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January 19, 2009

Market Action Abruptly Signals Renewed Caution

John P. Hussman, Ph.D.
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In recent sessions, we have observed a troublesome deterioration in credit default swap spreads among a number of major financials, which has prompted us to tighten our hedges in response. From a statistical perspective, what I've referred to as “early improvement” in our measures of market action has now been lost. The Strategic Growth Fund is fully hedged here, about half with pure long-put / short-call option combinations, and about half with what amounts to in-the-money put options (allowing the Fund to obtain a moderate positive exposure to market fluctuations in the event that the market recovers more than a few percent). Overall, I expect the Fund to experience only modest sensitivity to market fluctuations here, and the main driver of our returns is likely to be the difference in performance between the stocks that we hold in the Fund, and the indices we use to hedge (primarily the S&P 500 and Russell 2000).

On the hopeful side, the market appears generally oversold, and is near what could be considered reasonable support. Given the loss of favorable market action, we wouldn't invest on the expectation that this support will necessarily hold, but as noted above, about half the Fund's exposure is hedged with option combinations that amount to in-the-money put coverage. So a recovery in the market will put us in a more constructive position somewhat automatically, without having to rely on that outcome.

Another hopeful aspect to current conditions is the possibility of some significant policy announcement regarding financials as the Obama administration begins. From my perspective, the factor of immediate concern is again the capital cushion on the liability side of bank balance sheets. As banks experience losses on the asset side of their balance sheets, the same amount has to be subtracted from the liability side, and that amount comes out of “shareholder equity,” more commonly known as “capital.” Failing new capital injections, and quickly, could rapidly produce conditions similar to what we observed in October and November. That is what the rapid spike in credit default spreads is telling us here.

Second to fresh capital injections from TARP funds, the new Obama administration will need to directly address foreclosure abatement. Government policy is strongest and most appropriate in areas where there is a “coordination failure” that the private markets simply cannot address, and dealing with distressed mortgages is a prime example.

Suppose a homeowner borrows $200,000 from a bank, and it is clear that the homeowner is in distress, to the extent that the bank actually marks the value of the loan down to just $100,000. On the books of the bank, that loss is already written off. Yet if the bank continues to demand $200,000, the homeowner will actually be forced to default, with add-on effects to the economy in the form of foreclosure, lost consumption, credit distress, and a host of other problems.

But suppose that the borrower would be able to make regular payments on a principal amount of $100,000, and would even be willing to pledge $100,000 in future home price appreciation to the bank in order to make the bank whole. In that case, the present value of the loan need not be massively written off, since a stream of future payments can be allocated many different ways in order to preserve its present value. If the payment schedule of individual homeowners could be restructured, or even better, if some of the losses already taken on these mortgages could be, in effect, “passed along” to distressed homeowners in the form of principal reductions, the rate of foreclosure as well as all of the “add on” effects to the economy could be substantially reduced.

The problem is that there is no mechanism to make this happen in the private lending markets. So many of these mortgages have been securitized by cutting them into a million pieces that it is impossible to restructure the loans without consent of all of those security holders. What is needed is coordination from government. One possibility would be to encourage changes in foreclosure law at the state level, allowing judges in foreclosure proceedings the ability to reduce principal for homeowners in return for a property appreciation right (a claim on future appreciation of the home) to the lender. The other would be something along the lines of the original “troubled asset” plan of the TARP – but in this case, rather than purchasing mortgage securities in expectation of helping bank balance sheets (which is impossible unless the Treasury overpays), the objective would be to collect all of the pieces of various pools of securitized mortgages at a steep discount (say, through “all or none” auctions), and then actually have the government “pass along” those discounts in the form of mortgage principal reductions to the homeowners underlying those securities.

However the intervention occurs, it is clear that government coordination is needed here, in order to reduce the foreclosure rate and the associated economic spillover on consumption, credit markets, employment and other areas.

