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July 6, 2010

Implications of a Likely Economic Downturn

John P. Hussman, Ph.D.
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A week ago, we accumulated enough evidence to conclude that the U.S. economy is most probably headed into a second leg of recession. It is unclear whether this will be identified as a second recession or a continuation of an existing downturn. In either case, I've repeatedly noted that the apparent strength in the U.S. economy over the past year has been driven almost exclusively by an almost inconceivably large burst of fiscal and monetary "stimulus" last year, whereas intrinsic economic activity has stagnated. Personal income remains at its lows once government transfer payments are excluded, which is in stark contrast to typical post-war recoveries. Weekly jobless claims are pushing again toward 500,000, whereas prior post-war recoveries have seen jobless claims quickly retreat below the 400,000 figure that roughly delineates job growth from continued job losses. The most straightforward explanation of the economic data is that we've observed a stimulus-led recovery that has not translated into private economic activity, and that the effects of the stimulus are now diminishing.

Our recession warning composite, on which part of my present concern is based, reflects essentially the same combination of factors that produced the warning I reported in the November 12, 2007 weekly comment Expecting A Recession , as well as the recession warning I reported in October 2000 . Based on the high correlation and roughly 13-week lead that the ECRI Weekly Leading Index provides, compared with the ISM Purchasing Managers Index, I noted last week that the use of the ECRI Index provides somewhat more timely signals. I want to emphasize, however, that our use of the ECRI Index is as one component of a broader set of indicators that we look to observe in concert to produce a recession warning.

Emphatically, I am not suggesting that the Economic Cycle Research Institute itself is warning of a second downturn. How the ECRI uses its data is its own concern. But I am equally emphatic that when the ECRI index is included among the other components of our recession warning composite, the resulting recession signals have always and only been observed during or immediately preceding post-war economic downturns. The abrupt dropoff this month among various Purchasing Managers Indices in U.S., China and Europe is consistent with the ECRI data, though given the typical lead-time of the ECRI, we may have to wait another month or so to see those PMI indices breach readings of 50-54. I'll note in passing that the ECRI Weekly Leading Index growth rate deteriorated to -7.7% last week, from -6.9% the previous week.

From a Bayesian standpoint, if you always observe a certain combination of information when X occurs, and never observe that same data when X is not present, then even if X is hidden under a hat, you would conclude that X is most likely there. If I see clowns walking around the grocery store buying peanuts, and there's a big top tent with two unicycles in front of it in the middle of what is usually an open field, I'm sorry, I'm going to conclude that the circus is in town.

Investment Implications

My most urgent concern over the past few months has been directed toward investors with spending plans (tuition, home purchase, baby, medical, retirement) that rely on the near-term availability of funds. If you are following a disciplined investment strategy, your portfolio is well-diversified, and you are tolerant enough of risk that the declines in 2000-2002 and 2008-2009 did not materially derail your investment discipline, then please, ignore my views and the views of everyone else and just follow your discipline.

My concern is for individuals who will need the money within a small number of years and yet are invested as if they are long-term investors, not in adherence to a specific discipline, but simply because the market was, until recently, advancing. Too many people got their life plans derailed when the tech bubble crashed, and when the credit crisis hit. If a major market loss would derail your life plans, you're taking too much risk here. That said, I have no intent to cheerlead for the bears. In our most defensive stance, the Hussman Funds may be fully hedged, but the dollar value of our shorts never materially exceeds our long holdings. We don't "bet" on the market to decline.

Over the short and intermediate-term, credit crises are invariably deflationary, because they prompt a frantic demand for default-free government paper, which raises its value relative to goods and services (another phrase for deflation). So despite the huge increase in government obligations during these periods, you generally don't see inflationary pressures in the early years because that supply is eagerly absorbed. Short-term interest rates are pressed near zero, and monetary velocity tends to collapse. Commodities are usually hard hit as well, so investors who are concerned about inflation risk or are chasing gold here may have the long-term story right, but they probably have it too early to weather the interim volatility comfortably.

