April 28, 2008
Watching Ringside for Round Two
In the wake of the (now overbought) relief rally following the Bear Stearns debacle, we are hearing the increasingly prevalent notion that the financial markets have “put in a bottom” and that the mortgage crisis is largely behind us.
In my view, the problems that we've observed so far are only a warning shot. I have am becoming less optimistic on two fronts. First, my impression has been that the downturn in the U.S. economy should be fairly shallow, owing to a relatively lean inventory to sales ratio and the historical tendency for nominal consumer spending to hold up well even during recessions (“consumption smoothing”). Though we correctly avoided the damage to financials on the basis of valuations and market action, market action in consumer stocks has deteriorated surprisingly - suggesting more weakness is likely than I had envisioned.
Second, I have been too optimistic that other market analysts are capable of recognizing erroneous lines of thinking that aren't supported by either economic theory or empirical data. The main impact of this is that we keep observing recurring "bubbles," and our reluctance to participate has periodically restrained short-term (though not long-term) returns. So for example, we got out of technology and internet stocks about 18 months too early in the late 1990's (though the decision was clearly vindicated over the complete cycle). Similarly, we've avoided financial stocks during this market cycle, and missed the “private equity” enthusiasm early last year (though again, the decision was clearly vindicated as financials are now at multi-year lows). As a rule, once a market becomes overvalued and speculation becomes overextended, it becomes wise to panic before everyone else does, even at the risk of being early.
We've now observed a dot-com bubble, a techology bubble, a general bubble in equities ending in 2000 but "echoing" to rich valuations in recent years (especially on the basis of normalized profit margins), a bubble in housing, a bubble in private equity and low-grade debt, a mini-bubble in Shanghai (which has lost about half its value in recent months), and now a bubble in commodities that is well underway. When, when will we learn to recognize these for what they are?
Though Keynes is noted for saying “the market can stay irrational longer than you can stay solvent,” this statement cannot be taken as justification for participating in overextended speculative bubbles. Rather, it is a warning against taking investment positions that risk insolvency. In the Strategic Growth Fund, the dollar value of our index shorts never materially exceeds our long holdings, and we don't short individual stocks. Aside from acceptable “basis” risk between the stocks we hold long and the indices we use to hedge, and perhaps 1% of assets in option time-premium at any given time as a result of staggering our strikes to provide a stronger defense, we don't consider various speculative bubbles as threats to our own returns. Instead, our experience is that avoiding bubble risk can cause us to tread water for a while relative to the market (and particularly relative to the bubble sector) as speculation reaches its heights, and that we tend to enjoy strong relative performance as a bubble breaks.
With regard to recent performance, which has been positive but modest since the market peak last year, the main factor that has kept our returns relatively restrained despite the collapse of financials has been the simultaneous collapse of technology and consumer stocks, with cyclicals and commodities providing the greatest support to the major indices.
We can't rule out the possibility that further improvements in market action might prompt us to soften our hedges somewhat (particularly if we observe strength in price/volume behavior, breadth and industry group uniformity). But presently, market conditions are strenuously overbought in an unfavorable Market Climate – a condition followed often enough by spectacular vertical losses to be taken as a serious risk, if not a forecast. We continue to be out of financials, in the belief that delinquencies and foreclosures are only presently entering the heavy season, that losses have not been taken, and that lending and liquidity will enter a second phase of crisis as capital ratios are compressed.
Meanwhile, with 10-year Treasury yields no longer significantly negative in real terms, and increasing divergences in market action within the commodity space, we are rapidly cutting our exposure to commodities and oil. Finally, as we repeatedly hear guidance in recent earnings reports about expected “profit margin compression,” and associated initiatives to cut costs and reduce employment across-the-board, we are barring the doors in anticipation of collapsing profit margins, and much deeper job losses and economic weakness than we have observed to date.