Unfortunately, the fresh deterioration in market action and credit default spreads suggests that the need for intervention is becoming urgent. Again, there is a possibility that the new Obama administration will address some of these issues fairly quickly – particularly in regard to immediate capital infusions to major money center banks. In that event, a recovery of more than a few percent in stock prices would put us in a position to moderately participate in market fluctuations. Here and now, however, our immediate response is to move with the evidence at hand, and we have done so by tightening our hedges against the risk of fresh deterioration in the market.

If we get the S&P 500 back down toward the 700 level or below, I would expect that we will begin taking on more market exposure on the basis of valuation, as we did in October and November. That said, I would expect that we'll be somewhat slower to do so, given the generally poor follow-through that we've observed in the recent market recovery.

As always, we'll respond to market conditions as they evolve. I recognize that my tone regarding the stock market has taken a quick turn toward a defensive posture, but that quick turn reflects what we've observed in various measures of credit distress and market internals. This is why I avoid forecasts. We move as the evidence moves.

Here and now, we are relatively defensive, and do not expect to participate to a significant extent in market fluctuations. Our “local” sensitivity to market fluctuations here is just under 20%. It will tend to decline further on market weakness, and will tend to increase on market strength. Aside from this local exposure, most of the day-to-day fluctuations in the Fund will likely reflect day-to-day differences in performance between the stocks we hold in the Fund, and the indices we use to hedge.

Market Climate

As of last week, the Market Climate in stocks was characterized by favorable valuations but a deterioration to unfavorable market action. It's possible that the current oversold condition of the market, coupled with its position near a reasonable level of support (based on price action of recent months) will allow the market to find some footing here, but we can't rely on that. The “early improvement” in market action that we observed since November is now lost, and we have to act on the basis of the evidence – which is that investors are demonstrating a fresh aversion to risk. I do view stocks as relatively undervalued, but we have to be aware of the historical tendency for markets to overshoot on the downside in difficult conditions. I wish we had the evidence to hold to a favorable investment posture – it would be my preference for the sake of the economy, but as investors we can equally welcome market weakness because it would allow us to establish greater investment exposure at a point where stocks might be priced to deliver higher long-term returns.

For our part, the Strategic Growth Fund is currently relatively tightly hedged. We do have a “local” exposure that I would expect to reflect about 20% of market fluctuations within a range of a few percent. In the event of a substantial decline, that exposure to market fluctuations will gradually reduce further (as the “delta” of a put option becomes closer to 1-for-1 as it goes deeper into the money). Conversely, if the market recovers here, roughly half of the Fund's portfolio does not have short call options against it, so we would tend to acquire greater sensitivity to market fluctuations on market strength. Again, the reason we don't venture short-term forecasts is because the evidence can change as it has here. If market action shifts in a way that suggests a greater tolerance of investors toward risk (look particularly at credit spreads, breadth, and significant expansion of trading volume on advances), we would become more favorably inclined toward market risk.

In bonds, the Market Climate last week remained characterized by unusually unfavorable yield levels and moderately favorable yield pressures. In the Strategic Total Return Fund, we continue to carry most of our exposure in Treasury Inflation Protected Securities, with about 10% of assets in precious metals shares, about 10% in foreign currencies, and about 5% of assets in utility shares. The way to think about the relationship between TIPS yields and straight Treasury yields is that the nominal yield on a security is equal to the “real” yield plus expected inflation. At present, we have extraordinarily depressed nominal yields, but relatively high real yields, which means that the inflation rate implied in TIPS is extraordinarily low. Indeed, in order for TIPS to achieve the same total return as straight Treasuries over the next decade, we would need to observe a slight but sustained deflation over that period.

My impression is that we are not near the point where there is any real risk of inflation, and we may very well observe negative near-term inflation rates (which is why it is important to be careful with TIPS that trade at a substantial premium to par, since the apparently high “real” yields on near-term TIPS can be eroded by deflation). TIPS can't mature at less than par, but if there is a deflation, the accrued inflation adjustment on these securities can be whittled down. Suffice it to say that we are holding TIPS not because we anticipate a near-term resurgence of inflation, but because the real, inflation-adjusted yields available over the next decade are quite high on a historical basis, and will adequately provide for the maintenance and growth of purchasing power over time, regardless of the near-term course of consumer prices.

