach has nicely outperformed the S&P 500 over complete market cycles, with substantially less downside risk than a passive investment approach. We have implemented some modest changes to improve our potential to benefit from (even ill-advised) speculative runs, but we've done fine nonetheless, and we can sleep nights.

Whether or not I have focused too much on probable “second-wave” credit risks is something we will find out in the quarters ahead – my record of economic analysis is strong enough that a “miss” on that front would be an outlier. What I do think is that over the past decade, investors (including people who hold themselves out as investment professionals) have become far more susceptible to reckless myopia than I would have liked to believe. They have become speculators up to the point of disaster.

Frankly, I've come to believe that the markets are no longer reliable or sound discounting mechanisms. The repeated cycle of bubbles and predictable crashes over the recent decade makes that clear. Rather, investors appear to respond to emerging risks no more than about three months ahead of time. Worse, far too many analysts and strategists appear to discount the future only in the most pedestrian way, by taking year-ahead earnings estimates at face value, and mindlessly applying some arbitrary and historically inconsistent multiple to them.

This is utterly different from true discounting – which does not rely on multiples, but instead carefully traces out the likely path of future revenues, profit margins, cash flows and earnings over time, and explicitly discounts expected payouts and probable terminal values back at an appropriate rate of return. That's what we actually do here. Talking in terms of multiples can make the process easier to explain, and can be a reasonable approach to the market as a whole if earnings are normalized properly, but ultimately, an investment security is a claim to a long-term stream of cash flows. It is not simply a blind multiple to the latest analyst estimate.

Fortunately, the evidence suggests that the long-term returns to a careful discounting approach tend to be strong even if investors repeatedly behave in speculative and short-sighted ways. This is because long-term returns are fully determined by the stream of cash flows actually received by investors over time, and because inappropriate valuations ultimately tend to mean-revert. In the face of speculative noise, the long-term returns from a proper discounting approach may not capture as much speculative return as might be possible, but over time, many of those speculative swings tend to wash out anyway.

In part, the market's increasing propensity toward speculation reflects the increasing lack of fiscal and monetary discipline from our leaders. Policy makers who seek quick fixes and could care less about long-term consequences undoubtedly encourage investors to embrace the same value system. Paul Volcker was the last Fed Chairman to have any sense that discipline and the acceptance of temporary discomfort was good for the nation.

Our current Fed Chairman's voice literally quivers in response to the phrase “bank failure,” even though in the present context, a bank failure implies none of the disorganized outcomes that characterized the Great Depression. It simply means that the bondholders take a loss and the remaining part of the institution survives intact as a “whole bank” entity (and can be sold or re-issued back to public ownership, less the debt to bondholders, as such). The same outcome would have been possible with Lehman had the FDIC been granted authority from Congress to take conservatorship of a non-bank financial entity.

In my estimation, there is still close to an 80% probability (Bayes' Rule) that a second market plunge and economic downturn will unfold during the coming year. This is not certainty, but the evidence that we've observed in the equity market, labor market, and credit markets to-date is simply much more consistent with the recent advance being a component of a more drawn-out and painful deleveraging cycle. Meanwhile, valuations are clearly unfavorable here, and even under the “typical post-war recovery” scenario, we are observing an increasing number of internal divergences and non-confirmations in market action.

As Gluskin Sheff chief economist David Rosenberg noted last week, “Even if the recession is over, the historical record shows that downturns induced by asset deflation and credit contraction are different than a garden-variety recession induced by Fed tightening and excessive manufacturing inventories since the former typically induce a secular shift in behavior and attitudes towards debt, asset allocation, savings, discretionary spending and homeownership. The latter fades more quickly.

“This is why people didn't figure out that it was the Great Depression until two years after the worst point in the crisis in the 1930s; and why it took decades, not months, quarters or even years, for the complete transition to the next sustainable economic expansion and bull market.

