March 1, 2004
Just a note: The Semi-Annual Report of the Hussman Funds is now available online. The printed booklet is in production, and will be mailed shortly. The report includes a detailed letter to shareholders, performance charts, fund holdings, and financials as of 12/31/03 for both the Strategic Growth Fund and the Strategic Total Return Fund.
Some of the happiest people I know are accountants. It's not obvious why this should be true, given that most people seem to hate accounting. Maybe there is a certain comfort in knowing that everything can be accounted for. Maybe there is a certain sense of purpose in understanding that everything has a source and a use. Maybe accountants look at things properly, seeing the same thing that physicists discovered in the First Law of Thermodynamics: that nothing is truly created or destroyed, only transferred from one form to another. Then again, maybe I just know too many accountants.
In any event, a basic understanding of accounting is essential to both finance and economics. In finance, investors who choose their own stocks can get lost in a world of make-believe when they don't take the time to learn the path that revenues take to arrive at earnings, and the adjustments that earnings take on their way to distributable cash.
Even without knowing that Enron had major off-balance sheet debts, for example, the company's 2000 annual report was enough to wave red flags long before it went bankrupt. At the time, U.S. companies were making a big deal about reported cash flow, taking advantage of investors' belief that cash flow “underscores the quality of earnings.” But if you understood how cash flow is constructed, you quickly became aware that Enron's “strong” cash flow was the result of depleting its inventories at the same time that its payables were exploding. Sure, selling off your inventories and not paying your suppliers is a great way to generate “cash flow.” But not if you're operating as a going concern. Evidently, Enron wasn't.
Maybe learning a little bit of accounting would make investors happier.
The savings-investment identity and its implications
At the risk of activating synapses that would rather just sit there and accumulate amyloid plaque, let's review the definition of GDP:
GDP = Consumption + Investment (real, not financial) + Government spending + eXports – iMports
Y = C + I + G + X – M
Let's add and subtract taxes (T) and rearrange, which still preserves the identity:
I = (Y – C – T) + (T – G) + (M – X)
This puppy is known as the “savings-investment identity.” I've included some comments about this in the latest Semi-Annual Report of the Hussman Funds.
Basically, it says that all real investment (plant, housing, equipment, and other capital spending) must be financed by one of three types of savings: 1) private savings - what is left of income after consumption and taxes, 2) government savings – an oxymoron, which measures the excess of taxes over spending and is usually a really big negative number and thus a drag on investment, largely traceable to the spending side since the identity is neutral to the level of taxes except to the extent that they affect the other variables, and 3) foreign savings – the capital that flows here from foreigners – for every $100 of stuff we import, we have to export $100 of stuff. If we import $100 of goods and services and export only $70 in goods and services, we've got to export $30 of other stuff, and that stuff is U.S. securities. So what we call a $30 “trade deficit” also represents an import of $30 in foreign savings.
There. If you want U.S. domestic investment to grow, you've got to observe expansion in one of those three forms of saving. And there's your trouble. U.S. private savings are unusually low, though there is some pickup there from higher corporate saving due to an earnings rebound, the government is running a deep deficit, and as a result, U.S. domestic investment is now dependent on the deepest continuing inflow of foreign capital in history (i.e. the U.S. current account deficit).
As a result, the prospects for sustained growth in U.S. domestic investment are very poor. In the worst case, the U.S. could become protectionist, or China (the source of the largest inflows of foreign capital as they buy U.S. Treasury securities in attempts to support the dollar) could abruptly revalue its currency. In that case, we could see a quick “improvement” in our current account deficit – that is, a substantial decline in the amount of foreign savings flowing to the U.S.. One need only look at the left side of the savings-investment identity to understand why rapid improvements in the U.S. current account have always been associated with deep, investment-led recessions. The last thing that the U.S. needs is protectionist trade or currency policies aimed at rapid progress toward “balanced trade.”
In the best case, the current account moves toward adjustment through a gradual increase in U.S. domestic savings. In that event, U.S. domestic investment, consumption, and government spending would have to grow more slowly than U.S. output, thereby releasing output that could be used to expand net exports. In that event, we are likely to see little sustained growth in U.S. domestic investment (though at least not a sharp dropoff), with moderate growth in capital spending offset by moderate declines in other types of investment such as housing.
Social Security isn't (and can't be) a saving program, it's a transfer program
Last week, Alan Greenspan made some comments about Social Security that prompted very strong reactions. Personally, I'm not at all convinced that the difficulty with Social Security is the level of benefits. The difficulty is its profoundly regressive structure and the illusion that it is an insurance program at all.
Nearly 80% of Americans pay more in payroll taxes (including the employer share, which economists widely agree fall on the worker anyway) than they do in income taxes. But no matter how much income individuals earn, they only pay Social Security on the first $87,000.
Income tax cuts are often supported, with some amount of reason, by the observation that the top 5% of income earners in America earn about 30% of the income, but pay about 56% of the income taxes. So the income tax is progressive, and that's a good thing, because it lowers the burden at the lower end of the income scale. But if you include payroll taxes, the share of total federal taxes paid by the top 5% falls back to about 40%, which isn't much larger than their share of the income.
