September 26, 2011
Not Over by a Longshot
On Friday, the yield on 1-year Greek government bonds closed above 135%. As I've noted in recent weeks, the bond markets continue to reflect expectations of certain default on Greek debt. All they are working out now is the recovery rate. As of last week, the expected recovery rate implied by bond prices stands at about 43% of face value. Since Greece is still running a primary deficit (it can't pay its bills even if debt servicing costs drop to zero), my impression is that the eventual default may be even worse. Still, if I were to venture a guess, it would also be that Greece will be given a small amount of new funding in the coming weeks in order for the government to continue running and delay the inevitable. The reason is that Europe needs time to better prepare for a default, and European leaders appear to be scrambling to get banks to bolster their capital as quickly as possible (somehow investors responded to that news with a short-lived rally last week, as if the need to accelerate the timeline for banks to acquire additional capital is a good thing).
If you're attentive to how European leaders are phrasing things these days, you'll notice that (except for officials in Greece) they've stopped saying that Greece itself will not be allowed to default, and instead insist that the European financial system and the European monetary union will be defended. While it's possible that the equity markets will mount a relief rally in the event of new funding to Greece, it will be important to recognize that handing out a bit more relief would be preparatory to a default, and that would probably be reflected in a failure of Greek yields to retreat significantly on that news.
As for the euro itself, we presently estimate the value around $1.42, which wouldn't change much unless Europe inflates to avoid peripheral defaults. Ultimately, the value of a currency is determined by relative price levels and interest rates (see Valuing Foreign Currencies ). While the euro may come under pressure as default concerns develop, we actually expect the euro to survive among its strongest members, with some fiscally unstable peripheral members exiting and pegging instead. So we're not particularly compelled by the notion that the euro will collapse if Greece fails, and with European equities looking increasingly reasonable on a valuation basis, we're inclined to use significant further weakness as a longer-term opportunity. Massive buying of peripheral debt by the European Central Bank would dramatically weaken the prospects for a stable euro, but there seem to be more responsible policy makers overseeing the ECB than we have at the Federal Reserve.
On the bright side, our estimate of the return/risk profile for stocks moved from hard-negative to more moderately negative last week. It's a start. Undoubtedly, the best chance for a sustained advance (aside from short-term spikes on short covering or bailout hopes) would be for that advance to begin from significantly lower levels. Unless we observe a robust improvement in market internals from current levels, which appears doubtful given further confirmation of oncoming recession, the broad ensemble of data we observe doesn't offer much latitude to establish a constructive position based on, say, weak technical reversals or other scraps that the markets might toss out in the near term. The first 13 weeks of a recession are among the most predictably hostile periods for equities in the data. We'll take our evidence as it comes, but the primary risks - recession, default and global credit strains - continue to increase
As for valuations, our estimate of 10-year total returns for the S&P 500 has now climbed to 5.7% annually, albeit with the significant risk of losing perhaps 4 to 6 times that amount in the next year or so - most likely followed by much higher average returns in the back years, sufficient to bring the 10-year average back up to 5.7% overall. Needless to say, we're inclined to wait on a shift in evidence - at least enough to push the expected return/risk profile positive - before taking on significant market exposure.
Gold and gold stocks were whacked last week, which despite the discomfort is actually a good sign from a "Sornette-type bubble" standpoint. Parabolic ascent, if not regularly and materially corrected, is a sign of extreme, almost arrogant overconfidence that typically precedes true crashes. Though we're convinced that the economy is moving into recession, there is actually little evidence of poor performance for gold shares during recessions (certainly nothing like what we see in the broad equity market). Gold shares are generally more sensitive to the trend of Treasury yields, and real inflation-adjusted yields in particular (rising real yields are generally unfavorable). Moreover, the ratio of spot gold to the XAU is now at a record high, so even in the event of a more protracted decline in the metal, it is not clear that the equities will follow. The selloff appeared to be a reflex provoked by the need for some market participants to raise cash, with a relative desirability of selling the biggest gainers. We continue to estimate a strong expected return/risk tradeoff in precious metals shares, but given the volatility, even a 20% allocation in Strategic Total Return is sufficiently constructive in my view, and limits the potential for major discomfort even in the unexpected event that gold retreats significantly more.
