Tag: John Hussman

The premature ejaculators who love to scorn John Hussman for being wrong about the stock market always amuse me with their touchdown dancing before the game is over. Their pea-brains are incapable of understanding stock market cycles, history, basic math, investor psychology, and the lemming like behavior of the highly educated MBA Wall Street crowd. John’s method is designed to outperform the stock market over a COMPLETE bull/bear market cycle.

John’s latest article, Pushing Luck, is filled with facts, figures, charts, and common sense. The usual suspects will ignore the data and crow about Hussman being wrong since 2009. These knuckleheads are too enraptured with their gains through the first half of this bull/bear cycle that they are blinded to the bear portion of the cycle that has just begun. I’m sure they’ll exit gracefully before seeing all their paper gains vaporize.

There are a couple of charts and some choice facts that you should be noted in Hussman’s article. Five independent valuation models that have accurately assessed future stock market returns going back over 60 years are all in 100% complete agreement. The S&P 500 will be no higher in 2024 than it is today. I bet Boomers and Xers will not like that news, but reality bites.

There are certain points in history where the projections of S&P 500 total returns have differed somewhat depending on which fundamental measure one uses. At present, a wide range of valuation methods that are actually historically reliable show very little variation. Uniformly, and across fundamentals that have reliably correlated with actual subsequent market returns, we project likely S&P 500 total returns in the range of 1-3% annually over the coming decade. Given a 2% dividend yield, this implies that we fully expect the S&P 500 to be no higher a decade from today than it is at present.

Margin debt continues to rise as the speculative blow-off has arrived. Hussman points out the prior peaks and the subsequent valleys.

Points of rampant speculation on margin strongly overlap points of extreme bullish sentiment and extreme valuation. For that reason, and also because numerous valuation measures have a more direct relationship with subsequent market returns, margin debt is best used as a confirming indicator of cyclical market extremes. Prior spikes in margin debt / GDP in June 1968, December 1972, August 1987, March 2000, and October 2007 were followed by a bear market losses of at least one-third of market value shortly thereafter.

 Margin debt to GDP has been a fantastic indicator of stock market returns over the next 30 months. Note that the scale on the right side is inverted and the red line (S&P 500 stock market return) lags the marging debt ratio by 30 months. You can be pretty darned sure that in June of 2017 the S&P 500 will be at least 40% lower than today.

The myopic believers in the this time is different mantra will continue to scorn Hussman until reality sets in. They said the same thing in early 2000 when Hussman predicted negative returns over the next ten years. Returns were negative over the next ten years.The cycle is half over and the lemmings shouldn’t be doing their touchdown dance just yet. History always wins.

Still, nearly all of the current disputes about valuations, profit margins and so forth can be settled by an evaluation of the historical evidence. The unsettled arguments are the ones that require the present to depart from history against a century of evidence. There are two main beliefs here: that profit margins will remain elevated dramatically above norms that have been revisited in every cycle, including the two most recent ones; and that strenuously overvalued, overbought, overbullish conditions can be sustained indefinitely. These beliefs are identical to those in 2007 that we thought were settled by the 55% market plunge that followed. Investors have become speculators, and now rely on both, in the face of the same conditions that have repeatedly emerged at the most memorable market peaks in history.

Did you notice the bubble headed bimbos on CNBC hyperventilating and calling for Janet Yellen to do something about the 3% fall in the S&P 500? They have been programmed to regurgitate the falsity that the Federal Reserve can prop up Wall Street for eternity. This belief has been borne out by the fact the S&P 500 hadn’t had a 2.5% weekly decline since June of 2012. In a normal, non-manipulated, non-delusional, FREE market, there would have been 8 weekly declines of 2.5% or more over that time frame. This is how you get a bubble. If you think the 3% decline has been scary, just wait for the remaining 50%.

John Hussman provides some inconvenient facts this week for the bulls:

The ratio of nonfinancial equity market capitalization to nominal GDP is presently about 120%, compared with a historical average prior to the late-1990’s bubble of just 55%. The comparison – about double the historical norm – is about the same if one uses the Wilshire 5000, which includes financials, and for Tobin’s Q (price to replacement cost of assets). The price/revenue multiple of the S&P 500 is presently 1.6, versus a pre-bubble norm of just 0.8. All of these measures have a correlation of about 90% with subsequent 10-year S&P 500 returns, even including recent bubbles and subsequent busts.

The ratio of Shiller earnings (the 10-year average of inflation adjusted earnings) to S&P 500 current revenues is 6.4% here, versus a historical norm of 5.3%. At normal profit margins, the Shiller P/E would presently be 30 – right in line with other more reliable measures at about double its pre-bubble norm. Even at 25, however, the Shiller P/E exceeds every pre-bubble observation since 1871, except for a few weeks leading up to the 1929 peak.

Increasing our concern is a 10-week average of advisory bulls at 57.7% versus just 14.8% bears – the most lopsided bullish sentiment in decades. Add the record pace of speculation on borrowed money, with NYSE margin debt now at 2.5% of GDP – an amount equivalent to 26% of all commercial and industrial loans in the U.S. banking system. Add the currency collapses in Argentina and Venezuela, as well as fresh credit strains and industrial shortfall in China, and one has any number of factors that could be viewed in hindsight as a “catalyst” (as the German trade gap was viewed after the 1987 crash, in the absence of other observable triggers).

We all know the system is broken. We know the oligarchs meeting in Davos are worried. They think they are smarter than the plebs. They think they can fix an unfixable system with more debt. They can’t. They are just setting the world up for the greatest financial collapse in world history. As Hussman points out, China is broken. The U.S. is broken. The whole fucking world is broken.

My overall impression of the global economy here couples disruptions in developing economies with year-over-year growth in U.S. real GDP, real final sales, payroll employment and household employment all close to the border that has historically delineated expansions from recessions. The Wall Street Journal reported last week that “The China Beige Book, a quarterly survey of Chinese businesses and banks, concluded that the country’s ‘credit transmission is broken.’” The same appears to be true in the U.S., where there are $2.4 trillion of excess reserves already in the U.S. banking system.

It’s broken & it won’t be fixed.

“I feel like the problem you have is that you try to work honestly within a warped system, but in order to succeed in that system you need to have the same nature as it.” – John Hussman’s 17 year old daughter

Superstition Ain’t the Way

John P. Hussman, Ph.D.

“The problem with QE is that it works in practice but it doesn’t work in theory.”

– Ben Bernanke, Former Federal Reserve Chairman, January 16, 2014

“When you believe in things that you don’t understand, then you suffer. Superstition ain’t the way.”

– Stevie Wonder, Superstition, 1972

Bernanke clearly meant it as a joke, but it is also an unfortunate statement on recent monetary policy. It’s poetic that Stevie Wonder recorded Superstition in 1972, just before the stock market fell by half. A few weeks ago, William Dudley made the same point as Bernanke – even the Fed doesn’t quite understand how quantitative easing works. What FOMC officials are really saying is that aside from a very predictable effect on short-maturity interest rates, there is no mechanistic link between the monetary base and any other variables – financial or economic – that they are trying to control. There is a sense that creating more monetary base helps stocks advance, and that this contributes to economic confidence. What’s missing is a transmission mechanism that operates through identifiable banking and economic channels – other than promoting a speculative reach-for-yield and the psychological exuberance that accompanies a bull market.

The fact is that Treasury bond yields are above where they were when QE2 was initiated in 2010, and year-over-year growth in employment, real GDP and real-final sales have at best done little but hover at the thresholds that have historically bordered expansion and recession. Good economic policy acts to ease constraints that are binding, and monetary policy can clearly be useful in that regard – particularly during liquidity crises when depositors are rushing for cash. At present, however, quantitative easing acts by massively loosening a constraint that is not binding at all, drowning the economy with idle bank reserves that aren’t even desired. That’s going to have negative consequences.

The chart below shows the ratio of bank reserves to the M1 money supply. We no longer live in a “fractional reserve” banking system. Nearly 100% of deposits in the U.S. banking system are now backed by idle bank reserves. Keep in mind that these reserves don’t “go into” the stock market (every buyer of stocks is matched by a seller who gets the cash). Rather, these reserves may change owners, but stay in the banking system in aggregate, depressing short-term interest rates, and resulting in a pool of zero-interest deposits that change hands from one uncomfortable holder to another.

The crux of the issue is this. QE only “works” to the extent that zero-interest liquidity is treated as an undesirable “hot potato,” forcing investors to seek yield by chasing increasingly speculative assets. Having achieved that end, easy money will do nothing to support stock prices in situations where investors actually find short-term liquidity desirable, or approach speculative assets with the slightest amount of risk-aversion.

Of course, part of the impression that QE is effective also traces to misattribution: the belief that it was responsible for avoiding “global financial meltdown.” As I noted in Did Monetary Policy Cause the Recovery?:

“The novelty of quantitative easing, and the misattributed belief that monetary policy ended the banking crisis, has created financial distortions where perception-is-reality, at least for now. We believe that the modifier ‘for now’ will prove no more durable than it was during the tech bubble or the housing bubble.

