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April 12, 2010

Extend and Pretend

John P. Hussman, Ph.D.
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Over the past 12 years or so, I've been repeatedly astonished at the tendency of investors to do things that they should have known to avoid simply with the use of a calculator and basic arithmetic. We've used numerous metrics during this period to show that the estimation of long-term market returns (7-10 years and beyond) doesn't require calculus or statistics, but fairly direct methods to normalize earnings, plus a bit of arithmetic. Rich valuations are predictably followed by sub-par returns. As a result, investors have earned an average annual total return of just 2.4% in the S&P 500 over the past 12 years, while enduring two separate instances where they have lost about half of their money as part of the ride. Essentially, we have gone nowhere in an interesting way. At present, investors have priced the market at a level that makes a continuation of this experience likely for several years to come.

I noted last week that at current valuations, the S&P 500 is priced to deliver a total return of only about 5.7% annually over the coming decade. Though it generally takes about 7-10 years to reliably revert from valuation extremes, a good portion of that reversion often occurs within 5 years (outside of the twin bubbles to the 2000 and 2007 highs). Presently, a normalization of valuations, not to extreme undervaluation but simply a reversion to post-war, non-bubble norms, would imply an average annual return for the S&P 500 of just 2.97% over the coming 5 year period.

This outcome is not dependent on whether or not we observe a second set of credit strains, but is instead baked into the cake as a predictable result of prevailing valuations. The risk of further credit strains simply adds an additional layer of concern here. Investors have chased risky securities over the past year to the point where the risk premium for default risk has eroded to the levels we saw at the peak of the credit bubble in 2007. My sense is that this is a mistake that will be painfully corrected. Investors now rely on a sustained economic recovery and the absence of any additional credit strains - and even then would be likely to achieve only tepid long-term returns from these levels.

We certainly would have achieved better returns over the past year had I ignored the risk of further credit risks as investors, in hindsight, have done. But at this point, market conditions are unfavorable even on the basis of post-war data, and even on the assumption that the economy will improve further. Stocks historically have been vulnerable to abrupt losses at the point where the market environment reflects overvalued, overbought, overbullish, rising yield conditions. It's true that the market has a tendency to continue achieving marginal new highs for a number of weeks after those conditions are established, but significant damage often follows abruptly and unpredictably.

If you look at the performance of the stock market on a long-term historical basis, you'll observe that there are alternating periods of "secular" bull and bear trends, which are essentially driven by long transitions between unusually high valuation multiples and unusually low valuation multiples. "Secular" bear markets (which have generally lasted 17-18 years in U.S. data) are periods where the market begins from a very rich level of valuations, and then experiences several individual bull-bear cycles, but where each successive bear market typically achieves a lower level of valuation (though not necessarily a lower absolute price trough, if earnings and other fundamentals grow). Overall, the market provides little durable return over the full period. The last secular bear market period ran from the valuation peak of the mid-1960's to the valuation trough of 1982 - essentially a 17 year period. The last secular bull market ran from 1982 to 2000.

I suspect that the secular bear market that began at the valuation peak of 2000 is incomplete. As of last week, the S&P 500 remained strenuously overvalued on the basis of normalized fundamentals. From that perspective, even if the trough we observed in March 2009 was the ultimate price low of the secular bear market since 2000, it's not likely to represent the ultimate valuation trough. Given the current state of valuations, and the likelihood of several years of additional credit deleveraging, it seems that economic conditions, valuations, and the typical duration of secular bear markets converge on the likelihood of several more years of interesting but unrewarding market volatility. Secular bull market periods tend to begin with quite low multiples to normalized earnings (historically, on the order of 7), which is what provides the platform for a very long period of subsequent gains. It would not be surprising to observe a sequence of cyclical movements comprising a bear-bull-bear series, ending with a final and uncomfortable valuation trough (perhaps 6-8 years from now) before the market is finally priced to deliver that sort of sustained "secular" period of long-term gains. Current valuations provide no such platform.

Again, at this point it does not matter whether we anticipate further credit strains or not. Wholly on the basis of current valuations, stocks are priced to deliver unsatisfactory returns in the coming years - a situation that is worsened by strenuous overbought conditions and upward yield pressures here.

