Passed Pawns

John P. Hussman, Ph.D.
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“Patience is the most valuable trait of the endgame player. In the endgame, the most common errors, besides those resulting from ignorance of theory, are caused by either impatience, complacency, exhaustion, or all of the above.”

– Pal Benko

I’ve long been fascinated by the parallels between Chess and finance. Years ago, I asked Tsagaan Battsetseg, a highly ranked world chess champion, what runs through her mind most frequently during matches. She answered with two questions – “What is the opportunity?” and “What is threatened?” At present, I remain convinced that the key opportunity lies in closing down exposure to risk, because prices in both bonds and stocks have been driven to the point where the prospective additional compensation for risk is extraordinarily thin on a historical basis, and much of these gains are the result of monetary interventions in perpetual search of a greater fool.

The final minutes of a Chess game often go something like this – each side has exhausted most of its pieces, and many pieces that have great latitude for movement have been captured, leaving grand moves off the table. At that point, the game is often decided as a result of some seemingly small threat that was overlooked. Maybe a pawn, incorrectly dismissed as insignificant, has passed to the other side of the board, where it stands to become a Queen. Maybe one player has brought the King forward a bit earlier than seemed necessary, chipping away at the opponent’s strength and quietly shifting the balance of power. Within a few moves, one of the players discovers that one of those overlooked, easily dismissed threats creates a situation from which it is impossible to escape or recover.

My impression is that investors have been so entranced by the moves of their two Knights – Ben Bernanke and Mario Draghi – that they have allowed an entire army of pawns to pass across the board without opposition. In Chess, those overlooked, seemingly insignificant passed pawns can draw away the opponent's resources, or even be poetically transformed into the most powerful pieces in the game.

What are those passed pawns? On the basis of normalized earnings (which correct for the cyclicality of profit margins over the business cycle, as stocks are very, very long-lived assets) our projection for 10-year S&P 500 total returns is lower than it has been at any point prior to the late-1990’s bubble, with the exception of 1929. While it is very true that valuations have been even richer at various points in recent years, it should also be noted the S&P 500 (including dividends) has now underperformed Treasury bills for well over 13 years as a direct result. Similarly, the Shiller P/E remains higher than about 95% of instances prior to the late-1990’s bubble. Numerous recent weekly comments have detailed the variety of hostile indicator syndromes we presently observe, particularly the variants of “overvalued, overbought, overbullish” conditions that have regularly been followed by profound market losses over the intermediate-term (though not necessarily the short-term).

Meanwhile, my view continues to be that a recession in the U.S. is already an overlooked passed-pawn, as is the sharper-than-expected economic weakness in China, as is the overleveraged, undercapitalized state of the European banking system – particularly in Spain – where policy makers are misguided enough to believe that Draghi’s words alone are sufficient to substitute for bank capital and fiscal stability. The growing U.S. debt/GDP ratio is another passed-pawn, because while I expect the “fiscal cliff” will be resolved by a half-hearted combination of tax cuts and modest spending reductions, the final result is likely to leave a large structural deficit which we are only capable of financing due to the good fortune of unrealistically depressed interest costs and a combination of monetization and Chinese capital inflows (all which make endless deficits seem misleadingly sustainable).

Hugh Hendry of Eclectica recently got the tone right in his concerns about the endgame we are facing:

"Today, the world is grotesquely distorted by the presence of fixed exchange rate regimes. There are two. There is the Euro, and there is the dollar-remnimbi. All of Europe has defaulted. There are many stakeholders in the European project. There are financial creditors and then there are the citizens of Europe. Remarkably, the political economy of Europe is that the politicians chose to default on their spending obligations to their citizens in order to honor the pact with their financial creditors. And so of course what we're seeing is that as time moves on, the politicians are being rejected. So when I look at Europe, the greatest source of inspiration I have is fiction... We have the longest-serving Prime Minister, the Prime Minister of Luxembourg Mr. Juncker, who is on record as having said that 'when times get tough, you have to lie.' ... the truth is unpalatable to the political class, and that truth is that the scale and the magnitude of the problem is larger than their ability to respond, and it terrifies them. The reality is that you just can't make up how bad it is. But it has precedent, and precedent perhaps offers us some navigation tools.

