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June 18, 2012

A Brief Primer on the European Crisis

John P. Hussman, Ph.D.
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With Greek elections resulting in a fairly benign outcome that promises to hold the euro together in the near-term, the market may enjoy some amount of relief. The extent and duration of that relief will be informative. Based on broader factors, we don't expect that relief to survive very long, but we are willing to respond more constructively if our own return/risk measures become more favorable.

Our estimate of the prospective return/risk tradeoff in the stock market remains in the most negative 0.5% of historical instances. That said - and this is important - if market internals improve meaningfully over the next few weeks (measured across individual stocks, industries, sectors and security types), our estimate of the market's prospective return/risk profile would improve, despite what we view as rich valuations and a new recession. Very roughly speaking, this would require a solid rebound in market internals over a period of 2 or 3 weeks. That sort of outcome might accompany a Fed easing or other event, but our focus is on the measurable condition of market internals, not on Fed policy or other news per se. A positive shift in our measures of market action would likely be enough to ease back from our tightly hedged investment stance to a slightly constructive position. For now, we don't have the evidence to take anything but a very defensive stance, but we'll take changes in the evidence as they arrive.

It's fair to say that we don't foresee any development that would encourage us to remove a major portion of our hedges at present, and my personal expectation is that conditions are likely to deteriorate sharply rather than improve, but as always, I want shareholders to know where my attention is focused. Our measures of market action - and any meaningful improvement over the next few weeks - will be important in determining the whether we maintain a tightly defensive stance or shift to a slightly constructive one.

Investors have a large number of trees to occupy their focus - Greek austerity, Spanish banks, Italian yields, U.S. economic data, Fed policy, earnings preannouncements (just ahead) and so forth. On a day-to-day basis, developments on any one of these fronts may bring fresh concern or relief. The larger issue is that we suspect that the forest has already caught fire.

The global economy remains in a deleveraging phase - the difficult portion of what is known as the "financial cycle" - in the aftermath of a long period of excessive debt expansion and credit growth. Meanwhile, by our analysis, the U.S. has also now entered a recession in the business cycle (particularly based on what we infer from unobserved components methods, and also evidenced by observable factors such as weak growth in consumption and income, a dropoff in new orders and industrial production, an acceleration of negative surprises on short-leading indicators such as Fed surveys, and now even softness in short-lagging data such as new unemployment claims).

As researchers at the Bank for International Settlements have pointed out (h/t Cam Hui), "the financial cycle is much longer than the traditional business cycle. Business cycle recessions are much deeper when they coincide with the contraction phase of the financial cycle. We also draw attention to the 'unfinished recession' phenomenon: policy responses that fail to take into account the length of the financial cycle may help contain recessions in the short run but at the expense of larger recessions down the road."

To a large extent, the repeated monetary interventions of the past two years have been an attempt to contain the unfinished effect of the 2008-2009 downturn. Since we never restructured debt burdens, we never saw a sustained resumption of demand, so aside from short-lived bursts of activity on the heels of QE2, the Twist, and LTRO interventions, important leading economic indicators have hovered close to territory traditionally associated with recessions. Bill Hester notes that if we cluster broad economic data into two bell curves, one for recessions and one for expansions, the data of the past two years has generally resided in the very left tail of the expansion bell, and in the overlapping right tail of recession data. The softness in mid-2011 - and even more in late-2012 - fit the profile of an economy transitioning from expansion to recession, but large interventions pulled the economy from the brink. At present, the joint deterioration in the economic data is significantly worse than either of those instances. I doubt that a fresh Fed intervention will be sufficient to pull the economy from the brink this time, but we'll take our evidence as it comes.

With regard to the Federal Reserve, we do expect further monetary interventions, but doubt that further intervention will substantially stabilize, much less reverse, the Goat Rodeo of challenges that the economy faces. Specific options, in order of likelihood, are a) expanding dollar swap lines to increase the ability of European banks to access liquidity in the form of U.S. dollars; b) extending the length of the "Twist" program (whereby the Fed has sold much of its short duration holdings and replaced them with longer maturity Treasuries) by 3-6 months; c) "sterilized" QE3, whereby the Fed would purchase long-term Treasury securities, but require the proceeds to be held as reserve balances on deposit with the Fed. At close to 18 cents of base money per dollar of nominal GDP, and core inflation still running well above 2%, there is not much likelihood of massive, unsterilized quantitative easing. But I doubt that anything short of that will be satisfying to investors.

