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May 3, 2010

Violating the No-Ponzi Condition

John P. Hussman, Ph.D.
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Over the past few months, the stock market has been characterized by an overvalued, overbought, overbullish, rising yields syndrome that has historically proved unrewarding and often particularly dangerous for investors. It's important to underscore that even in post-war data, and even if we assume that the economy is in a typical post-war recovery, this particular syndrome has been unrewarding, on average, which places the Strategic Growth Fund in a fully hedged investment stance (essentially, the Fund holds long-put / short-call index option combinations having a notional value equal to the value of the stocks we hold).

As in 2007, the unusually low level of implied volatility, coupled with the syndrome of overextended conditions, has prompted us to establish a tight "staggered strike" position, raising the strike prices of our defensive put options close to the level of the S&P 500. Compared with a standard matched-strike hedge (long put options / short call options having the same strike price and expiration), a staggered position typically maintains about 1% of assets in additional put option premium. The Fund does not establish option combinations where more than one side is "in the money" when the position is initiated. Since we keep the new strike price of the put options below the level of the market, the potential downside (compared with a standard hedge) is limited to a modest loss of time premium if the market continues to advance.

Conversely, if the market declines below the strike price of the puts, the hedge provides a tighter defense for the stocks we hold, which can be helpful if the early sell-off is indiscriminate. This requires us to take day-to-day fluctuations with a slight grain of salt, because once the put options go "in the money" (i.e. the S&P 500 drops below the strike price of the puts), if the market then reverses back toward or above our strike prices before we have a good opportunity to reset our strike prices, we can give back some or all of our recent gains from those puts. So the puts can't lose more than the amount of time premium we originally invest, even if the market advances, but can result in gains (that are occasionally transient) if the market drops below their strike prices.

I note this because when the S&P 500 moved well above 1200 in recent weeks and implied volatility dropped toward 16-17%, we raised our strikes to the 1200 level at relatively low cost. Those strikes are now in-the-money, so we expect to be well-protected against the impact of general market declines. Though we continually adjust our position to reduce the potential for "give back" (as we did near the market close on Friday), it is probably best to anticipate a few transient day-to-day gains and give-backs if the S&P 500 extends its decline substantially below 1200.

More generally, the primary source of our day-to-day fluctuations when we are hedged is the difference in performance between the stocks held by the Fund and the indices we use to hedge. For example, the most notable source of fluctuation in the Strategic Growth Fund last week was not hedging, but volatility in restaurant stocks that led the recent rally.

Geek's Note: This asymmetry or "curvature" in the profile of option returns is called "gamma" (the second derivative of the option value with respect to price). Ideally, you would prefer to let this curvature run, and only adjust your position at the turning points of a market trend. In practice, we look for short-term overbought and oversold conditions to reset our strikes - a practice known as "gamma scalping." Gamma is really what you are paying for when you purchase an option. If the actual short-term volatility of the market is greater than the implied volatility that was priced into the option when you established the position, effective gamma scalping can substantially reduce the impact of time decay even if the market is ultimately unchanged.

Violating the No-Ponzi Condition

The credit picture remains mixed at present, though the next several months are likely to provide significantly more clarity. The Greek debt concerns are interesting in the lesson that investors are hoping to be taught, which is that all debt, no matter how foul, should be considered risk-free and can be counted on to be bailed out, so that market discipline need not provide any impediment to the poor allocation of the world's financial resources.

The basic problem is that Greece has insufficient economic growth, enormous deficits (nearly 14% of GDP), a heavy existing debt burden as a proportion of GDP (over 120%), accruing at high interest rates (about 8%), payable in a currency that it is unable to devalue. This creates a violation of what economists call the "transversality" or "no-Ponzi" condition. In order to credibly pay debt off, the debt has to have a well-defined present value (technically, the present value of the future debt should vanish if you look far enough into the future).

Without the transversality condition, the price of a security can be anything investors like. However arbitrary that price is, investors may be able to keep the asset on an upward path for some period of time, but the price will gradually bear less and less relation to the actual cash flows that will be delivered. At some point, the only reason to hold the asset will be the expectation of selling it to somebody else, even though it won't be delivering enough payments to justify the price.

