John Hussman: Anything but Academic

Excerpt from the Hussman Funds' Weekly Market Comment (6/01/09):

There's an economists' riddle that goes “Why are the debates in academia so bitter?” – the answer – “Because the stakes are so low.” Now, very often, that's true. I remember a presentation that Paul Krugman gave at Stanford where he was talking about a model of economic development. Paul drew a diagram on the board, and as he described it, he drew a few little arrows indicating migration of businesses from one area to another. A respected economic theorist at Stanford, Mordecai Kurz (who never drew an arrow without a differential equation), immediately jumped up and shouted “You haven't described the dynamics!!” to which Paul responded that he was indicating a general movement of economic activity toward one place to improve efficiency. Dr. Kurz pounded the table and screamed “Then erase the arrows!! ERASE THE ARROWS!!” and then stormed out of the room and slammed the door behind him. I think that was probably the exact moment that I decided to go into finance.

Presently, however, the debate about the long-term economic fallout from this defense of bank bondholders is anything but academic. I recognize that I have been on a virtual rant about it in recent months, but the reason is that it is literally the most important fiscal and bureaucratic event that we are likely to observe in our lifetimes, and is very possibly the precursor to enormous future economic difficulties. You simply cannot have an economy lend out trillions of dollars in bad debt, and then make the lenders whole with public funds (while still facing a massive second wave of probable mortgage defaults) without destructive repercussions. There is very little chance, in my view, that the current downturn is over. We have enjoyed a nice reprieve – if over a trillion dollars in redistribution could not accomplish even a reprieve, it would be a surprise. It's clear that investors are hopeful that we can simply return to rich valuations, debt-financed economic expansion, and abnormal profit margins based on excessive leverage. From my perspective, this hope is as thin as those that we observed at the peak of the internet bubble, the housing bubble, and the profit margin peak of 2007.

As I noted last week, our risk measures have shifted from a borderline neutral stance to a fresh defensive stance. From a valuation perspective, stocks are slightly overvalued except on the basis of earnings-based metrics that assume a quick return to 2007 profit margins. Stocks are not richly priced, but they are no longer compressed in valuation. They are also no longer compressed from a technical perspective, and are instead overbought on a variety of measures. Without compression to allow prices to advance as a sort of “release valve,” the market now relies on actual improvement in the economy – not simply news that is “less bad than expected.” That's not to say that we can rule out such improvement, but at this point, the market relies on it. For our part, the average return-to-risk profile of the market, given current conditions, does not justify much risk taking. Moreover, in view of the larger picture of economic and credit conditions, the risks are lined up clearly to the downside. The stock market features unimpressive valuation, overbought conditions, and a reliance on positive surprises and easing risk aversion. That sort of market certainly can continue higher, but the potential for further return comes with a great deal of potential risk.

Comments

[CautiousInv...:]

The fat lady has not sung.

We still have serious and growing problems with residential, commercial and industrail real estate loans. And these problems will extend far beyond the end of 2010, the end of the stress test horizon.

The general outcome of the stress test was to, more or less, let the banks earn their way out of this mess while raising $75 billion to serve as a capital buffer. But last week, because of dwindling interest in PPIP, it was leaked out that banks may need to rely less upon revenues/earnings to generate the capital required to offset lending losses.

Taking this to be case and the realization losses do not magically stop at the end of 2010, the banks remain in a precarious state and will need to raise more capital.

Jun 01 11:32 AM

[user396040:]

I think that the problem with most models is that we have never before had such an expansive monetary policy and we really do not have any experience on what it will do to equity markets. Bear in mind, that almost all performance measures of equity markets are in nominal(rather than real) dollars. I think it becomes very difficult to predict where things will go from here but it is hard to imagine a scenario in which a portfolio of reliable dividend paying stocks (JNJ, PG, XOM, MSFT, PM, KO, MCD) does not outperform treasuries over the next three to five years.

Jun 01 01:38 PM

[odin:]

Agreed. However, the banks are making money. They will need it this capital as more layers in the toxic wasteland ripen and come up to the surface.

The yield curve is steep, government is both lending them money cheaply at the short end and paying them more at the long end. No consumers necessary!

Thank god for small mercies.

Jun 01 07:11 PM

[H. T. Love:]

Small mercies would've been putting them out of *our* misery when it should have happened. As it is, after we have died - thereby relieving us of our misery - the misery *will* continue, afflicting our grandchildren.

HardToLove


On Jun 01 07:11 PM odin wrote:

> Agreed. However, the banks are making money. They will need it
> this capital as more layers in the toxic wasteland ripen and come
> up to the surface.
>
> The yield curve is steep, government is both lending them money cheaply
> at the short end and paying them more at the long end. No consumers
> necessary!
>
> Thank god for small mercies.

Jun 02 11:16 AM

[H. T. Love:]

Small mercies would've been putting them out of *our* misery when it should have happened. As it is, after we have died - thereby relieving us of our misery - the misery *will* continue, afflicting our grandchildren.

HardToLove


On Jun 01 07:11 PM odin wrote:

> Agreed. However, the banks are making money. They will need it
> this capital as more layers in the toxic wasteland ripen and come
> up to the surface.
>
> The yield curve is steep, government is both lending them money cheaply
> at the short end and paying them more at the long end. No consumers
> necessary!
>
> Thank god for small mercies.

Jun 02 11:17 AM

[H. T. Love:]

Small mercies would've been putting them out of *our* misery when it should have happened. As it is, after we have died - thereby relieving us of our misery - the misery *will* continue, afflicting our grandchildren.

HardToLove


On Jun 01 07:11 PM odin wrote:

> Agreed. However, the banks are making money. They will need it
> this capital as more layers in the toxic wasteland ripen and come
> up to the surface.
>
> The yield curve is steep, government is both lending them money cheaply
> at the short end and paying them more at the long end. No consumers
> necessary!
>
> Thank god for small mercies.

Jun 02 11:18 AM

[H. T. Love:]

Small mercies would've been putting them out of *our* misery when it should have happened. As it is, after we have died - thereby relieving us of our misery - the misery *will* continue, afflicting our grandchildren.

HardToLove


On Jun 01 07:11 PM odin wrote:

> Agreed. However, the banks are making money. They will need it
> this capital as more layers in the toxic wasteland ripen and come
> up to the surface.
>
> The yield curve is steep, government is both lending them money cheaply
> at the short end and paying them more at the long end. No consumers
> necessary!
>
> Thank god for small mercies.

Jun 02 11:18 AM

[Gregman2:]

"this defense of bank bondholders...is literally the most important fiscal and bureaucratic event that we are likely to observe in our lifetimes..." We've had to borrow from the future to fund the bailout. How much has been political versus just good and vital economic policy?

Jun 02 12:11 PM