July 30, 2012
No Such Thing as Risk?
The enthusiasm of investors about central-bank interventions has reached a pitch that is already well-reflected in market prices, and a level of confidence that with little doubt, investors will ultimately regret. In the face of this enthusiasm, one almost wonders why nations across the world and throughout recorded history have ever had to deal with economic recessions or fluctuations in the financial markets. The current, widely-embraced message is that there is no such thing as an economic problem, and no such thing as risk. Bernanke, Draghi and other central bankers have finally figured it out, and now, as a result, economic recessions and market downturns never have to happen again. They just won’t allow it, printing more money will solve everything, and that’s all that any of us need to understand. And if it doesn’t solve everything, they can just keep doing more until it works, because there is no consequence to doing so, and all historical evidence to the contrary can finally, thankfully, be ignored. How could anyone ever have believed, at any point in history, that economics was any more complicated than that?
Unfortunately, the full force of economic history suggests a different narrative. Up to a certain point, which seems to be about 100-120% debt-to-GDP, countries can pull themselves from the brink of sovereign crisis through a combination of austerity (spending reductions), restructuring (putting insolvent financial institutions into receivership and altering the terms of unworkable private and public debt), and monetization (relief of government debt through the permanent creation of currency). Austerity generally reduces economic growth (and corporate profits) in a way that delivers less debt reduction benefit than expected, restructuring is often stimulative to growth because good new capital no longer has to subsidize old misallocations, but is politically contentious, and monetization of bad debt produces clear but often quite delayed inflationary pressures. None of these choices is simple.
Moreover, once countries have created massive deficits and debt burdens beyond about 120% of GDP – typically not to accumulate productive assets and investments that service that debt, but instead to fund consumption, bail out insolvency, and compensate labor without output – austerity produces further economic depression, restructuring becomes disorderly and produces further economic depression, and attempts at monetization tend to be hyperinflationary.
Europe is fast approaching the point at which every solution will be disruptive, and remains urgently in need of debt restructuring, particularly across its banking system. It is a pleasant but time-consuming fantasy to believe that governments that are already approaching their own insolvency thresholds can effectively bail out a banking system that has already surpassed them. To expect the ECB to simply print money to solve the sovereign debt problems of Spain, Italy and other members is also dangerous. This hope prevents these nations from taking receivership of insolvent institutions now, and allows them to continue to operate in a way that threatens much more disorderly outcomes later. The reality is that Europe is not a unified economic and political entity with a single national character and obligations that are mutualized among its members. It is instead a geographic region where the economic, political and cultural differences remain very distinct. While each country is willing to cooperate in setting common rules and practices that are to their own benefit, they are unlikely to cooperate when it comes to decisions that require the stronger economies to interminably subsidize the insolvent ones through direct fiscal transfers or permanent money creation that has the same effect.
With regard to last week’s ebullience over the possibility of ECB buying of sovereign debt, my concern continues to be the danger of assuming that a solvency problem can simply be addressed as a liquidity problem. If the European Central Bank buys Spanish or Italian debt in volume, there is very little likelihood that it will ever be able to disgorge this debt. This is because: any eventual ECB sales of debt holdings – or failure to roll those holdings over - will have to be offset by private demand in the same amount, when Spanish and Italian debt/GDP ratios are unlikely to be smaller; the European banking system is already largely insolvent, and; the European continent is already in recession, which means that the volume of distressed sovereign debt is likely to expand even beyond the reasonable capacity of the ECB to absorb it. So major ECB purchases would effectively amount to money-printing, and Germany, Finland and other countries in opposition are fully aware of that. Reversible liquidity operations may be monetary policy, but non-reversible money-printing is quite simply fiscal policy.
For a review of some of the issues the ECB faces, see Why the ECB Won’t (and Shouldn’t) Just Print. In evaluating the repeated assurances that emerge out of Europe, keep in mind that details matter. For example, the phrase “Germany is prepared to do everything that is necessary to defend the Euro” has repeatedly meant “everything that is politically necessary” and “everything that is legally required.” It has also been demonstrated again and again that Germany (among other stronger European countries) has no intention of allowing a blank check for direct EFSF or ECB bailouts without a change in the EU law that imposes a surrender of fiscal sovereignty and centralized fiscal control of Euro member countries. Following Thursday’s assurances by ECB head Mario Draghi to protect the Euro (just after Germany’s Angela Merkel left on a hiking trip), it took until Saturday for the German finance minister to step into the void with the predictable, “No, these speculations are unfounded.” It was widely reported that Germany again tossed out the “everything that is necessary” bone on Sunday, but one had to read the French dispatch to find that this accord referred to nothing but an agreement between Germany and Italy to do everything necessary to quickly implement June’s plan for a plan to establish a centralized banking regulator: l'Allemagne et l'Italie sont d'accord pour “que les conclusions du conseil européen des 28 et 29 juin soient mises en oeuvre aussi rapidement que possible.”
