January 26, 2009
Okun's Law, Ockham's Razor, and Economic Stimulus
On Friday, the U.S. Commerce Department will report its fourth-quarter GDP estimate, which economists generally expect to show that the economy contracted at an annual rate of nearly 6% during the final months of 2008. The good news is that this figure will represent an annual rate, meaning that the actual contraction in GDP during the fourth quarter was about 1.5%. Put another way, roughly 98.5% of U.S. economic activity probably survived the final months of 2008 unscathed. The bad news is that with credit default spreads widening again, and unemployment claims continuing to push higher, we are likely to observe further economic contraction throughout 2009.
A week after the GDP report, the Labor Department will deliver the January employment report. If recent weekly unemployment claims are any indication, January job losses threaten to soar to the highest level since the recession began.
Several decades ago, economist Arthur Okun proposed a relationship between GDP growth and unemployment that came to be known as Okun's Law (or at least Okun's rule-of-thumb). Okun proposed that every 1% deviation in unemployment from its “natural” rate is accompanied by a 2-3% reduction in GDP. Current Fed Chairman Ben Bernanke and economist Andrew Abel re-estimated that relationship in 2003, and suggested that U.S. GDP declines by about 2% for every 1% increase in the unemployment rate. Since the “natural” rate of unemployment can't be observed, Okun's Law is typically expressed as a deviation from the long-term trend of real GDP, which has been about 3% annually. So a 1% increase in unemployment over the course of a year would be associated with GDP growth of about 1% (3% trend – 2 x change in unemployment), while a 1% increase in unemployment over the course of a single quarter would be associated with quarterly GDP growth of about -1.25% (0.75% quarterly trend growth – 2 x change in unemployment) or roughly -5% at an annual rate.
The U.S. unemployment rate surged by a full percent during the fourth quarter of 2008, from 6.2% in September to 7.2% by year-end. Yet even this slightly underestimates the economic impact of job losses because the civilian labor force participation rate also dropped by about 0.3%, making the overall contraction in employment activity the worst since the second quarter of 1980, when GDP declined by 2% (an 8% annual rate). It will be important to remember this week that relatively small differences in quarterly economic performance will be magnified in the headline numbers, which invariably quote growth figures at an annual rate.
In the coming days, Congress will contemplate an economic stimulus plan that is expected to approach $825 billion in size. Economist Paul Krugman recently used Okun's Law to estimate the impact of the proposed plan, concluding “This really does look like a plan that falls well short of what advocates of strong stimulus were hoping for.”
For my part, I tend to lean away from the Keynesian view that sees recessions as times of inadequate “aggregate demand.” Rather, recessions are essentially times when there is a mismatch between the mix of goods and services demanded by individuals in the economy, and the mix of goods and services that was previously supplied. The clear area of mismatch here is in housing, as well as various sectors of the economy that have made a business of irresponsibly increasing the debt burden of the nation (including mortgage companies, investment banks, and other purveyors of leverage). Those mismatched sectors are experiencing enormous losses, as they should. The job of economic policy is to ease that transition in a way that reduces the spillover onto the broader economy.
However the fourth-quarter data comes in, it is clear that about 99% of the workers who had jobs at the beginning of the quarter still had jobs at the end of the quarter. About 98% of the economic activity that was proceeding at the beginning of the quarter continued to proceed at the end of the quarter. From that perspective, the problem isn't that the economy as a whole has lost an enormous amount of purchasing power.
The retrenchment of economic activity and consumption that we're observing isn't explained by lost income among the majority of consumers, but rather because of increased risk-aversion and defensive saving. Generally speaking, American consumers aren't slowing consumption because of falling labor income. Rather, they are slowing consumption because they are protecting themselves from uncertainty and attempting to offset the impact of investment losses. Adding to this is the difficulty of obtaining credit, because of risk aversion among lenders. To try to “stimulate” people to spend and consume more is to miss the point. What the economy needs most is to mitigate the impact of foreclosures and the credit stress in the financial system that triggered this risk aversion in the first place.
The key problems here are bank capital and mortgage foreclosures. Foreclosed mortgages are approaching about 10% of total mortgages, with an average recovery rate of only about 50% of the mortgage value when the foreclosed home is sold. The resulting loss of value, approaching 5% of the U.S. mortgage market, has thrown the economy into disarray, because the losses have been borne by highly leveraged institutions. For many institutions, each $1 of their own capital (equity contributed by the company's own shareholders) has often supported $10, $20, or even $40 of loans, security investments and other assets. As a result, wiping out a few percent of their assets completely wipes out their own capital, leaving customers and depositors without a “capital cushion” and triggering withdrawals. This process started with the most egregiously leveraged companies like Bear Stearns and Lehman, and continues to put stress on enormous but capital-thin institutions like Citibank.
There is a time-honored principle called Ockham's Razor, which states that the explanation for any phenomenon should focus only on the essential and relevant elements, avoiding as many unnecessary “second-order” factors as possible. Albert Einstein put it this way: “A theory should be a simple as possible, but no simpler.”
There is certainly a wide range of important programs and objectives that the new Obama administration was elected to pursue, including investments in alternative energy, infrastructure, health care, and other programs. But from the standpoint of economic stimulus, Ockham's Razor suggests that we will fail as a nation to address the current economic crisis if we fail to address the source of that crisis. Again, this means focusing first on bank capital and mortgage foreclosures.
