The Burning Platform

Ignore the stock market rally today. Read this post carefully. John Hussman is not a chicken little screaming recession. He is a sober analyst who observes facts and history to determine what is happening in the economy and the stock market. The multiple factors he uses to determine if we are going into recession are 100% in alignment. EVERY TIME IN HISTORY this has happened, we went into recession. 100% of the time. You have only yourself to blame if you incur a 30% loss in your stock portfolio over the next year. You’ve been warned.

August 29, 2011

A Reprieve from Misguided Recklessness

John P. Hussman, Ph.D.
An immediate note on market conditions. Last week’s market advance cleared out the “predictable” expectation for constructive returns that briefly emerged from the recent market selloff. That doesn’t mean that the market can’t advance further, but given that the expected return/risk profile of stocks has now shifted hard negative again, any such advance would be a random fluctuation rather than a predictable one. Strategic Growth and Strategic International Equity have shifted from a briefly constructive position back to a full hedge. Our principal investment position in Strategic Total Return remains a 20% allocation to precious metals shares, where the ensemble of conditions remains very favorable on our measures, despite what we view as a welcome correction in the spot price of physical gold. The Fund has a duration of only about 1.5 years in Treasury securities, mostly driven by a modest exposure in 3-5 year maturities.

It is now urgent for investors to recognize that the set of economic evidence we observe reflects a unique signature of recessions comprising deterioration in financial and economic measures that is always and only observed during or immediately prior to U.S. recessions. These include a widening of credit spreads on corporate debt versus 6 months prior, the S&P 500 below its level of 6 months prior, the Treasury yield curve flatter than 2.5% (10-year minus 3-month), year-over-year GDP growth below 2%, ISM Purchasing Managers Index below 54, year-over-year growth in total nonfarm payrolls below 1%, as well as important corroborating indicators such as plunging consumer confidence. There are certainly a great number of opinions about the prospect of recession, but the evidence we observe at present has 100% sensitivity (these conditions have always been observed during or just prior to each U.S. recession) and 100% specificity (the only time we observe the full set of these conditions is during or just prior to U.S. recessions). This doesn’t mean that the U.S. economy cannot possibly avoid a recession, but to expect that outcome relies on the hope that “this time is different.”

While the reduced set of options for monetary policy action may seem unfortunate, it is important to observe that each time the Fed has attempted to “backstop” the financial markets by distorting the set of investment opportunities that are available, the Fed has bought a temporary reprieve only at the cost of amplifying the later fallout.

Recall how the housing bubble started. Back in 2002-2003, Alan Greenspan held short term interest rates at such low levels that investors felt forced to “reach for yield” – and they found that extra yield in mortgage securities, which up until then had never experienced major credit difficulties. Wall Street quickly got a whiff of that, and realized that it could earn enormous fees by cranking out more “product” to satisfy investor demand. Soon, a flood of mortgage securities was created featuring increasingly complex structures (in order to maintain “AAA” status) while the proceeds from issuing these securities were offered to borrowers who were less and less creditworthy. As long as a willing borrower could be found – however unable to actually pay off the mortgage, and as long as a willing lender could be found – pressed to reach for yield by the Fed’s distortive low interest rate policies, Wall Street and the banking system got them together, and obscured the gaping chasm between actual and perceived credit risk through “financial engineering” that created slice-and-dice securities with mind-numbing complexity.

Once the housing bubble collapsed, the Fed again responded with policies aimed primarily at distorting the set of investment opportunities through zero interest rates, preserving the misallocation of capital toward speculative investments (on Bernanke’s misguided and empirically unsupported belief that consumers spend out of speculative gains). Yet the underlying debt burdens have not been restructured, so consumers – particularly homeowners – continue to pare back spending in order to reduce those debt burdens. As a result, there is little expectation of significant growth in demand, and companies therefore have little reason to hire new employees – all of which reinforces a “low level equilibrium” in the economy.

The way to get out of this is to abandon the misguided belief that economic prosperity can be obtained by encouraging speculation and distorting the set of investment opportunities. Rather, we will eventually find, as was eventually also discovered in the post-Depression stagnation of the 1930′s, that the way to get the economy moving again is to restructure hopelessly burdensome debt obligations.

Of course, this same story is playing out on a global scale. It is worth noting that the yield on 1-year Greek government debt surged to 55% last week. At present, the global bond market is expressing a 100% expectation that this debt will default. The only question now is what the recovery rate will be.

Over the past three years, Wall Street and the banking system have enjoyed enormous fiscal and monetary concessions on the self-serving assertion that the global financial system will “implode” if anyone who made a bad loan might actually experience a loss. Because reversing this mantra is so difficult, policy makers are likely to continue fitful efforts to “rescue” this debt for the sake of bondholders, through mechanisms that are increasingly distasteful to the broader population. The justification for those policies will therefore have to be coupled with rhetoric that institutions holding these securities are too “systemically important” to suffer losses.