Transversality forces the price of the asset to be equal to the value of the discounted cash flows. It's not enough for a borrower to keep the payments up over the short term, and it's not enough for price of an asset to be on an upward track for a while - over time, securities actually have to be able to deliver enough cash flows to justify the price that investors pay. When investors abandon this requirement (as they did with dot-com and technology stocks during the runup to the market peak in 2000), the price they pay stops having any relationship with the stream of cash flows that will be delivered to them over time. An increasingly large portion of the asset price represents real money that is being paid for a "phantom asset" in the distant future, that bears no cash flows, and yet gets assigned positive value because investors assume they'll be able to sell it to a greater fool. Every asset bubble fundamentally reflects this error in thinking. Ponzi schemes violate transversality conditions, as do sub-prime (not to mention Alt-A and Option-ARM) mortgages when they are assigned higher values than the expected cash flows can justify. If not for the ability to print money, which will become increasingly handy in future years, the U.S. government might be in the same situation, resulting from existing debt, probable future deficits, and unfunded liabilities.

Unless Greece implements enormous fiscal austerity, its debt will grow faster than the rate that investors use to discount it back to present value. Moreover, to bail out Greece for anything more than a short period of time, the rules of the game would have to be changed to allow for much larger budget deficits than those originally agreed upon in the Maastricht Treaty. One can't rule this out, seeing as how our own nation has proved quite adept at dispensing with accounting provisions and other discipline that might have threatened bondholders. But if that is the case, our concerns about inflation pressures in the second half of this decade will only become more pointed.

We may very well see some short-term bridge financing in return for promises of greater fiscal discipline. This will do little but kick the can down the road a bit. [Late note - The EU and IMF announced late Sunday a 110 billion euro - roughly $146 billion - rescue plan for Greece, attached to an austerity plan that unions immediately denounced as "savage"]. Greece is a beautiful country, but its economy is not a model of flexibility. Anecdotally, having been, in my earlier years, among a train full of passengers tossed out near a field in the middle of the night upon arriving at the Greek border, hoofing it in the dark to the nearest town, bumming a ride to Thessaloniki, and eventually hiring a taxi to drive the full length of the country to Athens with five chain-smokers who refused to crack a window, while every other form of transportation was on a nationwide strike, I suspect that budget discipline to the extent required will not be easily implemented, and may be so hostile to GDP and tax revenues as to make default inevitable in any event.

With respect to mortgages, the most recent figures from Bloomberg covering residential delinquencies for over 12 million active, non-agency loans continue to show a record proportion of troubled loans. Non-agency (Fannie/Freddie) loans are those originated by the private sector, typically at even less stringent credit standards than Fannie and Freddie imposed. Bloomberg reports that delinquent, REO (real-estate owned), foreclosed, and bankrupt loans represented 33.78% of the total in March, the same level as in February. Of these, more than half (16.93%) were delinquent but not in foreclosure. While Subprime loans in foreclosure declined from 16.85% in January to 16.35% in March, and 30-day Subprime delinquencies declined from 4.86% in January to 4.34% in March, these declines were offset by increases in Alt-A foreclosures (12.23% to 12.43%) and delinquencies (4.18% to 4.45%). Overall, we clearly appear to be past the trouble in Subprime, but the rates for Alt-A and Option-ARM mortgages are trending the wrong way.

Jonathan Weil of Bloomberg made some observations a few weeks back about last year's FASB change, which suspended "mark-to-market" accounting for banks. He notes that in early 2009, the Federal Home Loan Bank of Seattle was the "poster child for everything supposedly wrong with mark-to-market accounting." While mark-to-market rules had forced the bank to write down its portfolio of mortgage backed securities by $304 million, the bank's executives said they expected to lose only $12 million on these loans. At a March 12, 2009 congressional hearing, this disparity was presented as a "disturbing" example of the problem with mark-to-market. Paul Kanjorski pointed to a similar "absurd" example that "fails to reflect economic reality", where the Federal Home Loan Bank of Atlanta was forced to report an $87 million mark-to-market writedown on a portfolio the bank expected to generate losses of only $44,000. In response to this pressure, the FASB ultimately caved. Unfortunately, the Federal Home Loan Bank of Seattle now says it expects $311 million of credit losses on its portfolio, while the Federal Home Loan Bank of Atlanta has raised its credit loss estimate to $263 million - both even worse than the original mark-to-market indications. The Seattle FHLB has filed lawsuits against Goldman Sachs and Morgan Stanley, among others, seeking refunds for mortgage-backed securities they underwrote.

