Distinction Without a Difference
Market comments by Hussman of Hussman Funds.
In recent weeks, market conditions have fallen into a cluster of historical instances that have been associated with average market losses approaching -50% at an annualized rate. Of course, such conditions don’t generally persist for more than several weeks – the general outcome is a hard initial decline and then a transition to a less severe average rate of market weakness (the word “average” is important as the individual outcomes certainly aren’t uniformly negative on a week-to-week basis). Last week, our estimates of prospective market return/risk improved slightly, to a level that has historically been associated with market losses at an annualized rate of about -30%. Though that improvement falls into the category of a distinction without a difference, at least we can say that conditions are not the most negative on record.
Over the course of the coming cycle, I expect that we will easily observe conditions among the many favorable clusters in the historical record, where we will not face the syndromes of hostile conditions we’ve seen recently (e.g. overvalued, overbought, overbullish, yields rising). Valuations, though rich, are nowhere near where they were in 2000, and even the tepid valuations of early 2003 provided ample opportunity to accept market risk without the need for significant hedging. Unlike 2009, the next cycle will not unexpectedly present us with the need to capture Depression-era data in our approach (which we’ve addressed). Even without significant undervaluation, there are many combinations of market conditions that have historically been associated with strong subsequent market returns, on average.
So there’s little doubt that market conditions will provide investors with a strong basis to accept risk at various points over the coming market cycle. The difficulty today is not only that valuations are rich, but that on our metrics, present market conditions cluster among those that have produced strikingly negative market outcomes on a blended horizon from 2-weeks to 18-months. Wall Street’s beloved forward-earnings multiples only seem reasonable here because profit margins are the highest in history (largely as a result of steep government deficits and depressed savings rates). Once we normalize for profit margins – which is necessary because stocks are very long-lived assets – valuations are elevated, and are coupled with a variety of historically hostile, overvalued, overbought indicator syndromes. Moreover, while our economic concerns do not significantly feed into our concerns about the equity market, we continue to view the U.S. economy as being in an unrecognized recession that started about mid-year.
Recession? The advance estimate for third-quarter GDP was released last week, showing a slow but above-consensus figure of 2% growth at an annual rate (paced by a 13% surge in defense spending). Surely, this is inconsistent with concerns about recession, isn’t it? No – not if we examine the historical pattern of data revisions early in previous recessions – a point that Lakshman Achuthan of ECRI also emphasized recently on Bloomberg.
Recall that in 2001, with the U.S. economy already in recession for months, Q1 GDP growth was initially reported at 1.2%. That figure was actually revised slightly higher a few months later, but based on final revision, Q1 2001 GDP is now reported at -1.3%. As a side-note, Q2 2001 GDP was positive, while Q3 2001 was negative. The 2001 recession did not contain two consecutive quarters of negative GDP growth. Contrary to what many analysts suggest, that is not how the National Bureau of Economic Research (the official arbiter) defines a recession in the first place.
The heavy revision of GDP figures is not the exception but the rule. In the first quarter of 2008, as another example, with the U.S. economy already in recession for three months, Q1 GDP was reported at 1% growth. That figure was later revised to -1.8%. Just like 2001, the following quarter was reported at positive growth. The economy then collapsed in the second half of 2008, but by the time that was evident in GDP figures, the stock market had already plunged. The upshot is that early GDP figures are often reported positive even after a recession is already well in progress, and waiting for two consecutive quarterly declines in GDP is a poor way of gauging recession risk, because that pattern sometimes doesn’t emerge until much later revision, if at all.
Based on the most leading economic signal that we infer from dozens of economic variables (see the note on extracting economic signals in Do I Feel Lucky?), the best we can say about recent data is that the signal is negative but the pace has not worsened, which suggests that at least over the next 4-5 months, the character of the recession is likely to be moderate, and not the sort of off-the-cliff collapse we saw in 2008. Again, this falls into the category of a distinction without a difference, as investors completely ignore the existence of a recession anyway, leaving them vulnerable to its eventual recognition.
Though our measures of economic prospects are holding fairly steady at negative levels, there are numerous risk factors that could accelerate this weakness, and not many that promise an abrupt improvement. So downside risks predominate here, in my view. First, simply because of the math of quarterly GDP figures, even if Hurricane Sandy was to cause a one-day net loss of activity across one-third of the country, the impact would slow Q4 GDP growth by about -1.5% at an annual rate. Beyond that, economic outcomes are likely to be sensitive to a variety of factors including European debt and banking strains, weakness in China and Japan, and fiscal policy decisions in the U.S.
Over the weekend, Germany’s der Spiegel published an article quoting ECB head Mario Draghi saying “I explicitly support this proposal” – the proposal being that of German Finance Minister Schauble, asking European governments to permanently surrender sovereignty over their own national budgets, and hand control over to EU leadership in Brussels. Draghi added “If we want to re-establish trust in the eurozone, countries must pass a part of their sovereignty to the European level.”
Investors should allow this to sink in, because this sort of “fiscal union” is the precondition for Germany to accept greater responsibility than it already has for bailing out its neighbors. Even then, Germany has already disavowed any responsibility to absorb the cost of a Spanish banking bailout, insisting that any funds provided from the European Stability Mechanism (ESM) will have to be repaid, and will represent additional debt of the Spanish government.
If it is not clear that European governments will unanimously agree to surrender their fiscal sovereignty, then it is also not clear that the euro will survive in its present form. My own impression is that the least disruptive outcome would be a split across central/peripheral lines, with stronger countries like Germany and Finland leaving first and redenominating either to their prior national currencies or to some sort of “euro forte”, and abandoning the existing “euro faible” to other grossly indebted countries, which could then inflate as they please.
All of this follows a very clean line of developments over the past two years, though that clean line is constantly blurred by rhetoric to the contrary, which investors have misguidedly celebrated in hope that eventual German bailouts and unconditional money printing will make the whole European crisis go away. What we are left with is the continued likelihood of a massive restructuring of European banks, particularly Spanish banks, as well as further haircuts to the debt of Greece and possibly Portugal, Ireland, Italy, and – if it takes banking sector bailouts onto itself – Spain as well. Bad loans in Spanish banks jumped to 10.5% of assets in the most recent report –not far from the “adverse scenario” that was assumed to be highly improbable in the European banking stress tests. As an analyst at Nomura put it, “you can’t assign a 1% probability to a scenario that already looks realistic.” To the extent these realities aren’t dealt with in a deliberate and orderly way, they will have to be dealt with in an abrupt and disorderly way not long from now.
On the subject of deficits, the situation in Japan seems increasingly strained. The gross debt/GDP ratio in Japan is now about 225%, and net debt (which excludes debt held by the government itself for monetary, pension and other reasons) is about 130%. During the entire post-war period, Japan has enjoyed a significant trade surplus, which has allowed it to run growing government deficits. Meanwhile, household savings have declined from nearly 15% in the 1990’s to next-to-nothing today. Needless to say, that large and persistent trade surplus has enabled economic dynamics that normally would not be sustainable. But over the past year, Japan has fallen into a trade deficit, which has deepened recently due in part to tensions with China. We are now observing an ominous combination of a significant trade deficit, a deep government deficit, non-existent household savings, a steep debt/GDP ratio, and a contraction in both manufacturing and service sectors according to the latest purchasing manager’s surveys out of Japan. While Europe remains our primary source of concern, I am concerned that both China and Japan are likely to have a more destabilizing impact than is widely assumed.
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.