Over the long-term, massive increases in government liabilities do have inflationary impact. This imposes a real burden, not simply a paper one. If the holder of government currency can command a certain stock of real goods and services, and then the government debases that currency so that it can command a lesser stock of real output, then it is undeniable that the difference in real value has been implicitly transferred to the government to finance its spending. While I do expect that TIPS, commodity exposure and precious metals will be important inflation hedges in the years ahead, investors chasing these assets here may have a difficult road. It is best to accumulate such assets when they are in liquidation, not when they are being chased on the basis of overly simplistic theories of inflation.

Policy Implications

Apart from encouraging investors to review their risk exposures, my other hope is to encourage a more constructive policy response than we observed last year. To-date, our policy makers have placed bondholders ahead of ordinary citizens, largely out of fear of disastrous consequences predicted by precisely those who stood to benefit most from government largesse. We have directed massive and ultimately real (not simply "paper") resources of the public to ensure that holde rs of bank debt, financial debt, and GSE debt get back 100 cents on the dollar plus interest.

With regard to "stimulus" plans, my difficulty with last year's policies is not so much an aversion to government spending as it is a rebuke of the notion that government spending is by its nature stimulative or beneficial to the economy. The issue is how this real value is used. Is it used to advance socially useful outcomes which private individuals, through some failure of coordination, could not achieve? Or is it used to defend bondholders, industries, and institutions with which the policymakers are most closely aligned?

The Keynesian view is that government spending is simply a monolithic letter "G." Keynes cared little about the productivity or lack thereof to which public resources were devoted, even writing " If the Treasury were to fill old bottles with bank-notes, bury them at suitable depths in disused coal-mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again... there need be no more unemployment." The only difference between Keynes and Tim Geithner is evidently that Geithner prefers to place the bottles a bit closer to Wall Street.

A 3-minute course in Keynesian Theory

OK, a few quick equations. Stick with me - there's a lot of insight for the effort. Let's start with the standard definition for GDP (ignore imports and exports for simplicity)

Output (Y) = Consumption (C) + Investment (I) + Government (G)

Move a few things around, and you'll notice that by definition, I = Y - C - G, which basically says that total real investment (factories, equipment, inventories, etc) can only be created by whatever output is not absorbed by consumers or government (i.e. savings). So real savings and real investment are always equal, even if the investment represents unwanted "inventory investment." This isn't a theory, it's an accounting identity.

Next, we introduce basic Keynesian theory in two lines:

C = cY : consumption is proportional to income

I = I_fixed : real investment is fixed

That gives you

Y = cY + I_fixed + G

so

Y = ( I_fixed + G ) / (1 - c)

Example: G = 100, I = 20, c = .75, so (1-c) = .25, and Y = (20 + 100) / .25 = 480. Every dollar of G or I conveniently has a "multiplier" effect of 1/.25 = 4.

Since Keynes assumes real investment I to be fixed during a recession, the best way for the Keynesian economy to produce more output is to increase government spending. It doesn't matter how. Go ahead and fill old bottles with banknotes and bury them at suitable depths. Worse, notice that if people try to reduce the proportion of income "c" they consume, that is, as they try to save more, (1-c) gets larger, and cruel Keynesian algebra says that output (Y) will fall. Again, the solution is to increase G.

Now, one might wonder why we should be so quick to assume that real investment is fixed. Keynes did it because he assumed that the only incentive to invest was a reduction in interest rates, and he assumed that interest rates were caught in a "liquidity trap" during recessions. Productivity, incentives, innovation, profit motives, and other factors weren't really on Keynes' radar. Once we assume that investment is fixed (which means that total saving is fixed), then every effort to save more becomes mathematically counterproductive because the economy contracts enough to prevent it. This is why saving is so hated by Keynesians. There is no purpose for it because Keynes assumed that purpose away.

One might also wonder why we don't consider the dynamics of output over time, which would also force us to ask how productive different sorts of spending might be. Surely, the allocation of resources is crucial, because every form of spending has a different effect on the cumulative amount of future output created. The true debate in economics is not between Keynesians and Monetarists, but between economists who care about the productivity of resource allocation and those who only pay lip service.

Crafting a Package

Once we begin to ask these additional questions, we immediately open up important policy options to that might reasonably be included in an (inevitable) stimulus package. While this may seem incomprehensible given the low political tolerance for deficits at the moment, we have yet to see a case where fiscal responsibility trumps perceived crisis. Fresh economic weakness is unlikely to be kind to the housing market, the credit market, or the employment market. The weak underpinnings in the private economy may not absorb new pressures well.