Although the troubled assets relief program (TARP) was originally based on an ill-considered idea to purchase distressed assets directly from financial institutions, the Treasury somewhat inadvertently discovered what we had strongly argued from the beginning – that providing capital directly to financial institutions was the most effective use of TARP funds. (see You Can't Rescue the Financial System if You Can't Read A Balance Sheet). Unfortunately, neither Treasury nor Congress has made an attempt to address foreclosure abatement. Without that, financial institutions will face a continued need to replenish capital, and far more Americans than necessary will lose their homes.
Part of the problem here is that the government cannot simply forgive debt for some and not for others. If it does so, mortgage delinquencies will accelerate, as homeowners attempt to get something for nothing. Another part of the problem is a “coordination failure” that prevents the mortgages from being restructured because they have been cut and repackaged into more pieces than Humpty Dumpty, allowing the holder of any piece to object. The only way to address the foreclosure problem is either to purchase whole loans at a substantial discount and then restructure them (so that the original lender, not the government, bears the loss), to accumulate all of the pieces of securitized mortgages through “all or nothing” auctions and then to restructure them, or to allow judges to reallocate cash flows as part of the foreclosure process itself, offering the homeowner a reduction in principal in return for the obligation to pay the balance out of subsequent property appreciation.
If there is any good news here, it may be that we have now passed the likely peak of the first wave of mortgage foreclosures. As I noted last April in “Which Inning of the Mortgage Crisis are We In?”, adjustable rate mortgage resets peaked in mid-2008, so that allowing for delinquency and notices of default and trustee sale, we could expect foreclosures to peak about 6 months later (and here we are). This peaking in losses is what has apparently placed renewed pressure on U.S. financial institutions in recent weeks. Unfortunately, a second wave of resets is due to arrive early next year. If we fail to address the foreclosure risk now, we can anticipate a second round of extreme economic difficulty which will cut short any nascent success of the economic stimulus plan that is now being considered.
In short, the essential problem is not “insufficient aggregate demand” but rather risk-aversion and anticipatory saving triggered by fear of financial instability. Ockham's razor cuts straight to bank capital and foreclosure risk. We can address a much wider range of interests in the cause of economic stimulus, but if we fail to address the central cause of the present economic crisis, the attempt to increase “aggregate demand” will predictably fail.
We still have the opportunity to do this right.
As of last week, the Market Climate for stocks remained characterized by favorable valuations and unfavorable market action. The appropriate investment policy in this Climate is to gradually, and I emphasize gradually, expand market exposure on significant price weakness. Unfortunately, the failure to address the foreclosure aspect of this financial crisis has revealed itself in a fresh widening in credit default spreads, which suggests that the add-on effects to the economy will be worse than they would otherwise have been. That suggests that we allow for the possibility of “revulsion” against stocks, at least until we observe market action that suggests better tolerance of risk. There are numerous stocks that I believe will be seen in hindsight as fantastic bargains a few years from now, and investors are only beginning to separate the wheat from the chaff. Hopefully, we'll observe that process continue even if the general behavior of the market is uncertain. The Strategic Growth Fund is predominantly hedged here, with only a small exposure to market fluctuations, so most of our returns at present are likely to be driven by differences in performance between the stocks we own and the indices we use to hedge (primarily the S&P 500 and Russell 2000).
There will probably be enough ebb-and-flow in the economic data to allow for significant strength in the financial markets at various points this year, but we will respond to economic developments, stock valuations and market action as that evidence unfolds. Meanwhile, it may be helpful to reiterate some comments I made in December (Recognition, Fear and Revulsion):
“Strong intermittent advances are typical during bear markets, and can often achieve gains of 20% as we've seen in recent weeks, and sometimes substantially more. But the very existence of bear market rallies can be a problem for investors, because they clear the way for fresh weakness. The scariest declines in bear markets are typically the ones when investors think they are making progress and recovering their losses, only to see stocks go into a new free-fall.
“That cycle of decline, followed by hope, followed by fresh losses, is really what ultimately puts a final low in place. The final decline of a bear market tends to be based on “revulsion” – a growing impatience among investors who conclude that stocks are simply bad investments, that the economy will continue to languish, and that nothing will work to help it recover. Revulsion is not based so much on fear or panic, but instead on despair and disillusionment. In a very real sense, investors abandon stocks at the end of a bear market because stocks have repeatedly proved themselves to be unreliable and disappointing.
“My impression is that regardless of near-term prospects, we will observe a tone of “revulsion” at some point next year, which we should certainly allow for especially during the first half of 2009. At that point, we should not rule out a low that would compete with the November lows and perhaps break them, but we should also expect that the market will be more selective at that point, so there will be many stocks that hold above the lows that have already been set.”
In bonds, the Market Climate remains characterized by unusually unfavorable yield levels and moderately favorable yield pressures. We continue to observe compressed yields as a result of an investor flight to safety, but would avoid intermediate- and long-term Treasury bonds because of the potential for brief upward yield spikes that may wipe out weeks (and eventually years) of total return in a very short time span. The Strategic Total Return Fund remains invested primarily in moderate duration Treasury Inflation Protected Securities. There is a wide variance in yields even at similar maturities because of coupon levels and accrued inflation compensation premiums over par value, but these securities continue to be priced for low or negative inflation levels not only over the next few years, but for a decade or more, and will still achieve good real returns if that occurs. The Fund also continues to hold about 10% of assets in precious metals, about 10% in foreign currencies, and about 5% of assets in utility shares.
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