Learning from History
I continue to expect that the coming years will contain far more disruptive behavior in the economy and the financial markets than investors may be conditioned to believe is "normal" from a post-war standpoint, and especially from the misleading experience of the recent bubble period. As Jeremy Grantham said last week, "This is no market for young men," meaning that unless you are a crusty veteran of market turbulence, it is dangerous to base investment decisions on beliefs about what ought to be "normal" (the bubble-based benchmarks that Wall Street analysts are applying price-to-forward-operating earnings, and their willingness to bake in the assumption of record profit margins for the indefinite future, is a good example of this danger).
I've always believed that the best supplement for age is data, which is why data is our largest expense next to payroll (as a side note, though we often get requests, our licenses prevent redistributing raw data). Once the credit crisis forced us to contemplate Depression-era outcomes, I admittedly took shareholders through some frustration during 2009 and 2010 as we reconfigured our methods to reflect data well beyond the post-war period, but as we are likely to experience conditions that are "out of sample" relative to recent decades, it was critical to have methods that performed strongly in data from as many periods as we could get our hands on. I believe that investors will invite difficulty if they simply assume that we live in a world of short recessions and automatic expansions, or base their valuation estimates on forward operating earnings using benchmarks reflective of the recent bubble period, or assume an economy that is obedient to Wall Street's perennial expectation for every downturn to be rescued by "a rebound in the second half." The ensembles are effective in reducing our reliance on any specific model or period of time.
I should note again that our ensemble methods, had they been in hand at the time, would not have supported an investment position that was nearly as defensive as we were in practice during much of 2009 and early 2010. They would, however, have been strongly defensive since about April 2010 (as we were in practice), and of course, have been defensive since we put them into use late last year. Still, we've had several periods of modestly constructive exposure since then, and are continually open to opportunities to establish market exposure at points where the expected return/risk profile of stocks becomes positive. So while more than a decade of dismal market returns has largely validated our generally defensive investment stance (and conversely, our defensive stances have generally anticipated dismal market returns), I expect that we are well equipped to identify constructive opportunities even if the market continues to have challenges in producing durable returns for a while. On the brighter side, we also expect to eventually have a market that is priced to achieve both strong and durable long-term returns, as we've had for much of market history outside the past 15 years or so, and in those environments we'll typically be able to get along without any hedge at all.
From an economic standpoint, it is also essential to approach the oncoming downturn with an understanding of history. On that note, the McKinsey Global Institute put out a report last year (Debt and Deleveraging: The global credit bubble and its economic consequences ) that provides a useful context for what we are now observing:
"While we cannot say for certain that deleveraging will occur today, we do know empirically that deleveraging has followed nearly every major financial crisis in the past half-century. We find 45 episodes of deleveraging since the Great Depression in which the ratio of total debt relative to GDP declined, and 32 of them followed a financial crisis. These include some instances in which deleveraging occurred only in the public sector; others in which the private sector deleveraged; and some in which both the public and private sectors deleveraged simultaneously. The historic episodes of deleveraging fit into one of four archetypes: 1) austerity (or 'belt-tightening'), in which credit growth lags behind GDP growth for many years; 2) massive defaults; 3) high inflation; or 4) growing out of debt through very rapid real GDP growth caused by a war effort, a 'peace dividend' following war, or an oil boom [for oil-producing countries].
"The historic episodes show that deleveraging can occur through different macroeconomic channels. These either reduce the growth of credit, increase nominal GDP growth, or both. The 'massive default' archetype results in deleveraging by reducing the outstanding stock of credit as loans are written down. The 'high inflation' archetype works by increasing nominal GDP growth. The 'growing out of debt' archetype works through a marked acceleration of real GDP growth, which historically has been the case only in war time or during commodity booms.
"The 'belt-tightening' archetype was by far the most common of the four, accounting for roughly half of the deleveraging episodes. If today's economies were to follow this path, they would experience six to seven years of deleveraging, in which the debt-to-GDP ratio declines by about 25 percent. Deleveraging would begin two years after the start of the crisis, and GDP would contract for the first two to three years of deleveraging, and then start growing again. [This] archetype works by slowing credit growth and increasing net saving while maintaining nominal GDP growth. Other channels, such as defaults and inflation, can also play a role in belt-tightening episodes. The difficulty is how to support nominal GDP growth as private saving increases, since that implies a reduction in consumption growth. If households save more and businesses invest less, GDP will be reduced unless it is supported by another factor.