As Pimco's Mohamed El-Erian succinctly put it on Friday, “It is still too early for investors and policymakers to unfasten their seatbelts. Instead, they should prepare for renewed volatility.”
Commodities – “Malthusian Breakpoint ” or Speculative Hoarding?
In prior comments, and in pieces like Going for the Gold and Valuing Foreign Currencies, I've frequently noted the importance of real (after inflation) interest rate pressures in driving commodity and currency fluctuations. And though spot commodity / equity ratios (like the ratio of the spot gold price to the XAU) are actually supportive of commodity stock prices in and of themselves, the historical tendency is for these ratios to lose some of their informative value when commodity prices themselves have run to extremes and real interest rates begin to turn. That's the situation we find ourselves in presently. We are also seeing an increased tendency for dollar fluctuations and commodity price movements to be less tightly linked (essentially an indication that commodity prices are fluctuating in other countries as well). Probably one of the surprises in the coming year will be fresh dollar weakness combined with falling commodity prices (i.e. global commodity prices falling faster than the value of the dollar itself).
Meanwhile, though first quarter GDP figures released this week may not be particularly weak, my impression is that as we observe the next significant hit to economic figures (most likely jobless claims over the next several weekly reports) the argument that we've skirted a recession will quickly flip on its head.
Part of the signal to cut and run from commodities is provided by various neo-Hobbesians (the natural state of mankind is “solitary, poor, nasty, brutish and short”) who argue that the world has reached a “Malthusian breakpoint.” Thomas Malthus was the 18th century demographer and dismal scientist who argued that agricultural output grows only linearly, while population grows geometrically, suggesting widespread famine when the population outstripped the food supply.
An impassioned email I received this week warned “Vastly lower supplies of EVERYTHING will outweigh any demand destruction… indeed, the entire WORLD'S experience has never included a Malthusian supply problem. This time it really IS different ... for the entire human race.“
Needless to say, I become very uncomfortable anytime I hear the phrase “this time is different,” as we can be sure that participants in every bubble have believed the same, both before and after the Dutch speculators who hoarded tulip bulbs. Still, the question is fascinating because it raises a legitimate question of why commodity prices are rising.
As Nobel economist (and one of my dissertation advisors at Stanford) Joe Stiglitz noted on Friday, a good part of the reason for rising oil prices is because the producers are already awash in U.S. assets, and to supply significantly more oil will just force them to accumulate more low-return assets. “Their best investment is to keep it in the ground.”
As for agricultural commodities, what we are observing is probably not a Malthusian breakpoint, but what I'd call “speculative hoarding.” Essentially, as the prices of commodities rise, particularly in developing nations, there is a tendency to save in the form of real goods. We've observed this historically in various countries as hoarding of every form of physical output, even spoons and other household items.
Supporting that thesis of speculative hoarding, it's interesting that on Wednesday, a news piece came out on Bloomberg noting “Wal-Mart Stores Inc's Sam's Club warehouse unit is restricting the purchase of some rice to four bags a visit because of ‘recent supply and demand trends.' Some consumers have started hoarding rice, the food staple for half the world, as supplies shrink. Some of Costco Wholesale Corp's stores, including locations in California, have put limits on sales of rice and flour, Chief Executive Officer James Sinegal told Reuters yesterday.”
In effect, we are observing a version of tulip-mania with foodstuffs. I would expect that prices will reach a speculative peak, probably within a few months, and then most probably plummet with very little in the way of relief rallies. That is a fairly predictable dynamic once commodity price movements reach the parabolic stage that they have entered lately. Still, it's not clear how high that parabola will ascend, because as the slope goes vertical, small differences in the exact point of the bust will lead to substantial differences in the price at the high. But the world has more arable land and more capacity to bring it into use within months and years than should cause near-term concern about a Malthuisan breakpoint.