In the U.S., quantitative easing has had the effect of helping oversold financial markets recover or slightly surpass the peak that the S&P 500 Index achieved over the preceding 6-month period, but there is much less evidence that it will do much for the financial markets when prices are already elevated and risk-premiums already deeply depressed (see What if the Fed Throws a QE3 and Nobody Comes?). The upper Bollinger band of the S&P 500 on both weekly and monthly resolutions is at about 1430. That level represents our best estimate for the market’s upside potential in the event that the Federal Reserve initiates a third program of quantitative easing. Given that our economic measures continue to indicate that the U.S. has entered a new recession, it is not clear that another round of QE will even achieve that effect.
In the event that another round of QE has a greater or more durable effect, we’ve introduced enough additional constraints on our staggered-strike hedges that we wouldn’t expect the decay in option premium that we experienced during QE2. The market reestablished an “overvalued, overbought, overbullish” syndrome last week, so another round of QE is unlikely to move us to a significantly constructive investment stance as long as that syndrome is in place. Still, we don’t expect to move our strike prices higher in the event of further improvement in market internals, so the “tight” character of our present hedge will moderate in the event the market advances from here. Suffice it to say that I’m not worried that another round of QE will create difficulties for our approach, though it should also be clear that such an event wouldn’t automatically prompt us to shift to a bullish investment stance.
What worries me most
Investors sometimes ask what I worry about most from the perspective of our investment strategy. Do I worry that the Fed will initiate another round of QE and distort the markets to such an extent and duration that our approach will not capture new realities? Do I worry that government interventions have created a world where old economic rules and relationships no longer apply? Do I worry about the quality of government statistics or the potential for misreporting or seasonal adjustment distortions in the data we use? The answer is that all of these issues can exert a short-run influence on the course of our investment approach, but none of them alter the relationship between valuations and long-term returns, and I don’t expect any of them to significantly reduce the effectiveness of our strategy over the complete market cycle.
As I noted as the market approached its highs a few months ago, what I worry about most is that conservative investors will become impatient with maintaining a defensive position in a dangerous and elevated market - not because investment prospects have materially improved, but simply because short-lived runs of speculative relief seem too enticing to miss. Volatile but ultimately directionless periods of elevated valuations, as we saw in 2000-early 2001, 2007-early 2008, and which we’ve observed since April 2010, tend to exhaust defensive investors and encourage complacency toward market risk at the worst possible time.
Certainly, for our shareholders in Strategic Growth Fund, I’ve compounded this impatience, because our “miss” in 2009-early 2010 - which I would not expect to be repeated in future cycles even under identical conditions – blends in with our defensiveness since early-2010, which aside from a few differences related to option positions, I would expect to be repeated in future cycles under identical conditions. The result is one long period of defensiveness, which understandably leaves those unfamiliar with that 2009-early 2010 period with the assumption that our approach will never be constructive.
I view these weekly comments as something of a conversation with shareholders, so I do my best to address questions that come up more than once or twice in a short period of time. In Strategic Growth Fund, understanding performance in recent years is one of those questions, so I ask the indulgence of shareholders who have walked through this discussion before, and I hope that the comments are useful even for those that have. Thanks.
Let’s first address the period since early 2010. Given the policy of central banks in recent years to provide what amount to free put options to investors, there are certainly ways we could have saved a few percent in actual put option premium (incorporated in our present methods as added criteria related to trend-following measures). But the fact is that the S&P 500 Index was within 5% of its April 2010 peak only a few weeks ago, and there remains a strong risk that the market will move significantly below that level in the months ahead. From a historical standpoint, the conditions we’ve seen since early-2010 have warranted a generally defensive position, and the negatives have accelerated significantly in recent months. We would expect to adopt a similarly defensive position again in future cycles under the same conditions. The only way to get around that would to be to take actions that would have produced significant losses if they were taken regularly on a historical basis.
Unfortunately, the warranted and repeatable defensiveness we’ve adopted since 2010 blends in with a non-recurring intervention during 2009-early 2010 (which I discussed regularly during that period) to ensure that our hedging approach was robust to Depression-era data.
Recall that this intervention was not driven by any problem with the performance of our investment approach. Indeed, by the beginning of 2009, a dollar invested in Strategic Growth Fund at its inception in 2000 had grown to about four times the value of the same investment in the S&P 500 Index. The Fund was ahead of the S&P 500 at every standard (1-year, 3-year, 5-year, 10-year), and non-standard investment horizon, with dramatically smaller losses. For example, from the 2007 stock market peak, the S&P 500 Index had suffered a peak-to-trough loss of 55.25%, while the deepest loss experienced by Strategic Growth Fund was 21.45%. To put that difference in perspective, note that simply moving from a 55.25% loss to a 21.45% loss requires an offsetting recovery of 75.53% [Calculation: (1-.2145)/(1-.5525) = 1.7553]. It takes extraordinary good fortune to recover from deep drawdowns, which is why we make such an effort to avoid them.