The upshot is that we continue to view market conditions as being among the most negative 0.5% of historical instances. Our analysis suggests that the U.S. has entered a new recession. Still, there is a significant prospect of further monetary interventions, and while we don't expect much of durable benefit from that, our focus is squarely on our own measures of market action. To the extent that we see material improvements in those measures, we would be inclined to ease our presently defensive position. My impression is that further Fed easing will be relatively weak and surprisingly poorly received by the market, but in the event our own metrics improve materially, we would respond with a more constructive stance. For now, we remain tightly defensive, and believe that the headwinds remain unusually strong.

Liquidity does not fix insolvency

With regard to the problems in Europe, investors have taken a great deal of hope from the promise of coordinated central bank "liquidity" operations in the event of deterioration. The problem here, in my view, is that whatever amount of liquidity central banks create, it cannot address the structural problem, which is insolvency and the need to restructure debt of peripheral European governments and the European banking system. Even if liquidity operations help to stabilize the markets, we will quickly return to a pattern of recurring strains. Make no mistake, Europe is in a solvency crisis. Central bank liquidity, coordinated or not, will not solve this problem.

As I noted in March 2008, at a similar point in the crisis cycle: "Think of it this way. A liquidity crisis is when you write a check for more than the amount in your checking account. You suddenly realize that you need to sell a big securities position to cover it, but selling everything at once might only get you "fire sale" prices. In this case, you need a loan for a few weeks to give you time to work out of your securities position. Without that short-term "liquidity," the check might bounce even though you really do have the assets to pay it off. In contrast, a solvency crisis is when the only asset you have to cover that check is an IOU from your Uncle Ernie, who keeps promising "I'll pay you every dime as soon as I win it back on the ponies."

Government always faces a "fiscal constraint" in that spending can only be financed in one of three ways: tax revenue, bond issuance, or money printing. In the "money printing" option, the government first issues debt, but the central bank permanently buys that debt and permanently creates currency. So a permanent purchase of debt by the central bank is effectively a fiscal operation - a solvency operation. In contrast, a liquidity operation involves a temporary purchase of government debt by the central bank, which creates new currency and bank reserves. But to be a liquidity operation, that operation must also be subsequently reversed so the government debt doesn't permanently reside on the central bank's balance sheet, and so that the money supply isn't permanently elevated.

Understanding this, it becomes clear that even coordinated central bank liquidity operations are at best a short-term response to European crisis. Indeed, even money printing by the European Central Bank itself can only address Europe's solvency crisis if it buys peripheral European debt without ever being repaid, and permanently creates new euros to do it. Indeed, at prevailing debt/GDP ratios, it is unlikely that the ECB would ever be able to reverse massive purchases of peripheral European debt without provoking a fresh crisis. It follows that massive purchases of peripheral debt would amount to an implied fiscal transfer from other European countries, since normally, all European countries would share in the "seignorage" revenue from new money creation. Not to mention that EU treaties would have to be changed to allow the ECB to rescue individual countries.

So the idea of a quick fix through ECB printing is an illusion - that solution would still effectively represent a massive fiscal transfer from other European countries, because the creation of new euros would otherwise be able to fund new spending within the Euro zone. Massive, permanent money creation might "save the euro" in its present form, but would also wreck the euro in substance through inflation and depreciation. The political decision is whether the people of Germany and stronger European countries want the euro enough to make permanent fiscal transfers (or permanent currency creation that amounts to the same thing) to peripheral European countries. The real fate of the euro rests with that political decision, not with central banks, and the final decision on that matter will not come without extreme disruption in any event. Maintaining the Euro will require European governments to cede their fiscal sovereignty to a central authority, and that will not be easy unless major disruptions make that choice better than the alternatives. Departing from the Euro would best be done in sequence from stronger-to-weaker (which would free the remaining countries to agree on whatever depreciation and inflation rate they choose), rather than weaker countries first, but any breakup path would be disruptive as well. The realistic perspective here is to accept the likelihood of significant and continuing disruptions from Europe, and to accept various investment risks within that context.

