October 12, 2003
John P. Hussman, Ph.D.
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Analysis Versus Superstition
One of the key elements of our investment approach is the recognition that market action conveys information. As I've frequently noted, the best indicators of oncoming economic conditions are not statistics such as employment, GDP or industrial production, but market action reflected through risk spreads (the difference in yields between risky corporate bonds and default-free Treasuries), stock prices, currency markets, yield curves, and other forward-looking indicators.
That said, investors put themselves in jeopardy when they rely on any indicator or model without a firm understanding of why it should be useful, and the mechanism behind it. Investment decisions made without this understanding are not based on analysis, but on superstition.
For example, in recent decades, investors had come to expect extremely positive stock market returns following two consecutive cuts in the Federal Funds rate ("two tumbles and a jump"). Unfortunately, this experience was based on a world where a significant portion of bank assets were actually subject to reserve requirements, and where the primary feature of economic recessions was temporary weakness in demand. In the early 1990's, however, the Federal Reserve abolished reserve requirements on all bank assets except for checking deposits, which represent a minor source of bank funding. In doing so, the Fed assured its own irrelevance. Meanwhile, the capital spending bubble, fueled by a wild surfeit of speculative investment, left the U.S. economy with a great deal of overcapacity - which remains in place today.
Fed easing works when it eases some constraint that is actually binding. In most prior economic recessions, banks were willing to lend and businesses were willing to borrow. In that environment, policy changes that increased bank liquidity and lowered borrowing costs were followed by increases in bank lending. As a result, the stage-one engines of economic recoveries - housing, autos, and capital spending - enjoyed strong and fairly timely improvement following a series of Fed easings.
Unfortunately, investors who relied on two tumbles and a jump in recent years learned that Fed policy in the current economic environment is largely ineffective. At least, that's what they should have learned, and the lesson should not be missed.
If you look carefully at the current evidence for economic strength, it is evident that investors have placed an almost superstitious faith in leading indicators. The most frequently cited indicators of coming economic strength generally have very heavy monetary and stock market components. This is certainly true of the so-called "leading economic indicators" published by the Conference Board, but it is equally true of leading indices produced by private research firms. The difficulty in these indices is that they do not distinguish the current downturn (characterized by overcapacity and predictably ineffective monetary policy) from typical cyclical recessions. Our reading of market action suggests that the strength in the stock market since October is mainly due to increased willingness of investors to take market risk. There is no strong reason to believe that investors are acting on useful information about improved prospects for income, employment, or the economy in general.
Make no mistake - I strongly believe that market action is far more informative than government statistics when it comes to gauging economic prospects. But a blind adherence to rules-of-thumb can never take the place of careful analysis and understanding.
A great second half does not make an economic boom
Third and fourth quarter GDP growth will clearly be strong. As the analysts at Bridgewater have noted, the jump in third quarter spending was driven by growth in after-tax income during that period. Yet pre-tax income was stagnant. In other words, the spending burst during the third quarter (which undoubtedly resulted in GDP growth well in excess of 4% at an annual rate) was the temporary effect of consumers spending their tax windfalls. Meanwhile, inventories dipped somewhat, indicating that businesses did not increase production in anticipation of sustained demand. Most likely, that inventory will be replaced during the fourth quarter, so there will probably be some amount of follow-through to strong third-quarter growth. After that, the picture becomes much less clear.
In my view, analysts have been far too apologetic about employment being a lagging indicator. To hear them explain it, the strength in the stock market and Fed easings "in the pipeline" make the continuing weakness of the job market irrelevant. That's simply not true. If you look at the data, the year-over-year growth rate of total non-farm employment begins to improve sharply and immediately at the end of typical recessions. Employment growth doesn't necessarily turn positive right away, but the momentum always reverses from accelerating job losses (more and more negative rates of growth) to moderating job losses (less and less negative rates of growth). In contrast, there has been no perceptible reversal in the momentum of job losses in current recovery. At the end of the recession in November 2001, job losses were running at about -0.8% of total employment at an annual rate. Job losses remain at that rate today.
Similarly, our two old friends - capacity utilization and help wanted advertising - remain at abysmal levels. The recently released August data on help wanted actually fell a point to 37, while stagnant capacity utilization at 74.6% also remains near recession lows. Until these indicators of demand for labor and capital begin to improve strongly, the sustainability of any economic expansion will remain in question. Of course, the deep current account deficit virtually ensures - via the savings/investment identity - that growth in gross domestic investment and consumption will be fairly restrained in the coming years (see prior updates for more on the relationship between current account deficits and subsequent economic activity).
In short, there is little question that third and fourth quarter GDP growth figures will be very strong. Unfortunately, this says little about the sustainability of the recovery. While many analysts are placing great faith on monetary and market indicators, I have real doubts that investors can rely on the typical mechanisms that have linked these indicators to an improving economy.
The Market Climate for stocks remains characterized by unusually unfavorable valuations and modestly favorable market action. In the Strategic Growth Fund, we remain fully invested in a broadly diversified portfolio of individual stocks, with about half of that value hedged against the impact of market fluctuations. As usual, our returns are driven by the individual returns of our favored stocks as well as by overall market fluctuations, so it is simplistic to believe that our returns will simply mirror half of what the market does. More importantly, the historical data is clear that avoiding market risk in overvalued markets does not compromise long-term returns, regardless of whether valuations become more extreme over the short run. We're still positioned primarily to gain from an advancing market, but there are already enough blemishes in market conditions to hold us to something less than an aggressive position.
In bonds, the Market Climate remains characterized by modestly favorable valuations and modestly favorable market action. We took the opportunity of depressed bond prices last week to modestly increase our position in long-term Treasuries. At present, the Strategic Total Return Fund has a portfolio duration of about 5 1/2 years, meaning that a 1% (100 basis point) move in interest rates would induce a roughly 5.5% fluctuation in the value of the Fund.
Even if this was a typical economic recovery, we would expect the yield curve to begin to flatten at about this point. That pressure is even stronger given the potential for economic softness after the fourth quarter. I have little doubt that much of the flattening in the yield curve will happen through an increase in short-term yields rather than a sharp decline in long-term yields, so we want to hold some portion of our assets in very short-term Treasuries on the likely prospect of extending the maturities at higher yields. In any event, given that we do want to have some exposure to interest rate fluctuations in this Climate, our current mixture of TIPS, Treasury bonds, and very short-term Treasuries is comfortable
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