As conservative economist Alvin Rabushka of the Hoover Institution has noted, the regressive structure of Social Security is preserved “to maintain the fiction that Social Security is a retirement insurance program in which contributions are linked to benefits, rather than what it is—a transfer of income from workers and the self-employed to retired people.” Payroll taxes single-handedly reverse the progressivity of the federal income tax. The appropriate policy in this regard is simple, but vastly under-considered: lower the rate and broaden the base. In other words, define the base beyond payroll income, but reduce the tax rate in a way that reduces the tax burden on the vast majority of income earners, but maintains the total revenue. This would vastly improve the distributional problems regarding Social Security.
The other issue is solvency. In order to see the reality of the situation, we again have to think in terms of accounting. The simple fact is that people consume goods and services, and the ability to transport these from one period to the next is very limited. Inventories are useful for smoothing short-term fluctuations in the supply and demand of goods, but not very useful in doing this over decades or between generations.
If the U.S. was a closed economy (with no foreign trade), it would follow that the only thing that can ultimately provide for the consumption of goods and services of Social Security beneficiaries in future decades will be the overall ability of the U.S. to produce goods and services at that time. While individuals may very well be able to “save for the future,” so that they can claim a larger share of the production that exists when they retire, we cannot do the same thing in aggregate, as a nation. In other words, far and away the most important factor in the Social Security debate is the issue of future productivity.
On that note, the sort of “productivity” that we've observed in recent years from imports, downsizing, and outsourcing, is inadequate. For more details on this, see The U.S. Productivity Miracle (Made in China). To be more productive in the long-run, we need greater U.S. savings, and fiscal policies adequately targeted to increasing investment in research and development, rather than indiscriminate stimulus plans that work largely by dropping money from helicopters.
Finally, there is one additional wrinkle, which could potentially work in our favor, but currently works against us. The U.S. is not a closed economy, and while the level of U.S. productivity is quite high, the prospects for rapid growth in productivity are much higher in many countries such as China. To the extent that we could potentially satisfy the needs of future Social Security recipients through the future import of goods and services from other countries, we would be well served by accumulating claims on that future production today.
We're doing exactly the opposite. Rather than improving private and government saving in a way that would allow us to run a current account surplus and accumulate foreign securities (i.e. claims on future foreign production), we are running the deepest current account deficit in history. In effect, we are promising future U.S. production not only to our own citizens, but to foreign countries as well. This is one of the most profound economic mistakes that America could make.
In short, the economic future of the United States is linked to unpleasant arithmetic called the savings-investment identity. Over the next several years, the growth or vulnerability in U.S. investment (plant, housing, capital spending) is dependent on whether our reliance on foreign capital is adjusted by a reduction in the supply of it from foreign countries like China, or on reductions in our demand for it based on improved saving behavior. Which is winning? The less willing foreign countries are to supply capital, the greater the downward pressure on the U.S. dollar. Over the longer-term, the U.S. savings imbalance has important implications for our ability to provide for the retirement needs of Americans.
It's useful to remember that every sustained U.S. economic expansion began from a current account surplus. Given the deepest deficit in history, my views on the sustainability of this recovery should be clear. It's notable that even this far into the rebound, capacity utilization and help wanted advertising remain near their recession lows (as they did before the fragile 1980 recovery failed). While it's possible that internet advertising and the like might impact the level of the help wanted index, it does not follow that this would prevent the index from reversing its trend. To the contrary, the poor level of help wanted advertising is consistent with anecdotal evidence from surveys of corporate hiring which indicate only tentative improvement in hiring plans.
Bottom line: the evidence is not nearly convincing that the U.S. economy is out of the woods.
Nor does the stock market appear to be out of the woods. As of last week, the Market Climate for stocks remained characterized by unusually extreme valuations and still modestly favorable market action. We continue to observe a pattern of distribution, with trading volume expanding on market declines and becoming dull on advances. Meanwhile, over 60% of investment advisors are bullish, with less than 20% bearish. We haven't observed such lopsided readings since August 1987, which was the peak of that cycle. That's not a forecast, but it does underscore the relative caution with which we are positioned. The Strategic Growth Fund continues to have about half of its diversified portfolio of stocks hedged against the impact of market fluctuations, with an additional put option position (about 1% of assets) with the potential to hedge an additional 35% of our exposure to market fluctuations in the event of a substantial market decline. This is a position that I would still expect to participate in any further market advance, but less than an unhedged position would. Clearly, risk matters here, and my perception of that risk is gradually increasing, though we still do not have sufficient evidence to hedge our exposure to market risk altogether.In bonds, the Market Climate remains characterized by modestly unfavorable valuations and modestly unfavorable market action. Though the yield pickup available from investments in long-term bonds appears reasonably wide, it comes with particularly wide risks. Upward market pressures on short-term rates (with or without Fed action) would erode the attractiveness of long-term bonds. Unless we observe offsetting downward pressures, particularly in vulnerable economic figures or widening credit spreads, the “carry trade” alone isn't sufficient to warrant a commitment to long-term bonds. The Strategic Total Return Fund continues to have a duration of about 2.5 years, meaning that a 1% (100 basis point) change in interest rates would tend to move the Fund's value by approximately 2.5% on account of bond price flucutations.
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