“A proper understanding of the credit crisis is essential. Much of the present faith in monetary policy derives from the belief that it was the central factor in ending the banking crisis during what is often called the Great Recession. On careful analysis, however, the clearest and most immediate event that ended the banking crisis was not monetary policy, but the abandonment of mark-to-market accounting by the Financial Accounting Standards Board on March 16, 2009, in response to Congressional pressure by the House Committee on Financial Services on March 12, 2009. The change to the accounting rule FAS 157 removed the risk of widespread bank insolvency by eliminating the need for banks to make their losses transparent. No mark-to-market losses, no need for added capital, no need for regulatory intervention, recievership, or even bailouts. Misattributing the recovery to monetary policy has contributed to a faith in its effectiveness that cannot even withstand scrutiny of the 2000-2002 and 2007-2009 recessions, and the accompanying market plunges. This faith is already wavering, but the loss of this faith will be one of the most painful aspects of the completion of the present market cycle.”

On Valuation

Ben Bernanke asserted last week that market valuations seem to be within historical ranges at the moment – which is true, if you take price/earnings ratios wholly at face value, with no adjustment for profit margins, and no consideration of the fact that stocks are long-lived claims on future cash flows. The problem here, as I detailed in An Open Letter to the FOMC: Recognizing the Valuation Bubble in Equities, is that the “equity risk premium” models embraced by Bernanke, Yellen and Greenspan are terribly unreliable compared with methods that account for the cyclical variation in profit margins. The fact is that even if year-to-year earnings are volatile, the discounted value of a long-term stream of those cash flows is very smooth. As a result, the most reliable valuation measures generally have a very smooth denominator. That’s why a dozen alternative measures are far better correlated with actual subsequent total returns (these include market cap/GDP, price/revenue, cyclically-adjusted P/E, price-to-record earnings, and others).

If one examines the errors of the Fed-embraced “equity risk premium” models, one immediately finds that those errors are highly (negatively) correlated with the level of profit margins. In other words, the higher profit margins are at any point in time, the worse actual subsequent market returns tend to be, compared with the returns implied by those models. That’s not a surprise. If you take cyclically elevated profit margins at face value, you’re going to overpay. This is the principal reason that the Fed overlooks valuation risks here.

The chart below shows corporate profits as a share of GDP, with a reminder of how elevated levels relate to subsequent profit growth. I can’t emphasize enough that the issue is not what happens to profits over just the next 4 years, however. The issue is whether current profit margins are representative of what investors should expect for the next 50 years. More on that below.

Past weekly comments have presented numerous valuation models that all have a roughly 90% correlation with actual subsequent 10-year market returns, based on properly normalized earnings, forward earnings, dividends, revenues, and so forth. All provide a uniform message:

We currently estimate a negative prospective return of the S&P 500 for all horizons of less than 7 years, with prospective nominal total returns most probably within the range of 0-3% over the coming decade. Notably, these estimates draw from the same valuation methods that – in real time – correctly warned of negative 10-year returns in 2000, defended us against the bulk of the 2007-2009 collapse, and estimated positive 10-year prospective returns in the 10-14% range in early 2009 (our stress-testing response at the time was emphatically not driven by valuation concerns). At an index level, the S&P 500 is richer than it was in 1937, 1972 and 1987. Valuations are similar to those at the 2007 peak and all but the final weeks of the 1929 peak. Index valuations are clearly less extreme than in 2000, but even so, the overvaluation of the median stock has never been greater than at present.

Suppose you own a security that promises a $100 payment, 7 years from today. Your expected return on that security over the next 7 years depends on the current price. If people are paying more than $100 today for that $100 in the future, everyone holding that security may feel “wealthier” in the sense that current prices are high, but those current prices have also “eaten” the future return. In other words, the “wealth effect” of higher current prices comes at the cost of dismal future returns. As the 2000-2002 and 2007-2009 plunges should have made clear, once asset prices become richly valued relative to their properly discounted stream of future cash flows, the piper must be paid.

Criticize me for missed returns from my insistence on stress-testing our estimation methods against Depression-era data in 2009 – despite the fact that our existing methods had performed admirably. Criticize my refusal to believe that “this time is different” in the face of a syndrome of overvalued, overbought, overbullish, rising-yield conditions that have previously appeared exclusively at the 1929, 1972, 1987, 2000 and 2007 peaks. But don’t imagine that there is actually a mechanistic cause-and-effect relationship that links QE to stock prices. Don’t imagine that 7-10 year total returns for the market will be much better than zero, or assume that objective data can be discarded because of our stress-testing miss or the deferred market response to untenably exuberant market conditions. I expect that this will end badly, and there will be far better opportunities to accept risk for those who consider themselves disciplined investors rather than speculative lemmings who again squeak that “this time is different.”

A quick note on the Shiller P/E (the S&P 500 divided by the ratio of 10-year inflation-adjusted earnings). I’ve noted elsewhere that the reliability of this measure is enhanced by also adjusting it for the level of embedded profit margins, as even 10-year averaging doesn’t wipe out the effect of margin variations (see the final chart in Does the CAPE Still Work?). As a technical note, investors should be aware that S&P 500 index earnings declined by about 80% from 1916 to 1921, which has the effect of boosting the Shiller calculation in 1929 with a far greater impact than the very brief earnings declines of the past decade have done. None of our valuation arguments rely on the Shiller P/E, and several metrics are much more reliable (price/revenue being just one), but it’s a convenient measure because it’s readily available. Our own calculations prefer geometric 10-year smoothing to arithmetic, both because it performs better – particularly in post-Depression data – and it’s more sensible than discrete cut-offs for most applications.

Suffice it to say that even on the Shiller P/E, we’ve never seen higher valuations outside of a handful of weeks in 1929 and the period since the late-1990’s bubble. It bears repeating that the 2000-2002 decline wiped out the entire total return of the S&P 500 – in excess of Treasury bill returns – all the way back to May 2006. The 2007-2009 decline wiped out the entire total return of the S&P 500 – in excess of Treasury bill returns – all the way back to June 1995. Even if valuations were to move higher, there is little likelihood that investors will retain any of it. Combine similar valuations (even 30% lower than present levels) with lopsided bullish sentiment, steeply overbought prices, and upward pressure on Treasury yields, and one captures the most memorable market peaks in history. The red bars on the graph below identify other instances where we’ve observed similar overvalued, overbought, overbullish, rising-yield conditions. The green line shows the present level of the Shiller P/E.

My 17-year old daughter made an interesting comment the other day – “I feel like the problem you have is that you try to work honestly within a warped system, but in order to succeed in that system you need to have the same nature as it.” It’s certainly true that the Fed has encouraged reckless behavior and punished historically-informed investors for not going along. Fiduciary behavior is unrewarding here, and as a result, there is likely less of it. But we continue to patiently adhere to our discipline – confident in how our present methods would have performed in this and prior cycles across history in the absence of our awkward stress-testing transition earlier in this cycle.

My impression is that while recent Fed-induced market distortions are well-intended, they lack an adequate grasp of market history, valuation, and consequence. At least over the past couple of years, it’s probably also true that to succeed in this speculative episode has required investors to share that same nature. But over the longer run, market returns turn out to be quite obedient to valuation and historically-informed discipline (as was clearly demonstrated in 2000-2002 and 2007-2009), and I expect that the most durable investment gains will be achieved by sharing that more durable nature.

Regardless of my objections to the course of monetary policy, I think the Fed’s intentions are good, and I share Janet Yellen’s concern for the unemployed. I just believe that there is no demonstrable mechanism that reliably links the actions of the Fed to the outcomes it seeks, and that the unintended effects are greatly underestimated. If there is any lesson to be learned from the past 15 years, it is that the U.S. economy is desperate for scarce savings to be allocated toward productive investment and job creation, and that the economy is enduringly harmed by policies that divert investment activity toward speculative revelry. The impulse to address the collapse of one cyclical distortion through the creation of yet another has the consequence of structurally undermining the economy for a far longer period.

Meanwhile, there is unavoidable damage that is now baked into the cake, because FOMC members seem to be gauging stock valuations only in reference to current earnings without considering the effect of any normalization of profit margins – even decades from now. It’s an unfortunate situation, but unfortunate mainly because we’ve seen it before – nearly always at market peaks that we label, in hindsight, as reckless speculative carnivals. With the Fed now leveraged 74 times against its stated capital, and bond yields above the weighted average at which the Fed accumulated its assets (implying significant capital losses already), the Fed is late but correct to conclude that it has done more than enough.

A Note on Equity Durations

It’s particularly worth observing, in advance, that combination of a very long duration and a very low implied long-term rate of return on stocks creates a powder keg of severe risk and poor expected return here. The duration of the S&P 500 Index – a measure of both investment horizon and price sensitivity – is presently 50 years. Regardless of growth rates, one can demonstrate that if dividends are at least relatively smooth, the duration of stocks works out algebraically to be roughly the price/dividend ratio. For an extensive discussion of this concept, see Buy-and-Hold For the Duration?

Stocks are a claim on a very long-term stream of cash flows. Current earnings, reflecting profit margins about 80% above the historical norm, are not a useful sufficient statistic for those cash flows. Investors (or FOMC officials) who take them at face value must effectively assume that profit margins will remain at these extremes not just for a year or two, but for about five decades. Emphatically, durations rise with valuations, meaning that as stocks or bonds become more richly priced, they also become riskier and longer-term investments from a present-value standpoint.

