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March 10, 2008

Recession, Far More Foreclosures, and Eventually, Commodity Weakness

John P. Hussman, Ph.D.
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“Stocks are not cheap,” Warren Buffett noted on Monday. Not surprisingly, given a market down 15% from its highs, with many stocks down much more, he did note “I find more things to look at now than I did six months or a year ago.” Buffett also remarked “from a common-sense standpoint right now, we're in a recession.”

Those comments match my own sentiments on all fronts. On the basis of normalized earnings (as opposed to earnings that assume profit margins will remain forever elevated at 40-50% above their historical norms), the S&P 500 would probably be a good value anywhere below the 1000 level. I have no particular expectation that we'll actually see that level in this cycle, but that level would require an only slightly above-average bear market loss from the highs (and certainly less than we observed in 2000-2002).

Overall, I am not enthusiastic about the potential return from accepting market risk here, so we remain well-hedged, but the extreme aversion to market risk I had last July (A Who's Who of Awful Times to Invest) and October (Warning – Examine All Risk Exposures) has moderated. An increasing number of individual stocks already appear to be solid values here, and the market has already declined enough that we would be willing to remove a portion of our hedges on an improvement in market internals.

My opinion is that the current market cycle will probably be completed with at least a standard, run-of-the-mill bear market decline that achieves a loss of about 30% from the highs. That's a plain-vanilla bear, and assumes that stocks do not move to what would historically be considered “undervalued” levels. While such a decline would put stocks at a relatively low multiple on the basis of existing “forward operating earnings” estimates, I have little doubt that those estimates will be slashed as the year progresses.

A run-of-the mill bear runs about 15 months, so if we mark the highs somewhere about July-October of last year, it would not be unreasonable to brace for the possibility of continued market difficulty for the bulk of 2008. If that is the case, we can also expect strong intermittent “bear market rallies” as we saw off the January low. Better valuations and periodic improvement in market internals may allow us to accept some amount of risk from time to time this year, but we're not in any hurry to “buy the dips” without supporting evidence, particularly giving growing debt problems in the economy.

A common argument lately is that the market's recent decline was simply anticipating the negative news we see today, and since “the market is a discounting mechanism,” we can go ahead and ignore the bad news and start looking ahead to the recovery. Not so fast. The market may be a discounting mechanism, but it usually doesn't look past economic trouble immediately after the trouble starts. Bill Hester has an interesting research piece this week – Recessions and the Duration of Bad News – that offers some perspective on how the economy, earnings and stock prices typically evolve in a recession (additional link at the end of this comment).

As usual, we don't invest on the expectation of any particular “scenario,” and neither should you. Our investment stance at any point in time is driven by the prevailing combination of both valuation (fundamentals) and market action (price/volume behavior and a wide range of other market-generated data). Given any particular “Market Climate,” we align our risk-taking in proportion to the average return/risk profile that a given Climate has produced. When the evidence changes, so does our investment position. Though the Market Climate doesn't flip around a lot, the evidence does change from time to time. Since we can't predict when, there is no use attaching ourselves to any particular scenario regarding future market or economic outcomes.

We don't require depressed valuations to remove part or all of our hedges, but we do require a combination of valuations and market action that has historically been associated with acceptable returns, on average. Presently, despite somewhat oversold conditions (which often become more so in down markets), we don't have sufficient evidence to justify removing hedges.

Shouldn't we try to pinpoint the bottom of this correction in order to catch a rebound in hopes of calling the next short-term peak and side-stepping the next decline? Sorry - we don't try to “catch” or “call” market turns. Investors wanting that sort of speculation will have to go somewhere else entirely. Investors who are inclined toward short-term timing should stay as far away from the Hussman Funds as possible, because our long-term focus will drive you completely out of your gourd. We pursue a risk-managed investment strategy that seeks to outperform the S&P 500 over the complete bull/bear market cycle with smaller periodic losses than a buy-and-hold, and we place very little weight on tracking short-term market fluctuations. Our offices are relaxed, friendly, and utterly tranquil because we focus on research and disciplined process, not speculation. We don't have a marketing department, but we have a very strong “anti-marketing” message: short-term investors and speculators are encouraged to go elsewhere.