"The number one rule in terms of looking after wealth is preserving that wealth... I think we are single digit years away from the most profound market clearing moment - a 1932 or a 1982, where you don't need smart guys or girls, you just need to be bold. The crisis started here, it went to Europe... we could see a hard landing in Asia, coinciding and indeed being encouraged by the problems in Europe, and if you get those two events colliding, and given the lack of protection on such a scenario in Asia, then you would have another profound dislocation. And that's the point where you reach the bottom, and you don't need wise guys, you just need courage."

As an economist, I think it is important to recognize the underlying factors that support the present situation, as well as those that threaten it. The U.S. has benefited from low monetary velocity - the willingness of U.S. savers, financial institutions, China’s central bank, and others, to hold idle currency balances without meaningful compensation. Indeed, the reason that tripling the monetary base has not resulted in inflation is that monetary velocity has declined in direct proportion to that increase. In effect, people have passively held zero-interest money in whatever amount it is created. Contrast this with the German hyperinflation, when velocity rose as money became a “hot potato” – causing prices to rise even faster than the rate at which money was printed. Contrast the present situation also with the period from 1973 to 1982, when monetary velocity was rising, which also resulted in prices rising faster than the money supply. What creates inflation is the unwillingness of people to passively hold money balances, which then turns money into a hot potato. Higher interest rates on safe assets would have this effect, as that would create an alternative to zero-interest currency (which is why continued low inflation now relies on either holding interest rates at zero indefinitely, or massively contracting the Fed’s balance sheet should non-zero interest rates ever be contemplated).

Somehow, I suspect that all of us recognize that the present state of the world economy is being held up by extraordinary distortions both in the monetary realm and in fiscal policy, but for whatever reason, it is more pleasant to simply assume that everything is just fine, instead of thinking about the adjustments that would be required in order to move back to a sustainable global economic and financial situation. To some extent, we’ve become desensitized to extraordinarily large numbers – if hundreds of billions don’t solve the problem, then a few trillion will – ignoring the magnitude of those figures relative to our actual capacity to produce economic output.

Our problems are not insurmountable, but they are very difficult problems that do not have an easy solution or quick fix in some bold policy action (even in unrestrained ECB monetization). Deleveraging is hard. You simply cannot bring down the debt/GDP ratio unless a) economic growth exceeds interest rates by enough to offset the primary deficit*, or b) the government chooses to default on and restructure its debt obligations.

[*Geek's note : technically, the requirement is that (g - i) * Debt/GDP + PD/GDP > 0, where g and i are GDP growth and the interest rate on the debt, respectively (either both real or both nominal), and PD is the primary non-interest deficit (or surplus if positive)].

Importantly, printing money can bring down debt/GDP only if the government first locks in a low interest rate on its publicly-held debt by issuing very long term bonds, and then pursues enough inflation to raise nominal economic growth above that interest rate. Inflation will not devalue debt if the interest rate on the debt can be continuously reset in response. Presently, nearly all of the publicly-held U.S. debt is of short maturity. At an overall deficit of nearly 10% of GDP and a primary deficit of about 6%, there is very little chance that the ratio of publicly-held debt/GDP, which has nearly doubled since 2008, will easily stabilize in the coming years – particularly if we experience another recession. Moreover, we are unlikely to get consumer demand sustainably growing without dealing head-on with the problem of mortgage restructuring and underwater home equity – something that has been utterly ignored by policymakers. Done correctly, all of that is uncomfortable enough. Done poorly, it is profoundly destructive. Europe has already done it poorly, and it is not finished.

That said, I should emphasize that our present defensiveness does not rely on the assumption that we’ll see some profound economic dislocation. Rather, our defensiveness is driven by syndromes of evidence that have repeatedly been associated with negative return/risk outcomes in dozens of subsets of historical data. I’ll say this again: we are not defensive because of recession concerns or views about global financial strains. We are defensive because the market conditions that most closely resemble those at present have regularly, and throughout history, been associated with negative return/risk outcomes, on average.

The endgame of the market cycle

Just as the endgame is the part of the Chess match that counts the most, the final part of a market cycle is often where the most critical choices are made. The fact is that a bear market wipes out more than half of the gains achieved during the average bull market. For cyclical bear markets that occur during extended “secular” bear periods as we’ve observed since 2000 (featuring multiple bull-bear cycles, each which achieves successively lower valuations at the bear troughs), the bear markets typically wipe out closer to 80% of the gains achieved during the preceding bull period.

