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June 13, 2011

Internal Injuries

John P. Hussman, Ph.D.
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Last week did a great deal of damage to our measures of market internals, suggesting that investors have shifted measurably toward risk-aversion in an environment where risk premiums are very thin. Historically, this combination of unfavorable valuations and unfavorable market action is strongly associated with a negative return/risk profile. However, we've also reached this point after six consecutive down-weeks, so the short-term condition of the market is fairly compressed and open to a fast, furious rebound to relieve that compression. The prospects for that would admittedly be better if there was less complacency among investors. Even after these consecutive declines, the CBOE volatility index (VIX) is still only about 18% (the VIX tends to spike toward 30% or higher at points where investors can reasonably be viewed as "fearful"). Likewise, though Investors Intelligence reports that the percentage of bullish investment advisors has pulled back modestly, most of them have simply gone to the "correction" camp, suggesting that the confidence in a rebound is still fairly universal. The percentage of bearish investment advisors remains way down at 22.6%.

Overall then, we're seeing a measurable and potentially dangerous breakdown of market internals in an environment where risk premiums remain very thin. Short-term conditions are fairly compressed, which invites a rebound, but the expectations for that have to be tempered by the still-complacent sentiment of investors. Indeed, about the only areas where we see real concern is in measures where such concern is actually predictive (rather than being a contrary indicator). These include widening interest-rate spreads in peripheral European debt, and surging credit-default swap spreads for major U.S. banks.

A few notes on the banking sector. My view continues to be that the massive interventions of recent years have essentially kicked the can down the road, encouraging a writing-up of assets that are still not performing. The same basic view applies to European interventions to buy time for countries like Greece and Portugal. The problem is that while we have bought time, at great expense, our policy makers continue to waste that time by failing to prepare the markets adequately for debt restructuring.

With fiscal and monetary palliatives stretched to their limits, it is beginning to appear that the global economy is "up the creek without a paddle" - but this really ignores the fact that the boat has a motor, if we only had the courage to use it. That motor, which would be loud and uncomfortable to start, but would actually help to get the economy moving again, is debt restructuring. In some cases, such as Greek debt, this will require actual losses - a form of debt forgiveness. In other cases, such as U.S. housing, it is possible to restructure the payment stream without the need for subsidies or massive losses (though there will be some adjustment). Last week's comment details my views on property appreciation rights as one avenue to coordinate this and revive a functioning housing market.

Presently, the major issue relating to banks surrounds the question of capital requirements. Late last year, international banking negotiations known as "Basel III" adopted a guideline to require banks to hold capital (equity and retained earnings) in an amount of at least 7% of risk-weighted assets. Technically, the figure is 4.5%, with a 2.5% buffer during periods of "excess credit growth." Below those thresholds, banks would be required to raise more capital, with regulators expected to exercise resolution authority if bank capital dropped below 4% of assets.

The discussion now is about the additional margin-of-safety that large systemically-important banks should be required to hold - the likely figure being about 3% - which would put the total capital requirement as high as 10% of risk-weighted assets, for major banks during periods of rapid credit growth. That would still allow these banks a 10-to-1 leverage ratio - which given the range of default rates on various classes of bank debt, is appropriate, and not unreasonably restrictive. That's especially true because debt created at points of rapid credit growth is often of fairly low-quality, as we saw in the aftermath of the housing bubble. Lehman and Bear Stearns ran leverage ratios near 30, with disastrous results. Fannie and Freddie's leverage multiples were even higher, at about 40. You might recall that Long-Term Capital Management also ran at a leverage multiple of about 40-to-1 before it imploded. It's probably worth noting that according to the Fed's consolidated balance sheet as of June 8, Ben Bernanke has now taken the Federal Reserve's leverage ratio to 53.4. Fortunately or unfortunately, U.S. taxpayers would automatically end up subsidizing any Fed losses, so unlike commercial banks, the Fed could actually go insolvent without major consequences.

After significant price weakness, the banks advanced late Friday when CNBC suggested - without any identified source - that the additional capital buffer for major banks might end up being closer to 2-2.5%. A lower capital cushion would put the allowable leverage ratio at about 11 in periods of rapid credit growth and as high as 15 otherwise. Undoubtedly, part of the pressure to ease the requirements is due to the fact that bank stocks have been declining. It's ironic that the proposals most likely to boost bank stocks are those that would make the banking system more systemically vulnerable and more likely to require government bailouts. But that's essentially how option pricing works. If your downside risk is covered, higher volatility actually increases the value of the option. For our part, we're 100% behind FDIC head Sheila Bair - "On obvious things like higher capital standards, I say full speed ahead and the higher the better."

From an economic standpoint, the last several weeks have generated more damage than may be readily apparent. Credit spreads are now wider than they were 6 months ago, the ISM Purchasing Managers Index is below 54, total non-farm payroll growth is far below 1.3% over the past year, and the spread between 10-year Treasury yields and 3-month T-bill yields is less than 3.1%. If the S&P 500 was to fall by about 2% further, it would also be lower than it was 6 months ago. The reason I note these particular measures is that they combine to form the "Aunt Minnie" that I noted in our November 2007 comment "Expecting A Recession" - a combination of indicators that has always and only been observed prior to or fairly early into post-war U.S. recessions.