I'm pleased to note that as of Friday, the performance of the Strategic Growth Fund is ahead of the S&P 500 for the most recent 3-year period, and of course remains substantially ahead of the S&P 500 since inception in 2000. Still, our horizon of interest is the complete market cycle. As I noted in our semi-annual report, the Fund has clearly achieved its full-cycle objectives since inception, but the single-digit returns of the past few years have been a fraction of my long-term expectations. The S&P 500 would have to decline about 12% further (holding the Fund constant) to put us even with the S&P 500 for the 5-year period since early 2003, when the bull market started. Of course, the Fund does take risk, even when it is fully hedged, since the stocks held by the Fund may perform differently than the indices we use to hedge.

Recession, far more foreclosures, and eventually, commodity weakness

Last week's employment report produced the second monthly decline in non-farm payrolls, consistent with the recession that we've anticipated since November. Though economists are now downgrading their growth expectations, the idea of a recession is still widely rejected. It's unlikely that we'll observe a durable low in stock prices until a recession is fully recognized (and only expected to worsen). We can't rule out the standard fast, furious “clearing rallies” that emerge from time to time, but bear markets attached to recessions don't bottom until coincident indicators look like death and recession is taken as an obvious fact. While it might turn out that the economy is not, in fact, in a recession, that outcome would go against the markers that have accurately identified every past recession.

Adding to the data set, the recent plunge in consumer confidence has taken that index more than 20 points below its 12-month average – an event which has generally occurred near the start of past recessions. Indeed, among indicators that have generally turned negative early into recessions, about the only one that has not is manufacturing capacity utilization, which generally drops below 80% as the economy turns down (the January figure was 81.5%). Given the low inventory/sales ratio, I've argued that we may observe less weakness in the real economy than we observe in asset prices. Still, it would be useful to keep an eye on that cap-use figure when it is reported on March 17.

On the mortgage front, the Mortgage Bankers Association noted that delinquency rates rose to 5.82% in the fourth-quarter of last year, while the foreclosure rate rose to 2.04%. So as of December, nearly 8% of all U.S. mortgages were in delinquency or foreclosure. This is troubling, because as I've frequently noted, the real wave of mortgage interest rate resets only started in October and will continue into 2009. I had not expected delinquency and foreclosure rates to be so high in the fourth-quarter data, because the impact of those resets has hardly even been felt.

Equally troubling was a comment last week by Ben Bernanke, who noted that bank recoveries from foreclosures are only averaging about 50% of loan value, partly because of low auction values on foreclosed properties, and partly because of high legal expenses. Bernanke urged financial companies to reduce principal values on troubled mortgages in order to stem the surge in foreclosures. In my opinion, that would be a “moral hazard” disaster, encouraging virtually every financially strapped homeowner in the country to go delinquent in hopes of forcing a principal writedown.

The Fed did bump its “term auction facility” up to $100 billion on Friday, which was interesting because it is a material increase of about $40 billion in Fed liquidity. So the Fed did indeed expand its promise of liquidity provision. The problem is that even that $40 billion only represents repurchase agreements. This is not permanent money – just short-term liquidity that gets reversed after a month or two. Even if the Fed was making permanent purchases of defaulting securities (which it's not), the amount would be a drop in the bucket in a $13 trillion banking system, with about $5 trillion of that as mortgages, 8% of which were already delinquent or in foreclosure last December, with far more to come, of which banks are only recovering 50% of principal value. And that's just FDIC insured institutions. Let's not even talk about non-bank institutions, much less credit cards and other unsecured loans.

This will get worse. The latest FDIC Quarterly Banking Profile notes:

“Insured institutions' loss reserves posted their largest increase in 20 years in the fourth quarter, but this growth did not keep pace with the growth in non-current loans. At year-end, one in three institutions had non-current loans that exceeded reserves.”

It is difficult to believe this situation has improved in recent weeks, that the write-offs are behind us, or that $40 billion in Fed repurchases will change the situation.

