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February 7, 2011

Misquoting Keynes

John P. Hussman, Ph.D.
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The famous quote attributed to John Maynard Keynes - "the market can remain irrational longer than you can remain solvent" - is a favorite of speculators here. Actually, I very much agree with this observation, provided that it is correctly understood. Solvency is always a function of debt, and it's extremely important for investors to recognize that when you take investment positions by borrowing on margin, you'd better use stop-losses, because the debt obligation stays intact even if the investment values decline.

On the other hand, we certainly don't believe that this aphorism amounts to a recommendation that it is required (or even advisable) for investors to accept speculative risks just because prices are advancing, particularly at the point where overvalued, overbought, overbullish conditions are joined by rising interest rates, as they are at present.

In my view, the more appropriate quote for the present environment is from Benjamin Graham: "Speculators often prosper through ignorance; it is a cliché that in a roaring bull market knowledge is superfluous and experience is a handicap. But the typical experience of the speculator is one of temporary profit and ultimate loss."

Ironically, while the "irrational longer than you can remain solvent" quote is embraced by speculators as a license to take risk, they may not recognize that whatever lesson might be learned from Keynes has nothing to do with his views about "irrational" market advances. Rather, Keynes' learned his lesson as a result of steep losses that resulted from holding a poorly diversified portfolio - apparently on margin - during a market plunge, years after the Depression trough of 1932. As biographer Robert Skidelski observes, "In the year of the 'terrific decline' which had started in the spring of 1937, he lost nearly two-thirds of his money."

Let's briefly walk through the 1930's, to examine the context in which Keynes was operating. As I've noted in prior commentaries, the U.S. stock market at its 1929 peak was priced to achieve slightly negative total returns over the following decade (based on estimates using our standard methodology). Once the market had lost half of its value, the prospective 10-year total return reached 10% annually. From there, however, the market would lose another two-thirds of its value to its ultimate trough in 1932. All told, the market lost more than 80% from the 1929 peak to the 1932 low (which is what you get when a 50% loss is compounded with a 67% loss).

By 1937, the favorable valuations that existed at the 1932 trough were long gone. Stocks were overbought and overvalued, and interest rates were rising. The Dow moved above 194 at the beginning of March 1937, when in a conversation with Felix Somary ("the Raven of Zurich"), Keynes said "We will not have any more crashes in our time." Over the following year, the market lost about half its value, with the Dow reaching its trough near the 100 level. Based on our standard methodology for estimating prospective 10-year total returns on the S&P 500, a reasonable projection at the March 1937 market peak was only about 6% annually. The Shiller P/E was over 23 (meanwhile, long-term Treasury yields were at 2.84% and trending higher). By March 1938, the plunge in the market was enough to increase the projected 10-year total return of the S&P 500 to over 14% annually.

Judging from Keynes' confident assertion in 1937 that major market losses could be ruled out in the future, we might infer that the sentiment of investors at the time was probably overbullish, as well as being overvalued, overbought and coupled with rising yields. Needless to say, from our perspective, Keynes walked right into the 1937-1938 plunge.

That said, by early 1938, the market troughed, and with prospective long-term market returns now significantly higher, the market would gain nearly 50% in the next 8 months before stumbling again, experiencing a series of 20-30% gains and losses - though with little durable progress - for nearly a decade. One could have performed quite well over the full period by recognizing that while prospective returns may be very attractive at market troughs, they are no longer attractive - and sometimes abysmal - once a substantial advance has occurred.

Fast forward to the present, and the lessons that we should keep in mind here. First, it matters critically to long-term investors whether stocks are priced to achieve strong or weak long-term prospective returns. Moreover, regardless of what segment of historical data one examines, there is enormous risk in market conditions that feature overvalued, overbought, overbullish conditions coupled with rising interest rates. It is crucial to understand that the valuations we observe today are nothing like the valuations of early 2009. At the trough, our estimates of 10-year prospective returns exceeded 10% annually (though our concern at the time was that we could not rule out the sort of sustained follow-through we've seen in other crises). At present, we estimate that the 10-year prospective total return for the S&P 500 is just 3.2% annually. The Shiller P/E is currently about 24.

Risk premiums are no longer wide - they are dangerously compressed. Bullishness is excessive. Interest rates are rising. While the conditions we observed in early 2009 had mixed implications depending on whether one considered U.S. post-war data or data from other periods of credit crisis, the implications of the present set of conditions is unequivocal regardless of which data set one chooses.

If we can clear out any component of this syndrome - most likely the overbought or overbullish components - without a substantial deterioration in market internals, there will be enough ambiguity in market conditions that we can expect to accept at least a moderate exposure to market fluctuations. The ensemble methods that we've implemented in recent months have expanded the range of Market Climates we identify, so shareholders can expect to see more variation in the market exposure we accept than we've had in recent years. But without clearing some component of the present, hostile syndrome, we are simply in a set of conditions that has rarely worked out well in any subset of the data we consider - even during "uptrends" from a technical standpoint, even during "seasonally favorable" conditions, and even in periods when the Federal Reserve was easing monetary policy conditions.