If individuals are attempting to increase saving, and Keynesians view this as undesirable, an obvious but underutilized response is to promote productive investment through tax incentives, R&D credits, and other means. Private sector investments are often well-beyond the planning stages, and may provide a quick road to immediate economic activity in response to incentives that move their timing forward. We should not overlook productive forms of government-funded non-profit research. Among those avenues, one might consider restoring funding to the National Institutes of Health and the National Science Foundation, both which have historically been successful in advancing innovation and producing major discoveries in public health and technology.

We might also consider investments that cannot be easily made privately due to coordination failure. Various forms of public infrastructure, particularly those that increase the efficiency of large numbers of individuals (roadways, telecommunications) have been shown to have a good payoff over time in terms of output, relative to the cost of those investments. In contrast, one might view "rural broadband" as somewhat questionable, precisely because of the relatively high cost per beneficiary. In a challenging downturn such as this one, where the duration of economic difficulty may be extended, some amount of infrastructure expense makes sense. In contrast, during most post-war recessions, these have been difficult to coordinate on a timely basis.

In any case, numerous moderate investment-like projects - including infrastructure, research, alternative energy projects, and so forth - are more likely to be effective than massive "pick the winner" approaches, not only because technology is usually too dynamic to pick a winner correctly, but also because the marginal returns from massive expenditure tend to diminish quickly. If the Keynesian problem is increased saving, the natural response should include incentives to initiate real, physical investment and research (not simply tax cuts on investment income). Moreover, projects having the capacity to spread their effects over a large number of beneficiaries should be heavily preferred to projects having a high cost per beneficiary. This should be obvious, but concentrated pork and bridges to nowhere are strikingly common.

Finally, in an economy likely to push 12% unemployment, a compassionate society ought to consider extended - if tapering - unemployment compensation as a necessary "counter-cyclical" element of fiscal policy, at least in my opinion.

In any event, we should be thinking not in terms of brute "stimulus" here, but rather should be thinking in a more nuanced way about incentives, productivity, and resource allocation. Government spending is not one monolithic "G" but is instead comprised of countless projects with very different productivities and long-term consequences. If we abandon all of that subtlety and simply call for government to spend, we can be certain that the spending will benefit those who are best connected to the policy makers doing the spending.

Avoiding a Reprise

Meanwhile, I continue to believe that both Bernanke and Geithner's hands should be tied quickly. If we have learned anything over the past 18 months, it is clear that these bureaucrats can misallocate an enormous quantity of public resources with mind-numbing speed. The diversion of public resources to the bondholders of failing financials - to precisely the worst stewards of capital in society - is not stimulative, but ruthless. A second economic downturn should encourage the repudiation of the policies that Bernanke and Geithner pursued during the first.

By all appearances, Ben Bernanke has a four-second tape in his head that says "We let the banks fail during the Depression, and look what happened." Then the tape repeats. There is no subtlety that says, "yes, but we let the banks fail in the most disruptive and disorganized way possible, forcing them into piecemeal liquidation as Lehman had to do. Today, the FDIC is fully capable of preserving and transferring the operating entity while properly cutting away the failing bondholder and stockholder liabilities so that depositors and customers are not affected." This understanding would prove useful in the event we observe further credit strains.

Basic ethical principle dictates that policy makers should not burden ordinary Americans to pay the losses that well-informed bondholders voluntarily took when they lent money to failing institutions. From my perspective, it is urgent to recognize that Fannie Mae and Freddie Mac obligations are not legally obligations of the U.S. government, that its backing was always at best implicit, and that even the Treasury's distressingly generous 3-year promise to bail out Fannie and Freddie only takes those obligations through 2012. Longer-term GSE securities held by the Fed and by investors represent debt obligations of insolvent institutions, yet are still treated by investors as if they are default free. Congress should quickly clarify that FHA obligations are explicit government commitments and GSE debt is not. Traditionally, the Fed's open market operations have been almost exclusively using Treasuries. Any other securities were purchased on a repo basis only, which meant that the Fed would get its money back predictably, regardless of the quality of the security. Without these, the Fed can unconstitutionally engage in fiscal policy, and has recently done so by purchasing Fannie and Freddie debt outright. Congress should limit the Fed to purchasing sovereign debt of the U.S., with a limited role for sovereign debt of major, fiscally intact trading partners, or it should bless GSE debt explicitly so Americans understand that the U.S. dollar will ultimately become the Reichsmark.