"It is doubtful today that one single macroeconomic factor will enable deleveraging, given the large sizes of the economies involved. It is more likely that deleveraging will occur through marginal improvements in many factors: some improvement in net exports, perhaps some increase in labor force participation, further defaults, maybe some inflation, and hopefully sustained productivity growth. Policies to enable and support these changes will be critical.
"Several features of the crisis today, including its global nature and the large projected increases in government debt, could delay the start of deleveraging and result in a longer period of debt reduction than in the past. In past episodes, a significant increase in net exports often helped support GDP growth during deleveraging. But it is unlikely today that the most highly leveraged major economies could all simultaneously increase their net exports. Moreover, current projections of government debt in some countries, such as the United Kingdom, the United States, and Spain, may offset reductions in debt by households and commercial real estate sectors. We therefore see a risk that the mature economies may remain highly leveraged for a prolonged period, which would create a fragile and potentially unstable economic outlook over the next five to ten years. They may then go through many years in which, all else being equal, GDP growth is slower than it would have been otherwise as debt is paid down. These highly leveraged economies may therefore remain vulnerable to economic shocks for some time.
"At this writing , the deleveraging process has barely begun. Each week brings news of another country straining under the burden of too much debt or impending bank losses from over-indebted companies. The bursting of the great global credit bubble is not over yet."
How to Restructure a Major Bank
And finally, since by all appearances we are likely to observe further strains in the banking sector, both on account of Greek concerns and as a follow-on to likely economic weakness, it is a good time to review some comments on bank restructuring by Robert Hall (the Chairman of the NBER's Recession Dating Committee and one of my former dissertation advisors at Stanford), and economist Susan Woodward. This from 2009, but equally applicable today. Hall and Woodward include some technical details, but the upshot is that there is no reason to believe that banks need to be bailed out at every turn, or that bank bondholders have to constantly be made whole, in order to protect depositors or maintain an intact financial system:
"Economists are increasingly puzzled by the government's treatment of banks and other financial institutions that are teetering near insolvency. The doctrine is widely accepted that institutions in this state are a danger to the economy (because their incentive is to take some big risks to try to get out of the hole, as the S&Ls did in the 1980s) and that regulators should take prompt, aggressive action to return them to sound financial condition. This doctrine calls for institutions to be reorganized or recapitalized so that they are unambiguously solvent and the consequences of risk-taking are mainly their own. The government's actions for Chrysler and General Motors follow the doctrine. In Chrysler's case, bankruptcy converts the claims of debtholders into equity, making its new relationship with Fiat financially attractive to Fiat. General Motors may be able to continue as a stand-alone automaker if the claims of its debtholders, including the debt-like claims of retirees, become equity.
"By contrast, the government's current policy for all large financial institutions is to dribble taxpayers' funds into the institutions so that they can meet their stated obligations to all parties, including debtholders, but just barely. The government injects funds into AIG, Citigroup, the Bank of America, and many other institutions to keep them just above water. The government has forgotten the doctrine of immediate full recapitalization in the case of financial institutions, despite the clear lessons of international experience. The Scandinavian countries aggressively reorganized and recapitalized banks after the crisis of the early 1990s and quickly restored full employment and growth; the Japanese followed the policy of supporting marginal banks for what became the 'lost decade.'
"The celebrated stress tests illustrate the current policy perfectly. The stress test takes the current condition of the bank as the goal for the future. The test has nothing to do with ensuring that banks are heavily capitalized, ready to resume their normal roles in the economy. The stress test is the right way to figure out the minimum amount needed to inject in weak banks to keep them barely afloat, but that is the wrong policy. The government turned to stress tests, it appears, out of discomfort with the answers the standard capital tests gave, based on seeing that properly measured capital was adequate in relation to obligations.
"The effect of the government's current policy is to pay off all claimants on financial institutions at face value, including those which, when they were first issued, had no expectation of federal bailout and received substantial interest premiums on account of their willingness to accept the risk of default. There are much better uses for federal money than handing capital gains to debtholders.