Still, as the credit crisis worsened in 2009, it became clear that both the economy and the financial markets were behaving in ways that were “out of sample” from the standpoint of the post-war data on which our existing return/risk estimates were based. That kind of situation demands stress-testing; a concept that too few investors take seriously until it’s too late. I took our existing approach to Depression-era data and found that though it performed reasonably well over the full period from a return perspective, it also allowed a number of very deep interim losses before recovering. Even though our approach had performed well, a Depression-like outcome could not be ruled out (and to some degree still can’t), so I insisted that our methods should be robust to “holdout” data from both the Depression era and the post-war period. I discussed that challenge repeatedly in the weekly comments and annual reports as our “two data sets” problem. We reached a satisfactory solution in 2010 through the introduction of ensemble methods in our hedging approach. But by that point, we had also missed a significant market rebound.
The result has been my elevation to the title of Permabear, Doomsayer, and other lovely aliases. It’s kind of tragic that I both lessened my reputation and missed returns for shareholders – though I expect only temporarily - because of what I viewed (and continue to view) as fiduciary duty. At least shareholders can be sure that I’ll never knowingly lead them down a rabbit hole. While we have – apart from the most recent cycle – been successful in strongly outperforming the market over complete cycles (bull-peak to bull-peak, bear-trough to bear-trough) with substantially smaller drawdowns, it’s important to recognize that we do have a much greater tolerance for tracking differences versus the S&P 500 over the course of the market cycle than some investors can accept. Our investment approach is simply not appropriate for those investors. Significant tracking differences will occur again and again over time, because they are inherent in our approach, particularly in the richly-valued portion of a given market cycle.
Meanwhile, I’m confident that that our stress-testing miss during the most recent cycle (which works out to a cumulative lag of just under 13% over the peak-to-peak market cycle from 2007-2012) is something we can more than offset in future cycles. Also, given our willingness to remove the majority of our hedges in early 2003 at valuations that were in no way compelling from a historical standpoint, it should be clear that we don’t require Armageddon to adopt a constructive or even aggressive investment stance.
So what do I worry about? I worry that investors forget how devastating a deep investment loss can be on a portfolio. I worry that the constant hope for central bank action has given investors a false sense of security that recessions and deep market downturns can be made obsolete. I worry that the depth of the recessions and downturns – when they occur – will be much deeper precisely because of the speculation, moral hazard, and misallocation of resources that monetary authorities have encouraged. I worry that both a global recession and severe market downturn are closer at hand than investors assume, partly despite, and partly because, they have so fully embraced the illusory salvation of monetary intervention.
Our measures of prospective stock market return/risk deteriorated slightly last week, from the most negative 0.8% of market history, to the most negative 0.6%. These are minor distinctions, of course, but it is important to emphasize how rare and negative present conditions are from a historical standpoint. I recognize that many analysts consider stocks to be cheap on the basis of “forward operating earnings,” but I continue to believe that the 50-70% elevation in profit margins relative to historical norms is an artifact of extreme deficit spending and depressed savings rates, and that as a U.S. recession unfolds, profit margins and forward earnings estimates will collapse. This is currently seen as heresy (as was my assertion just before the tech-collapse that technology earnings would turn out to be cyclical), but that’s how earnings and profit margins work.
Looking out anywhere from 2 weeks to 18 months, our measures remain very defensive, with the worst horizon being about 7 months out. Additional firming in market action from here would modestly improve our near-term measures of prospective return (which are more dependent on trend-following factors), but would generate little improvement beyond a horizon of several weeks. Meanwhile, our estimate of prospective 10-year S&P 500 total returns (nominal) is now only 4.7%. This figure may seem appealing relative to a 1.5% yield on 10-year Treasury bonds, but as I’ve noted before, you don’t “lock in” a long-term return on an investment; you ride it out over time. My expectation is that this ride will be extremely uncomfortable for passive buy-and-hold investors over the coming decade, and that there will be numerous opportunities to accept both stock and bond market risk at substantially higher prospective returns.
Strategic Growth and Strategic International remain tightly hedged, Strategic Dividend Value remains hedged at about half of the value of its holdings – its most defensive stance, and Strategic Total Return continues to carry a duration of about one year, with about 10% of assets in precious metals shares and a few percent of assets in utility shares and foreign currencies.
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.
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