In honor and memory of Dr. Martin Luther King, Jr.

I say to you today, my friends, that in spite of the difficulties and frustrations of the moment, I still have a dream. It is a dream deeply rooted in the American dream.

I have a dream that one day this nation will rise up and live out the true meaning of its creed: "We hold these truths to be self-evident: that all men are created equal."

I have a dream that one day on the red hills of Georgia the sons of former slaves and the sons of former slave owners will be able to sit down together at a table of brotherhood.

I have a dream that one day even the state of Mississippi, a desert state, sweltering with the heat of injustice and oppression, will be transformed into an oasis of freedom and justice.

I have a dream that my four children will one day live in a nation where they will not be judged by the color of their skin but by the content of their character.

I have a dream today.

I have a dream that one day .. little black boys and black girls will be able to join hands with little white boys and white girls and walk together as sisters and brothers.

I have a dream today.

I have a dream that one day every valley shall be exalted, every hill and mountain shall be made low, the rough places will be made plain, and the crooked places will be made straight, and the glory of the Lord shall be revealed, and all flesh shall see it together.

This is our hope. This is the faith with which I return to the South. With this faith we will be able to hew out of the mountain of despair a stone of hope. With this faith we will be able to transform the jangling discords of our nation into a beautiful symphony of brotherhood. With this faith we will be able to work together, to pray together, to struggle together, to go to jail together, to stand up for freedom together, knowing that we will be free one day.

This will be the day when all of God's children will be able to sing with a new meaning, "My country, 'tis of thee, sweet land of liberty, of thee I sing. Land where my fathers died, land of the pilgrim's pride, from every mountainside, let freedom ring."

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Loving Your Enemies
November 17 1957

“I want to use as a subject from which to preach this morning a very familiar subject, and it is familiar to you because I have preached from this subject twice before to my knowing in this pulpit. I try to make it a, something of a custom or tradition to preach from this passage of Scripture at least once a year, adding new insights that I develop along the way out of new experiences as I give these messages. Although the content is, the basic content is the same, new insights and new experiences naturally make for new illustrations.

“So I want to turn your attention to this subject: "Loving Your Enemies." It's so basic to me because it is a part of my basic philosophical and theological orientation—the whole idea of love, the whole philosophy of love. In the fifth chapter of the gospel as recorded by Saint Matthew, we read these very arresting words flowing from the lips of our Lord and Master: "Ye have heard that it has been said, ‘Thou shall love thy neighbor, and hate thine enemy.' But I say unto you, Love your enemies, bless them that curse you, do good to them that hate you, and pray for them that despitefully use you; that ye may be the children of your Father which is in heaven."

“Over the centuries, many persons have argued that this is an extremely difficult command. Many would go so far as to say that it just isn't possible to move out into the actual practice of this glorious command. But far from being an impractical idealist, Jesus has become the practical realist. The words of this text glitter in our eyes with a new urgency. Far from being the pious injunction of a utopian dreamer, this command is an absolute necessity for the survival of our civilization. Yes, it is love that will save our world and our civilization, love even for enemies.

“Now let me hasten to say that Jesus was very serious when he gave this command; he wasn't playing. He realized that it's hard to love your enemies. He realized that it's difficult to love those persons who seek to defeat you, those persons who say evil things about you. He realized that it was painfully hard, pressingly hard. But he wasn't playing. We have the Christian and moral responsibility to seek to discover the meaning of these words, and to discover how we can live out this command, and why we should live by this command.