For passive buy-and-hold investors who don’t hold any particular view about market direction, the general rule in financial planning is to align the duration of your assets with the duration of your liabilities (the horizon over which you’ll spend). For example, an investor that expects to start drawing from a retirement account 10 years from now, and then spend down the assets over the following 20-25 years, has an effective duration of something close to 20 years overall. A passive investor would target a similar portfolio duration. Given that stocks have a duration of about 50 years and 10-year bonds have a duration of about 9 years here, one could achieve a duration of about 20 years with a portfolio equally weighted between stocks, bonds and cash. Of course, our estimate is that the 10-year prospective return on such a portfolio is likely to be less than 2% annually, and we strongly believe that opportunities to achieve higher prospective returns at controlled durations will emerge over the course of the present market cycle. So our own preference is to align our durations more strategically, by extending them in response to high return/risk prospects and shortening them when – as we presently observe – return/risk prospects are dismal.

Low market durations are associated not only with high prospective returns, but also make equities appropriate for a larger fraction of a portfolio. The duration of the S&P 500 Index was just 7 years at the trough of the Depression in 1932, followed by market returns of about 34% annually over the next 5 years before overvalued, overbought, overbullish conditions (less extreme than today) prompted another plunge; the duration was 10 years in 1917, followed by market returns over 20% annually in the 12 years that led up to the 1929 crash; and the duration was 16 years at the 1982 trough, when the market returned 19% annually over the 18 years that preceded the 2000 peak.

In contrast, high market durations are associated with lower prospective returns, and also make equities appropriate for a smaller fraction of a portfolio. The duration of the S&P 500 was 33 years at the 1929 pre-crash peak; 37 years in January 1973, just before stocks lost half their value; 38 years at the August 1987 peak; 90 years at the 2000 peak, from which the S&P 500 has – even now – seen annual total returns averaging little more than 3% (with the likelihood of still another decade of similarly low returns); and 58 years at the 2007 peak. Again, the duration of the S&P 500 is presently 50 years – about double its historical average.

If you wonder why bear markets seem to be more severe since 2000 than in the past, it is because the high duration implies enormously larger price impact in response to increases in required risk premiums and expected returns. Risk premiums (estimated not using single-year earnings but far more reliable cyclically-adjusted methods) are now thinner than at any time other than the final advance to the 2000 peak, and about the same as they were in 1929 and 2007. The sensitivity of stock prices to any increase in required return is likely to be similarly breathtaking.

In honor and remembrance of Dr. Martin Luther King, Jr.

Dr. King noted that he tried to speak on the subject below at least once a year. That still seems an appropriate way to honor him. If you’ve never read Dr. King’s writings, this talk is a good place to start.

If you don’t like to read detailed analysis of why the stock market is overvalued by 80%, here is the key paragraph from Doctor Hussman:

The price/revenue ratio of the S&P 500 has reached 1.5, compared with a historical norm of just 0.8 prior to the late-1990’s bubble. The Shiller P/E (S&P 500 divided by the 10-year average of inflation-adjusted earnings) remains near 24. Importantly, despite weak earnings at various points over the past decade, the denominator of the Shiller P/E remains well within the historical growth channel that has contained Shiller earnings historically. In other words, the Shiller P/E is not being biased upward by an unusually low denominator. If anything, the ratio of “Shiller earnings” to  S&P 500 revenues is among the highest in history, so much like other price/earnings measures, even the Shiller P/E is biased downward by elevated profit margins in recent years. That said, the Shiller P/E is essentially a useful shorthand for discussion purposes, as we use numerous other measures in practice that have an equal or stronger relationship with S&P 500 total returns. I continue to view the S&P 500 as being about 80% above the level that would be associated with “fair value”, but that’s simply another way of saying that I expect annual S&P 500 total returns to average little more than 3% nominal over the coming decade. Valuations are not a timing tool, but in a mature, overbought half-cycle, where advisory bulls dramatically outpace bears, my impression is that the likelihood of a long and pleasant future for stocks is quite low, at least until much more reasonable valuations are established.

Know when to hold em and know when to fold em.

Following the Fed to 50% Flops

 John P. Hussman, Ph.D.      

One of the most strongly held beliefs of investors here is  the notion that it is inappropriate to “Fight the Fed” – reflecting the view  that Federal Reserve easing is sufficient to keep stocks not only elevated, but  rising. What’s baffling about this is that the last two 50% market declines –  both the 2001-2002 plunge and the 2008-2009 plunge – occurred in environments  of aggressive, persistent Federal Reserve easing.

It’s certainly true that favorable monetary conditions are  helpful for stocks, on average. But that average hides a lot of sins.

There are many ways to define monetary conditions using  policy rates, market yields, and variables such as the monetary  base or other aggregates. But given the strong relationship between monetary  base/GDP and interest rates, these measures overlap quite a bit, and the  results are quite general regardless of the precise definition. For discussion  purposes, we’ll define “favorable” monetary conditions here as: either the  Federal Funds rate, the Discount Rate, or the 3-month Treasury bill yield lower  than 6 months prior, or the last move in the Fed Funds or Discount Rate being  an easing. Historically, this captures about 52% of historical periods. During  these periods, the total return of the S&P 500 averaged 13.5% annually,  versus just 8.8% annually when monetary conditions were not favorable.

This is a worthwhile distinction, but it doesn’t partition  the data enough to separate out periods where the average return on the S&P  500 was below Treasury bills. So historically,  using this indicator alone would have suggested holding stocks regardless of monetary conditions. One might  expect to do better by taking a leveraged exposure during favorable monetary  conditions, and a muted exposure during unfavorable conditions, but this  strategy would have invited intolerable risks. Strikingly, the maximum drawdown  of the S&P 500, confined to periods of favorable monetary conditions since 1940, would have been a 55% loss. This compares with  a 33% loss during unfavorable monetary  conditions. This is worth repeating – favorable monetary conditions were  associated with far deeper drawdowns.

If this all seems preposterous and counterintuitive, consider  the last two market plunges. While investors seem to have forgotten this inconvenient  history, the 2001-2002 market plunge went hand-in-hand with continuous and  aggressive monetary easing.

Ditto for the 2008-2009 market plunge. Persistent monetary  easing did nothing to prevent a 55% collapse in the S&P 500.

From an asset allocation perspective, even simple  trend-following methods have performed far better historically than following  monetary policy. For example, since 1940, when the S&P 500 has been above  its 200-day moving average, the total return of the index has averaged 14.2%  annually, versus just 4.5% when the index has been below its 200-day average.  That separation in returns is meaningful, because the return during periods of  unfavorable trends did not exceed Treasury bill returns, so it would not have  harmed long-term performance to be out of the market during those periods (at  least, before transaction costs, taxes and slippage). The deepest loss of the  S&P 500, confined to periods of “favorable” trends and reflecting  occasional whipsaws, was -26%, versus -53% during unfavorable trends.

As I noted a few weeks ago (see Aligning Investment  Exposure with the Expected Return/Risk Profile), all of the net historical  benefit of favorable trend-following has occurred in periods where “overvalued,  overbought, overbullish” characteristics have been absent.  In the presence of this syndrome, the average  total return of the S&P 500 collapses below Treasury bill yields, on  average. The same is true, on average, when favorable monetary conditions are  coupled with overvalued, overbought, overbullish features.

Hands-down, the worst-case scenario is a market that comes  off of such overextended conditions and then breaks trend-support in the  context of an economic downturn. That’s not something we observe at present,  but it is something to keep in mind, as I doubt that we will avoid that  sequence over the completion of the current market cycle.

Part of the reason that monetary policy was so ineffective  during 2001-2002 and 2008-2009 is that these market collapses were preceded by  overvalued, overbought, overbullish euphoria, and then gave way to economic  downturns. Though monetary policy certainly fed the preceding bubbles, monetary  policy did not  prevent or halt those recessions, and those recessions  were not broadly recognized until stocks had already lost about 30% of their  value. At least in post-war data (Depression-era data is more challenging), the  proper investment approach has generally been to accept market risk in the  presence of favorable market action, particularly if monetary conditions are  supportive, to start walking when overvalued, overbought, overbullish  conditions emerge, and to run once  momentum rolls over (as it has already). There’s a grey area when such  overextended conditions are cleared, which can allow for recovery rallies if  market action is still supportive. But regardless of monetary policy, investors  should avoid risk in richly-valued environments once market action  deteriorates, and buckle up hard on  signs of economic weakness once an overvalued market loses trend support.

The following point should not be missed. I am not saying  that monetary conditions are unimportant. Indeed, provided that trend-following  conditions are favorable and overvalued, overbought, overbullish conditions are  absent, favorable monetary conditions have contributed to stronger total  returns for the S&P 500, and reduced periodic losses, in data since 1940.  Favorable monetary conditions are most useful in confirming and supporting favorable evidence on other measures. My  concern here,  however, is that investors  seem to believe that favorable monetary conditions are a veto against all other possible risks, regardless of whether those  risks are financial (e.g. overvalued, overbought, overbullish conditions) or  economic. This is dangerously incorrect.

There is no question that Fed action can affect economic outcomes when it relaxes some economic constraint that is actually binding (for example, during bank runs, when Fed-provided liquidity  is essential). But there is little evidence of any transmission mechanism whereby a greater supply of idle bank reserves promises to make a dent in the economy beyond occasional and short-lived can-kicks. There is also no question that interest rates matter, given that stocks must compete with bonds. But stocks are much longer duration securities than investors seem to appreciate, and the relationship between stock yields and interest rates is not even close to one-to-one, despite what Fed Model proponents might suggest.