Undoubtedly, the "unpleasant skew" that we've observed in recent months has been a challenge, as has the equally skewed performance of individual stocks toward cyclicals, commodity stocks, speculative small-caps, and highly-indebted, inconsistent businesses that we typically avoid as "low quality." Given how extended some of these speculative trends have become, and the hostile nature of the present set of market conditions, I certainly expect this to be resolved, but there's no assurance that we'll observe that resolution over the short-term.

From its all-time high in 2008, the Strategic Growth Fund is down about 16%, with about 12% of that decline occurring since mid-2010 in response to the simultaneous speculation in 'risk assets' and punishment of 'stable assets' that was triggered by QE2 (which I continue to view as the Emperor's Clothes). That's certainly a tough loss for us, which is saying something in a market that has lost more than 50% on two separate occasions in the past decade alone. Having broadened the set of Market Climates we define, and having introduced robust methods to allow us to combine the implications of multiple data sets in a satisfactory way, I'm comfortable that our long-term strategy is well suited to a far wider range of market environments than even we anticipated in 2008.

It's imperative to learn the right lessons from market. While simple aphorisms such as "don't fight the tape" and "don't fight the Fed" are appealing, their performance can be tested historically and their shortcomings can easily be evaluated. The lessons of recent years emphatically do not include the notion that trends should be blindly followed, or that an "easy" Fed can be trusted to defend the market against losses in a speculative environment. In our view, good lessons can be demonstrated to be valid in historical data, and good research improves the expected long-term performance of a strategy without substantially increasing the depth of its periodic losses. This remains our focus, and is the basis of the confidence we have in our investment discipline.

On the subject of the long-run (which we generally define as at least one complete market cycle measured from peak-to-peak or trough-to-trough), another favorite quote of speculators here is Keynes' remark that "The long-run is a misleading guide to current affairs. In the long run we are all dead." Once again, this quote is taken far out of context. Keynes was speaking about monetary reform, arguing that government intervention was necessary to control inflation, and that economists could not simply comfort themselves that the price distortions and misallocations resulting from inflation would be eliminated over time. With respect to investing, Keynes' views about the long-run could not be clearer: "I should say that it is from time to time the duty of a serious investor to accept the depreciation of his holdings with equanimity and without reproaching himself... An investor should be aiming primarily at long-period results."

Personally, I prefer self-reproach and self-criticism to a lack of reflection, but I also believe that abandoning long-term discipline in order to "fix" short-term returns is a mistake more often than not. We're excited to implement new research when we're convinced it will improve our process, but otherwise, we focus on adhering to our long-term investment discipline even in the face of short-term setbacks. I've always had a straightforward investment philosophy - find a set of actions that you believe will produce results if you follow them consistently, and then follow them consistently. We continue to approach each day with that objective.

QE jumps the shark

On Monday, Wall Street let out a collective squeal of excitement as Thomas Hoenig, the president of the Kansas City Federal Reserve said that QE3 "may get discussed" if economic progress turns out to be disappointing as the year progresses. Part of the subtext that was lost in this enthusiasm is that Hoenig has consistently dissented on the policy of quantitative easing, and has called for the Fed to immediately raise interest rates to 1% and possibly higher. In saying that QE3 may get discussed, he wasn't offering hope to Wall Street, but was instead criticizing the existing policy of the Fed. The way to understand the comment is to put it in the context of Hoenig's long-standing dissent and open criticism of quantitative easing. My guess is that his complete remark was something like "The current trajectory of Fed policy is dangerous. When will it stop? Who knows? Aside from fueling speculation and inflation risk, QE2 won't help the real economy, but if the numbers are disappointing, even more reckless policies like QE3 may get discussed." Last week, Hoenig warned of another boom-and-bust cycle, and repeated his call for the Fed to reverse course, saying "I hope I'm wrong. I hope they're right. But I don't think so."

Near the end of the old TV series Happy Days, as the writers became desperate for material, there was an episode where Fonzie jumped his waterskis over a shark. That episode was widely viewed as the point where the show had simply gone on too long. My impression is that the sudden hope for QE3 is Wall Street's version of jumping the shark.

Look, if the Fed successfully completes its current program of quantitative easing, individuals, banks and other parties in the U.S. economy will have to collectively hold 16 cents of base money (currency and bank reserves) for every dollar of nominal GDP. The willingness to hold base money is a tight function of the level of interest rates - since base money doesn't bear interest, high levels of base money (relative to nominal GDP) must be accompanied by low short-term interest rates, otherwise the yield competition reduces the willingness to hold the paper money and you get inflationary pressures. In order for the economy to choke down 16 cents of base money per dollar of GDP, short-term yields have to be held extremely close to zero, and the prospective returns on other far less perfect substitutes (such as stocks) also have to be suppressed. At that point - which is about where we are already - upward pressure on any competing yield, short-term or otherwise, will produce inflationary pressure unless the Fed responds by quickly contracting the monetary base to compensate.