Finally, on the commodities front, the CRB (a broad index of commodities prices) has hit fresh highs in recent days, but Friday's weak employment report has spurred questions about the sustainability of the runup in commodities. If you look at long-term commodity charts, you'll quickly become convinced of one thing – commodity prices are cyclical. They don't necessarily overlap economic cycles, but it is dangerous to believe that the cyclical dynamics of commodities prices have been forever changed by China and India. The price levels may very well be higher in the future than they were in the past, but cyclicality is something that should be expected in both commodities and the stock prices of companies that produce them.

It is accurate intuition that commodities are generally stronger in economic expansions than they are in contractions, but that intuition can fail when U.S. real interest rates are negative. At those times, the heavy downward pressure on the U.S. dollar tends to be supportive for commodities. Given that commodities have already had an extremely strong run, it would be overly speculative to take positions here on the expectation that the run will continue, but the evidence suggests that we should expect a serious break only when the rate of inflation breaks.

As a simple way to capture the pattern, we can define the economy as “strong” or “weak” depending on whether the ISM Purchasing Managers Index is above or below 50. We can capture real interest rate pressures by noting whether the latest year-over-year CPI inflation rate is above or below the 10-year Treasury yield. This is not a true “real” interest rate measure, but it generally captures periods where recent inflation is high or accelerating and bond yields are not particularly supportive of the U.S. dollar. Using the recent CPI inflation rate (overall, not core) also introduces a “trend following” component, since rising food and energy prices will push up that year-over-year rate as well.

Most of the past half-century has been associated with an ISM above 50 and a CPI inflation rate below the 10-year Treasury yield. During these periods, the CRB index has increased at a modest average rate of about 4.3% annually. When the ISM has been below 50, with CPI inflation below 10-year Treasury yields, the CRB has declined at an average rate of -5.4% annually. So there is certainly evidence to suggest that commodity prices are vulnerable during periods of economic weakness.

When CPI inflation is running higher than 10-year Treasury yields, the pattern is different. This doesn't happen often, but the return differences are large enough to be statistically significant despite the small sample size. During these periods of downward real interest rate pressure, the CRB has advanced at an average rate of 10.0% annually when the ISM has been above 50, and 39.6% annually when the ISM has been below 50. This result has been largely due to downward pressure on the value of the U.S. dollar.

In short, my impression is that the commodities run, though increasingly extended and dangerous, may have a final push due to further weakness in the U.S. dollar. Most likely, as we approach the second half of 2008, rising credit problems will reduce monetary velocity enough to finally put a lid on the rate of inflation. At the point where the year-over-year CPI rate drops below 10-year Treasury yields, most of the damage to the U.S. dollar will likely have been done (even if the economy weakens further), and that's probably when commodities will become poor speculations.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully-hedged investment stance. Though stocks are emphatically not cheap, we would be willing to remove a portion of our hedges in response to improved market internals, particularly at levels below about 1250 on the S&P 500. At that point, the index would have declined by 20% from its high, allowing investors to concede a "bear market" and to begin trying to put it behind them. I would expect a stronger potential for more committed buyers to emerge on that theme. Still, we will change our investment positions on the basis of evidence, not merely price levels, so I certainly would not look at any particular level on the S&P 500 as a “downside target” or a reliable “entry point.”

In bonds, the Market Climate remains characterized by unfavorable valuations and relatively neutral market action. The Strategic Total Return Fund has a very short 1-year duration here. While it is unusual for the Fund to hold primarily Treasury bills, this is one of those times, because there is very little yield premium for accepting maturity risk. A “flight to safety” has sharply depressed yields at maturities of even 2-5 years, real TIPS yields are negative at intermediate maturities, agency spreads are widening, and I expect rising default rates to continue destabilizing this market before conditions improve.

Meanwhile, the strenuously extended run in precious metals and other commodities provided a good opportunity to clip our exposure in precious metals shares to slightly below 15% of assets last week. The Market Climate in precious metals remains favorable on our measures, but the tone of the market is becoming increasingly speculative. As usual, we tend to trade around our core position, adding exposure on short-term weakness and clipping it on short-term strength. Consider us increasingly risk-averse, but we do allow for somewhat more strength in commodities before we zero out our precious metals exposure perhaps later this year.

New from Bill Hester: Recessions and the Duration of Bad News

 

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