How did Europe get here? A brief primer on the European crisis

The root of the European debt problem is very similar to how we got the housing bubble in the US. Here, we deregulated the banking system in 1999 (by repealing the Glass-Steagall Act), but kept a government backstop in place for the banks. As a result, lenders could go ahead and do irresponsible things, knowing that they could piggyback on the good faith and credit of Uncle Sam if things went wrong, and that’s exactly what happened.

Similarly in Europe, the creation of the Euro gave European countries a common currency, which for a while allowed them all to borrow at very similar interest rates, regardless of whether that borrowing was responsible or not. As a result, Greece, Portugal, Spain and Italy, among others, were able to run significant budget deficits without being penalized for it, knowing that they could piggyback on the stronger European countries like Germany if things went wrong. To a large extent, the hope for Eurobonds is based on a yearning to return to those halcyon days where European countries could borrow without regard to their own individual credit standing.

The risks were made even worse by banking regulations that allowed banks to load up on European government bonds without needing to hold any capital against those bonds. That’s how European government debt problems and European banking problems got so intertwined.

The credit crisis in 2008-2009 threw a huge wrench into the works, because the recession caused all of those government deficits to balloon far beyond anything that was agreed on in the European treaties. Suddenly, the markets started treating each European country differently, with Greece being the first to have a crisis because their debt/GDP ratio was the highest.

Normally, when countries have a crisis, they have access to their own central bank, and can print currency to pay their debts, choosing whatever amount of inflation and currency depreciation that they are willing to endure. But this option isn’t as available to individual European countries because they share a common currency. As a result, if the European Central Bank prints money to buy Greek, Portugese, Spanish, or Italian debt, the larger countries – particularly Germany – implicitly pay for it. Likewise, if these countries seek loans from the whole European Union, the bulk of that money has to come from Germany and France, because two of the most indebted countries – Italy and Spain – are also the third, and fourth largest countries within the Euro, and would essentially be lending to themselves.

France has been more willing to continue those bailouts than Germany, because its banking system is so loaded with peripheral debt. Germany has insisted that in return for loans, these countries have to submit to much stronger control of their fiscal policy, with those controls coming from the outside. The fact that nearly every “easy” solution relies on Germany bailing out peripheral European countries is why “easy” solutions like Eurobonds or ECB money printing are so difficult, and why Merkel always seems to be the “holdout.”

So today, we have a world where European governments are hugely in debt, and European banks are hugely loaded up with European government debt, at very high leverage ratios (so small losses would wipe out capital). That has produced a series of bank runs in Greece, Spain and elsewhere.

From my perspective, the markets will not be durably satisfied with more “liquidity” because this is really a “solvency” crisis. Liquidity allows you to pay next week’s bills and get past the immediate crisis. Solvency means that you can actually pay off your debts over time. If you’re not solvent, the next crisis isn’t far away.

So how can Europe address these problems? A solvency crisis usually involves a mix of several pieces:

1) Fiscal discipline – So far, Europe has tried to solve the problem largely through “austerity” - forcing massive cuts in government spending in Greece and elsewhere. This is problematic because it typically deepens economic weakness, so that revenues fall, and the deficits actually get worse. Over a longer period of time, it’s possible to reduce the debt/GDP ratio through gradual changes in fiscal policy, particularly if interest rates are lower than the growth rate of the economy (which helps you to grow your way out of the debt), but focusing so much on austerity hasn’t been helpful. Germany has been focused on creating a “fiscal union” to provide stronger external control of budgets, but that sort of agreement would take time, because it would have to be approved by all of the EU member governments.

2) Bailouts – Germany has already loaned 11 billion euros to Greece, and its banks have lent 34 billion euros (for France, these loans to Greece are 8 billion and 53 billion respectively). They are clearly reluctant to lend more. A bailout fund – the EFSF (European Financial Stability Fund) which will shift to the ESM (European Stability Mechanism) has been set up for broader purposes, but again, the funding relies heavily on Germany and France, because the next two countries by size – Spain and Italy – are likely to be users, not net contributors. The continuation of bailouts is largely a political decision – how much the German and French people are willing to spend in order to sustain the euro and avoid bank restructuring. We may not have reached the limit, but we are probably not very far.