“Now first let us deal with this question, which is the practical question: How do you go about loving your enemies? I think the first thing is this: In order to love your enemies, you must begin by analyzing self. And I'm sure that seems strange to you, that I start out telling you this morning that you love your enemies by beginning with a look at self. It seems to me that that is the first and foremost way to come to an adequate discovery to the how of this situation.

“Now, I'm aware of the fact that some people will not like you, not because of something you have done to them, but they just won't like you. But after looking at these things and admitting these things, we must face the fact that an individual might dislike us because of something that we've done deep down in the past, some personality attribute that we possess, something that we've done deep down in the past and we've forgotten about it; but it was that something that aroused the hate response within the individual. That is why I say, begin with yourself. There might be something within you that arouses the tragic hate response in the other individual.

“This is true in our international struggle. Democracy is the greatest form of government to my mind that man has ever conceived, but the weakness is that we have never touched it. We must face the fact that the rhythmic beat of the deep rumblings of discontent from Asia and Africa is at bottom a revolt against the imperialism and colonialism perpetuated by Western civilization all these many years.

“And this is what Jesus means when he said: "How is it that you can see the mote in your brother's eye and not see the beam in your own eye?" And this is one of the tragedies of human nature. So we begin to love our enemies and love those persons that hate us whether in collective life or individual life by looking at ourselves.

“A second thing that an individual must do in seeking to love his enemy is to discover the element of good in his enemy, and every time you begin to hate that person and think of hating that person, realize that there is some good there and look at those good points which will over-balance the bad points.

“Somehow the "isness" of our present nature is out of harmony with the eternal "oughtness" that forever confronts us. And this simply means this: That within the best of us, there is some evil, and within the worst of us, there is some good. When we come to see this, we take a different attitude toward individuals. The person who hates you most has some good in him; even the nation that hates you most has some good in it; even the race that hates you most has some good in it. And when you come to the point that you look in the face of every man and see deep down within him what religion calls "the image of God," you begin to love him in spite of. No matter what he does, you see God's image there. There is an element of goodness that he can never slough off. Discover the element of good in your enemy. And as you seek to hate him, find the center of goodness and place your attention there and you will take a new attitude.

“Another way that you love your enemy is this: When the opportunity presents itself for you to defeat your enemy, that is the time which you must not do it. There will come a time, in many instances, when the person who hates you most, the person who has misused you most, the person who has gossiped about you most, the person who has spread false rumors about you most, there will come a time when you will have an opportunity to defeat that person. It might be in terms of a recommendation for a job; it might be in terms of helping that person to make some move in life. That's the time you must do it. That is the meaning of love. In the final analysis, love is not this sentimental something that we talk about. It's not merely an emotional something. Love is creative, understanding goodwill for all men. It is the refusal to defeat any individual. When you rise to the level of love, of its great beauty and power, you seek only to defeat evil systems. Individuals who happen to be caught up in that system, you love, but you seek to defeat the system.

“The Greek language, as I've said so often before, is very powerful at this point. It comes to our aid beautifully in giving us the real meaning and depth of the whole philosophy of love. And I think it is quite apropos at this point, for you see the Greek language has three words for love, interestingly enough. It talks about love as eros. That's one word for love. Eros is a sort of, aesthetic love. Plato talks about it a great deal in his dialogues, a sort of yearning of the soul for the realm of the gods. And it's come to us to be a sort of romantic love, though it's a beautiful love. Everybody has experienced eros in all of its beauty when you find some individual that is attractive to you and that you pour out all of your like and your love on that individual. That is eros, you see, and it's a powerful, beautiful love that is given to us through all of the beauty of literature; we read about it.

“Then the Greek language talks about philia, and that's another type of love that's also beautiful. It is a sort of intimate affection between personal friends. And this is the type of love that you have for those persons that you're friendly with, your intimate friends, or people that you call on the telephone and you go by to have dinner with, and your roommate in college and that type of thing. It's a sort of reciprocal love. On this level, you like a person because that person likes you. You love on this level, because you are loved. You love on this level, because there's something about the person you love that is likeable to you. This too is a beautiful love. You can communicate with a person; you have certain things in common; you like to do things together. This is philia.