Notably that particular composite did not signal recession risk in the summer of 2010. Based on the historical tendency of the ECRI weekly leading index (WLI) to deteriorate in advance of the ISM indices with a lead-time of several weeks, my double-dip concerns in 2010 were driven by the clear plunge in the WLI. But the ISM figures never dropped to 54 or below, and in any case, the Fed's initiation of QE2 provoked a burst of enthusiasm and pent-up demand sufficient to buy some time. The problem now is that we have bought the time and wasted it, because policy makers have done nothing to either facilitate or reduce the impact of necessary debt restructuring.

My argument here is not that the economy is headed for a fresh recession (though a further loss in the S&P 500, continued weakness in the ISM, widening credit spreads, a sudden drop in the "future expectations" component of consumer confidence relative to the "present situation" component, a quarterly decline in aggregate hours worked, falling capacity utilization, and a flattening yield curve would all contribute to evidence in that direction). Nor do I think that we necessarily need a "day of reckoning" where debt strains again reach crisis levels (though I also remain unconvinced that we should rule it out). Rather, my view is that the economy retains most of the key vulnerabilities it did in 2007, including re-established overvaluation and an overhang of unserviceable debt.

Clearly, there are intense efforts underway to reduce the requirement for banks to carry more capital, and the FASB has now effectively abandoned even modified versions of mark-to-market, which could have included reasonable approaches such as 3-year averaging. From our perspective, the problem in the economy is not that banks are over-regulated, but that they are quietly holding a large amount of non-performing assets, and remain unlikely to expand their risk portfolio further. Either we subsidize these assets for years through interest rate spreads that are hostile to depositors, small savers and the elderly, or we initiate approaches to allow the existing debts - particularly mortgages - to be reasonably restructured. Policy makers seem to be on a fairly strong course in favor of the first option - essentially allowing a zombie banking system like Japan's. It's a choice, but it comes with the consequence of anemic economic prospects.

Market Climate

As noted above, market internals deteriorated notably last week, suggesting a measurable shift among investors toward risk aversion. The compressed short-term condition of the market invites something of a rebound, particularly given that markets frequently advance toward prior support once they break below it. Still, the relative complacency evidenced by a low volatility index and muted bearish sentiment give us the impression that there are still more potential sellers than willing buyers at nearby prices. Value investors will eventually be interested, but probably at much lower levels (even with the recent decline, our 10-year total return projections for the S&P 500 have barely cracked 4%). Meanwhile, the QE2 trade is essentially unwinding, and our impression is that the Fed's balance sheet is extended enough to make QE3 a difficult (though not impossible) sell. Further economic and market weakness might modify that possibility, but it's not clear how much latitude would be possible for a Fed that is now operating at more than 53-to-1 leverage.

For our part, we've made every attempt to give the market the benefit of the doubt, by rolling down index put strikes as the market has declined, and holding a put-only hedge against 20-35% of the Strategic Growth Fund's stock portfolio (varying the effective exposure of the Fund between a tight hedge and 10-20% exposure to market fluctuations). Given that market internals have now broken down significantly on our measures, we require either a recovery of market internals or a large improvement in valuations to warrant a significant exposure to market fluctuations. Accordingly, we've slowed our willingness to reduce strike prices and the like, so our hedge should be fairly tight in the event of further market weakness. Strategic International Equity is tightly hedged here as well.

Recovering market internals would be easier than significantly improving valuations, of course, but that also requires some uniformity of improvement across a wide range of measures (breadth, credit spreads, leadership, and numerous industry groups and security types) that are currently going strongly in the wrong direction. That doesn't make a reversal impossible, or even particularly unlikely, but it does suggest that the "quality" of a rebound - in terms of uniformity across a large range of market internals - will be critical in improving the prospective return/risk profile of the market.

In bonds, the Market Climate remains generally constructive, but not aggressive, with unfavorable yield levels largely offset by favorable downward pressures on yields and now widening credit spreads as well. The Strategic Total Return Fund continues to have a duration of about 3 years, meaning that a 100 basis point change in interest rates would be expected to affect the Fund by about 3% due to bond price fluctuations. Notably, and in contrast to the broad stock and bond markets, our measures of prospective return/risk in gold shares has surged, with falling long-term yields, negative real interest rates, weakening economic statistics and a very high gold/XAU ratio all provoking a distinct jump in our expected return/risk measures for gold stocks (see my 1999 article Going for the Gold for a discussion of some of these factors). Accordingly, we've built Strategic Total Return's exposure to precious metals shares to nearly 18% of assets, which is significant, but far from the most aggressive 30% exposure that the Fund could hold (which would require stronger inflation pressures and a weaker ISM, combining to create severe pressure on the U.S. dollar). Even near 18% of assets, however, fluctuations in gold stocks are likely to be the most important driver of day-to-day fluctuations in the Fund here.

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