“Once you are in the endgame, the moment of truth has arrived... The amount of points that can be gained (and saved) by correct endgame play is enormous, yet often underestimated.”

– Edmar Mednis

In early March, our estimates of prospective stock market return/risk dropped into the most negative 2.5% of historical data (see Warning, A New Who’s Who of Awful Times to Invest), yet the S&P 500 is presently about 4% higher than it was then, and our estimates have dropped further, to the most negative 0.5% of historical observations. As I observed at the time, “While a few of the highlighted instances were followed by immediate weakness, it is more typical for these conditions to persist for several weeks and even longer in some cases ... When we look at longer-term charts like the one above, it's easy to see how fleeting the intervening gains turned out to be in hindsight. However, it's easy to underestimate how utterly excruciating it is to remain hedged during these periods when you actually have to live through day-after-day of advances and small incremental new highs that are repeatedly greeted with enthusiastic headlines and arguments that ‘this time it's different.’”

And so, we find ourselves facing the likelihood of another cyclical endgame, where in Benko’s words “impatience, complacency, exhaustion, or all of the above” can encourage investors to ignore rich valuations, weak economic fundamentals, heavy insider selling, overbullish sentiment, overbought market action, increasingly negative earnings preannouncements, and other syndromes that have historically been hostile for stocks.

These risks are easy to dismiss. Yields and prospective returns have been driven lower as investors seek an alternative to an ocean of zero-interest money, and prices have been driven higher – a fact that makes rising prices seem somehow automatic. The question is this - what else is left for investors to anticipate, with prices not depressed at all (as they were at the start of prior rounds of QE), and with QEternity now having removed any further “announcement effects.” Though market risk has been advantageous, it is doubtful that the market returns we’ve observed are durable.

“It often happens that a player is so fond of his advantageous position that he is reluctant to transpose to a winning endgame.”

– Samuel Reshevsky

So while it is true that stocks have advanced a few percent since March, my strong view is that this is good fortune born entirely of investor anticipation of ECB and Fed announcements that are now behind us. Indeed, the S&P 500 is lower now than when QEternity was announced, and on a volume-weighted basis, is also lower than when Draghi threw his hail-Mary pass over the Bundesbank. By our estimate, the present ensemble of market conditions is associated with a historical rate of loss in the S&P 500 approaching -50% annualized. Now, I don’t expect conditions to be similarly negative for a full year - the typical course is for the market to transition to less negative conditions after an initial hard decline. But I continue to believe that the gain in the S&P 500 since March, when our return/risk estimates became overwhelmingly negative, should not be the basis for complacency here.

“In the endgame, an error can be decisive, and we are rarely presented with a second chance.”

– Paul Keres

From a strategic standpoint, I believe that the best approach to the complete market cycle is to accept risk roughly in proportion to the return that can be expected as compensation. Indeed, this is one of the key results of finance theory. Our estimates of return/risk vary over the market cycle based on prevailing market conditions – being very hostile in periods when the market is in a mature, overvalued, overbought, overbullish market environment, and generally being aggressive when the market is in an undervalued, oversold, overbearish environment. To believe that we simply will never see the latter environment again, or that the next point we observe it will be at even higher prices than today, is an assumption that strains credibility from a historical standpoint. In any event, my perspective is that investment positions should not be based on a one-off forecast of what will occur in this specific instance, but on the average return/risk profile that has historically accompanied each prevailing set of market conditions.

“It is not a move, even the best move, that you seek, but a realizable plan.”

– Eugene Znosko-Borovsky

As Tsagaan suggested, the two ways to progress, and the two ways to err, are embodied in the questions “What is the opportunity?” and “What is threatened?” For our part, this particular cycle – this particular chess game – has been unusual in that we were forced to ask in 2009 whether far more was threatened than what had typically been at risk during other post-war market cycles. The “two-data sets problem” to address that question took enough time to solve that we missed an opportunity that we could have taken if our methods were already robust to out-of-sample Depression-era data at the time. That said, I believe that investors are committing a mistake in casually dismissing the question of “What is threatened?” in a mature, overvalued, overbought, overbullish market here. From my perspective, it appears to be the same error they made in 2000 and 2007.

