June 22, 2009
Long-Horizon Risk Aversion Creates Headwinds
No question about it, the stock market has enjoyed a nice rebound from deeply oversold conditions, amounting to a recovery of just under 1/3 of losses that the market suffered from its 2007 peak. This has been accompanied, until recent weeks, by an easing in risk aversion from what, in hindsight, could be called “fear lows” (though not necessarily the “revulsion lows”) of this downturn.
I say “until recent weeks” because over the past couple of weeks, we've observed a persistent climb in credit default swap spreads on a number of major banks. It's not clear whether this is simply mean-reversion from the giddiness about secondary offerings a couple of weeks ago, or whether there is information content there about fresh credit concerns. Suffice it to say, however, that credit concerns are off of their peak, but still persist.
I remain concerned about the poor level of price-volume sponsorship we've observed, about the massive second-wave of adjustable rate resets that will begin later this year, and about the clear structural headwinds posed by a deleveraging economy (historically, economic expansions are paced by lively growth in debt-financed gross domestic investment, which is going to be hard to come by). In recent weeks, however, we've seen some new concerns – a fairly subtle deterioration in measures of risk aversion that were already tenuous, which prompted us close the 1-2% position in index calls that we've been using as an “anti-hedge” since March.
What we're seeing focuses not on short-term “green shoots” stuff, but on longer-term concerns that investors appear to be grappling with – concerns that have to do with the longer-term potential for economic growth, and nagging concerns about the sustainability and effects of the massive fiscal deficits we are running to defend bank bondholders (we are emphatically not defending bank customers here – there is an enormous cushion of bondholder capital in the financial system. Even the failure of the largest banks in the country would not pose a single dollar of loss to depositors).
A very simple way to observe the long-term concerns of investors is to couple what we observe in the precious metals market with what we observe in the Treasury bond market. Specifically, despite very weak inflation figures, gold prices have remained relatively strong, while Treasury bond prices have been spectacularly weak. This suggests that despite any short-term optimism, investors are harboring a persistent sort of risk aversion about the long-term. This may seem like a small point, but it is actually a fairly powerful consideration here. Historically, when both gold prices and the 10-year Treasury yield have been above where they were 6 months earlier (representing just under a quarter of the historical record), the S&P 500 has averaged a total return of just 3.5% annualized until that condition was reversed. Excluding such periods, the S&P 500 has averaged a total return of 14.3% annualized. The depressing effect has been largely independent of prevailing valuations and even market action.
More sophisticated measures of risk aversion lead to similar conclusions here. Specifically, the problems aren't over and investors seem to know it. Investors appear to be quite concerned that the fiscal wasteland we've entered into to address the situation poses a host of long-term problems. The somewhat knee-jerk rebound since March has been driven by short covering, “green shoots” optimism, and a misplaced belief that stocks are cheap just because they've declined from untenable overvaluations. That dynamic has largely played out, and now requires real, tangible economic improvements to justify further strength.
On that front, Bill Hester reports that his tally of economic surprises, relative to consensus expectations, has begun to fall short in recent weeks. The latest chart is presented below. For further details, see Bill's April article A Stock Market Rebound Closely Linked With Economic Data Surprises. As the Wall Street Journal's Mark Gongloff observes, "a more-significant rally from here will depend, in no small part, on economic data surprising again, and the bar has gotten higher."
That's not to say that we can't observe a fresh wave of positive economic surprises, or that we can rule out further upside. But we should approach the market here with the knowledge that the headwinds, both in terms of economic prospects, and in terms of longer-term investor risk aversion, remain very strong.
As a side note, in observing the proposals for changing the regulatory structure of the financial markets, it strikes me that the idea that some banks are “too big to fail” is a dangerous and misguided premise. The best way to defend ourselves from further crises like we've observed over the past year is to a) give regulatory authorities with a clear and unbiased stake in customer protection – ideally the FDIC – authority to force the government receivership of insolvent bank holding companies and non-bank financial institutions, with no option to perform bailouts at public expense. This receivership authority should emphatically not be under the discretion of officials at the Treasury or the Fed, who are prone to instead use public funds for for private benefit, and who hop into bed with bank executives more eagerly than a five-dollar gigolo; b) eliminate the use of “cross-covenants” that allow the default of subordinated debt to trigger the default of senior debt – this would allow the receivership of an institution to properly wipe out both the equity and a portion of the subordinated debt, without resulting in a blanket default of all of the institution's other debt obligations; c) similarly, restrict the use of credit default swaps to senior debt, and then only for bona-fide hedging purposes. The upshot of these changes would be to make equity and subordinated debt work in practice as they ought to work – as capital buffers that are truly capable of absorbing extraordinary losses of a financial institution without provoking endless domino effects in the event that an institution goes into receivership.
As of last week, the Market Climate for stocks remained characterized by slightly unfavorable valuations and mixed market action, the combination which produces a tepid enough return/risk profile to hold the Strategic Growth Fund to a fully hedged investment stance. In bonds, the Market Climate was characterized by relatively neutral yield levels and unfavorable market action. The spike in yields a couple of weeks ago was sufficient to warrant a very small increase in the average duration of the Strategic Total Return Fund, which now stands at just over 3 years, mostly in TIPS but with a modest exposure to straight Treasuries. A 3-year duration essentially implies that a 100 basis point move in interest rates would be expected to produce a roughly 3% fluctuation in Fund value on the basis of bond price changes. The Total Return Fund also currently holds about 20% of assets in a mix of foreign currencies, precious metals shares, and a small exposure to utility shares.
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