April 19, 2010
Earning More by Setting Aside Less
As of last week, the stock market remained characterized by strenuous overvaluation, strenuous overbought conditions, overbullish sentiment, and hostile yield pressures. The fraud charges brought against Goldman Sachs by the SEC may or may not provide a catalyst for market weakness, but significant risk is already baked into observable market conditions. The present syndrome tends to be followed by large and abrupt losses (though with somewhat unpredictable timing). To the extent that investors tend to attribute market fluctuations to the immediate news surrounding them, the Goldman Sachs issue may become more of a subject of investor attention in the weeks ahead than it deserves. But really, is anybody actually surprised?
With regard to credit concerns, I think the best characterization of recent data is that cross-currents are building between the recovery view adopted by Wall Street, and emerging data suggesting fresh deterioration. Clear evidence of either is still absent.
On the cheerful side, Equifax reported a slight decline the first quarter delinquency rate among the mortgages it tracks, from 6.60% to 6.57%. This almost imperceptible decline was attributed by Equifax to seasonal factors, but it has been enthusiastically reported as evidence that the housing market has turned around.
Also last week, we saw upbeat first quarter earnings reports from J.P. Morgan and Bank of America, with J.P. Morgan reporting net income of $3.3 billion, and Bank of America reporting net income of $3.2 billion. In contradiction to these indications of improvement, last week included several reports like the following:
April 12, 2010: The latest Mortgage Monitor report released by Lender Processing Services, a leading provider of mortgage performance data and analytics, shows that the total number of delinquent loans was 21.3 percent higher than the same period last year. The nation's foreclosure inventories reached record highs. February's foreclosure rate of 3.31 percent represented a 51.1 percent year-over-year increase. The percentage of new problem loans also remains at a five-year high. The total number of non-current first-lien mortgages and REO properties is now more than 7.9 million loans. Furthermore, the percentage of new problem loans is also at its highest level in five years. More than 1.1 million loans that were current at the beginning of January 2010 were already at least 30 days delinquent or in foreclosure by February 2010 month-end.
April 8, 2010: First American CoreLogic reports that distressed home sales – such as short sales and real estate owned (REO) sales – accounted for 29 percent of all sales in the U.S. in January: the highest level since April 2009. After the peak in early 2009, the distressed sale share fell to 23 percent in July, before rising again in late 2009 and continuing into 2010. Distressed sales are non-arms-length transactions such as REO or short sales. Market sales are arms-length transactions between a willing buyer and willing seller and they exclude distressed sales. Distressed sales have a very strong influence on home price trends and are an indicator of a housing market's health."
First American CoreLogic observes that when the proportion of distressed sales becomes a significant share of total sales, there is a negative and non-linear price effect. Specifically, "the prices in the two markets (distressed and non-distressed) begin to converge into one large distressed market."
Meanwhile, it is notable that the "favorable" earnings reported by J.P. Morgan and Bank of America in the first quarter were due to reduced provisions for credit losses - charges that are largely discretionary. In the fourth quarter of 2009, J.P. Morgan charged $8.9 billion against earnings to provide for credit losses, but in the first quarter of 2010, it charged $7.0 billion. Thus $1.9 billion of the $3.3 billion in earnings reported by JPM reflected reduced provision for credit losses. Likewise, the main factor driving Bank of America's earnings was a reduction in loss reserves. Indeed, the provision for credit losses was $3.6 billion lower than it was a year ago (when delinquency rates and credit losses were running at a fraction of current levels).