Even so,  investors have come to believe that there is a direct  cause-and-effect link from monetary easing to rising security prices. The  historical evidence is much less supportive. Interestingly, if we look at  conditions that have been most generally hostile for stocks on average (S&P  500 below its 200-day moving average, or overvalued, overbought, overbullish  conditions in place), more than half of these periods were accompanied by  “favorable” monetary conditions. Stocks proceeded to underperform Treasury  bills anyway, on average, with steep interim losses.

Conversely, monetary conditions have been unfavorable in  nearly half of historical periods where trends were supportive and overvalued,  overbought, overbullish features were absent. In those periods, the average  total return of the S&P 500 was still quite strong, and returns were only  slightly lower than when monetary conditions were favorable under otherwise similar  conditions (15.6% vs. 18.9% at an annual rate), while periodic drawdowns increased  only slightly.

So again, the point is not that favorable monetary  conditions are irrelevant. The point is that they are not omnipotent – and that  the most severe market losses on record have been accompanied by aggressive easing. Without question, quantitative  easing has been very effective in suppressing spikes in risk premiums in recent  years. More recently, it has been effective in removing any perception that  stocks have risk and creating the impression that easy money is enough to  override every possible economic or financial concern. But that is where perception  has moved beyond reality. There is no evidence in the historical record for  such optimism. Indeed, even the recovery from the 2009 lows was more directly  linked to the change by the Financial Accounting Standards Board to eliminate “mark-to-market”  accounting (keeping banks from insolvency even if they were technically  insolvent) and the shift to an outright guarantee of Fannie Mae and Freddie Mac  debt by the U.S. Treasury. It is superstition to believe that monetary easing  is a panacea. Investors who recognize (actually, simply remember) this now  are likely to fare better than those who are forced to relearn it later.

Needless to say, all of this will be summarily ignored by speculators  who have been rewarded by the strategy of following the Fed in a mature,  overvalued, overbought, overbullish, unfinished half-cycle that recently hit new  highs. Advice from Kenny Rogers – you never count your money when you’re sittin’  at the table.

Economic Notes

We’re observing some very wide dispersion in regional  economic surveys in recent reports. On one hand, the Chicago Purchasing  Managers Index surged to 58.7 last month, with the important new orders  component jumping to 58.1 (a level of 50 on the PMI is neutral). This sort of  strength, if sustained over several months and joined by strength in the  Philadelphia Fed index, would  help to ease our economic concerns  here, as several months of strength on these two measures are among the more  reliable leading indicators of economic shifts.

On the other hand, in nearby Milwaukee, the PMI collapsed  from 48.4 to 40.7, while the Philadelphia Fed index itself dropped into negative  territory, falling from +1.3 to -5.2, with the new orders component  deteriorating from -1.0 to -7.9. That general weakness was much more in line  with what we’re observing from other surveys, including the Chicago Fed  National Activity Index, Empire Manufacturing, Dallas Fed, and Richmond Fed.

When we plot “outliers” (where the Chicago PMI deviates from  the average of the other surveys), against subsequent changes in the Chicago PMI, what results is a clearly downward-sloping scatter,  meaning that positive outliers, as we presently observe, are typically  corrected by subsequent disappointments in the Chicago PMI. Conversely,  however, outliers in the Chicago PMI are typically not related to subsequent positive surprises in the other indices.  Again, joint strength in the Chicago PMI  New Orders component and the Philly Fed index, sustained over a period of 3-4 months, does tend to lead broader  improvements. This is not what we observe here.

In short, the coincident and leading economic evidence is  deteriorating, not improving. Even the chart below incorporates a strong Chicago PMI  figure that appears to be a temporary outlier. Employment data is a well-known  lagging indicator, and is always somewhat “rear-view”, but it’s fair to say  that given what is now the lowest labor participation rate in 30 years, the  relatively restrained level of new claims for unemployment has been a bright spot.

It seems to be universally assumed that surprisingly strong  data on the economic and jobs front would pose the greatest risk to the market,  as it would accelerate the “taper” of quantitative easing. To the contrary, the  largest risk here would be an acceleration of disappointing economic data, as  it would further reinforce the case made by former Fed Chairman Paul Volcker  that the benefits of quantitative easing are “limited and diminishing.” Disappointments  on the economic front may be met with knee-jerk enthusiasm. But the quickest  path to an extended bear market would be a deteriorating economy, coupled with  recognition that quantitative easing has an even weaker benefit/cost tradeoff  than is already plain.

The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Only comments in the Fund Notes section relate specifically to the Hussman Funds and the investment positions of the Funds.

Fund Notes

Investors, like the proverbial frog, invariably wish to remain  in a boiling pot as long as possible. But as I noted a few weeks ago, very few  live frogs can be pulled from a boiling pot once a syndrome of overvalued,  overbought, overbullish market conditions is coupled with a deterioration in  the market’s momentum. When we examine the set of historical periods  where the market has been overvalued, overbought, and overbullish even to a lesser extent, very few instances have been followed by positive returns once  measures of price momentum deteriorate. This is the  situation we presently observe.

The price/revenue ratio of the S&P 500 has reached 1.5, compared with a historical norm of just 0.8 prior to the late-1990’s bubble. The Shiller P/E (S&P 500 divided by the 10-year average of inflation-adjusted earnings) remains near 24. Importantly, despite weak earnings at various points over the past decade, the denominator of the Shiller P/E remains well within the historical growth channel that has contained Shiller earnings historically. In other words, the Shiller P/E is not being biased upward by an unusually low denominator. If anything, the ratio of “Shiller earnings” to  S&P 500 revenues is among the highest in history, so much like other price/earnings measures, even the Shiller P/E is biased downward by elevated profit margins in recent years. That said, the Shiller P/E is essentially a useful shorthand for discussion purposes, as we use numerous other measures in practice that have an equal or stronger relationship with S&P 500 total returns. I continue to view the S&P 500 as being about 80% above the level that would be associated with “fair value”, but that’s simply another way of saying that I expect annual S&P 500 total returns to average little more than 3% nominal over the coming decade. Valuations are not a timing tool, but in a mature, overbought half-cycle, where advisory bulls dramatically outpace bears, my impression is that the likelihood of a long and pleasant future for stocks is quite low, at least until much more reasonable valuations are established.

Strategic Growth remains fully hedged, and the recent  decline has taken the market to or below the “staggered” strike prices that we  established at higher levels on the index put option side of our hedge, raising the value of those options toward 2% of Fund value at present. While  recent Fund returns have been primarily driven by differences in performance  between the stocks held by the Fund and the indices we use to hedge, the impact  of these index put options will likely become a source of day-to-day Fund  variability if a market decline takes them significantly in-the-money. This can  create a give-and-take profile in day-to-day returns, where a sharp market  decline may benefit those put options one day, and a market advance the next  may withdraw that benefit. My suggestion here is to take day-to-day fluctuations with  something of a grain of salt, because if this sort of give-and-take profile  emerges, it will most likely be because a market decline has taken the Fund’s put options “in-the-money,” and market action is generally validating a defensive stance. My strongest concern in early declines from overbought peaks is the tendency for selling to become indiscriminate. Our staggered strike hedge is largely insurance against that potential risk here.

Of course, we do shift our strike prices opportunistically,  and I expect to lessen or remove portions of our hedges as constructive  evidence emerges. As I’ve often noted, the most likely opportunity to accept a  greater exposure to market fluctuations would be a moderate retreat in  valuations coupled with a firming of market internals, and the absence of an overvalued, overbought,  overbullish syndrome of conditions.  I  have little doubt that we will observe such combinations of evidence during the  completion of the present market cycle, not to mention future ones.

Meanwhile, Strategic International remains fully  hedged, and Strategic Dividend Value remains hedged at about 50% of the value  of its stock holdings. In Strategic Total Return, we boosted our duration  slightly on the recent spike in Treasury yields, bringing the Fund’s duration to  about 3.5 (meaning that a 100 basis point move in interest rates would be  expected to impact Fund value by about 3.5% on the basis of bond price  fluctuations. Conversely, we are observing a growing tendency toward risk  aversion from a variety of sectors such as corporate debt, and the combination  of higher Treasury yields and lower inflation pressures tends not to be as  supportive as we would like for precious metals shares, despite what we see as  undervaluation. Balancing these considerations, we scaled our precious metals  position below 10% of assets for a while.

John Hussman is the master of the understatement. Heed his warning:

“Markets move in cycles. Investors learned  that by the 2002 lows, but only after terrible losses. They learned it again in 2009. They  have already forgotten, so investors will have to learn it yet again.”

The show may go on for a few more weeks, but the stampede for the exits will be epic. Your “friends” on Wall Street have blocked the exits and caged you in.

Not In Kansas Anymore

John P. Hussman, Ph.D.      

Having rested the case for a defensive investment stance in  a series of recent weekly comments (see Closing Arguments for  a summary), what remains is simply to update the status of those  considerations. Importantly, our concerns are driven by the average outcomes that have accompanied  similar evidence. We don’t need to forecast near-term direction, and while we  have very strong views about long-term return prospects, there are likely to be  numerous constructive opportunities along the way to more favorable valuations.  Our approach is to align our investment position with the return/risk profile  that we estimate based on observable evidence at the present moment. The fact that  similar evidence has historically been so one-sidedly hostile is certainly  worth noting, but in fact, no forecasts are required, and we have every  expectation of moving with the evidence. What is most necessary here is simply  the recognition that markets move in cycles, that investment conditions will  change over time, and that returns born of euphoria are not easily retained.

