January 13, 2014
Hovering With an Anvil
In July 2011, just before the market lost nearly 20% (but also the last time it corrected materially), I observed “Like Wile E. Coyote holding an anvil just past the edge of a cliff, here we are, looking down below as if there is much question about what happens next.” In my view, the stock market is hovering in what has a good chance of being seen in hindsight as the complacent lull before a period of steep losses. Meanwhile, we would require a certain amount of deterioration in stock prices, credit spreads, and employment growth to amplify our economic concerns, but even here we can say that there is little evidence of economic acceleration. Broad economic activity continues to hover at levels that have historically delineated the border of expansions and recessions.
With the S&P 500 price/revenue ratio more than twice its historical norm prior to the late 1990’s market bubble, the ratio of market capitalization to GDP also more than twice its historical norm, the most lopsided bullish sentiment in decades, an overbought market trading at a record highs – and two standard deviations above its 20-period moving averages at weekly and monthly resolutions, a “log-periodic” bubble at its most likely finite-time singularity (see Estimating the Risk of a Market Crash), bond yields well above their 6-month average, an economy where growth in real GDP, real final sales and employment are all near or below the growth rates at which historical recessions have started, and our own estimates of prospective market return/risk quite negative based on a broad ensemble of observable market conditions, we view prospective near-term and multi-year returns as strongly unfavorable, and prospective market risk as unusually elevated.
Emphatically, our investment stance here doesn’t presume or require a market crash (though we wouldn’t rule one out). As usual, we align our view with the prevailing return/risk profile that we estimate on the basis of observable evidence at each point in time. We have no downside target for the market, nor do we rely on any particular scenario. We estimate likely return/risk as conditions change over time. These estimates have been persistently negative in the face of the recent market advance because similarly extreme conditions throughout history have come to dismal ends. Our stance will change as the evidence does.
On valuation, we continue to see extremes in a broad range of measures that are very well correlated with actual subsequent market returns. Of course, there are some measures like the “Fed Model” (forward earnings yields less 10-year Treasury yields) that are fairly benign, and suggest no valuation concerns at all. The problem is that these alternative models don’t perform nearly as well in explaining actual subsequent market returns. Much of the reason is that they take profit margins at face value even when margins are elevated. At present, this is equivalent to assuming that the current extreme in profit margins will be permanent, and then fully reflecting that assumption in stock prices, even when all of history demonstrates that margins are cyclical.
We can calculate the historical errors of various valuation models in forecasting actual subsequent 7-10 year market returns. A good model should have random errors – that is, the errors should not themselves be highly predictable based on data that was readily available at the time. For the “equity risk premium” models that Janet Yellen and Alan Greenspan often reference as evidence that stocks are not overvalued, it turns out that the errors of these models have a correlation of about 85% with profit margins that were observable at each point in time. In other words, these models make large and systematic errors because they fail to account for the cyclical variation of profit margins over time (see An Open Letter to the FOMC: Recognizing the Valuation Bubble in Equities, and The Coming Retreat in Corporate Earnings).
A few quick charts will bring some of our present concerns up to date. The chart below shows the ratio of nonfinancial equity market capitalization to GDP. Again, this measure is about twice its pre-bubble norm, and is presently associated with an expectation of negative total returns for the S&P 500 over the coming decade. Measures based on properly normalized earnings are a little bit more favorable, with the overall outcome that we broadly expect nominal total returns for the S&P 500 of about 2.3% annually over the coming decade, with negative total returns on horizons of less than about 7 years.
Keep in mind that the 2000-2002 decline wiped out the entire total return of the S&P 500, in excess of Treasury bills, all the way back to May 1996. The 2007-2009 decline wiped out the entire total return of the S&P 500, in excess of Treasury bills, all the way back to June 1995. Our present expectations are rather conservative by comparison.
On the economic front, we really don’t take a great deal of “signal” from the December payroll report, which fell short of expectations. The fact is that the seasonal adjustment for January alone was 876,000 jobs (and the change in the seasonal adjustment was 320,000 jobs). It’s quite difficult to get a good read from monthly employment changes just before and after the holidays.
Normally, we can get useful economic signals from a broad range of leading measures such as various components of Fed surveys and purchasing managers indices, but in the face of repeated bouts of quantitative easing, the correlation between the most historically reliable leading measures and subsequent economic outcomes has been utterly destroyed in recent years (though probably only temporarily). Indeed, the correlation has actually turned negative (see When Economic Data is Worse than Useless).
