Iceberg at the Starboard Bow

I’ve extracted the important parts of Hussman’s weekly letter below. The pundits, experts, and permanent bulls are as confident as the captain of the Titanic. I wonder what happens next.

“I cannot imagine any condition which would cause a ship to founder. I cannot conceive of any vital disaster happening to this vessel. Modern shipbuilding has gone beyond that.”

Edward Smith, Captain, RMS Titanic

“One reason that risk premiums may be low is precisely because the environment is less risky… The Fed has long focused on ensuring that banks hold adequate capital and that they carefully monitor and manage risks. As a consequence, banks are well-positioned to weather the financial turmoil.”

Janet Yellen, July-September 2007

What was the difference between the Titanic that left Southampton with all of the advantages and technology of modern shipbuilding, and the Titanic that plunged to the bottom of the Atlantic – still carrying all of the advantages of modern shipbuilding? Just one condition, really: a hole in the side of the ship. But distinctions matter.

One of our central themes in recent months is that – departing from what we’ve observed for most of the advance in recent years – market internals and credit spreads have deteriorated materially (see The Ingredients of a Market Crash). Particularly since late-2011, extreme overvalued, overbought, overbullish syndromes have persisted without significant corrections, despite the historical tendency for those same syndromes to devolve rather quickly into severe market losses. What follows is the primary lesson we’ve drawn from our own struggle with this. I am going to repeat it again because even a few days of strong market action make it easy to forget. My hope is that those who value our work will find it useful in placing the recent cycle in perspective. Moreover, it provides a consistent framework to understand the bubbles and crashes that have manifested over the past 15 years, and the behavior of market cycles across history.

Market history, including the series of bubbles and crashes over the past 15 years, does not teach that valuation is irrelevant, but instead that a key distinction affects whether stability or instability is likely to prevail. When rich valuations are coupled with tame credit spreads and uniform strength across a broad range of market internals and security types, one can infer that investors remain tolerant toward risk. In that environment, risk premiums may be low, but there’s no particular pressure for them to normalize, even if the speculation is driven by mindless yield-seeking. Trend uniformity and well-behaved credit spreads are an indication of risk tolerance, which allows overvalued markets to remain overvalued without immediate consequence. In stark contrast, increasing dispersion across securities and sectors, deteriorating market internals, and widening credit spreads are all subtle but observable indications of growing risk aversion – icebergs that can easily rupture the Titanic of severe overvaluation. Monetary easing then no longer supports risky assets, because risk-free liquidity is no longer seen as an inferior asset. This risk-aversion creates upward pressure on low risk premiums, which normalize not smoothly but in spikes, resulting in air-pockets, free-falls and crashes.

As warned in October 2000, “when the market loses that uniformity, valuations often matter suddenly and with a vengeance. This is a lesson best learned before a crash rather than after one.” I offered the same warning just as Janet Yellen was making her dismissive remarks about low risk premiums in 2007 (see Market Internals Go Negative).

Notably, the rather breathtaking short-squeeze we observed late last week was not accompanied by a material shift in internals or credit spreads. Understand that such improvement would not reduce the overvaluation of the market, but it would significantly reduce the immediacy of our downside concerns. Meanwhile, however, we interpret last week’s short-squeeze as more likely to be one of those “short-lived announcement effects.” Even here, despite enthusiasm over the word “patient,” the Fed announced no meaningful change of course.

Monetary easing is reliably supportive to risky assets only when safe, low-interest liquidity is viewed as an inferior asset. This can be inferred from the behavior of market internals and credit spreads. At present – again, aside from short-lived announcement effects – we don’t observe the conditions under which monetary easing should be expected to be particularly supportive to risky assets. While the current meme is that monetary easing is equivalent to rising stock prices, recall that the Fed was already aggressively lowering interest rates in the fall of 2007, and eased monetary policy aggressively and persistently through the entire course of the 55% stock market collapse that followed.

For now, we observe conditions that have historically been consistent with extraordinary equity market losses. Those conditions will change in time, and we’ll adjust our outlook accordingly.

Coupled with an increasingly synchronized global economic downturn, we’ve seen a particular collapse in oil prices. Some observers view this as if it is “stimulative” to the economy, but that perspective confuses the price decline resulting from an inward shift of the demand curve as if it was caused by an outward shift of supply. Our view is that the concerted decline in commodity prices, foreign currencies, and Treasury yields, coupled with a blowout of credit spreads in junk debt (particularly energy-related debt) is all consistent with weakening global economic prospects. Given the “cleanest dirty shirt” perception of the U.S. dollar, the greenback has certainly benefited from this dynamic. But to expect this benefit to persist assumes that a) the dispersion between U.S. and global prospects will continue to widen, and b) that widening is not already priced into the currency markets.

Given the currency weighting of the dollar index, all of this implies a general overvaluation of the dollar amounting to roughly 10% by our estimates, with Japan clearly being the most severe outlier. While we view both the global equity markets and the global banking system as precarious here.

Read John Hussman’s entire Letter Here.

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MuckAbout

I really like John and his calm, cool evaluations of U.S. and global FX and commodity markets. He quietly and calmly makes the case that we’re well and truly screwed, TEOTWAWKI is just over the hill and across the river and never raises his voice to do it.

A true honorary member of TBP..

MA

BUCKHED
BUCKHED

The Baltic Dry Index has been tanking since Thanksgiving .

Erasmus Le Dolt
Erasmus Le Dolt

The S&P index is on course for 2350. We’re currently at 2170. Yes, this will all end in tears….someday,but not now.

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