3) Debt restructuring - Greece has already restructured a good portion of its debt, with lenders taking actual losses, and terms being renegotiated. It’s likely that some European banks will eventually have to be restructured (which is different from a “bailout” in that a restructuring wipes out the stockholders and some portion of the bank’s debt, so that loans are written down and renegotiated, and bank owners actually take a loss), but so far, most of the efforts have centered on bailouts. Fortunately, it’s possible to restructure banks without depositors being hurt - the FDIC does this routinely - but as we saw in 2008, fear-mongering about “the system going down” can lead to a policy of bail-outs as a knee-jerk reaction. Suffice it to say that the financial industry prefers to fight debt restructuring tooth-and-nail.

4) Central Bank intervention – The central bank can buy government debt and creates currency in its place. If the purchases are only temporary, we call this a “liquidity injection.” But if the central bank never sells the debt, or if the government never pays off the debt, it ends up being money printing. The objection of Germany to more ECB intervention is not only that it would be inflationary, but that it would violate existing treaties, which prohibit the bailout of individual European countries. Germany’s terrible experience with hyperinflation in the 1920’s also colors its position here.

In the end, we’re likely to see a further combination of all of these responses, but even then, it’s not clear that the problems of the more indebted European countries can be resolved that way.

The bottom line is simple – Europe has repeatedly been successful at addressing its recurring liquidity crises with the help of other central banks, but it’s still an open question whether they can durably solve the solvency crisis without more disruption and more restructuring of both government debt and troubled banks. In my view, the hope for an easy solution is misplaced, and the likelihood of recurring disruptions from Europe will remain high.  

Market Climate

From present levels, we estimate a 10-year nominal total return for the S&P 500 of 5% annually, based on our standard methodology. As I've often noted, investors do not "lock in" projected returns - they ride them out. My impression is that a 5% projected return is unlikely to be anywhere near the best projected return that investors will have the opportunity to accept in the coming years. It's also helpful to remember that stocks have historically been priced at much higher prospective returns even in periods where interest rates were quite low. The whole "Fed Model" mentality has no support in data outside of the 1982-2000 period. It's actually an artifact of the simultaneous decline in interest rates and operating earnings yields during that specific period, but does not reflect any kind of informed "fair value" relationship, nor any statistical regularity that can be observed outside of that window.

A prospective 10-year return in the area of 9-10% annually would require the S&P 500 to move into the 850-950 range. Notice that long-term "secular" bull markets - which feature a succession of market cycles where each bull market peak achieves a higher level of valuation - have typically started from projected returns of nearly 20% annually. Whatever one believes about the durability of present valuations, it should be clear that we are nowhere near the start of a secular bull market, nor should we expect a secular bull market to emerge from next cyclical bear market trough (in the absence of utter catastrophe). Suffice it to say that in order to establish valuations consistent with prior secular bull market starting points, "S&P 500" would not just be an index - it would be an upside target.

All of that said, rich valuations don't always resolve into immediate weakness. To produce a really hostile market condition, rich valuations generally have to be accompanied by one of two factors: either unfavorable market action (measured across a broad set of market internals), or some specific syndrome of indicators (what we call an "Aunt Minnie") that captures an overvalued, overextended market that has lost some important driver. The most familiar Aunt Minnie is what we call an "overvalued, overbought, overbullish" syndrome, but we've seen a whole army of others in recent months. We presently have a window where an improvement in market action would not yet be accompanied by an Aunt Minnie sufficient to create downward pressure. So a meaningful improvement in market action here would ease our return/risk measures from strongly negative to modestly constructive - at least for some period of time. We don't have such an improvement in hand, we aren't extremely close to this kind of shift, and frankly, my personal view is that the market is more likely to suffer sharp weakness instead, but it's important that shareholders know what we are watching, and why. Presently, our closest attention is on our own measures of market action.

For now, Strategic Growth and Strategic International remain tightly hedged. Strategic Dividend Value is hedged at close to 50% of the market value of its stock holdings (its most defensive position). Strategic Total Return carries a duration of less than 1 year in Treasury securities, with a few percent of assets in utility shares and foreign currencies, and a bit less than 14% of assets in precious metals shares.

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