“Mortgage applications for new home purchases hit a 12-year low in the middle of November (down 22% in the past month!), fully two weeks after the Administration said it was going to not only extend but expand the program to include higher-income trade-up buyers. Once again, there is minimal demand for autos and housing, and that is partly because the market is still saturated with both of these credit-sensitive big-ticket items after an unprecedented credit and consumer bubble that went absolutely parabolic in the seven years prior to the collapse in the financial markets an asset values. We are probably not even one-third of the way through this deleveraging cycle. Tread carefully.”

Andrew Smithers, one of the few other analysts who foresaw the credit implosion and remains a credible voice now, concurred last week in an interview with my friend Kate Welling (a former Barrons' editor now at Weeden & Company): “The good news so far is that the stock market got down to pretty much fair value or even, possibly, a tickle below it, at its March bottom. But now it has gone up… we probably have a market which is, roughly, 40% overpriced. In order to assess value, it is necessary either to calculate the level at which the EPS would be if profits were neither depressed nor elevated, or to use a metric of value which does not depend on profits. The cyclically adjusted P/E (CAPE) normalizes EPS by averaging them over 10 years. It thus follows the first of those two possible methods. Using even longer time periods has advantages, particularly as EPS have been exceptionally volatile in recent years - and using longer time periods raises the current measured degree of overvaluation. The other methodology we use measures stock market value without reference to profits: the q ratio. It compares the market capitalization of companies with their net worth, also adjusted to current prices. The validity of both of these approaches can be tested and is robust under testing - and they produce results that agree. Currently, both q and CAPE are saying that the U.S. stock market is about 40% overvalued.”

In the chart below, the current data point would be about 0.4, not as extreme as we observed in 1929, 2000, or 2007 of course, but equal to or beyond what we've observed at virtually every other market peak in history. This aligns well with our own analysis, where as I've noted in recent weeks, the S&P 500 is priced to deliver one of the weakest 10-year total returns in history except for the (ultimately disappointing) period since the mid-1990's.



One of the fascinating aspects of the past few months is the lack of equilibrium thinking with respect to what happened to the trillions of dollars in government money that has been spent to defend the bondholders of mismanaged financial companies. Almost by definition, money given to corporations will show up most quickly as improvements in corporate earnings, and then slightly later, as executive compensation. A few pieces came across my desk last week, hailing the ability of the corporate sector to bounce back from the recent economic downturn even though revenues have continued to suffer and employment has been steeply cut. Why is this a surprise? Where else could the money have gone? Labor compensation? It is truly mind-numbing that a moment after a temporary surge of trillions of dollars, borrowed and tossed out of a helicopter (though to specific corporations and private beneficiaries), analysts would hail a subsequent improvement in corporate results as evidence of “resilience.”

What matters is sustainability, and unfortunately, it is clear that credit continues to collapse. Banks are contracting their loan portfolios at a record rate, according to the latest FDIC Quarterly Banking Profile. Even so, new delinquencies continue to accelerate faster than loan loss reserves. Tier 1 capital looked quite good last quarter, as one would expect from the combination of a large new issuance of bank securities, combined with an easing of accounting rules to allow “substantial discretion” with respect to credit losses. The list of problem institutions is still rising exponentially. Overall, earnings and capital ratios have enjoyed a reprieve in the past couple of quarters, but delinquencies have not, and all evidence points to an acceleration as we move into 2010.

Urgent Policy Implications

From a policy standpoint, it is effectively too late to forestall further foreclosures absent explicit losses to creditors. The best policy option now is to make sure that the second wave does not result in a debasement of the U.S. dollar. The way to do that is to require three things:

First, the FDIC should be given regulatory authority to take non-bank financials into conservatorship the way they should have been able to do with Bear Stearns and Lehman. If this authority had existed in 2008, Bear's bondholders would not now stand to get 100% of their money back, with interest, as they presently do, and Lehman's disorganized liquidation would have been completely unnecessary. As I've noted before, the problem with Lehman was not that it went bankrupt, but that it went bankrupt in a disorganized way. If the FDIC had authority over insolvent non-bank financials and bank holding companies, it could wipe out equity and an appropriate amount of bondholder capital, and sell the fully-functioning residual to an acquirer, as is typically done with failing banks, without any loss to depositors or customers.