The reduced provision for credit losses might be reassuring were it not for the fact that delinquencies, foreclosures, non-performing loans, commercial mortgage strains, and actual charge-offs reported by various sources have been either unchanged or accelerating. Bank of America, for example, reported that 30-day delinquencies on residential mortgages hit a new record of 8.5% in the first quarter (though the surging FHA-insured portion will allow them to pass some of the consequent losses off onto the American public). Moreover, provisions for credit losses are again falling short of net charge-offs, which is what we saw in 2008 before banks got into trouble (see the June 2, 2008 weekly comment: Wall Street Decides to Close Its Ears and Hum). For example, actual net charge-offs at Bank of America were $10.8 billion during the first quarter of this year (versus $6.9 billion a year ago), exceeding the provision of $9.8 billion that was deducted from earnings in the first quarter. In effect, the Bank reduced its reserve for future losses by about $1 billion, which had the effect of boosting reported earnings accordingly. This accounts for the entire improvement in earnings from the fourth quarter of 2009, and then some.
Overall, the current data presents at best a mixed picture of credit conditions. My impression is that investors should not be surprised by a significant second-wave of credit strains. Still, as we've anticipated for months, we have now entered the window where those strains would be expected to begin, so I won't maintain this view if the data don't increasingly support it. Some evidence is consistent with fresh deterioration, but not nearly to the extent that we would consider decisive. Meanwhile, indications of improvement are also extremely thin. It seems unwise for investors to celebrate variations of a few basis points in delinquency rates. It seems equally unwise to celebrate "favorable" bank earnings reports that are exclusively driven by reduced loan loss provisions, particularly when the volume of impaired loans has not declined proportionately. Keep in mind that Enron and Worldcom were able to report outstanding earnings for a while by adjusting the manner by which revenues and expenses were accrued. I suspect that the U.S. banking system has become a similar breeding ground for innovative accounting.
As of last week, the Market Climate for stocks remained characterized by strenuous overvaluation, strenuous overbought conditions, overbullish sentiment, and hostile yield pressures. The Strategic Growth Fund remains in a tightly defensive stance. On Friday, we benefited both from our avoidance of financial stocks, and from our higher-strike put options (reflecting the "staggered strike" position we've been maintaining). The additional time premium required to raise our put option strikes is typically only about 1% of assets, and we do have the potential to lose that time premium if the market moves sideways or continues higher. Also, market declines that put those options "in the money" can result in gains which may be reversed if the market suddenly recovers before we have a good opportunity to reset our strikes. So while our original outlay in the higher strikes may be fairly small, once we establish gains in those higher-strike puts, we can also get a bit more day-to-day volatility depending on how frequently we lower those strikes as the put options move in-the-money
In bonds, the Market Climate remains characterized by relatively neutral yield levels and unfavorable yield pressures. My expectation remains that fresh credit strains would tend to be friendly to Treasury bonds and the U.S. dollar (as relative safe-havens), while being hostile to precious metals, commodities and TIPS (on deflation concerns). Since our long-term inflation outlook is much more hostile than what we expect over the intermediate term, I would expect to gradually accumulate inflation sensitive securities such as TIPS, precious metals and foreign currencies on weakness.
In a long-term inflationary environment, I expect that foreign currencies may also be useful vehicles, but not as clearly as precious metals and commodities. The reason is that the U.S. is certainly not the only country demonstrating open-checkbook monetary and fiscal policy here. That means that currency positions largely represent the choice of which currency is "less bad." It's quite likely that hard assets such as precious metals and other commodities will advance relative to a wide range of currencies, beginning in the second half of this decade (which is another way of saying that we would expect inflation to be largely a global phenomenon). Conversely, while some currencies will most probably depreciate less than others against a fixed basket of commodities (i.e. exchange rates between different currencies will fluctuate even in a global inflation), those choices may turn out to be more subtle.
In short, nearly all developed economies are behaving badly in terms of fiscal and monetary discipline. I do expect that there will be relative valuation differences in currencies and policies that will provide a basis for currency positions as we gradually transition from a low-inflation world eager for safe-havens to a post-credit crisis inflationary outcome several years from now. But the most likely beneficiaries (and the securities that we would be inclined to accumulate on significant deflation fears), are likely to be commodities, precious metals and TIPS. As usual, we'll respond to the data as it emerges, but the foregoing is a reflection of where I would expect the opportunities to emerge.
NEW from Bill Hester: Business Cycles, Election Cycles and Potential Risks
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