November 7, 2005
Speculating on Speculation
Just a reminder – both the Hussman Strategic Growth Fund and the Hussman Strategic Total Return Fund will pay their annual capital gains distributions in November, which are expected to amount to a few percent of net asset value, representing a mix of long-term and short-term gains. Please see last week's comment for further remarks regarding mutual fund distributions in general.
There's a difference, in the financial markets, between a “self-fulfilling prophecy” and a “discounted expectation.” A self-fulfilling prophecy is an expectation about a specific outcome that actually produces that event in reality (for example, both the belief that the world is a fundamentally friendly place, as well as the belief that the world is a fundamentally hostile place, are fairly reliable self-fulfilling prophesies). On the other hand, a “discounted expectation” is an event that is so widely expected that it becomes already reflected in current prices, even though the event has not yet arrived (and might not either).
My impression is that Wall Street's expectations for year-end strength in the stock market have, to date, been self-fulfilling prophesies that have actually produced short-term strength in the market. At the same time, it's likely that those expectations are now so widely accepted that the hope for future market strength is probably already reflected in current prices. In short, with so many investors and analysts foreseeing a year-end advance, there's at least an even chance that we've already seen it.
Meanwhile, recent day-to-day economic figures have been at least moderately upbeat, save for the relatively tepid employment figure. Given that backdrop, as well as the move from a short-term oversold condition a few weeks ago to what I would currently view as a short-term overbought condition, it strikes me that investors are substantially overlooking the growing risk of recession that is evident in more reliable and less transitory information.
Here is a brief overview of what I view as some of the best indicators of an oncoming recession (see http://www.hussmanfunds.com/html/economy.htm#recession for a more complete discussion of these indicators) and their current status:
Widening credit spreads: Last week, the spread between BAA and AAA corporate yields quietly widened to the largest gap since 2003, as did the spread between lower rated BBB corporate bonds and default-free Treasury yields. The spread between 6-month commercial paper and 6-month Treasury bills has been somewhat better behaved, and will be an important indicator of “imminent” risk of an economic downturn.
Flattening maturity spreads: Presently, the spread between 30-year Treasuries and 3-month Treasury bills is less than 1%, which alone is not a reliable indicator of economic weakness, but combined with other indications has historically been an important precondition for recessions.
A flat or declining stock market on a 6-month look-back: While the S&P 500 is currently slightly above its level of 6 months ago, that difference has fluctuated between positive and negative on a week-to-week basis. The fact that our broader measures of market action have turned negative is a more reliable indication of the recession risk that's currently being reflected in stock price behavior.
An ISM Purchasing Managers Index below 50 : This measure is still fairly safe, at 59.1. Still, the PMI can experience significant movements from month-to-month, so the distance from 50 doesn't necessarily offer any sort of robust protection against economic weakness. Suffice it to say that the PMI looks OK for now, and is one of the few bright spots in the current picture.
Sudden weakening in consumer confidence: A drop in the consumer confidence index about 20 points or more below its 12-month moving average typically coincides with the beginning of recessions. The current level is about 15 points below the 12-month average, which is of concern. Equally problematic is that the “consumer confidence spread” between “future expectations” and “current conditions” has deteriorated markedly, which often foreshadows recessions by as little as 6 months.
A sharp slowing in the annual growth of consumer installment debt: Although consumer credit growth has only slowed moderately, it is now below 4% annually and less than the year-over-year rate of inflation. So on an inflation adjusted basis, we are now seeing a contraction in real liquidity. This is also evident in other measures. The next chart displays the growth of real liquidity (a combination of M2, adjusted monetary base, and consumer credit growth in excess of inflation) since 1965, versus growth in real GDP. Notice that the most recent growth rate for real liquidity is negative, which is a negative for probable economic performance as well.
Low or negative real interest rates: As of last month, the year-over-year CPI inflation rate now exceeds short-term Treasury yields, so (ex-post) real interest rates are negative on Treasury bills and are low on longer maturities as well.