On overvalued, overbought, overbullish conditions

Last week, Investors  Intelligence reported that the percentage of bullish investment advisors  moved to 54.2% (from 52.1% the prior week) with just 19.8% of advisors bearish.  The Shiller P/E (S&P 500 Index divided by the 10-year average of inflation-adjusted  earnings) reached 24.5. The S&P 500 is well-through its upper Bollinger  bands (two standard deviations above its 20 period moving average) on weekly  and monthly resolutions, in a mature bull market advance, with 10-year Treasury  yields higher than they were 6-months prior.

None of these conditions in isolation has enormous impact;  each usually only modifies expected  returns. The problem is that when significantly overvalued, overbought,  overbullish conditions have been observed together – particularly coupled with  rising bond yields – the syndrome indicates a disease that none of the symptoms identify individually.

I’ve noted before that even a Shiller P/E above 18 combined  with a wide spread of bulls versus bears at some point during the prior 4-week  period is generally enough to outweigh trend-following considerations, such as  the S&P 500 being above its 200-day moving average (see Aligning Market Exposure  with the Expected Return/Risk Profile). I’ve also noted that some  conditions can be more simply defined. For example, instances featuring bearish  advisors below 20%, with the S&P 500 at a 4-year high and a Shiller P/E  above 18 are limited to the present advance, May 2007, August 1987, December  1972 (though with an early signal in March-May of that year), and February 1966,  all which were followed by significant bear market losses.

Various definitions of an overvalued, overbought, overbullish  syndrome can capture slightly different instances. Less stringent definitions  capture a larger number of danger zones, but also allow more false signals.  Still, as long as the basic syndrome is captured, the subsequent market outcomes  are almost invariably negative, on average. Presently, what we observe is among  the least frequent and most hostile syndromes we identify.  As I observed in the weekly comment that  turned out, in hindsight, to accompany the 2007 market peak (see Warning – Examine All Risk  Exposures):

“There is one particular syndrome of conditions after which  stocks have reliably suffered major, generally abrupt losses, without any  historical counter-examples. This syndrome features a combination of  overvalued, overbought, overbullish conditions in an environment of upward  pressure on yields or risk spreads. The negative outcomes are robust to  alternative definitions, provided that they capture that general syndrome.”

The chart below highlights each point in history that we’ve  observed the following conditions: Overvalued: Shiller P/E anywhere above 18;  Overbought: S&P 500 at least 7% above its 12-month average, within 3% of  its upper Bollinger bands on weekly and monthly resolutions, and to capture a  mature advance, the S&P 500 well over 50% above its lowest point in the  prior 4 years; Overbullish: a two-week average of advisory bulls more than 52%,  and advisory bears less than 28%. Rising yields: 10-year Treasury yields higher  than 6-months earlier. The instance in 1929 is based on imputed sentiment data,  as bullish and bearish sentiment is correlated with the extent and volatility  of prior market fluctuations.

One of the difficulties with this sort of analysis is that instances  that appear to be very clear peaks on an 85-year chart are actually periods  where there was often a cluster of instances with further market advances for  several more weeks. In 1929, the market advanced another 5% to its final peak  in the two weeks following the first instance of this syndrome. In 1972, the  market advanced a final 3% over 6 weeks. The 1987 and 2000 peaks occurred the same  week that the syndrome emerged. In 2007, the S&P 500 advanced to within 2%  of its final peak 3 weeks after this syndrome emerged, and crawled within 1% of  that peak after 9 weeks. The S&P 500 then dropped nearly 10% over the next  4 weeks, and then staged a final 11% spike over 8 weeks to a marginal new high  which actually marked the 2007 peak. In 2011 the market enjoyed a choppy 6%  advance, dragged out over 16 weeks, before rolling into a 19% correction over  the following 12 weeks. The present signal reiterates the first one that we  observed in late-January, 17 weeks ago. To a long-term investor, this is the  blink of an eye, but in the context of day after day of bullish euphoria, it  seems like an absolute eternity.

In general, the initial decline from these peaks tends to  occur as a sharp 6-10% market drop over a handful of weeks, typically followed  by a partial recovery attempt toward the prior peak. This sort of activity both  before and after major peaks gives the market the impression of near-term  “resilience” that dilutes the resolve even of investors who know the history of  these things.

I should note that present conditions are extreme enough  that neither trend-following nor momentum factors can be used to separate out  favorable outcomes from this small set of decidedly unfavorable ones. As I’ve  previously noted, a great deal of our research during this advance has focused  on this sort of “exclusion analysis.” I recognize that many investors have  simply decided on the strategy of holding stocks until QE ends, or some similar  formulation of “strategy,” but for better or worse, we do insist on approaches  that we can validate in historical and out-of-sample data, and that have been  strongly effective over full market cycles. When we examine the past few years,  as well as long-term history, the most effective “exclusions” aren’t simple  ones like “don’t fight the trend” or “don’t fight the Fed.” Rather, they are  more subtle prescriptions like “stay with the trend in an overvalued market,  but only until overvalued, overbought, overbullish conditions are established.”  These considerations aren’t actually required to do well over complete market cycles, but quantitative  easing has held off the resolution of historically unfavorable market  conditions much longer than usual, and these subtle considerations would have  undoubtedly made recent experience less frustrating.

If this bull market is to continue, I have little doubt that  considerations like this will provide the opportunity to be constructive on the  basis of well-tested evidence that  actually supports a constructive stance. Here and now, a constructive stance is  an experiment about whether QE can override market conditions that have always  preceded unfortunate outcomes. My views and research should be of no impediment  to investors with a different view, assuming that they have a reliable exit  criterion that will precede the attempts of tens of millions of others to exit.  It would be far easier to conduct that experiment without me than to convince  me that it is a good idea.

As the respected technician Bob Farrell once noted, “exponential rapidly rising or falling markets usually  go further than you think, but they do not correct by going sideways.” This  is really all the 1987 crash was – a mass of investors trying to preserve  profits from the preceding advance by acting on the identical trend-following  exit signal simultaneously.

On valuations

Even in the event that quantitative easing is sufficient to  override hostile market conditions in the near-term, it is worth noting that long-term outcomes are likely to be  unaffected. We presently estimate a prospective 10-year total return on the  S&P 500 Index of just 2.9% annually (nominal). See Investment,  Speculation, Valuation and Tinker Bell for the general methodology here,  which has a correlation of nearly 90% with subsequent 10-year market returns – about  twice the correlation and nearly four times the explanatory power as the “Fed  Model” and naïve estimates of the “equity risk premium” based on forward  operating earnings.

We presently estimate  that the S&P 500 is about 94% above the level that would be required to  achieve historically normal market returns. If you work out present  discounted values, you’ll find that depressed interest rates can explain only a  fraction of this differential, even assuming another decade of QE – and even  then only if historically inconsistent assumptions are made to combine normal  economic growth with deeply depressed rates.

This chart gives a good overview of what has actually  transpired in the stock market through post-war history. Points of deep  undervaluation like 1942, 1950, 1974 and 1982 created foundations on which long secular bull market advances were  built. The rich valuations of the mid-1960’s were enough to ensure that any  return to undervaluation would result  in a long period of poor market returns. The late-1990’s bubble took valuations  far above any historical valuation norm, and ensured that even a return to valuations previously considered “rich” would  produce devastating returns, and we saw that in 2000-2002. The advance to the  2007 peak did not go nearly as far, but still ensured that even a return to normal valuations would produce  devastating returns, and we saw that in 2007-2009.

At present, valuations are less extreme than they were in  2000, approach levels that were reached in 2007, and remain well beyond those  observed at the late-1960’s secular peak. The question is where valuations will  go from here, and while other indicators can be applied to that question,  valuations alone don’t provide the answer. Matching the valuations of the 2007  peak would require another 8% advance in the S&P 500. A return to  historically normal valuations would imply a 48% market decline – the average cyclical bear market in a secular bear market period has typically  represented a decline closer to 38%. A move to secular lows (about 0.5 as a  multiple of fair value) would imply a Depression-like drop of about 75%, but  such lows are typically associated with macroeconomic crises such as world war  or uncontrolled inflation. Still, these are all valuations that we’ve actually  observed in the post-war period. None of these calculations are indicative of  where the market is going, but we should at least be aware of the extremes that  are already in place.

On the economy

Among the better leading indicators of the economy, the  Philadelphia Fed Index of economic activity deteriorated to 1.3 in April, and  dropped to a disappointing -5.2 reading for May. The Chicago Purchasing  Managers Index slipped from 52.4 to a contractionary reading of 49 in April,  though the important “new orders” component held above 50, coming in at 53.2.  The chart below shows data on a variety of national and regional surveys from  the Fed and the Institute of Supply Management. Notably, the chart shows data  only through April. The May reports released thus far are the Philly Fed and  Empire Manufacturing surveys, both which surprised significantly to the  downside.

