July 13, 2009
High Loan-to-Value + Trigger Event (Unemployment) = Default
With the decline of recent weeks, the market has cleared away the short-term overbought condition it established in June. The percentage of stocks above their respective 50-day averages, for example, has retreated from a disturbingly high 92% to a slightly but not profoundly oversold level of 32% here. Investors have predictably been staring at the “green shoots” and have noticed a conspicuous absence of root formations so far. From our standpoint, the next several weeks look as if they may be critical in either offering evidence that something deeper is taking hold, or pulling those shoots up as weeds.
Because of the enormous second-wave of adjustable mortgage rate resets due to begin in late 2009 and to continue through 2011, as well as the increasing upward pressure that unemployment is putting on delinquencies (e.g. mortgages, credit cards, and home equity loans), I am very concerned about the outlook for the economy in the coming year or two. A wide range of academic studies reach the universal conclusion that two variables account for the majority of fluctuations in mortgage defaults and foreclosures. They are 1) a high “loan-to-value” ratio; that is, the ratio of mortgage loan to the outstanding value of the home, and 2) trigger events - particularly job loss or change in family status. It is also notable that the existence of junior liens, particularly home equity loans, also significantly increases the likelihood of mortgage default when a “trigger event” like unemployment occurs.
It is very important to recognize that the increasing unemployment rate is likely to exert a different dynamic in this economic downturn than it has in prior downturns, because of the high ratio of household debt-to-income, and the high ratio of mortgage loan-to-value at present. In normal downturns, unemployment does trigger a certain amount of loan losses, but the general tendency is for unemployment to behave as a lagging indicator. In the current cycle, high debt-to-income and loan-to-value ratios create a situation where unemployment can easily be the trigger event for further defaults, and could therefore create a tendency for job losses to lead economic weakness (rather than just lagging it). Now I don't think that the feedback will be strong enough to lead to a self-reinforcing collapse, but I do think that it is naïve to expect that the economy will just “shake off the blues” and roar ahead.
As of the first quarter, over 22% of U.S. homes, condominiums and other residential properties have negative equity, meaning that the outstanding mortgage loan exceeds the value of the home. It is likely that this ratio deteriorated further in the second quarter. Meanwhile, the latest data from the American Bankers Association notes that delinquencies on home equity loans hit record highs in the first quarter. Likewise, the latest FDIC quarterly banking profile notes that the credit card loss rate is at an all-time high.
At the same time, bank chargeoffs continue to lag the deterioration in credit. The FDIC notes “The high level of chargeoffs ($37.8 billion) did not stem the growth in noncurrent loans in the first quarter. On the contrary, noncurrent loans and leases increased by $59.2 billion (25.5 percent). The percentage of loans and leases that were noncurrent rose from 2.95% to 3.76% during the quarter. The noncurrent rate is now at the highest level since the second quarter of 1991. The rise in noncurrent loans was led by real-estate loans, which accounted for 84 percent of the overall increase.”
Now, note that the $59.2 billion figure is the increase, not the total value, of noncurrent loans for the first quarter alone. In a banking system where total capital only represents 10% of total assets (and even that level only thanks to TARP infusions), 3.76% of total loans in the noncurrent category is not a small figure.
All of this underscores my concern about the broad prospects of the economy, particularly given the remaining adjustable mortgage reset schedule, and the likelihood that unemployment will continue to advance and provide the “trigger event” for fresh defaults as the year progresses.
That said, I don't have particularly strong views about the next quarter or two, and it's possible that we could have positive GDP figures as the economy moves more-or-less sideways for much of 2009. To the extent that investors are perched to extrapolate news, we have to allow for strong investor reactions, even if positive economic progress is unlikely to be sustained. Historical market and economic precedents don't provide strong arguments about likely market direction in the near term, unless one is willing to place great faith in technical and sentiment indicators on the assumption that this is nothing more than the typical post-war recession.
The past several weeks have basically represented a backing-off from the risk appetite that investors developed after the March lows. As Barron's reporter Bob O'Brien noted last week “Several classic characteristics of risk aversion have evidenced themselves. A flight to safe havens, such as Treasuries and the dollar. An unwillingness to trade much at all, as evidenced by the remarkably low volume total at the New York Stock Exchange. And the pronounced decline in raw materials prices, the most-caustic of the problems that have cropped up, because those have correlated so closely with the performance of the equities market.”
Still, the major indices have experienced fairly contained declines in the 7% range, and market internals – though tepid – have not suffered the sort of cascading collapse that signals a shift to strong investor fear. The measured nature of this decline, at least thus far, still holds out the possibility that investors could gather their nerves and provide more sponsorship (which we would look for first as a decided shift toward heavy trading volume). To allow for that possibility, we re-established a small “anti-hedge” in index call options last week, amounting to about 1% of assets. Certainly not a huge commitment or a constructive investment stance (we're otherwise fully hedged), but now that the market has cleared its overbought condition, at least on short-term measures, we wanted to allow for a broader range of potential outcomes here.
In short, I remain deeply concerned about the next couple of years in both the financial markets and the broad economy, but am also somewhat agnostic about the short-term prospects for both. The significant economic headwinds should certainly temper any inclination to accept a great deal of market risk here, because stocks are not cheap and economic disappointments may bite with abrupt force. At the same time, there is little prevailing evidence to suggest that a major breakdown is predictable or imminent, and internals are still mottled enough to allow for the possibility that investors will recruit new faith based on this or that economic development. We don't want to exclude that possibility, so we have a small 1% anti-hedge in index call options, while at the same time we retain our hedge against any significant market weakness.
As of last week, the Market Climate for stocks remained characterized by modest overvaluation and uneven market action. As noted above, we haven't observed a cascade of internal weakness, so it's still possible that investors could adopt a fresh willingness to assume risk. Still, the underlying fundamentals remain disturbing, so we remain well hedged, but with a 1% allocation to index call options to provide something of an “anti-hedge” that allows for fresh strength.
In bonds, Treasuries advanced last on a wave of risk-aversion and some amount of skepticism about “green shoots.” Overall, the Market Climate for bonds is now characterized by slightly unfavorable yield levels but slightly favorable yield pressures, all of which holds the Strategic Total Return Fund to an overall duration of about 3-years (meaning that 100 basis point move in interest rates would be expected to impact the Fund by roughly 3% on the basis of bond price changes). We continue to hold TIPS primarily, but also have some straight Treasuries that we purchased when the 10-year yield approached 4% a few weeks ago. Our bond position is still somewhat defensive because the main reason to hold longer maturities here is not the expectation of capital appreciation, but simply the ability to capture higher yield given the upward slope of the curve.
In short, we're willing to accept intermediate durations because of yield considerations, but are not taking a lot of duration exposure in anticipation of any major price advance in bonds. As usual, we tend to add somewhat to our durations when yields spike higher, and clip off that exposure on declines in yields (i.e. increases in bond prices). Similar considerations hold for other assets in the Strategic Total Return Fund such as currencies and precious metals. In an environment where there are not compelling arguments about market direction, we're content to be liquidity providers by putting out bids during price weakness and letting go of some of our exposure on price strength.
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