Given that leading measures have been of no use at all in gauging economic activity, a reasonable (though somewhat lagging) gauge of the economy is to examine growth rates in output and employment (though on much more than a month-to-month basis). On that front, we continue to observe an economy that hovers at the border that has historically delineated expansions from recessions. I think it’s quite optimistic to believe that this situation has improved considerably in recent months – we see little basis for that inference. At the same time, we’ve seen a far longer period of “hovering” at this edge than in prior economic cycles – about three years in fact, with very little variation. This hovering and negative correlation between leading economic measures and actual economic outcomes has made it very difficult to form economic expectations in this cycle. In any event, we don’t observe any meaningful acceleration.
It’s worth emphasizing that our market concerns are rather independent of our economic views here. Given elevated valuations, thin risk premiums, and heavy issuance of low-quality debt in recent years, economic deterioration would contribute a great deal to weakness in the financial markets. However, our concerns about financial weakness aren’t predicated on expectations of economic weakness. The likelihood of poor market returns is largely baked into the present set of overvalued, overbought, overbullish, rising-yield conditions. I’ll note in passing that market peaks tend to be associated with strong consumer confidence and low new claims for unemployment, so neither of those provide any comfort about stocks. Of course, the deepest market declines in history have also eventually been complicated by recession, but it’s not advisable to wait for that. The market has typically experienced deep losses well before even a hint of recession has become evident to the consensus of economists.
The chart below shows the growth of real final sales (GDP less inventory accumulation) over the past 6-quarters. The chart of real GDP itself is quite similar, but real final sales give a complementary picture of final demand. Presently, activity is at levels about where previous recessions have started.
That’s not an assertion that a recession must begin in this instance. Our own recession concerns would spike if the S&P 500 was to decline below its level of 6-months prior, employment growth was to slow another few tenths of a percent (to about 1.4% on a year-over-year basis or 0.5% on a 6-month trailing basis), and credit spreads (the difference between corporate bond yields and Treasury bond yields) were to perk up a bit more. For now, the main point is that there is little evidence of a material shift in economic prospects. The economy continues to hover at the borderline that has historically delineated expansion from recession.
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.
We continue to hold to a defensive stance toward stocks both domestically and internationally, with a constructive – though moderate – stance toward Treasuries and precious metals shares. Particularly in the equity markets, it’s important as earnings season approaches to recognize that earnings surprises in individual stocks, both positive and negative, may induce modest day-to-day fluctuations in the Funds that are unrelated to our hedging stance or market exposure.
It's also worth noting that each of the Hussman Funds has the ability to accept an unhedged investment stance, with Strategic Growth Fund able to expand an unhedged exposure by holding a modest percentage of assets in call options as well. At a time when speculators are using the largest amount of margin debt in history, to amplify their investment exposure at record stock prices, historically elevated valuations, and rare extremes of bullish sentiment, it should be very clear why we are not employing our aggressive latitude here. Present conditions are opposite to those that would warrant the use of unhedged positions and leverage.
Complete market cycles have typically provided the evidence for both defensive and aggressive investment stances. Absent the necessity of stress-testing against the potential for Depression-era outcomes in 2009-early 2010, we might have been able to accept aggressive opportunities in the most recent cycle, which in hindsight overlapped much of that period. I called this our "two data sets" challenge at the time: our existing methods of estimating return and risk were based on post-war data, and I insisted on methods that were robust to Depression-era data even though our existing methods had navigated the crisis nicely. In contrast, I certainly don't view the past year as a "missed opportunity." In my view, 2013 was a bad risk that happened to work out well, not unlike the gains earned near the end of a Ponzi scheme. I doubt that investors will retain any of these gains over the completion of the present market cycle.
By 2009, it was difficult to question the validity of our disciplined, value-conscious, risk managed approach - certainly not on the basis of long-term returns and controlled risk, relative to the market. Absent my stress-testing response to the credit crisis, I doubt that our present defensiveness would be subject to as much debate and second-guessing, because the same concerns allowed us to anticipate deep market losses in the 2000-2002 and 2007-2009 plunges. I view quantitative easing not as some novel and permanent form of economic and financial levitation, but as a reckless distortion that has no mechanistic relationship with either the economy or stocks except by creating discomfort with zero interest rates and a reach-for-yield into speculative assets. In my view, the painful resolution of this distortion - like the dot-com bubble, the technology bubble, and the housing bubble - is yet to unfold.
Given that our stress-testing response is well behind us, I have every expectation that we will have the opportunity to take an unhedged or aggressive investment stance during a significant portion of the market cycle ahead. I am equally convinced that patience is a virtue here. It is the worst fiction of the investment imagination to believe that prices will advance diagonally forever, or that investors following the identical strategy can exit the market simultaneously once that strategy has become nearly universal. It is only after such delusions end that aggressive investment stances become reasonable. By then, of course, they are likely to be far less popular than they are today.
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