Falling capacity utilization below 80%: Generally economic expansions are able to push capacity utilization at least above 80%. The current one has not even done that, nor has help wanted advertising expanded notably. That gives the current expansion the very strong look of being based on “helicopter money” stimulus, rather than intrinsic, organic growth in demand, innovation and productivity. The current cap-use rate is 78.6%.
Slowing growth in employment and hours worked: Most recessions start at about the point where total non-farm employment has grown by less than 1.0% over the prior 12 months, or less than 0.50% over the prior 6 months. The current figures on those measures are 1.4% and 0.58%, so clearly the 6-month performance of the job market is an early cause for concern. Meanwhile, the aggregate weekly hours index has averaged 103.1 over the past three months, compared with 102.5 over the prior three months. Typically, recessions begin with a quarterly decline in this index, so we've got tepid performance in the job market, but not yet a clear warning from that part of the economy.
In short, despite hopeful signs from various short-term indicators, there are increasing signs of deterioration in the underlying condition of the economy. We're still not at the point where an oncoming recession could be considered a reliable expectation or a strong implication of the data. But it's clear that the true condition of the economy is far less robust than many analysts seem to believe. The indicators reviewed above will be important to monitor in the next few months, because recession risk now seems to be more a question of “when” than “if.”
As a side note, data monkeys can find links to many of these historical data series on the economic data page of this site ( http://www.hussmanfunds.com/html/datapage.htm ).
As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and still unfavorable market action. Stocks have now moved to what I would view as an overbought condition. It's possible that we could observe enough further strength in internals to indicate that investors have once again adopted a preference toward risk and speculation. However, that evidence has not emerged here, so we have to take the evidence we have. Unfortunately, if we examine historical combinations of a) an overbought condition b) in an unfavorable Market Climate c) with upward interest rate and inflation pressures, we observe some excruciatingly bad outcomes. That's not a forecast, but my hope is that it will go some distance in reconciling the fact that I have not responded to the current rally by taking any material amount of exposure to market fluctuations. I'll certainly act on new evidence that provides any reliable basis to expect a reasonably good expected return from accepting market risk, but here and now, I don't observe that.
Given current conditions, the bulk of my efforts continue to be on the stock selection and portfolio construction side of our investment approach, where there is always useful work to be done and, in my view, useful risk to be accepted. Consider that even if my view on the Market Climate was to turn favorable, I would only be inclined to accept about a 35% exposure to market risk given current valuations and economic conditions. If, then, the market was to advance by 10%, fully captured, that shift in exposure would still only be worth about 3.5% in portfolio performance. That's not a large figure in relation to the performance differential that our favored stocks have generally achieved relative to the market. In other words, I believe that the best use of our “risk budget” is to accept investment positions in individual stocks having what I see as valuations and market action. Very little of my daily actions here are concerned with day-to-day fluctuations in the major indices.
In bonds, the Market Climate as of last week was characterized by both unfavorable valuations and unfavorable market action. Despite the possibility that bonds have moved to a higher “trading range” that has some potential for short-term declines in yields, I view the risk of further upward pressure on yields as substantial. That's another way of saying that increased exposure to interest rate risk will probably wait until we observe more imminent signs of oncoming economic weakness, particularly in the area of widening credit spreads. The commercial paper – Treasury bill spread is a good place to look for the sort of abrupt change that might prompt an increase in portfolio duration in the Strategic Total Return Fund. For now, the Fund's duration remains about 2 years (meaning that a 100 basis point move in interest rates would induce a roughly 2% fluctuation in the value of the Fund). Meanwhile, gold has performed well despite relative strength in the dollar, which begs the question of what might happen if the dollar were to weaken. In my view, the precious metals (and related stocks) continue in a favorable Market Climate, and the Fund continues to carry a roughly 20% exposure to this group.
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