Second, bank capital requirements should be altered to require a substantial portion of bank debt to be of a form that automatically converts to equity in the event of capital inadequacy. This would force losses onto bondholders, rather than onto taxpayers. This policy adjustment is urgent – we have perhaps a few months to get this right.

Finally, Congress should be clear that government funds will be available only to protect the interests of depositors, not bondholders. Specifically, any funds provided by the government should be contingent on the ability to exert a senior claim to bondholders in the event of subsequent bankruptcy, even if a category is created to allow those funds to be counted as “capital” for purposes of satisfying capital requirements prior to such bankruptcy. Government-provided capital should be subordinate only to depositor claims, if equity and bondholder capital ultimately proves insufficient to meet those obligations.

Since early 2008, beginning with the provision of non-recourse funding in the Bear Stearns debacle, the Federal Reserve and the Treasury have repeatedly allocated or implicitly obligated public funds to defend the bondholders of mismanaged financial companies. This has included the outright and non-recourse purchase of nearly a trillion dollars in mortgage securities that have no explicit guarantee by the U.S. government. By purchasing these securities outright (rather than through a well-defined repurchase agreement), the Fed is effectively obligating the U.S. government to either guarantee them or to absorb any future losses.

Aside from the fraction of bailout funding that was specifically allocated by Congress through legislation, these actions represent an unconstitutional breach into enumerated spending powers that are the domain of the elected members of Congress alone. The issue here is not whether the Fed should be independent from political influence. The issue is the constitutionality of the Fed's actions. The discretion that it has exerted over the past two years crosses the line into prerogatives reserved for Congress. That line needs to be clarified sooner rather than later.

Emphatically, the trillions of dollars spent over the past year were not in the interest of protecting bank depositors or the general public. They went to protect bank bondholders. Instead of taking appropriate losses on those bonds (which financed reckless mortgage lending), those bonds are happily priced near their face value, for the benefit of private individuals, thanks to an equivalent issuance of U.S. Treasury debt. But that's not enough. Outside of a very narrow set of institutions that are subject to compensation limits, just watch how much of the public's money – which benefitted several major investment banks following a very direct route – gets allocated to Wall Street bonuses in the next few weeks.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and mixed market action. The market remains significantly overbought on an intermediate-term basis, and we've seen increasing divergences from breadth, small and mid-cap stocks, trading volume, and other internals, which have lagged the most recent advance in the S&P 500 and other cap-weighted indices.

The prospect of a debt-repayment “standstill” from Dubai prompted some weakness in foreign markets that spilled over to the U.S. on Friday. This was interesting given that David Faber reported the issue on CNBC on Wednesday, to no reaction. Importantly, the payment difficulties do not stem from oil revenues, but largely from tourism and financial activity, as those are Dubai's chief industries (Dubai is home to the tallest building and the largest man-made islands in the world, for example). From that standpoint, it is difficult to imagine much in the way of contagion as a result of Dubai's difficulties.

Whatever shock the market will get from left field is likely to come from larger financial or geopolitical risks. The market for credit default swaps bears watching, but thus far we haven't observed spikes to indicate that something major is imminent. Unfortunately, as I noted earlier, investors have earned an “F” for vigilance in recent years, so our lead time on new difficulties may be shorter than we might like.

In any event, I'm pleased with the overall behavior of our stock holdings, and I expect that we'll have plenty of opportunity to increase our exposure to market fluctuations at more appropriate valuations. Presently, we've got a small amount of exposure to market fluctuations, but not enough to cause any material difficulties if the market experiences some trouble. The largest source of day-to-day fluctuations remains the difference in performance between the stocks we hold long and the indices we use to hedge. That source of risk has also been the primary contributor to returns over the life of the Fund.

