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September 14, 2003

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

First, Do No Harm

There's a teaching that when an action intended to help a situation has the result of making it worse, it is because the action was not grounded in right understanding. The lunacy of U.S. policy toward China continued this week, with a punitive CHINA act being proposed in the House by legislators who evidently have no idea how the U.S. economy works. The simplistic notion is that by forcing China to make its currency more expensive, competition from "cheap" imports will be reduced, and U.S. manufacturers will thrive.

Economic activity is not a one-sided phenomenon, but an exquisitely complex equilibrium that allocates resources among countries and individuals. Still, an understanding of a few simple truths can often get to the heart of the matter. One of these is that a substantial portion of what we "import" from China actually represents outsourced production of U.S. firms. This is precisely why the unusual "productivity growth" in recent years has been found not in technology, but instead in seemingly odd industries such as retail and wholesaling. What we observe as productivity growth is the maintenance of reasonably high final output at lower prices and with less labor input. Want to shut down this productivity growth? Shut down trade in manufactures and intermediate goods from China.

Equally important is that nearly half of all publicly held U.S. Treasury securities are owned by foreigners, the largest buyers being Japan and China. At present, the U.S. exports far more securities to foreigners than it imports, which is what we call a "capital account surplus." This surplus on capital account is the mirror image of our whopping "current account deficit." In other words, if the U.S. imports $100 of goods, but only exports $70 of goods in return, we must be exporting $30 of other stuff, and that other stuff is securities. So we run a $30 current account deficit, offset by a $30 capital account surplus. That $30 represents savings imported from foreigners, which we use essentially to finance our economic activity here in the U.S.

Now, it might be tempting to think that we could shut down that current account deficit by forcing foreigners to revalue their currencies (driving import prices higher, and the value of the dollar lower), in an attempt to induce foreigners to buy more goods from the U.S.. Of course, this would be hostile to both consumers and businesses that benefit from inexpensive imports, and would be both inflationary and quite literally counterproductive. At the same time, there is little probability that this move would trigger a substantial increase in foreign buying of U.S. goods, certainly not by Asian trading partners who have a cultural tendency to run extraordinarily high savings rates. Any attempt to abruptly revalue the currencies of our trading partners (taking away their incentive to support the U.S. dollar through their securities purchases) must result in simultaneous shocks to both the current account and the capital account. Specifically, the flow of foreign savings into the U.S. would plunge, shutting down the capital account surplus, accompanied by a plunge in U.S. domestic investment and import consumption which would shut down the current account deficit. In short, the quick way to "fix" a trade deficit and bring it into balance (and the way that it has typically occurred historically) is for the U.S. to suffer a deep recession, with U.S. gross domestic investment being the primary casualty.

There's no chance that the Chinese will allow the yuan (renminbi) to be fully convertible into U.S. dollars, and the U.S. wouldn't want them to, because this would produce immediate capital flight by Chinese savers into dollars, further strengthening the dollar and cheapening the yuan - exactly the opposite of what the U.S. wants. So it's both misleading and moot to talk about "freely floating" the yuan. It won't happen. Rather, the U.S. is attempting to force China to accept an abrupt revaluation, by changing the official rate at which the yuan is pegged to U.S. dollars. This sort of abrupt shift would be a mistake.

Recessions are an unavoidable part of economics, but it takes major policy failures to produce depressions. It's one thing to take an offensive stance toward international trade when you're running nearly balanced trade. It's another matter to do so when your country is more dependent on foreign capital inflows than ever before in history. I've frequently noted that as our record current account deficit adjusts to more sustainable levels, we can expect U.S. investment and consumption growth to be slower in the coming years than is typical. That's a predictable outcome, but is not particularly dire. Unfortunately, ill-conceived economic policy could easily turn this somewhat benign long-term risk into an immediate and damaging liquidity crisis. As we work off the excesses of our nation's consumption and investment binge, our policy makers seem eager to follow the road sign that reads "fastest route possible." They fail to understand that this is a road that goes directly over the edge of a cliff. No shock absorbers are that good. We would do better to take the slower, scenic route.