“The Greek language comes out with another word for love. It is the word agape. And agape is more than eros; agape is more than philia; agape is something of the understanding, creative, redemptive goodwill for all men. It is a love that seeks nothing in return. It is an overflowing love; it's what theologians would call the love of God working in the lives of men. And when you rise to love on this level, you begin to love men, not because they are likeable, but because God loves them. You look at every man, and you love him because you know God loves him. And he might be the worst person you've ever seen.

“And this is what Jesus means, I think, in this very passage when he says, "Love your enemy." And it's significant that he does not say, "Like your enemy." Like is a sentimental something, an affectionate something. There are a lot of people that I find it difficult to like. I don't like what they do to me. I don't like what they say about me and other people. I don't like their attitudes. I don't like some of the things they're doing. I don't like them. But Jesus says love them. And love is greater than like. Love is understanding, redemptive goodwill for all men, so that you love everybody, because God loves them. You refuse to do anything that will defeat an individual, because you have agape in your soul. And here you come to the point that you love the individual who does the evil deed, while hating the deed that the person does. This is what Jesus means when he says, "Love your enemy." This is the way to do it. When the opportunity presents itself when you can defeat your enemy, you must not do it.

“Now for the few moments left, let us move from the practical how to the theoretical why. It's not only necessary to know how to go about loving your enemies, but also to go down into the question of why we should love our enemies. I think the first reason that we should love our enemies, and I think this was at the very center of Jesus' thinking, is this: that hate for hate only intensifies the existence of hate and evil in the universe. If I hit you and you hit me and I hit you back and you hit me back and go on, you see, that goes on ad infinitum. It just never ends. Somewhere somebody must have a little sense, and that's the strong person. The strong person is the person who can cut off the chain of hate, the chain of evil. And that is the tragedy of hate – that it doesn't cut it off. It only intensifies the existence of hate and evil in the universe. Somebody must have religion enough and morality enough to cut it off and inject within the very structure of the universe that strong and powerful element of love.

“I think I mentioned before that sometime ago my brother and I were driving one evening to Chattanooga, Tennessee, from Atlanta. He was driving the car. And for some reason the drivers were very discourteous that night. They didn't dim their lights; hardly any driver that passed by dimmed his lights. And I remember very vividly, my brother A. D. looked over and in a tone of anger said: "I know what I'm going to do. The next car that comes along here and refuses to dim the lights, I'm going to fail to dim mine and pour them on in all of their power." And I looked at him right quick and said: "Oh no, don't do that. There'd be too much light on this highway, and it will end up in mutual destruction for all. Somebody got to have some sense on this highway."

“Somebody must have sense enough to dim the lights, and that is the trouble, isn't it? That as all of the civilizations of the world move up the highway of history, so many civilizations, having looked at other civilizations that refused to dim the lights, and they decided to refuse to dim theirs. And Toynbee tells that out of the twenty-two civilizations that have risen up, all but about seven have found themselves in the junk heap of destruction. It is because civilizations fail to have sense enough to dim the lights. And if somebody doesn't have sense enough to turn on the dim and beautiful and powerful lights of love in this world, the whole of our civilization will be plunged into the abyss of destruction. And we will all end up destroyed because nobody had any sense on the highway of history.

"Somewhere somebody must have some sense. Men must see that force begets force, hate begets hate, toughness begets toughness. And it is all a descending spiral, ultimately ending in destruction for all and everybody. Somebody must have sense enough and morality enough to cut off the chain of hate and the chain of evil in the universe. And you do that by love.