Extend and Pretend

With regard to credit conditions, the U.S. financial system continues to pursue a strategy of "extend and pretend." A year ago, the Financial Accounting Standards Board (FASB) suspended rule 157, which had previously required banks to mark their assets to market value when preparing balance sheet reports. The basic argument was that fair values were not appropriate because there was "no market" for troubled assets. Certainly, the FASB could have implemented something at least modestly reasonable, such as 2-year or 3-year averaging, but instead, they changed the rules to allow "significant judgment" in the valuation of bank assets in their financial reports.

To a large degree, the idea that there was "no market" for troubled assets was false even at the time. Last year, Dean Baker of the well-regarded Center for Economic Policy Research (CEPR) testified before Congress, observing "There has been considerable confusion about the nature of the troubled assets held by the banks. While banks do hold some amount of mortgage-backed securities, these securities are in fact a relatively small portion of their troubled assets. The troubled assets on the banks' books are overwhelmingly mortgages, both first and second or other junior liens, not mortgage-backed securities. The FDIC has acquired large quantities of mortgages from its takeover of several dozen failed banks over the last year. It auctions these assets off on an ongoing basis. The results of these auctions are available on the FDIC website. Non-performing mortgages typically sell in these auctions at prices in the vicinity of 30 cents on the dollar."

He continued, "It is not clear on what basis these auctions can be said not to constitute a market. While the downturn and the constricted credit conditions affect the market, it is simply inaccurate to claim that there is no market for these assets. The major banks are undoubtedly not pleased at the prospect of having to sell off their loans at these prices, but this merely indicates that they are unhappy with the market outcome, just as a homeowner might be unwilling to sell her house at a loss. However, the unhappiness of the seller does not mean that there is no market."

The impact of "extend and pretend" is to create a gap between the reported value of assets and the value they would have on the basis of the cash flows that those assets can reasonably be expected to generate over their maturity. In order to avoid having to restate assets, banks have allowed an increasing gap to develop between the volume of delinquent loans and the volume of loans actually in foreclosure, creating a growing "shadow inventory" of impaired but unmodified and unforeclosed loans.

Moreover, regulatory changes over the past year have affected what actually gets reported as "troubled." As the New York Times recently observed, " A bank owed, say, $4 million on a property now worth $3 million would previously have had to classify the entire loan as troubled. Now it can do that to the $1 million difference only." In effect, even though impaired loans tend to sell at only 30-50 cents on the dollar (reflecting a modest haircut to the amount typically received in foreclosure), banks can choose the amount of assets it reports as troubled simply by choosing what value to assign the property while it holds the bad loan on its books.

While it's interesting that credit card delinquencies have eased off modestly in recent months, this is not necessarily a healthy sign. Even in the third quarter of 2009, TransUnion reported that consumers delinquent on their mortgages but current on their credit cards increased by 6.6%. In effect, people have been choosing to pay their credit cards in priority to their mortgages.

As for policy efforts to reduce delinquencies, I've long argued that it is a bad idea for policy makers to announce delinquency prevention plans that have, as their centerpiece, publicly subsidized reductions in mortgage principal. It's one thing to extend the loan in a way that preserves its present value, by swapping a claim on future appreciation in return for principal reduction, but it's quite another to offer to cut the principal outright. The reason is that instead of confining the assistance to presently troubled borrowers, you create a whole new set of borrowers who then choose to be troubled in order to get the assistance. According to a University of Chicago study, "strategic defaults" - where people choose to default on their mortgages even though they can afford to pay - accounted for 35% of all residential defaults in December 2009, up from 23% in March 2009. Offering public subsidies for this behavior, when too many homeowners are already legitimately struggling, does not smack of a bright idea.

The New York Times recently provided a good picture of how the delinquency situation stood at the end of 2009 (based on FDIC data):

Bad Bank Loans Soar

The real concern from my perspective remains the potential for a second wave of delinquencies beginning in data as of the first quarter of 2010 and extending well into 2011. While we've seen some suggestions that many Alt-A and Option-ARM loans have already been modified, the premise of this argument is problematic since it is also true that about three-quarters of modified mortgages go on to default a second time, and few of these modifications result in substantial alterations in principal or interest payments beyond 12 months.

In short, my impression is that investors are deluding themselves about the solvency of the banking system. People learned in the 1930's that when you don't require the reported value of assets to have a clear and tangible link to the value that the assets would have in liquidation, bad things happen. Yet this is what regulatory and accounting rules are allowing for the banking system at present. While I do believe that bank depositors are safe to the extent of FDIC guarantees, my impression is that the banking system is still quietly insolvent.