If you examine the historical data (see Sixteen Cents - Pushing the Unstable Limits of Monetary Policy ), it's clear that the U.S. economy has never been willing to carry more than 9-10 cents of base money per dollar of nominal GDP, except when Treasury bill yields have been well below 2%. By the time the Fed completes QE2, the U.S. monetary base will be about $2.4 trillion, versus nominal GDP of about $14.9 trillion.

It's fairly straightforward to estimate (see the Sixteen Cents article for more formal calculations) that in order to accommodate short-term interest rates even in the 1-2% range without inflationary pressure, we would presently require the monetary base to contract to $1.4 trillion - still far higher than the pre-1998 norm of $800 billion, but $1 trillion less than what will be outstanding once QE2 is completed.

Carnegie Mellon economist Allan Meltzer, who is a well-respected monetary economist and former chair of the "Shadow Open Market Committee", wrote a piece last week in the Wall Street Journal ( Ben Bernanke's 70's Show ), which argued for an immediate increase in short-rates to about 1%. Meltzer noted "Current slow growth and high unemployment is not a monetary problem. The financial system has more than ample liquidity... perhaps most importantly, we need a new Fed policy to prevent 1970's-style inflation. Inflation is coming. Now is the time to head it off."

In my view, Meltzer is right, but I would qualify the timing of inflation pressures by carefully monitoring the level of short-term interest rates relative to the outstanding monetary base. If the Fed indeed completes QE2 and pushes the monetary base to $2.4 trillion, we'd better see the 3-month Treasury yield at roughly 0.05%. Even a yield of 0.25% would be incompatible with that level of monetary base, and would place upward pressure on inflation. Worse, any exogenous pressure (loan demand, reduction of default concerns, etc) pressuring short-term yields to even 1% without a corresponding contraction in the monetary base would generate near term upward pressure on the GDP deflator of about 20%, and a longer-run inflationary pressure of close to 90% - that is, a near doubling in the level of U.S. prices. Frankly, I doubt that we'll observe that, but that's another way of saying that the Fed is likely to be forced into a very hard reversal of its present course unless economic conditions stay weak enough, and credit fears remain strong enough, to hold short-term interest rates at roughly zero.

Market Climate

As of last week, the Market Climate for stocks was characterized by strenuous overvaluation, coupled with overbought, overbullish conditions, and rising interest rates, to complete a syndrome that has historically been hostile to stocks. As I've noted in other instances of this syndrome over the past decade, this combination of factors tends to be accompanied by what we call "unpleasant skew" - a series of small but persistent advances to successive marginal new highs, typically followed by an abrupt vertical decline that can wipe out weeks or months of upside progress within a few sessions. We continue to work on methods to better identify when these stretches of ultimately unprofitable marginal highs are likely to end, in hope of being able to capture the advancing portion better, but the abruptness of the declines is disconcerting, and - at least in our existing research - doesn't seem to lend itself to much predictability once the basic syndrome is in place. The financial markets simply aren't that precise, so we are forced to deal with averages and probabilities.

Both the Strategic Growth Fund and the Strategic International Equity Fund remain tightly hedged here. We've had some good opportunities to shift our portfolio mix in Strategic Growth to reduce our sector overweights and underweights, but given our strong long-term stock selection record, we continue to focus on our knitting - which favors predictable long-term cash flows, reasonable valuation, consistent growth, and margin stability. To some extent, I agree that there is a longer-term case for commodity exposure in our equity portfolios, but I continue to see the recent exaggerated relative strength in what we view as "low quality" as a short-run phenomenon born of blind faith in QE.

That said, as soon as we clear some element of this condition (provided we don't also get a substantial deterioration in market internals), we expect to immediately exercise the latitude to accept at least a moderate exposure to market fluctuations. A more significant correction that (initially) includes a major deterioration of market internals could create the eventual opportunity for a larger and more sustained exposure to market fluctuations, but we'll take our evidence as it comes. Whether our next shift is moderate and transitory (which would probably require only a 5-7% pullback), or large and durable (which would follow a more substantial correction), our exposure will be essentially proportional to the return/risk tradeoff we observe based on the Market Climate we identify. At present, the Market Climate here is associated with a steeply negative Sharpe ratio, and we don't take well to the notion that Ben Bernanke has little dials at his fingertips which precisely control the financial markets. Frankly, we seriously doubt that Bernanke has any sense at all of the needless and ultimately damaging speculative risks he has created.

In bonds, the Market Climate last week was characterized by relatively neutral yield levels and unfavorable yield pressures. The pickup in the ISM Purchasing Managers Index tends to correlate with higher yield pressures, but interestingly, the correlation between the PMI and subsequent stock market returns is negative, with present readings historically correlated with flat or negative returns over the following 3-12 months. The Strategic Total Return Fund continues to carry a duration of only about 1.5 years. The Fund presently holds just over 8% of assets in precious metals shares as well, which is a moderate but not aggressive position for us. A more aggressive position would most likely accompany evidence of economic weakness and a downturn in long-term Treasury yields (particularly downward pressure on real yields, which would create significant additional pressure on the U.S. dollar). For now, our precious metals exposure remains moderate.

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