Biofuels don't help, but biofuels are the result of high oil prices, which are the result of poor incentives to bring oil up (both because of low yielding U.S. assets and political resentment over U.S. foreign policy). As the Buddha said, this is because that is; this is not, because that is not. In any event, commodity prices reflect immediate supply and demand pressures, but are not an indication that the world as we know it has fundamentally and permanently changed. Future commodity price levels might certainly be different, on average, in the future than they were in the past, but we should not jump to the conclusion that the long-term boom-bust dynamics of commodities have vanished as a result.
In case we need a red herring to suggest that the end is nigh, last week saw the debut of a little Denver fertilizer company, which promptly jumped 58% above its IPO price on its first day of trading. The company: Intrepid Potash (IPI). Hand in hand with the surge in grain prices has been a surge in the price of this fertilizer (basically water-soluble potassium), and the frenzy for potash has increased in step with the speculative hoarding of foodstuffs. Clearly the company is a direct “play” on potash prices. But this is interesting – according to the company's own prospectus, “ Fertecon Limited, a fertilizer industry consultant, expects global potash fertilizer consumption to grow 3.7% annually from 2007 to 2011.” On that growth rate, and on the basis of elevated earnings due to high potash prices, the companies in this group are selling at P/E multiples of 40-60.
As a side note, the word “intrepid” (adjective: resolutely fearless; dauntless) in the context of fertilizer is strangely reminiscent of the late-1960's “Go-Go” market, when dull little companies gave themselves exciting names to divert investors attention from the fact that they were, in fact, dull little companies – as when Minnie Pearl's Fried Chicken renamed itself “Performance Systems.”
On the earnings front, we continue to expect significant pressure on profit margins and resulting cost-cutting pressures to weigh on employment. Given that Wall Street analysts continue to build a major second half recovery into earnings projections, it is important to ask whether those earnings estimates are likely to be reliable.
Since analyst estimates of earnings are almost invariably higher than current operating earnings, and earnings tend to grow over time, it is easy to assume that analyst estimates usefully “lead” earnings. Unfortunately, this isn't true, particularly at turning points when earnings trends are slowing or improving. James Montier at Societe Generale demonstrates this nicely by subtracting the upward linear trend from both operating earnings and analyst estimates. What remains are the deviations of earnings and estimates from their long-term trends.
If analyst estimates anticipate subsequent earnings, the “forecasts” line (black) should turn upward or downward before the “earnings” line (red) turns. But as James notes, “The chart makes it transparently obvious that analysts lag reality. They only change their minds when there is irrefutable proof they were wrong, and then only change their minds very slowly.”
Moreover, as Tim Hayes of Ned Davis Research points out, the difference between GAAP earnings (based on generally accepted accounting principles) and operating earnings “has reached its second widest level on record. What all this means is that the greater the focus on operating earnings, and especially forecasted operating earnings, the greater the vulnerability to disappointment on the GAAP earnings reality. And it supports giving the cyclical bear market downtrend the benefit of the doubt.”
In short, we are open to “softening” our hedge somewhat in the event that market action exhibits sufficient improvement in price/volume behavior, breadth, industry action, and so forth, but here and now we continue to identify the Market Climate as unfavorable. Given the present overbought status of the stock market, my concerns about near-term risk are particularly strong. Further mortgage writedowns, defaults and increased credit difficulties remain a concern, as does commodity price weakness (not necessarily immediate, but soon enough) and the prospect of earnings risk and layoffs driven by cost reductions.
As of last week, the Market Climate for stocks was characterized by unfavorable valuations and still unfavorable market action (particularly in price/volume behavior and internals, despite strength in various indices). Given the additional overbought condition of the stock market, we should be concerned about abrupt downside risk, but as noted above, we are willing to soften our hedges in the event that market action improves sufficiently.
In bonds, the Market Climate remains characterized by unfavorable valuations and unfavorable yield pressures, holding the Strategic Total Return Fund to a duration of less than 1 year. We continue to look for opportunities to clip off our exposure to precious metals on strength. That exposure now stands at less than 10% of assets in the Strategic Total Return Fund.
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