Beyond Sub-Prime

John P. Hussman, Ph.D.
All rights reserved and actively enforced.
Reprint Policy

Ever watch those old Road Runner cartoons where the Wile E. Coyote goes over the edge of a cliff holding an anvil and just hovers there for a moment, while it sinks in that he's in trouble? That's about what this market feels like. In particular, the current environment in housing, financials, and the stock market feels a lot like what we observed in the dot-com bubble in the late 90's. It was the clear (or should have been) that speculation had gone too far, and that the excessive bullishness of investors would probably end badly. But even after individual stocks began to collapse, many investors maintained hope until it was far too late.

We don't rely on further weakness in the housing market or the stock market here, but we certainly shouldn't rule it out. Presently, we've even got a modest positive exposure to stock market fluctuations - essentially holding a limited position in index call options against an otherwise fully hedged portfolio. Still, the stock market is very close to suggesting that investors have abandoned their desire for risk-taking.

Meanwhile, stocks remain very richly valued. The bait taken by investors here is the belief that the market's "price-to-forward operating earnings" ratio is reasonable. Unfortunately, this morsel of bait carries a very sharp hook. "Forward operating earnings" did not even exist prior to the 1980's, and if one proxies it historically as Cliff Asness has done (based on how it relates to other fundamentals with longer records), you find that the historical norm of "price-to-forward operating earnings" is about 30% below current levels. Adjusting for the present elevation of profit margins, the normalized level is probably even lower.

In short, the evidence does suggest that investors are holding onto a thread of willingness to speculate, which allows us to hold a modest exposure to market fluctuations through call options here. But that thread is short and thin - another 2% of downside, say, on a weekly closing basis, would be enough to suggest breakage. So with valuations rich on the basis of historically reliable fundamentals, our investment position is constructed to behave as a fully-hedged stance fairly quickly into any further decline, while still retaining a modest benefit of the doubt through call options.

Beyond sub-prime

According to the latest Mortgage Bankers Association survey, the loan delinquency rate increased during the fourth quarter of 2006 for all loan types. For prime loans, the rate increased from 2.44% to 2.57%; for sub-prime loans from 12.56% to 13.33%, and for FHA loans from 12.80 to 13.46%. Delinquency rates increased both for adjustable rate mortgages as well as for fixed rate mortgages. Foreclosure rates also increased across the board, to a record high.

The latest FDIC quarterly banking report notes that non-current loans registered their largest quarterly increase in 6 years during the fourth quarter of 2006, while reserves for loan losses, as a ratio of loans outstanding, fell to the lowest level in more than 20 years. Non-current mortgage loans increased by 15.6% during the quarter, while construction and development loans that were non-current increased by 34.8%. These increases were fortunately off of relatively low levels, but they have undoubtedly continued into 2007.

Among all FDIC insured institutions, total assets represented $11.8 trillion at the end of 2006, of which about 40% were real-estate related loans. Though foreclosures currently represent just over 1% of total mortgage debt outstanding, it's important to remember that the average return on assets (earnings as a percentage of assets) in the U.S. banking system is also only about 1%. So any continuation in defaults will quickly find its way into earnings figures, either by provisions for loan loss reserves or by actual charge-offs.

Remember also that banks operate on a ratio of about $10 of assets (generally loans outstanding) per $1 of shareholder equity capital. So a 1% loss of existing loans can wipe out about 10% of shareholder capital. Since banks are required to hold such capital against their loan portfolio, wiping out capital also wipes out part of their ability to originate new loans. Importantly, bank capital requirements are a separate constraint from the reserve requirements placed on a bank's demand deposits

Note the difference. Reserve requirements apply to the liabilities of a bank (basically customer deposits), while capital requirements apply to the assets of a bank. If banks have insufficient reserves to meet, say, the demand of customers for cash, the Fed can intervene by buying up Treasury securities from banks and paying with reserves (this is what the FOMC really does when we talk about a "Fed rate cut"). Banks can then meet their obligations to depositors without having to call in loans. This is a legitimate "lender of the last resort" function for which the Fed actually does have a critical role (as I've noted elsewhere, except during banking crises, the Fed's powers to affect the economy are largely imagined). While some individual banks may be at greater risk than others, we should not be concerned about a general banking failure, precisely because of the Fed's ability to act as a lender of last resort.

But capital requirements impose a different constraint altogether. A Fed easing might loosen a binding constraint on bank reserves, but it does not increase shareholder equity capital. Loan losses still go straight to the bottom line, and if the losses are sufficient to reduce shareholder capital, they also limit the amount of new loans that banks can make. It's that risk of earnings weakness and "de-leveraging" of the U.S. financial system (not the risk of a general banking collapse), that is a growing concern here.

That is not to say that the Fed is anywhere close to "coming to the rescue" here. The latest inflation figures were fairly hostile to any hope for a near-term rate cut. Meanwhile, overall U.S. capacity utilization has pushed up to 82% - a level at which the Fed has historically been much more inclined to raise rates than lower them. To call this a "Goldilocks" environment where inflation and economic risks are balanced is like the proverbial image of the guy with his head in the freezer and his feet in the oven, saying the temperature is just right. Inflation and economic risks are balanced because both are unfavorable.

Yet even if the Fed were to cut rates, the implications for the stock market may be more disappointing than investors seem to believe. Bill Hester's latest research piece is a good reminder that context matters - the stock market's response to a Federal Reserve easing has historically been fairly poor in conditions that have resembled the present.

Market Climate

As of last week, the Market Climate for stocks was characterized by unfavorable valuations and tenuously favorable market action. The Strategic Growth Fund continues to hold a position that is essentially fully-hedged, but adds a moderate position in call options in order to maintain a limited exposure to market fluctuations. If the market declines substantially here, the Fund's profile would fairly quickly resemble a full-hedge. As always, the Fund also experiences day-to-day fluctuations related to the difference in performance between its individual stock holdings and the indices we use to hedge (the S&P 500 and Russell 2000). When the Fund is hedged (and provided that our long-put/short-call index option combinations have identical strike prices and expirations), this difference in performance is the main source of day-to-day risk, and is also the primary source of return for the Fund. The performance of the Fund's stock selection since inception is presented in the latest semi-annual report.