On this note, it is critical to remember that nearly all financial institutions have enough capital and obligations to their own bondholders to completely absorb restructuring losses without customers or counterparties bearing any loss at all. So keep in mind that the debate here is not about protecting customers or counterparties – it is really about whether the stockholders and bondholders of banks and other financial institutions should bear a loss. The “failure” of a bank only means that existing stockholders and bondholders are disenfranchised – the company simply takes on a new life under new ownership. Existing stockholders lose everything, unsecured bondholders typically lose something, and senior bondholders get any residual obtained as a result of the sale or transfer of the company. If the global economy is fortunate, the financial system two or three years from now will look much the same as it does today, but the ownership and capital structure will have changed almost entirely. A major restructuring of debt is the clearest path to long-term economic recovery, and the accompanying losses to those who recklessly made bad loans would be the highest realization of Schumpeter’s idea of “creative destruction.”

From that perspective, Warren Buffett’s $5 billion investment in Bank of America preferred stock last week was essentially a defense of the old guard. Buffet observed, “It’s a vote of confidence, not only in Bank of America, but also in the country.”

Yes – to be specific, it’s a vote of confidence that the country will bail out Bank of America in any future crisis. We should all hope that Buffett’s investment is successful – provided there is no future crisis – and we should equally hope that Buffett loses the entire investment otherwise.

A reprieve from misguided recklessness

On Friday, Ben Bernanke gave his long-awaited speech at Jackson Hole, which notably did not include any pronouncement about a third round of quantitative easing. The stock market advanced anyway, largely because investors seemed to take Bernanke’s comments as a cue that the Fed will revisit the prospect of QE3 in September. Specifically, analysts focused on Bernanke’s observation that “the Federal Reserve has a range of tools that could be used to provide additional monetary stimulus. We discussed the relative merits and costs of such tools at our August meeting. We will continue to consider those and other pertinent issues, including the course of economic and financial developments, at our meeting in September, which has been scheduled for two days (the 20th and the 21st) instead of one to allow a fuller discussion.”

Part of the reason for the expanded discussion, of course, is that three FOMC members have already declared mutiny, opposing even the Fed’s promise to hold interest rates near zero through mid-2013 (which is the most resistance to a Fed decision in two decades). Still, this opposition unfortunately seems to be for the wrong reason – not because they recognize that QE2 didn’t actually work, nor because they understand that consumers don’t spend out of speculative gains – particularly in stocks and commodities, nor that they recognize that QE isn’t effective in relieving any constraints on the economy – given that interest rates are already low and banks are already awash in liquidity (though not necessarily capital – and there is a difference). Rather, the reason for their opposition seems to be that they don’t believe that economic conditions warrant further “stimulus.”

Look. Imagine that Ben Bernanke announced that he is going to stop spitting watermelon seeds into a can. Should we all become concerned that he is suddenly not doing enough to stimulate the economy? Well, only if you think that spitting watermelon seeds into a can is stimulative to the economy. And this is precisely the point. The successes of QE2 included a brief boost to pent-up demand which has already reversed, a boost to speculation in the stock market that has already reversed, a plunge in the value of the U.S. dollar that has persisted because the increased stock of U.S. dollars has persisted, and a wave of commodity hoarding that injured the world’s poor by raising prices of food and energy – because commodities are viewed as currency substitutes when governments are debasing purchasing power through money creation.

Moreover, this failure was predictable even before the Fed launched QE2, because with near-zero interest rates, depressed long-term rates, and already massive bank reserves, the policy could not hope to relieve any constraints that were actually relevant to the economy (see The Recklessness of Quantitative Easing ); because consumers don’t spend out of volatile forms of “wealth” (see Bubble, Crash, Bubble, Crash, Bubble… ); and because a monetary easing that creates inflation expectations while pressing down interest rates invariably leads to an “overshooting” depreciation in that currency and a surge in commodity prices that are quoted in that currency (see Why Quantitative Easing is Likely to Trigger a Collapse of the U.S. Dollar ). Of course, given that other central banks have also attempted to keep pace through competitive devaluations, the most spectacular collapse of the dollar has been against the currency substitute that cannot be printed by fiat – namely gold.

Even Bernanke seemed to acknowledge that further attempts at monetary intervention could only provide short-term juice, saying “most of the economic policies that support robust economic growth in the long run are outside the province of the central bank.”

On that subject, Bernanke offered some of the only sound words of his tenure, stressing that “U.S. fiscal policy must be placed on a sustainable path that ensures that debt relative to national income is at least stable, or, preferably, declining over time,” and warning against excessive austerity by observing “Although the issue of fiscal sustainability must urgently be addressed, fiscal policymakers should not, as a consequence, disregard the fragility of the current economic recovery.”

It was encouraging that Bernanke did outline several elements of a more promising policy response not involving monetary interventions, which were consistent with our own views: “To the fullest extent possible, our nation’s tax and spending policies should increase incentives to work and save, encourage investments in the skills of our workforce, stimulate private capital formation, promote research and development, and provide necessary public infrastructure. We cannot expect our economy to grow its way out of our fiscal imbalances, but a more productive economy will ease the tradeoffs that we face,” adding that “Good, proactive housing policies could help speed that process.”

The upshot is that it remains unclear whether the Fed will revert to reckless policy in September, or whether the growing disagreement within the FOMC will result in a more enlightened approach – abandoning the “activist Fed” role, and passing the baton to public policies that encourage objectives such as productive investment, R&D, broad-benefit infrastructure, and mortgage restructuring – rather than continuing reckless monetary interventions that defend and encourage the continued misallocation of resources and the repeated emergence of speculative bubbles.