In bonds, the Market Climate was characterized last week by moderately unfavorable yield levels and generally favorable yield pressures. We saw a good example of how the market is inclined to respond to fresh credit concerns last week, with upward pressure on the U.S. dollar and U.S. Treasuries, and downward pressure on foreign currencies and commodities. While I continue to believe that the dollar faces substantial risk of further erosion in its exchange value, as well as a near doubling of the CPI over the coming decade or so (both reflecting the massive increase in U.S. government liabilities in recent years), those prospects are not likely to emerge until risk-aversion about credit default materially abates. Credit concerns typically create a spike in demand for default-free assets such as U.S. government liabilities, so even though there is a much larger float than is likely to be sustained over time without inflation as the ultimate outcome, credit concerns tend to support the value of these liabilities and hence mutes immediate inflation pressures (essentially, monetary velocity declines as these liabilities are sought as a default-free store of value).

Gold...the King

I love that most of the people I speak to who are involved in the investment world think Gold is too expensive. That tells me there is a ways to go before we have our first intermediate top of this pulse upward. Looking at the chart below, you can see that gold has repeated the same cycle four times in its almost ten year old secular bull market. A break above it's previous high, followed by an appx 15% move upward, followed by a brief 4 to 8 week consolidation period, followed by another equal pulse upward (appx 15%) before having a more significant correction, only to repeat all over again. With this pattern in mind, I'm guessing we have a few months left before gold begins it's significant consolidation phase, which would be the end of the intermediate rally, but not the end of the bull. As I've said before, secular bulls end one way...with the public becoming euphoric, and thus, irrational about the prospects of riches to be had by the asset in question. This drives the price to ridiculous levels, and convinces the masses that it will never again go down.

How many of you own gold? How many of you have dumped everything you own to buy gold? I bet no one is nodding yes at this point. My guess is that when your friends and family are all starting businesses buying jewelry, and there are multi-level marketing positions open for you to join businesses to do just that, the top will be near, and you should be selling everything you own that is gold to buy land. That is at least a oouple of these rinse repeat cycles away in my opinion.

Anyway, here is the chart.



I continue to add to positons in GLD, SLV and GDX. Do not do this because I am. Speak to a financial professional if you are considering investing in gold, and speak to them about your goals, and risk tolerance.

I reserve the right to be wrong 50% of the time. Prioritizing risk management makes that level of accuracy profitable.

Fubsy

Another Awesome Story by Matt Taibbi

Ok. For the past couple weeks I've been thinking I need to give more focus to the infuriating goings on at Goldman Sachs, the investment bank that basically staffs the federal reserve, and consequently, takes a significant slice of the trillion dollar pie per year. What does GS doe with all this generosity by the taxpayer via the Fed? Do they payt their taxes? Nah, not really. Do they contribute to charities, non profits, or many of the other pssible means of giving back to common man? Nope. They pretty much take every liberty they can to profit off the loss of public wealth, and continue to push the envelope for more. Goldman is the poster child of greed, and avarice, and they act as though they can get away with murder. Hmmm, can they Check out Matt's latest piece.

Fubsy

http://www.rollingstone.com/politics/story/30481512/wall_streets_naked_swindle

Housing...Fair Value??

The following chart is one of the most compelling reflections of the credit bubble that I have seen. It was published by Robert Shiller, and shows the average home price adjusted for inflation from 1890 to the present. The chart shows that that although housing values have decreased by some 30% since 2006 they remain above the highest relative value of any period prior to 2002.

With all the emphasis that the government and federal reserve are putting into stabilizing home values, including purchasing 1.2 trillion dollars worth of risky mortgage backed securities (bundles of debt backed by mortgages as collateral), providing an $8,000 refund upon the purchase of a home, offering loan modifications to underwater home owners, providing FHA loans with 3% down, and remarkably, often for principal greater than the assessed value of the home being purchased, I have the following questions:

Is the housing market ready to be stabilized?

Wouldn't it make the most sense for the market to return to historic valuations?

What would a swing to historic valuation look like following the most massive bubble in housing, and arguably, credit over the past 110 years?

