April 13, 2009
Green Shoots over Thin Ice
In recent weeks, the financial markets have taken enormous hope from economic data that has outpaced depressed expectations – generally only slightly, but uniformly enough to encourage investors that the “green shoots” of recovery are in place.
Careful. We've seen a nice bounce to clear an oversold condition, coupled with the very ordinary “ebb and flow” of economic data that periodically offers intermittent relief even in the worst economic downturns. What we haven't seen to any real extent is “revulsion.” Quite to the contrary, investors have frantically bid up the worst credits – distressed financials, homebuilders, and heavily leveraged cyclicals, while the percentage of bullish investment advisors has quickly surged above the percentage of bearish advisors.
As veteran market observer Richard Russell noted following a tribute Saturday evening, “one question that was asked repeatedly was ‘What is the difference between investors' sentiment now and that which existed at the 1974 bottom?' My answer was that there is a lot of complacency today. In fact, many leading analysts are already saying that ‘this is a new bull market.' … At the 1974 bottom, the sentiment was the opposite -- people and funds were black-bearish. Nobody talked about ‘the danger of missing this advance.' In fact, when I turned bullish in late-1974 I received hate-letters and angry notes saying that ‘Russell, you have lost your mind,' and ‘Russell, why don't you hang it up and find a business that you're fitted for.' I mean people were furious that I had turned bullish, pretty much the opposite of sentiment today. Actually, I'm surprised to see how quickly analysts and investors are willing to turn bullish today.”
That's not to rule out the possibility that the final low of the bear market is behind us (though I doubt it). What I do see as unlikely is a “V” bottom where stocks will now proceed to durably recover their losses without (at least) a very difficult and extended sideways period that take stocks back to levels that compete with the prior lows. Historically, advances of the size we've observed have only “stuck” when the major indices had already advanced past their 200-day moving averages by the time stocks were about 20% off the lows.
There's a reason for that. During a true bottoming process, favorable market internals are typically “recruited” even as the market is moving down or sideways. Investors work through the ebb-and-flow of information through repeated cycles of enthusiasm and disappointment. To expect the disappointments to quickly come to an end and to be replaced by clarity is to expect something that is not characteristic of historical experience.
As Russell noted, “When the tide reverses and turns bullish, there are usually many phenomena that appear. It is usual to see some sort of non-confirmation in the Averages (we saw that at the 1974 bottom). It is usual to see Lowry's Selling Pressure decline substantially prior to the actual bottom (Lowry's Selling Pressure declined very reluctantly prior to the March 9 low, and this alone makes me suspicious). Normally, once the tide reverses the stock market starts up carefully in a slow persistent plodding rise.”
Very simply, new bull markets are generally not widely heralded, and investors should be awfully suspicious when there is a consensus that “the bottom is in.” As I noted back in December, in Recognition, Fear and Revulsion (before the market took a plunge to fresh lows over the next two months):
“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.”
Could the final low of the bear market be in place? Sure. But even if that were the case, it does not follow that the markets will recover their lost ground quickly, and it is particularly dangerous to believe that the major indices will not meaningfully retest (if not substantially break below) the prior lows.
On the basis of market action, one of the features of the recent advance that has me concerned is the unimpressive, waning trading volume that we've observed. A strong advance on heavy trading volume is a measure of determined sponsorship in the face of disagreement. A strong advance on waning volume is probably a short-squeeze – forced purchases in the face of sellers who have temporarily backed off. Moreover, stocks are currently overbought to the same extent that they were near the end of the bear market rallies we observed during the 2000-2002 decline.
As the brilliant Dow Theorist William Peter Hamilton wrote a century ago, in 1909, "One of the platitudes most constantly quoted in Wall Street is to the effect that one should never sell a dull market short. That advice is probably right oftener than it is wrong, but it is always wrong in an extended bear swing [i.e. an overbought bear market rally]. In such a swing the tendency is to become dull on rallies and active on declines."
In short, I would be more impressed with market action here if we were observing stronger trading volume with an established core of improved market internals. A good retest in the major averages, coupled with quiet strengthening of market internals, would be more characteristic of a durable “bottoming process.” My opinion (which we don't invest on and neither should you) is that we're not even close to completing a bottoming process. Frankly, we can't rule out that the final low is in place either. So as usual, we'll evaluate the evidence as it emerges.
Thus far, we've got a strong rally off the recent trough, with uninspiring sponsorship but good breadth, reasonable but not strikingly attractive valuations, and an overhang of increasingly distressed mortgage and non-residential debt that looks like Armageddon Part II in the offing, because we are doing nothing to restructure it. In my view, the recent advance looks not like a garden of “green shoots,” but very much like a short-squeeze off of an oversold trough. It would be convenient if such bounces could be predicted in advance, but as we observed last year, the market can become very persistently oversold during bear markets, and even an “oversold” decline can go much deeper until the oversold condition is abruptly cleared.