As I noted last week, holding  hours worked constant, the U.S. economy would have lost the equivalent of  550,000 to 600,000 jobs in April. Meanwhile, excitement about improvement in  the federal deficit is largely driven by several one-off factors and quite rosy  assumptions. These include special distributions, repayments from Fannie Mae  and Freddie Mac, the expiration of accelerated depreciation deductions for  investment, and capital gains realizations taken in advance of the “fiscal  cliff.” Projections of further deficit reductions are predicated on assumptions  that inflation in health costs will be controlled; that corporate tax revenues will  increase by 57% by 2014 (and 88% by  2015); that the U.S. economy will avoid any recession in the coming decade; and  that real GDP growth will increase to 4% (6% nominal) in the coming years,  despite a 9% decline in discretionary outlays by the government next year. The CBO projections also assume that tax revenue as a percentage of GDP will move sustainably  above the long-term average. I do expect that the Federal deficit will gradually come down over time. But barring  a massive, domestically financed increase in gross real investment (which the  data do not suggest is presently in the works), the 2-quarter lagged effect of a  smaller government deficit is likely to be weaker corporate profit margins, for  reasons I’ve articulated previously.

On quantitative easing

Over the past three years,  the U.S. economy has repeatedly approached levels that have historically marked  the border between expansion and recession. There is little question that  massive quantitative easing by the Federal Reserve has successfully nudged the  economy away from this border for a few months at a time. But as I’ve noted  before, the belief that monetary easing solved the 2008-2009 financial crisis  is an artifact of timing. The Fed was easing monetary policy throughout 2008,  and while it is tempting to view the recovery as a delayed effect, the more  proximate factors were a) the change in FASB accounting rules to dispense with  mark-to-market accounting, which relieved banks of insolvency concerns even if  they were technically insolvent, and b) the move to government conservatorship and  Treasury backstop of Fannie Mae and Freddie Mac, which reduced concerns about  default risk among mortgage securities.

The Pavlovian response of  investors to monetary easing – as if it has anything more than a transitory and  indirect effect on the economy – fails to distinguish between liquidity and  solvency; between economic activity and market speculation; and between  investment value and artificially depressed risk premiums. The economy is not  gaining anything durable from these policies, and the conditions for the next  bear market are already established. Meanwhile, the chart below updates the  extreme that monetary policy has already reached (data points since 1929).

The 3-month Treasury yield  now stands at a single basis point. Unwinding this abomination to restore even  2% Treasury bill rates implies a return to less than 10 cents of monetary base  per dollar of nominal GDP. To do this without a balance sheet reduction would require 12 years of 6% nominal growth (which  is fairly incompatible with sub-2% yields), a more extended limbo of stagnant economic  growth like Japan, or significant inflation pressures – most likely in the back  half of this decade. The alternative is to conduct the largest monetary  tightening in the history of the world.

None of this is to suggest  that speculation cannot go further – though present overvalued, overbought,  overbullish extremes weigh against it. Still, valuations and monetary  conditions are far removed from what is sustainable, and there is more evidence  to indicate that the economy is weakening than support of the idea that it is  strengthening.

Knowing where you are doesn’t mean that you’re leaving, but you should still know where you are. We’re  not in Kansas anymore.

The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Only comments in the Fund Notes section relate specifically to the Hussman Funds and the investment positions of the Funds.

Fund Notes

Last week, market conditions reiterated the most hostile  syndrome of overvalued, overbought, overbullish, rising-yield conditions we  identify. Strategic Growth Fund remains fully hedged, with a “staggered strike”  hedge that raises the strike price of the index put option side of the hedge  closer to market levels, but we continue to significantly lag those strikes  below the market in order to minimize time decay. Presently, that staggered  strike position represents less than 1% of assets in additional time premium  looking out to mid-summer. This also means that until the market declines by  more than several percent, most of the day-to-day fluctuation in Fund value is  likely to be driven by differences in performance between the stocks owned by  the Fund and the indices we use to hedge. Strategic International remains fully  hedged. Strategic Dividend Value is hedged at about 50% of the value of the  stocks held by the Fund. Strategic Total Return continues to carry a duration  of about 3 years (meaning that a 100 basis point move in interest rates would  be expected to impact Fund value by about 3% on the basis of bond price  fluctuations), and just over 12% of assets in precious metals shares.

There are countless investment strategies that offer  aggressive investment approaches, long-only exposure, and loads of various  market risks for investors who desire them. We follow a specific, long-term  discipline defined by an effort to accept market risk in proportion to the  expected return/risk profile that we estimate based on prevailing conditions.  We make every attempt to refine that discipline over time, but the Funds are  defined by the specific investment objectives and disciplines that we promise  to our shareholders. We constantly research promising indicators and investment  considerations. Those that place heavy weight on trend-following and  Fed-following are testable strategies,  and their return/risk characteristics can be carefully evaluated. Once  overvalued, overbought, overbullish conditions emerge, they don’t perform  nearly as well over time as investors seem to believe. Quantitative easing is certainly  “new” in the sense that such extreme policies have never been pursued. But data  on interest rates, Fed action and the monetary base go back nearly a century,  and even analyzing more recent experience with quantitative easing by Japan,  England, the European Central Bank and the Federal Reserve leaves us with  little confidence that QE does much more than to temporarily suppress periodic  spikes in risk premiums.

Investors who wish to follow the Fed to the exclusion of  other evidence should feel no compulsion to consider our own research, or our  own performance in the years prior to the recent bull market advance. In my  view, we are now in a very mature, unfinished half of a market cycle  spectacularly distorted by monetary and fiscal imbalances. The prospects that  the financial markets will face over the next few years are quite unlikely to  mirror the lovely ones that they enjoyed while these imbalances were being  established.

Nearly all of my own assets remain invested in the four  Hussman Funds, with the largest allocation to Strategic Growth, because despite  the challenges we’ve experienced in the advancing portion of this cycle, I have  no doubt that the financial markets will experience cycles – not endless parabolas  – over time. We accept a significant of “tracking difference” versus a  buy-and-hold approach because our objective is to achieve full-cycle returns above  the long-term norm for equities, with smaller losses than the general market over  the full-cycle. There is no assurance we’ll achieve that objective, and the  recent cycle has been an extraordinary challenge for reasons that I’ve  frequently detailed. In contrast, I view the performance of Strategic Growth in  the 2000-2008 period to be a reasonable reflection of those objectives in practice, even in an  environment where the general market achieved no net gain.

With regard to the challenges of the most recent market  cycle, my insistence on stress-testing our approach against Depression-era data  in 2009 to early-2010  led to an unfortunate miss in the interim, but I believe  that it will make us more resistant to extreme market conditions in the future.  I also believe that we’ve addressed most (though probably not all) of the challenges  created the monetary-driven speculation of recent years by incorporating what  I’ve described as “exclusion analysis.” This involves refining the pool of  periods where average expected  outcomes are negative in order to “exclude” the largest set of constructive  instances from that pool, and validating the exclusion criteria in out-of-sample data. For example, trend-following considerations can be important  even in periods where our return/risk estimates are negative, but only in the absence of overvalued,  overbought, overbullish syndromes. That refinement could have saved us some  trouble in recent years, but such considerations still do not encourage a  constructive position here. That may be a shame, or it may turn out to be a  blessing. All we know with certainty is that nearly a century of evidence –  even including trend-following and monetary factors – supports a defensive  stance from our investment approach here.

This will change. Markets move in cycles. Investors learned  that by the 2002 lows, but only after terrible losses. They learned it again in 2009. They  have already forgotten, so investors will have to learn it yet again

John Hussman reveals Bernanke to be a filthy stinking liar by using some basic facts. Bernanke can never unwind his balance sheet without destroying the U.S. economy. He says he is waiting for unemployment to drop under 6.5%. If it ever drops below that level, he will come up with another excuse to unwind his balance sheet. He’s trapped. He is stalling while his masters finalize their exit and extract the remaining wealth of the nation. Bennie has no intention of ever unwinding anything. He will print to infinity and beyond.

Roach Motel Monetary Policy

 
John P. Hussman, Ph.D.
All rights reserved and actively enforced.
Reprint Policy

While we continue to observe some noise and dispersion in various month-to-month economic reports, the growth courses of production, consumption, sales, income and new order activity remain relatively indistinguishable from what we observed at the start of the past two recessions. The chart below presents the Chicago Fed National Activity Index (3 month average), the CFNAI Diffusion Index (the percentage of respondents reporting improvement in conditions, less those reporting deterioration, plus half of those reporting unchanged conditions), and the year-over-year growth rates of new orders for capital goods excluding aircraft, real personal consumption, real retail and food service sales, and real personal income. All values are scaled in order to compare them on a single axis.

Strong leading indicators such as the CFNAI and the Philly Fed Index have been weak for many months, and the deterioration in new orders has moved from a slowing of growth to outright contraction in recent months. In the order of events, a slowing in real sales, personal income, and personal consumption expenditure typically follows – these are called coincident indicators. These growth rates generally only weaken materially once a recession is in progress, and reach their highest correlation with recession about 6-months into the downturn. That’s what we’ve begun to observe over the past few months, adding to our impression that the U.S. joined a global (developed economy) recession during the third quarter of this year. The most lagging set of economic indicators includes employment measures, where I’ve frequently noted that the year-over-year growth rate of payroll employment lags the year-over-year growth rate of real consumption with a lag of about 5 months. As a result, the year-over-year growth rate in payroll employment reaches its highest correlation with recession nearly a year after a recession has started – another way of saying that it is among the last indicators to examine for confirmation of an economic downturn.

All of that said, our concern about recession emphatically is not what drives our concern about the stock market here. In early March, our measures of prospective return/risk moved to the lowest 1% of historical data based on a broad ensemble of indicators and consistent evidence of market weakness following similar conditions in numerous subsets of historical data. Those conditions remain largely in place today.