Overall, it strikes me that the markets have wholeheartedly embraced the view that the recent downturn was nothing but a typical and purely transitory post-war wrinkle. Yet income continues to deteriorate once government transfer payments are backed out, in stark comparison to other post-war recoveries (see Bill Hester's recent piece Business Cycles, Election Cycles and Potential Risks).

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Investors have looked past the effects of temporary stimulus and opaque accounting, maybe on the Madoff-like thesis that neither sustainability nor accurate disclosure really matter as long as the numbers are good. Yet there's also no denying that this thesis has worked beautifully, and we've missed out by questioning it. As I detailed last week in Looking Back, Looking Forward, the criteria for accepting risk - on the basis of valuation and market action - have been more stringent in periods of credit crisis (both U.S. and internationally) than we could have, in hindsight, got away with last year. I continue to believe that the market's enthusiasm may turn out badly, given the extent to which GDP gains have been induced by unparalleled deficit spending, and earnings gains have been predominated by financials enjoying suspended accounting transparency. But we'll see how this plays out over time.

That said, even the guidance from strictly post-war models has been decidedly defensive during 2010, and remains so today. If the evidence based on post-war data improves, we'll become moderately more constructive. We're currently giving about as much weight to a standard post-war recovery as we are to a continued credit crisis, but the evidence currently suggests a fully hedged investment stance for both cases, so these possibilities represent a distinction without a difference. To the extent that valuations or market action improve in a manner that would, in a normal post-war world, justify accepting some amount of market risk, we would presently move about half-way in that direction. If we observe no further crisis-level credit strains, I expect that we'll be applying strictly post-war criteria by year end. So we're allowing some time to move into our main window of concern, but our defensiveness won't persist indefinitely without obvious evidence of credit deterioration.

Market Climate

As of last week, the Market Climate for stocks was characterized by strenuously unfavorable valuations, and a syndrome of overvalued, overbought, overbullish, rising-yield conditions that has historically been associated with poor outcomes. As noted above, our present hedged position is not dependent on the expectation of further credit strains. Needless to say, the additional clarity regarding credit risks that we expect in the months ahead will be welcome, regardless of the outcome.

In bonds, the Market Climate remained characterized last week by relatively neutral yield levels and unfavorable yield pressures. Credit spreads have been generally widening in recent weeks, with a somewhat unstable spike in the credit default swap spreads of major banks. I say "unstable" because it may be based on immediate concerns about Greece, rather than more persistent risk concerns. Broader measures of credit risk have ticked up modestly, but not as notably as CDS spreads. My expectation continues to be that inflation pressures will pose a significant challenge to the economy in the second half of this decade, benefiting inflation hedges and TIPS. However, over the shorter term, commodities appear overbought and a bit vunlerable.

The uncertainty about Greece and, by extension, the euro, has been a positive for precious metals recently, and while a default event could generate a "fear" spike in the metals, intermediate concerns about economic consequences and deflation in that event could result in a subsequent period of commodity weakness. In contrast, a near term agreement to provide bridge financing would ease fears and might take some air out of commodities more immediately. In short, the longer term prospects for precious metals and inflation hedges continue to diverge somewhat from near and intermediate term prospects. We closed our small 2% of precious metals exposure from the Strategic Total Return Fund last week on strength, and also have a limited exposure of only about 2% in foreign currencies here. Among currencies, the euro appears somewhat undervalued on our metrics, and possibly for good reason (versus a central value of about $1.49-$1.51 based on our "joint parity" methodology - see Valuing Foreign Currencies), as does the British pound, while the yen appears about fairly valued, and the Canadian dollar appears somewhat rich. I continue to believe that a credit shock would provide the best opportunity to accumulate longer-term positions in commodities, TIPS and certain foreign currencies, but I expect that we'll respond to smaller opportunities - particularly fresh precious metals weakness - to establish more moderate exposures.

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