Great expectations

Meanwhile, stock prices have now fully anticipated a strong recovery in the economy. With the S&P 500 now trading at over 19 times prior peak earnings, stock prices now reflect the same valuations seen in 1929, 1965, 1972 and 1987, exceeded only in the advance to the 2000 extreme. On any other measure than earnings, valuations are higher than any prior peak except 2000. Of course, the argument is that current multiples are justified by low interest rates and inflation, but this argument relies on excluding all data prior to 1965, when interest rates and inflation were regularly lower than they are today. It also relies on the assumption that interest rates, inflation, and valuations will remain at current levels into the indefinite future - not just 2 or 3 years, but forever. A failure of this assumption even a decade from today would result in weak or even dismal total returns in the future. For example, even if S&P 500 earnings quickly recover all of their lost ground and grow along the very peak of their long term earnings growth channel forever, a return toward normal historical valuations even a decade from now would be associated with total returns of just 3-5% annually on the S&P 500.

Vickers reports that the pace of selling by corporate insiders (relative to buying) has accelerated to the highest level in 17 years. Market action has begun to show subtle signs of distribution, with rallies increasingly occurring on dull trading volume while declines occur on expanding volume. Meanwhile, advisory sentiment remains quite bullish. All of these are background indications that in themselves do not reverse the moderately favorable implications in overall market action, but these early indications are worth watching.

The housing market has also been uncharacteristically strong. The Economist reports that the ratio of home prices to rents - a sort of P/E ratio for housing - is a steep 18% over its 25-year average. These deviations tend to be corrected by changes in housing prices over the following 4 year period. Again, low interest rates seem to be a natural explanation, but as the Economist points out, interest rates are not unusually low in real inflation-adjusted terms, and this is what matters. "Initial interest payments may seem low in relation to income, but inflation will not erode the real burden of debt as swiftly as it used to. So in later years, mortgage payments will absorb a bigger slice of a borrowers income than when inflation was higher."

With valuations fairly rich in both the stock market and the housing market, we turn to the current economic picture. Recall that the NBER has dated the end of the recent recession at November 2001. In other words, the economy has been in an "expansion" for nearly two years. By this point, and certainly as implied by the financial markets, even lagging indicators such as employment should have improved significantly.

It is somewhat uncomfortable to refer to the current economic situation as a recovery at all. Every past economic expansion has begun with a current account surplus. With one exception, every economic expansion has also been accompanied by a quick surge in capacity utilization and help wanted advertising (indications of demand for capital and demand for labor). The exception was the brief 1980 "recovery", which was promptly followed by a second and much deeper recession. In 1980, we saw surges in consumer confidence, the Purchasing Managers Index, and the index of leading indicators (which is largely based on indicators such as interest rates, stock prices, and money growth). Still, weakness in capacity utilization and help wanted suggested a sluggishness in demand for capital and labor that belied favorable sentiment and monetary indicators.

At present, the U.S. current account is the most negative in history. Capacity utilization remains at its lows, and the help wanted index has drifted steadily downward. It is lower today than it was the end of the recession.

In short, sentiment says recovery, but there is an increasing failure of real indicators to confirm these expectations in any meaningful way. While we do expect good economic strength in the current quarter and through year-end, the data should be improving much more than we've seen to date. Information is always in the divergences, and the information we're observing on the economy is not encouraging. There's still potential for improvement, and our measures of market action continue to hold us to a constructive position. Still, given the uninspiring fundamentals for the economy and stocks in general, there's a limit to how far and how long they can swim against the current.

Market Climate

The Market Climate for stocks remains characterized by unusually unfavorable valuations and modestly favorable market action, holding us to a moderately constructive position. As of last week, about 2/3 of our stock holdings in the Strategic Growth Fund were hedged against the impact of market fluctuations, leaving us with a positive but comfortably limited exposure to market movements. As usual, this position does mean that we risk missing out on a portion of short-term rallies that might occur. However, this possibility has not historically created risk to long-term returns. To the contrary, the ability to limit market risk during periods of substantial overvaluation would have historically added to long-term returns, relative to a strategy always exposed to market risk. Not that we'd recommend the following strategy - selling the S&P 500 at 19 times peak earnings, sitting tight in T-bills, and repurchasing stocks only when the market reaches 15 times peak earnings - but doing so from 1945 to the present would have generated a final balance twice what a buy-and-hold approach would have delivered. In pre-1945 data, the results would be even better by waiting until stocks hit 7 times peak earnings. Though we saw stocks decline to similar multiples in 1974 and 1982, it's clearly not optimal to require such deep plunges in post-1945 data. In any event, the point is that avoiding market risk at extreme valuations simply doesn't cost investors long-term returns.

In bonds, the Market Climate remains characterized by modestly favorable valuations and modestly favorable market action, also holding us to a constructive position. As of last week, the Strategic Total Return Fund had an average portfolio duration of about 6.2, meaning that a 100 basis point change in interest rates could be expected to impact the Fund's value by about 6.2%.


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