A few additional notes. We are likely to observe a substantial increase in U.S. government debt in the next couple of years, not only because of stimulus spending and possible further bailouts, but also due to tax shortfalls and aid to states and municipalities. The key question to ask is the extent to which the increase in debt is matched by an increase in productive capital or urgently needed social benefit. Remember also that the crucial consideration is how the money is first spent - how productively the money is used. Once the funds are spent, there will be government liabilities as evidence of that spending, but it is important to recognize that those liabilities are simply IOUs.

Interestingly, some observers lament that corporations and some individuals are h olding their assets in "cash" rather than spending and investing those balances, apparently believing that this money is being "held back" from the economy. What is preposterous about this is that the "cash" that companies and individuals are observed to be holding is primarily in the form of government securities and base money created over the past couple of years, which somebody has to hold at every point in time until those liabilities are retired. This is not money that is waiting to be spent. It is a stack of IOUs representing resources that have already been squandered, and now somebody has to hold these pieces of paper until they are retired.

In short, instead of directing savings toward investments in real, productive assets that we would observe as physical output, fixed capital, and equipment (and claims on those assets in the form of corporate stocks and bonds), our economy has been forced to choke down a massive issuance of government liabilities in order to bail out bad debt. For every dollar of debt that should have defaulted, we now have two dollars of debt outstanding (the original debt, and a newly issued government security). What appears to be "sideline cash" is simply the evidence of past spending. Again, the crucial consideration is how the government spent the funds in the first place. Rapidly mounting evidence suggests that the answer is "not very well."

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action. The stock market is certainly oversold on a short term basis, but we're also seeing a tendency toward accelerating volatility at 10-minute intervals, which I've previously noted can be associated with abrupt episodes of illiquidity. Technicians are very attentive here to a large "head-and-shoulders" pattern which has now completed a (predictably) truncated right shoulder. While we don't put any weight on such patterns, it is often helpful to monitor levels that a large number of traders might consider to be support or resistance. To that end, the area about 1040 on the S&P 500 was the previous widely observed level of "support." Having broken below a major support level, it is somewhat obligatory, if not entirely reliable, for the market to advance back to that prior level of support if only briefly. It would not be surprising to observe that attempt, but beyond that, it is asking rather much to expect investors to drive the market substantially higher simply to clear an oversold condition, when the economic evidence is souring so rapidly at the same time. Suffice it to say that we're not trying to "trade a rebound" or "buy the dip."

The overwhelming risk at present is that we are in what I've called the "recognition phase" where economic reality and earnings guidance deviates substantially from the expectations that have been priced into stocks. Two phases of a market downturn are generally the most hostile. The recognition phase and the capitulation (or "revulsion") phase. This market is nowhere near completing the shift in psychology that one would expect in a recognition phase, much less a capitulation phase. At worst, we see reports like "A few naysayers are worried about a double dip, but this can be ignored because double dips are rare." We will be fine, and even willing to shift to a moderately constructive position if we observe a sufficient reversal in market internals and economic statistics. But here and now, the strongest indications are highly defensive, and the required shift in evidence - at least at present - would have to be so broad that it appears unlikely.

In bonds, the Market Climate remains characterized by moderately unfavorable yield levels and favorable yield pressures. The Strategic Total Return Fund continues to carry about a 4-year duration, mostly in intermediate-term Treasuries, as well as a few percent of assets in utility shares, foreign currencies, and precious metals shares. The most notable shift for us was in precious metals last week, where we took some profits and pared our exposure back toward 5% of assets. That is a position we can carry even if commodity prices collapse on deflation concerns, but it leaves us with a conservative exposure in the event that the recent market enthusiasm for precious metals continues a while longer. Again, I don't think the long-term thesis for precious metals is wrong, but near-term concerns of investors are more likely to involve deflation, which may make for some serious discomfort for precious metals investors. This may include potential liquidation pressure from hedge funds, which are not known for maintaining long-term theses well.

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