 “The winner of the game is the player who makes the next-to-last mistake”

– Savielly Tartakover

From an investment perspective, the menu of opportunities appears very limited in an elevated stock market, with 10-year Treasury yields now down to 1.6%, and even corporate bond yields down to 2.7%. The opportunity here seems much more likely to be in limiting risk and taking gains than in extending risk and seeking further advances. Meanwhile, the historical chronicle of bull market gains that have been lost during the endgame, and the extent to which bear markets cause the surrender of those gains, should be a compelling answer to the question of what is threatened.

... and a final quote with absolutely no context

“A computer once beat me at chess. But it was no match for me at kick-boxing.”

- Emo Philips

The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Only comments in the Fund Notes section relate specifically to the Hussman Funds and the investment positions of the Funds.

Fund Notes

As of last week, our estimates of prospective return/risk in stocks remained in the most negative 0.5% of historical instances. Strategic Growth Fund remains fully hedged, with a staggered-strike position where the put option side of our hedge is now less than 2% below current market levels. The broad market can underperform the major indices during sharp market declines, which is one of the reasons we periodically bring those put option strikes closer to market levels, but our present investment stance would obviously welcome a sharp market decline where our holdings keep pace or outperform the indices we use to hedge. Earnings season is also now moving into full swing, which increases the potential for both positive and negative surprises as they relate to individual holdings. As a result of all this, it’s likely that we’ll observe moderately greater day-to-day volatility in Strategic Growth, particularly if the market moves down more than a few percent. In that event, I would expect the net result to be positive, but we should expect a certain amount of giveback on days when the market advances from below our put strikes, or individual holdings come under pressure as a result of earnings news.

Strategic International also remains fully hedged here. While valuations are generally better internationally than they are in the U.S., one of the regularities in international investing is that diversification helps far less than investors might expect during periods of significant market weakness. International markets tend to have fairly high betas to the U.S. market during periods of U.S. market weakness, so very negative return/risk estimates on the U.S. market tend to feed into a defensive position on the international side as well. That isn’t to say that our hedging will always be tightly correlated between U.S. and international positions, but we estimate that very significant negative return/risk expectations on the U.S. market are associated with unfavorable international outcomes, on average, even when international valuations are not as extreme.

Strategic Dividend Value remains hedged at about 50% of the value of its stock holdings – its most defensive investment stance. The Fund has enjoyed a fairly small sensitivity to market fluctuations, but we haven’t yet seen a major decline since the Fund’s inception, and my preference remains for investors to use the Fund as a way to transition from higher risk investments. I expect that lower market valuations and higher yields will provide good opportunities for dividend-seeking investors, and will also significantly reduce the need to hedge the Fund’s stock holdings. I have little doubt that strong opportunities like this will emerge over the course of the market cycle ahead.

Strategic Total Return continues to carry a relatively short duration of about 1.4 years (meaning that a 100 basis point move in Treasury yields would be expected to impact the Fund by about 1.4% on the basis of bond price fluctuations). The Fund presently holds less than 5% of assets in precious metals shares. While our estimates of prospective return/risk remain positive in that sector, real interest rates are now negative even on long-maturity Treasuries while nominal yields have flattened out. Precious metals shares tend to perform best when there is downward pressure on both real yields and nominal yields. Negative real yields, stable nominal yields, and easing inflation concerns don’t really give you that.

Meanwhile, despite significant growth in the monetary base, the behavior of monetary velocity and cyclical economic pressures don’t suggest near term inflationary pressure – particularly in the U.S. where I expect the exchange value of the dollar to be helped by European strains more than it is hurt by further quantitative easing. I continue to expect substantial inflationary outcomes in the back-half of the decade, but at least at present, I doubt the resolve of investors to adhere to an inflationary investment stance through the course of a likely global economic downturn in the interim. The question isn’t so much whether we’ll observe inflation over time, but rather what the likely returns will be from investing on that thesis in present conditions. For now, those conditions suggest positive but fairly restrained returns relative to the risk involved.

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The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

Prospectuses for the Hussman Strategic Growth Fund, the Hussman Strategic Total Return Fund, the Hussman Strategic International Fund, and the Hussman Strategic Dividend Value Fund, as well as Fund reports and other information, are available by clicking "The Funds" menu button from any page of this website.

Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 reflect our standard valuation methodology, focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle (see for example Investment, Speculation, Valuation, and Tinker Bell, The Likely Range of Market Returns in the Coming Decade and Valuing the S&P 500 Using Forward Operating Earnings ).