There’s no question that massive fiscal and monetary interventions have played havoc with the time-lag between unfavorable conditions and unfavorable outcomes in recent years, which prompted us back in April to introduce various restrictions to our hedging criteria (see below). Still, present conditions remain strongly negative on our estimates. Meanwhile, the stock market is not “running away” –  at best, these interventions have allowed the market to churn at elevated levels. Only a month ago, the S&P 500 Index was below its level of March 2012, when our estimates shifted to the most negative 1% of the data, and was within about 11% of its April 2010 levels, which is the last time that our present ensemble approach would have encouraged a significant exposure to market risk. Notably, as of last week, an upward spike in long-term Treasury yields took market conditions to an overvalued, overbought, overbullish, rising yields syndrome – which has tended to be anathema to the stock market, even prior to the more limited downward bouts of recent years.  

Beyond that, a natural question is – if recession concerns don’t factor into our present defensiveness in the first place, why should we be concerned about recession at all, and devote so much analysis to this issue in the weekly comments? The first answer is that the foundation of this particular cyclical bull market has rested on the continuation of massive fiscal and monetary interventions, and a new recession would stretch those interventions to untenable limits (and to some extent already have), which should be of concern regardless of one’s stock market views. The second answer is that much of Wall Street’s overbullish sentiment, as well as its “valuation” case for stocks, rests on the continuation of record high profit margins that are largely an artifact of extreme government deficits and depressed personal savings (see Too Little To Lock In). A contraction in sales, coupled with a contraction in profit margins – which is what we presently expect – is likely to devastate the “forward operating earnings” case for stocks, and I continue to expect Wall Street to be blindsided by this fairly predictable outcome (as it was in 2001-2002, as it was in 2008-2009).

The distortions we presently observe in the economy will have significant long-term costs, but it is entirely naïve to believe that these costs should be evident precisely at the point where the wildest distortions are taking place. Federal deficits presently support about 10% of economic activity, and the primary driver of improvement in the unemployment rate has not been job creation but a plunge in labor participation, as millions of workers drop out of the labor force. In a post-credit crisis environment, and particularly with Europe’s sovereign debt in question, it should be no surprise that the world has been willing to accumulate U.S. currency and Treasury debt at near-zero interest rates. That makes debt seem benign and money creation seem without consequence. But it is absurd to point at that happy short-term outcome and dance under the illusion that escalating debt won’t matter in the longer term, or that massive money creation will be easily reversed, or that strong inflation will be avoided if it is not reversed.

We have already accumulated enough government debt to place a broad range of current and future government services under a cloud. Given that most of the publicly held U.S. government debt is of short maturity, there is no way of inflating away its real value over time, because interest rates would adjust at each rollover of that debt. In the event that the sheer size of the U.S. debt results in a loss of confidence (which is a 5-10 year proposition, though not yet a present one), there is no reason that we could not expect the same short-term funding strains that many European countries are facing in fits and starts today.

Meanwhile, last week, Ben Bernanke announced that the current “Twist” program (where the Fed buys long-term Treasuries and sells an equal amount of shorter-dated Treasuries) will be replaced with outright “unsterilized” bond purchases. In doing so, Ben Bernanke has put the economy on course to choke down 27 cents of monetary base for every dollar of nominal GDP by the end of next year – in an economy where even the slightest normalization to interest rates of just 2% would require the monetary base to be cut to just 9 cents per dollar of GDP to avoid inflationary outcomes. The chart below is a reminder of where we are already.

Understand that Fed policy now requires interest rates to remain near zero indefinitely, because competition from non-zero interest rates would reduce the willingness to hold zero-interest currency, provoking inflationary outcomes unless the monetary base was quickly reduced. Given an economy perpetually at the edge of recession, so far, so good. But as interest rates essentially measure the value that an economy places on time, Ben Bernanke’s message to the U.S. economy is clear: time is worthless.  

Monetary policy has become a roach motel – easy enough to get into, but impossible to exit. Bernanke seems pleased to note that inflation presently remains low, but why shouldn’t it? In a structurally weak economy, velocity drops in exact proportion to new monetary base, with zero effect on real output or inflation. The problem is that Bernanke seems incapable of running thought experiments. Suppose the economy eventually strengthens at some point past 2013. At that point, the Fed would have to sell nearly $3 trillion of U.S. debt into public hands in order to reabsorb the money creation he claims “is only a temporary matter.” These sales would add to the stock of U.S. debt already held by the public, very likely while a significant government deficit is still in place. Such a sale would be, by two orders of magnitude, the largest monetary tightening in U.S. history. Is that possible to achieve without disruption? I doubt it.

So instead, the Fed must rely on the economy remaining weak indefinitely, so it will never be forced to materially contract its balance sheet. To normalize the Fed’s balance sheet without contraction and get from 27 cents back to 9 cents of base money per dollar of GDP without rapid inflation, we would require over 22 years of suppressed interest rates below 2%, assuming GDP growth at a 5% nominal rate. Indeed, Japan is on course for precisely that outcome, having tied its fate 13 years ago to Bernanke’s experimental prescription (stumbling along at real GDP growth of less than 1% annually since then). Bernanke now sees fit to inject the same bad medicine into the veins of the U.S. economy. Of course, a tripling in the consumer price index would also do the job of bringing the monetary base back from 27 cents to 9 cents per dollar of nominal GDP. One wonders which of these options Bernanke anticipates. Psychotic.

Big picture – my perspective remains unchanged: the long-term viability of the global economy is being increasingly wrecked by short-sighted policies focused on avoiding short-term economic adjustments, and at bottom, on avoiding the restructuring of unserviceable sovereign, mortgage and financial debt. Yet only that restructuring is capable of unchaining the economy from reckless past misallocations; only that restructuring is capable of unleashing robust new demand that would form the basis for sustainable economic activity and job creation. You either pull the bad tooth, or you provide every kind of pain killer and symptom reliever, and let the problem rot indefinitely.

From an investment perspective, we know that the impact of quantitative easing both in the U.S. and abroad has generally been limited to a rally in stocks toward the highs of the prior 6-month period, in some cases moving as high as the monthly Bollinger band (2 standard deviations above the 20-month average). Given that the S&P 500 is within a few percent of its highs, and that conditions have already established an overvalued, overbought, overbullish, rising-yields conformation, much of the “benefit” of QE on stocks appears already priced in, as it has been since October when Bernanke effectively announced the present policy. The downside risk overwhelms the upside potential, in my view, but we can’t confidently rule out some amount of upside potential – which would still seem dependent on the avoidance of negative economic surprises.

The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Only comments in the Fund Notes section relate specifically to the Hussman Funds and the investment positions of the Funds.

John Hussman points out the obvious. Obvious to everyone except the the big swinging dicks on Wall Street and the high frequency trading computer nerds. If the market has not fallen because it believes Ben Bernanke will come to the rescue with QE3, then it is already priced in. The previous QE efforts have been nothing but a dose of adrenaline to a patient dying of cancer. They have had zero impact on the real economy. QE has created no jobs. QE has not raised wages. QE has only enriched Wall Street traders and bankers. Recession is here. Europe is imploding. Greece is dead country walking. The market is poised to drop. Are you poised to survive the drop?

Extraordinary Strains

  John P. Hussman, Ph.D.

Just weeks after the enthusiasm over Europe’s plan to plan for the possibility of using the European Stability Mechanism to bail out Spanish banks, the subtle technicality – that direct bailouts would make all of Europe’s citizens subordinate to even the unsecured bondholders of Spain’s banks – has predictably deflated that enthusiasm. On the growing recognition that addressing Spain’s banking problem will mean taking those banks into receivership, wiping out unsecured debt (much of which unfortunately was sold to unknowing Spanish savers as secure “savings” vehicles), and having the Spanish government sort out the damage, Spanish 10-year debt plunged to new lows last week (see chart below), and Spanish yields hit fresh Euro-crisis highs. At the same time, interest rates in Germany, Finland, Holland, Denmark and Switzerland all moved to negative levels looking 2-5 years out. The world is paying these governments to lend money to them, because the only way to acquire other default-free, non-commodity assets is to hire armored trucks and secure vaults to take delivery of physical currency. This set of conditions is not normal or sustainable, and indicates extreme credit market strains in Europe.

The Euro also hit a fresh 2-year low last week at 1.21, just a shade above its 2010 crisis low of 1.20. Likewise, the yield on 10-year U.S. Treasury bonds dropped to 1.45%, matching the historic low it reached a few weeks ago. Yields were higher even in the depths of the Great Depression, when the S&P 500 was trading at less than 2 times the pre-Depression level of earnings, the Shiller P/E on 10-year normalized earnings was less than 5, and the S&P 500 was yielding 16%. As a side note, many analysts seem almost woozy at the “incredible value” that supposedly exists in stocks because the 2.3% yield on the S&P 500 exceeds the 1.45% yield on 10-year Treasuries. It’s worth pointing out that prior to the point that inflation took off after 1960, the yield on the S&P 500 exceeded the yield on Treasury bonds in fully 93% of the data.

Keep in mind that once you subtract out the necessary compensation for default risk (which is rapidly increasing in Spain, for example), interest rates represent the value that the economy places on time. Long-term interest rates have plunged to record lows, and real interest rates are negative after inflation. What interest rates are telling you; what the Federal Reserve is telling you; what the equilibrium created by lenders and borrowers is telling you – is that time is economically worthless and that economic malaise will extend for years.