Will it work? Will it change?

Regardless of whether the U.S. banking system would not presently be able to meet its liabilities with its assets, there is another question: assuming that banks are allowed to extend and pretend for a long enough period of time, will they ultimately be able to accumulate enough retained earnings in the years ahead to cover eventual loan losses? In other words, is it possible that everything will be OK if we just look the other way long enough?

From my perspective, it depends on what "OK" means. Simply in terms of long-term solvency - assets being ultimately able to meet liabilities - my impression is that yes, given enough time, retained bank earnings should cover the losses on existing loans. Indeed, it's possible that banks might be able to report fairly healthy "operating earnings" to investors, and then somewhat more quietly write off losses as "extraordinary" charges over a period of years. This type of outcome is beginning to look possible, because investors evidently don't mind repeatedly having their pockets picked as long as "operating earnings" come in above analyst estimates.

Unfortunately, in that sort of world, the economy would likely be hobbled for a long period of time, as Japan has discovered over the past couple of decades. With banks focused primarily on survival and recapitalization, retained earnings would be directed to making the existing liabilities whole, rather than contributing to productive new investment.

In January, the London Economist reported a study by the McKinsey Global Institute, noting "Assigning the odds of further deleveraging is not the same as gauging its likely economic impact. To do that, the study looks to history. It finds 32 examples of sustained deleveraging (at least three consecutive years in which ratios of total debt to GDP fell by at least 10%) in the aftermath of a financial crisis. In some cases the debt burden was reduced by default. In others it was inflated away. But in about half the cases—which the report regards as the most appropriate points of comparison—the deleveraging came through a prolonged period of belt-tightening, where credit grew more slowly than output. The message from these episodes is sobering. Typically deleveraging began about two years after the beginning of the financial crisis and lasted for six to seven years. In almost every case output shrank for the first two or three years of the process. (Countries which defaulted or inflated their debt away saw bigger recessions at first, but had higher output growth than the belt-tighteners by the end.)"

So to the extent that "extend and pretend" is successful in averting insolvency concerns, it will also tend to weigh down lending activity, as resources are allocated toward servicing existing debt burdens on bad assets, rather than toward new lending for productive activity. The most efficient outcome is always for lenders who provide capital to take losses if the loans go bad. That sort of market discipline is the only way to ensure that capital gets allocated properly. This is not the world that we have lived in over the past year, as policy makers have pledged public money to make private bank bondholders whole, regardless of how irresponsibly the banks allocated the money. But it is important to recognize that this policy comes with longer term costs.

It is not clear how long accounting standards will continue to enable this obscured portrait of the banking system. Last week, the International Accounting Standards Board and the U.S. Financial Accounting Standards Board said that they expect to issue a proposal in the next few weeks that might change the way that banks are required to report assets. But even if they do, formal consideration would not take place until perhaps the third quarter of 2010. Sir David Tweedy, who heads the IASB, said "Politicians have been saying a major objective of financial reporting is stability -- we think it's transparency." Thus far, this is still only talk. But it's something worth watching, and it is crucially important. Accounting standards that obscure the true value of assets and liabilities cannot be consistent with a properly functioning financial system. Uncomfortable as it might be, the only way to escape darkness is to shed light.

Market Climate

As of last week, the Market Climate for stocks remained characterized by strenuous overvaluation, strenuous overbought conditions, overbullish sentiment, and hostile yield pressures. True to its short-term form in these conditions, the market pushed to yet another marginal new high last week. The tendency for the market to shrug off widely observed overbought conditions may make it seem that these conditions don't matter. But I can't stress enough that the pattern of short-term continuation to marginal new highs is quite typical once the market establishes this syndrome of conditions, following which abrupt, nearly vertical losses are also typical - if unpredictable in timing. The Strategic Growth Fund remains fully hedged, with a "staggered strike" position that raises the strike prices of our defensive puts to tighten that defense (given the very low level of implied volatility, which sunk below 17% last week). Compared with a standard fully hedged investment stance, the amount invested in additional put option premium to raise those strikes represents just over 1% of assets at present.

In bonds, the Market Climate last week continued to be characterized by relatively neutral yield levels and unfavorable yield pressures. The 10-year yield bounced off of the 4% level last week. While a move moderately above 4% might prompt us to extend our durations in the Strategic Total Return Fund, we are presently comfortable with a duration of slightly less than 4 years.

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