Fundamentally, my view is that the U.S. economy is on very thin ice, and that by focusing on the bailout of corporate bondholders rather than the restructuring of debt, we are courting the risk of a far deeper downturn. Last year, I didn't think it was conceivable that policy-makers would attempt to address this problem by making lenders whole with public funds. This is an ethical abomination, putting the public in the position of absorbing the losses that should properly be borne by those who provided capital to these institutions. It is not sustainable. What it does is place the public in the position of losing first, but it will not, and cannot prevent the ultimate failure of the debt – for the simple reason that without restructuring, the debt can't be serviced.
It is true that insurers, pension funds, and other entities own part of the debt of these financial institutions, but they certainly do not own all of it, and to the extent that it is in the public interest to use public funds to reimburse the losses of various entities, that can and should be part of the political process. But to broadly immunize every bondholder of these institutions with public funds is repulsive. Even the bondholders of Bear Stearns can expect to get 100% of their principal back, with interest.
Aside from the abuse of the public trust inherent in these bailouts, it is also offensive to anybody who devotes a significant portion of their income to charity, because there are so many better uses for trillions of dollars. Think about it. Two of the wealthiest people on Earth, Warren Buffett and Bill Gates, after lifetimes of work, will be able to commit a combined total of less than $100 billion to charity if they give everything they have. That figure is dwarfed next to the sums being allocated to protect corporate bondholders from taking a “haircut” on distressed debt, or swapping a portion of it for equity – both perfectly appropriate ways of compartmentalizing the losses of these financial institutions, without public funds, and without receivership or “nationalization.”
Congress needs to quickly legislate the ability to take receivership of non-bank financial institutions, including bank holding companies. The use of credit default swaps should be restricted to bona-fide hedging only. Of course, restructuring mortgage debt by swapping principal for a claim on future appreciation (with the Treasury administering a “conduit fund” to collect, aggregate and disburse those claims) would be one of the best ways of minimizing the need for these bailouts in the first place.
Echoing the concerns I've noted in recent quarters, Alan Abelson of Barron's shared some research this week that estimates probable losses of financial companies from mortgage and non-residential loans at $2.1 to $3.8 trillion, less than half of what has been realized to date. These figures are much in line with my own estimates, and exclude additional loan losses to non-financial companies (witness General Motors). Though existing home sales were up recently, the report notes that 45% of them were distressed sales. The report concludes, correctly I believe, that the U.S. is “in the middle innings of an enormous wave of defaults, foreclosures, and auctions.”
Until we observe large-scale restructuring of mortgage debt and the debt obligations of major financial institutions, we will be applying trillion dollar band-aids while the underlying cancer metastasizes. The longer we wait to restructure debt, to swap debt for equity, and to expect those who made the loans bear the losses as well, the more we risk allowing this downturn to become uncontrollable and unfathomably costly to the public.
As Harvard historian Niall Ferguson observed last week, “Only somebody who studies financial history could say, as I was trying to say, ‘Look, something as big as the liquidity crisis of 1914 or as big as the banking crisis of 1931 is imminent.' We don't really have a great many options here. If we stay the present course, you're going to see the tailspin continue. To be effective, a large-scale restructuring of household indebtedness would need to be mandatory. The Great Depression was initially a U.S. financial crisis. But what made it a depression was its global contagion, and then the breakdown of trade and the retreat into protectionism. All of that can happen. All of that is in fact happening with terrifying speed.”
Whatever green shoots are out there rest over a patch of thin ice.
Last week, the Market Climate for stocks was unchanged - fair valuations (modestly but not significantly undervalued on measures based on prior earnings, still overvalued on measures that do not rely on a reversion to above-average profit margins in the future). Market action continued to demonstrate good breadth (advancing versus declining issues), prompting us to hold about 1% of assets in index call options on that basis, but the overall price-volume behavior still appears more consistent with a standard bear market rally, punctuated by periodic short-squeezes like we observed on Friday. More financials (Goldman, J.P. Morgan and Citigroup) will release earnings reports this week, so we'll undoubtedly observe volatility, with some potential for further short-squeezes, but also potential for disappointment of now-elevated expectations. Aside from the small position in call options we hold on the basis of market breadth, the Strategic Growth Fund remains well hedged. The largest losses during bear markets tend to come on the heels of overbought advances, and our measures presently don't offer happy green-shoot optimism that the market's difficulties are now behind it.
In bonds, the Market Climate remained characterized by moderately unfavorable yield levels and relatively neutral yield pressures. The Strategic Total Return Fund remained positioned largely in Treasury Inflation Protected Securities, with about 25% of assets allocated between precious metals shares, foreign currencies, and utility shares. The recent economic optimism has benefited the U.S. dollar recently, while long-term Treasury yields have increased. It is likely that fresh economic disappointments would reverse those trends. While that would benefit our existing positions, our current investment stance is not aggressive in any event.
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