"If an institution has substantial amounts of debt outstanding that is subordinated to all other claims, reorganization is fairly simple. The danger to the institution is that the subordinated claimants will put the institution into bankruptcy at some future time when the institution fails to make required payments to those debtholders and that the bankruptcy will plunge the entire organization into Lehman-like chaos. To sidestep this danger, the reorganization alters the claims of the subordinated debtholders so that they cannot trigger a bankruptcy or so that the bankruptcy that they can trigger does not interfere with the activities of the institution.
"The first approach is easy. It is the one that the government pushed on the debtholders of the automakers–convert debt to equity. With new powers granted by Congress, the government could figure out a conversion value for a large amount of debt that gave the debtholders the same market value as equity as they currently enjoy. The debtholders would suffer no capital gain or loss. As the experience with automakers' debt showed, it is virtually impossible to achieve such an exchange voluntarily, because both sides will play “chicken” until adult supervision intervenes. The compulsion of new law is necessary.
"If a borderline institution lacks enough fully-subordinated debt to achieve an adequate level of capital by converting debt to equity, longer-term debt could be treated as if it were fully subordinated. Again, the debtholders could be given equity equal in value to the market value of the debt they gave up. In this case, the claimants subordinate to the converted debtholders would enjoy a captial gain, at the cost of the shareholders.
"Actual exchanges of debt for equity are not needed to recapitalize shaky institutions. Recall that the goal is to prevent bankruptcy from interfering with substantive business, not to prevent bankruptcy entirely. Reorganizing an institution so that the debtholders retain a debt claim is practical. If the institution suffers further losses in value which cause it to default on the debt, a bankruptcy will occur. Our earlier post (The Right Way to Create a Good Bank and a Bad Bank) described how to do this. In brief, the debtholders' and existing shareholders' claims are moved to a holding company (if they are not already in a holding company) which owns all of the equity in the operating institution. Some people, including us in our earlier post, called the holding company the “bad bank” and the operating entity the “good bank.” If the earnings of the operating institution are insufficient to meet the obligations to the debtholders at some future time, the holding company does a simple Chapter 7 bankruptcy in which the debtholders become the shareholders in the holding company, with no implications for the operating institution. This type of reoganization involves quite a few alterations in the contracts between the operating institution and its customers and counterparties, so it definitely requires the kinds of new powers that the Treasury has sought recently from Congress.
"The bottom line is that Congress and the taxpayers are intolerant of continued expenditures for bailouts that generate large capital gains for debtholders, that the bailout policy maintains shaky financial institutions while a better policy would deliver fully capitalized, reliable ones.
"Among economists, a consensus is forming that regulation of the financial instutitons that enjoy the government's protection should compel those institutions to have a structure that eases the type of reorganization discussed above (see the Statement of the Squam Lake Working Group , an alliance of leading financial economists). The simplest version is to require that banks hold fully subordinated debt and equity of, say, 40 percent of assets, in a holding company, in such a way that the bankruptcy of the holding company would not interfere even briefly with the immediate operations of the bank. As we discussed above, if the operations of the bank, paid as dividends to the holding company, could not meet the obligations to the debtholders, the holding company would go through a Chapter 7 bankruptcy and the bondholders would take over as shareholders. The Squam Lake proposal would sidestep the bankruptcy by designing the debt to convert to equity on its own terms under adverse conditions.
"Under a requirement of substantial amounts of subordinated debt, bank deposits would become almost completely safe. Banks would be limited to financing their activities through deposits to the remaining fraction, 60 percent in our example above. For larger banks, this would not be a binding limitation."
As of last week, the Market Climate for stocks remained negative, but less so than in recent weeks. Strategic Growth and Strategic International Equity remain well-hedged, but we are open to shifting to a constructive exposure if the evidence changes. The best likelihood for a sustained market advance is for that advance to begin from significantly lower levels, but we'll respond to the data as it evolves. In Strategic Total Return, we continue to have a duration of about 1.5 years, with about 20% in precious metals shares, about 4% in utility shares, and a couple of percent of assets in non-euro foreign currencies.
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