This does not reflect a well-functioning economy. To the contrary, if you look across history and across nations, strong prospects for sustained economic growth are typically accompanied by high real interest rates, because the demand for capital is robust and good ideas have to compete for funding. Interest rates are an indication of both the demand for loans and the incentive to save. It is not “stimulative” to depress interest rates in an environment where households, businesses and governments are desperately trying to reduce debt. That policy may insult the value of time enough to deter people from saving, and to reduce the immediate penalty for assuming even larger amounts of debt (as the U.S. government continues to do), but it should be clear that these actions move the economy further from a sustainable equilibrium, not closer to it.

I do expect that it will be possible to navigate the coming years well, but it will not be by locking in negligible yields and depressed risk premiums in the futile hope that one plus one will end up being something other than two. Prospective returns vary a great deal over the course of the market cycle, and the strategy of varying risk exposure in proportion to the prospective compensation for that risk will be essential.

On the economic front, as we expected based on leading economic evidence, new orders and order backlogs have dropped abruptly in recent reports. These indices are short-leading indicators of production, which is likely to show a striking decline beginning in the July data. Note carefully whether any positive surprises are in May and June data, because these reports will still be mixed. I continue to expect negative employment changes in the coming months, though as I’ve noted before, we may only find this out later on revisions rather than the initial prints in real-time. In any event, I am convinced that we will ultimately learn that the U.S. economy, slightly trailing the global economy, entered a new recession in June.

While July components are still coming in, the chart below shows the most recent condition of coincident U.S. economic data, reflecting a variety of Fed surveys and Purchasing Managers surveys.

The key question – in view of extreme credit market strains in Europe, and accelerating economic deterioration in the U.S. – is why the S&P 500 continues to trade within a few percent of its April bull market high. The answer is simple: investors are scared to death of missing the widely anticipated market advance that they expect to follow a widely anticipated third round of quantitative easing. Good economic news may be a relief for investors, but bad economic news in this context is just as much of a relief because it brings forward the anticipated delivery date of the sugar. The follow-up question, however, is that if more QE is widely anticipated, and a market advance is widely anticipated to result, isn’t that the precise definition of an event that is already priced into the market?

If you look at the Federal Reserve’s own research on quantitative easing – large scale asset purchases (LSAPs) – nearly every paper emphasizes the “portfolio balance” effect. Put simply, as the Fed removes longer-term Treasury securities from the menu of portfolio choices available to investors, it forces investors to consider alternative securities, raising their prices and lowering their yields – with a particular impact in driving down the risk premiums of risky securities. Indeed, as we’ve noted, QE has generally been effective in helping stocks to recover the peak-to-trough loss that they have suffered in the prior 6-month period (though the most recent LSAPs in the UK and Europe have been failures in that regard).

Still, once risk premiums are already deeply depressed (we estimate the likely 10-year prospective total nominal return for the S&P 500 to be only 4.8% annually), once stocks are trading near their bull market highs, and once Treasury debt already sports the lowest yield in history, should investors really expect much of a portfolio-balance effect from further attempts at QE? Frankly, I doubt it, but in the eventuality of a third round of QE, we’ll focus on our own measures of market action – not on any blind faith in the Fed.

The more troubling issue is that Fed papers on the effectiveness of QE focus almost singularly on the effect of QE on interest rates and risk premiums in the financial markets, with the notable absence of any analysis of the resulting effect on the real economy. This is like showing that squirting gas into an engine will make the engine run faster, without any concern for the fact that there is no transmission that connects the engine to the wheels. In a nutshell, the problem with QE is the lack of any material transmission mechanism from monetary interventions to real economic activity. This is a problem that the Fed should have recognized years ago, because there is strong and consistent historical evidence that real economic activity has very weak “elasticity” with respect to financial market fluctuations, particularly in equity values. Invariably, a 1% change in the value of the stock market is associated with a change of just 0.03-0.05% in GDP, and even that change is transitory. What the Fed has been doing is little but bubble-blowing, while at the same time driving the global financial system further from equilibrium rather than toward it.

Unfortunately, I expect these efforts to continue, but I also expect that it will be useless in averting an unfolding global recession. If the Fed was to initiate a third round of QE near present levels, it would likely be disappointing in the sense that it would fail to reverse economic weakness and at the same time would fail to drive equity prices higher than they already are, or interest rates materially lower than they already are. This would damage confidence in the Federal Reserve and force it to resort to language about monetary policy working with “long and variable lags.” Moreover, at a 1.45% yield and an 8-year duration on a 10-year bond, any interest rate increase of more than about 18 basis points a year will now produce a negative total return for the Federal Reserve over the period that the bonds are held, which comes at public expense (reducing the amount of interest that the Fed would otherwise turn over to the Treasury). As a result, talk is presently much cheaper than action. It seems likely that another round of QE will await obvious economic weakness and a significant spike in risk premiums – probably best measured by the depth of the drawdown in the S&P 500 from its most recent 6-month peak. Still, given that the rationale for much higher risk premiums is very real, it’s not clear that QE will have durable effects on stocks even in that event.

In short, a broad array of observable evidence suggests extraordinary strains in Europe, and abrupt though expected deterioration in U.S. economic activity. The Federal Reserve certainly has policy options, but those options have no material transmission mechanism to the real economy. We’ve always viewed the Federal Reserve as having an important and legitimate role in providing liquidity to the banking system in the event of heavy withdrawals; creating new reserves in return for high-quality, default-free securities backed by the full faith and credit of the U.S. government. This remains an important role, but the Fed’s actions have gone far beyond this role into areas that distort financial markets without transmission to economic activity. That’s just a reality we have to accept, and we’ll respond to further interventions with particular attention to trend-following measures of market action.

Here and now, we remain defensive in the face of accelerating strains the global economy – new highs in Spanish yields, negative interest rates across more stable European countries, new lows in the Euro and U.S. Treasury yields, collapsing new orders and backlogs, a sudden plunge in the employment component of the Philly Fed index, collapsing M2 velocity, and other factors. Due to some modest interest-rate considerations, our estimates of prospective return/risk have improved negligibly from the most negative 0.5% of historical observations, and are now among the most negative 0.8% of historical data. This rare extreme keeps us on red alert for now.

Market Climate

As noted above, accelerating strains are evident both in the global economy – particularly Europe – and in the U.S. economy. Stock valuations remain stretched on the basis of normalized earnings. Profit margins are nearly 70% above their historical norms at present, but these margins reflect very high deficit spending and very weak savings rates – something that can be related to corporate profit margins through accounting identities. Unless one anticipates continued deficits indefinitely, either revenues will revert closer to the level of labor compensation, or less likely, labor compensation will increase toward the level of revenues, but in any event the gap will tend to narrow. This may not be an immediate outcome, but stocks are instruments with an effective duration of over 40 years (mathematically, the duration of stocks is essentially equal to the price-dividend ratio, regardless of growth rates or repurchases). The very long-term stream of cash flows matters enormously in asset valuation.

One of the immediate issues I have with stocks here is the “exhaustion syndrome” (see Goat Rodeo) that has re-emerged in recent weeks. Examining the rare past instances of this syndrome, in 1961, 1987, 2000, and early-2008 among others, the key feature is a breakdown in measures of market action from an overvalued, overbought extreme, followed by a recovery rally toward the prior high and accompanied by earnings yields below their level of 6-months earlier. Normally, the recovery carries the market back to the prior “line” of support that surrounds the peak. The emergence of this exhaustion syndrome may seem benign or unimportant, but it has historically been an important precursor of major market declines. Given what are already significant challenges for both the economy and for the prospective return/risk tradeoff in stocks, my concerns about the potential for deep market losses remain elevated.

Investors often have the impression that the market simply collapses once a bull market peak is set, but this isn’t typical. What is typical is exactly the sort of exhaustion pattern we’ve observed since April. To illustrate this, the chart below presents market behavior around several market peaks that were also followed by an exhaustion syndrome as we observe today. The bull market peaks are aligned at 1.0. The remaining scale is set as a fraction of that peak. Time is measured in trading days before and after the bull market peak. Note that after a quick initial decline from the bull market peak, it’s typical for the market to recover much of the lost ground before the downside progress continues, in some cases producing the “exhaustion syndrome” that we presently observe. Exhaustion syndromes can go on for several weeks, but have historically been very dangerous advances to trade, because more often than not, there is a bear market just behind them. This was not the case in three instances: the July 1998 instance – followed by a decline of only 18%, the July 1999 instance – down only 12% over the next several months, and of course the instance in late January of this year, which occurred at about 1326 on the S&P 500 and still hasn’t yet resolved into losses beyond the weakness we saw in May. It’s possible that the market outcome will be benign in this case, and that the market will go on to set further bull market highs. We have no intention of taking that improbable gamble in the face of present headwinds.

Strategic Growth and Strategic International continue to be fully hedged, with a staggered-strike option position in Strategic Growth (which raises the strike prices of the put side of our hedge). We presently estimate the time-decay or “theta” of the staggered-strike position at about 0.25% of assets monthly – which we are willing to accept based on the extremely negative outcomes that are typical of the current climate, and the expectation that we will not remain in this position for a long time. Strategic Dividend Value is hedged at about 50% of the value of its stock holdings, and Strategic Total Return continues to carry a duration of just over one year, with about 10% of assets in precious metals shares and a few percent of assets in utility shares and foreign currencies.