“There's another reason why you should love your enemies, and that is because hate distorts the personality of the hater. We usually think of what hate does for the individual hated or the individuals hated or the groups hated. But it is even more tragic, it is even more ruinous and injurious to the individual who hates. You just begin hating somebody, and you will begin to do irrational things. You can't see straight when you hate. You can't walk straight when you hate. You can't stand upright. Your vision is distorted. There is nothing more tragic than to see an individual whose heart is filled with hate. He comes to the point that he becomes a pathological case. For the person who hates, you can stand up and see a person and that person can be beautiful, and you will call them ugly. For the person who hates, the beautiful becomes ugly and the ugly becomes beautiful. For the person who hates, the good becomes bad and the bad becomes good. For the person who hates, the true becomes false and the false becomes true. That's what hate does. You can't see right. The symbol of objectivity is lost. Hate destroys the very structure of the personality of the hater.

“The way to be integrated with yourself is be sure that you meet every situation of life with an abounding love. Never hate, because it ends up in tragic, neurotic responses. Psychologists and psychiatrists are telling us today that the more we hate, the more we develop guilt feelings and we begin to subconsciously repress or consciously suppress certain emotions, and they all stack up in our subconscious selves and make for tragic, neurotic responses. And may this not be the neuroses of many individuals as they confront life that that is an element of hate there. And modern psychology is calling on us now to love. But long before modern psychology came into being, the world's greatest psychologist who walked around the hills of Galilee told us to love. He looked at men and said: "Love your enemies; don't hate anybody." It's not enough for us to hate your friends because—to to love your friends—because when you start hating anybody, it destroys the very center of your creative response to life and the universe; so love everybody. Hate at any point is a cancer that gnaws away at the very vital center of your life and your existence. It is like eroding acid that eats away the best and the objective center of your life. So Jesus says love, because hate destroys the hater as well as the hated.

“Now there is a final reason I think that Jesus says, "Love your enemies." It is this: that love has within it a redemptive power. And there is a power there that eventually transforms individuals. That's why Jesus says, "Love your enemies." Because if you hate your enemies, you have no way to redeem and to transform your enemies. But if you love your enemies, you will discover that at the very root of love is the power of redemption. You just keep loving people and keep loving them, even though they're mistreating you. Here's the person who is a neighbor, and this person is doing something wrong to you and all of that. Just keep being friendly to that person. Keep loving them. Don't do anything to embarrass them. Just keep loving them, and they can't stand it too long. Oh, they react in many ways in the beginning. They react with bitterness because they're mad because you love them like that. They react with guilt feelings, and sometimes they'll hate you a little more at that transition period, but just keep loving them. And by the power of your love they will break down under the load. That's love, you see. It is redemptive, and this is why Jesus says love. There's something about love that builds up and is creative. There is something about hate that tears down and is destructive. So love your enemies.

“There is a power in love that our world has not discovered yet. Jesus discovered it centuries ago. Mahatma Gandhi of India discovered it a few years ago, but most men and most women never discover it. For they believe in hitting for hitting; they believe in an eye for an eye and a tooth for a tooth; they believe in hating for hating; but Jesus comes to us and says, "This isn't the way."

“As we look out across the years and across the generations, let us develop and move right here. We must discover the power of love, the power, the redemptive power of love. And when we discover that we will be able to make of this old world a new world. We will be able to make men better. Love is the only way. Jesus discovered that.

“And our civilization must discover that. Individuals must discover that as they deal with other individuals. There is a little tree planted on a little hill and on that tree hangs the most influential character that ever came in this world. But never feel that that tree is a meaningless drama that took place on the stages of history. Oh no, it is a telescope through which we look out into the long vista of eternity, and see the love of God breaking forth into time. It is an eternal reminder to a power-drunk generation that love is the only way. It is an eternal reminder to a generation depending on nuclear and atomic energy, a generation depending on physical violence, that love is the only creative, redemptive, transforming power in the universe.

“So this morning, as I look into your eyes, and into the eyes of all of my brothers in Alabama and all over America and over the world, I say to you, "I love you. I would rather die than hate you." And I'm foolish enough to believe that through the power of this love somewhere, men of the most recalcitrant bent will be transformed. And then we will be in God's kingdom.”

 

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