Doesn't it seem feasible that housing prices would not only return to mean valuations, but possibly even mirror the spike up with an exaggerated devaluation of home values as excess credit is purged from the system?

If home values do come back to Earth, what will all the incentives aimed at decreasing inventories, boosting consumer sentiment, and jump starting the credit markets really promote? To my thinking, just the opposite. People getting into these new mortgages may again find themselves under water. If they do, this will likely lead to another round of loan defaults, foreclosures, and the tightening of consumer and lender purse strings. Not to mention that in this scenario the stimulative efforts of our government pertaining to the housing sector will add to the weight of already unprecedented US debt relative to economic production.

A grim scenario, but based on the chart, and our as of yet unpurged credit markets, one with reasonable potential.

Fubsy

Does History Rhyme? or Repeat?

Here are two charts. The chart above is courtesy of Barry Ritholtz' The Big Picture blog. It compares the 1937-38 DJIA to the 2008-09 SPY, as well as the 1929-39 DJIA to 2000-2009 Nasdaq. Uncanny!

The link below shows a chart found on Mish's Global Economic Analysis blog comparing the

GDP of US from 1990 to 2009 overlaying GDE of Japan from 1989 to 2009. Intriguing.

https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiSpUcyXpcQmGRH1r5y-TA91HRgrraiaSPzf40mKjwZG-kFjVp4jnn9jTz3zXi4tSBlURomteRhv6GkS0XD7S9pLj3jhDyKHQbdBRX-hCOZy4tJRybjBNfKY8ZFr20rhix0hR4ArsEH-PkO/s1600-h/footsteps+of+japan.png

What is the take away? For me, that markets are mechanisms of human behavior. That humans react to similar situations in similar ways. That the last credit crisis with the magnitude to match our current sutuation was during the great depression, and the current market has behaved accordingly.

From chart #2 US GDP vs. Japan GDE I believe we have the most recent example of a major economy moving through a credit crisis. Given that our government's response to our credit crisis is similar to Japan's response of printing massive amounts of currency (quantitative easing), using taxpayer dollars to prevent insolvent companies from failing, bringing interest rates to zero and leaving them there, and now buying our own debt, it becomes intriguing to analyze the slope of the Japanese stock market over the past two decades.

http://stockcharts.com/h-sc/ui?s=$NIKK&p=M&st=1980-09-24&id=p91741461629&a=179098887&listNum=4

Keep in mind that when Japan's financial system went bust, their populace had substantial savings compared to ours with negative savings, and their economy began it's slide during the most prosperous 20 year period of the 20th century, whereas we enter our crisis with the global economy in recession. Thus, this comparison may be trite for several reasons, one being that the outcome of the current crisis in the US could be more dire than theirs.

Fubsy

Give Me Liberty or Give Me Debt

The stock market is on a tear. The S&P 500 has logged gains of more than 50% in the last six months! Is it time to celebrate? Are we out of the woods? Is the stock market once again the road to riches? Is it time to buy stocks? Perhaps not. Contrary to what the USA Today, CNBS, and other mainstream media darlings would like us to believe, this market may not be reflecting the health of the economy. In my opinion, it is more likely reflecting the insane strategy of our government to cure a crisis born of excessive debt and risk taking with guess what? Excessive debt and risk taking.

Here's a link that says it better than I can.

http://www.huffingtonpost.com/robert-reich/why-the-dow-is-hitting-10_b_294682.html

My questions:
-Can our government service its debt without substantial cost to our budget?
-What will happen when interest rates rise to historic norms causing the cost of
our debt to increase to mulitples beyond what it is today?
-What option will the government choose if faced with a choice between defaulting on our
debt, or printing the money to pay it off?
-What will be the value of our dollar if the printing presses continue to run?
-Is the stock market reflecting real economic growth, or the ability of the federal reserve to
prop up asset prices?
-At what point will the fed be unable to support the stock market?
-What will be the cost?

Fubsy