John Hussman: Reckless Myopia

Excerpt from the Hussman Funds' Weekly Market Comment (11/30/09):

In my estimation, there is still close to an 80% probability (Bayes' Rule) that a second market plunge and economic downturn will unfold during the coming year. This is not certainty, but the evidence that we've observed in the equity market, labor market, and credit markets to-date is simply much more consistent with the recent advance being a component of a more drawn-out and painful deleveraging cycle. Meanwhile, valuations are clearly unfavorable here, and even under the “typical post-war recovery” scenario, we are observing an increasing number of internal divergences and non-confirmations in market action.

As Gluskin Sheff chief economist David Rosenberg noted last week, “Even if the recession is over, the historical record shows that downturns induced by asset deflation and credit contraction are different than a garden-variety recession induced by Fed tightening and excessive manufacturing inventories since the former typically induce a secular shift in behavior and attitudes towards debt, asset allocation, savings, discretionary spending and homeownership. The latter fades more quickly.

“This is why people didn't figure out that it was the Great Depression until two years after the worst point in the crisis in the 1930s; and why it took decades, not months, quarters or even years, for the complete transition to the next sustainable economic expansion and bull market.

“Mortgage applications for new home purchases hit a 12-year low in the middle of November (down 22% in the past month!), fully two weeks after the Administration said it was going to not only extend but expand the program to include higher-income trade-up buyers. Once again, there is minimal demand for autos and housing, and that is partly because the market is still saturated with both of these credit-sensitive big-ticket items after an unprecedented credit and consumer bubble that went absolutely parabolic in the seven years prior to the collapse in the financial markets an asset values. We are probably not even one-third of the way through this deleveraging cycle. Tread carefully.”

Andrew Smithers, one of the few other analysts who foresaw the credit implosion and remains a credible voice now, concurred last week in an interview with my friend Kate Welling (a former Barrons' editor now at Weeden & Company): “The good news so far is that the stock market got down to pretty much fair value or even, possibly, a tickle below it, at its March bottom. But now it has gone up… we probably have a market which is, roughly, 40% overpriced. In order to assess value, it is necessary either to calculate the level at which the EPS would be if profits were neither depressed nor elevated, or to use a metric of value which does not depend on profits. The cyclically adjusted P/E (CAPE) normalizes EPS by averaging them over 10 years. It thus follows the first of those two possible methods. Using even longer time periods has advantages, particularly as EPS have been exceptionally volatile in recent years - and using longer time periods raises the current measured degree of overvaluation. The other methodology we use measures stock market value without reference to profits: the q ratio. It compares the market capitalization of companies with their net worth, also adjusted to current prices. The validity of both of these approaches can be tested and is robust under testing - and they produce results that agree. Currently, both q and CAPE are saying that the U.S. stock market is about 40% overvalued.”

In the chart below, the current data point would be about 0.4, not as extreme as we observed in 1929, 2000, or 2007 of course, but equal to or beyond what we've observed at virtually every other market peak in history. This aligns well with our own analysis, where as I've noted in recent weeks, the S&P 500 is priced to deliver one of the weakest 10-year total returns in history except for the (ultimately disappointing) period since the mid-1990's.

Comments

[John Galt]

<“This is why people didn't figure out that it was the Great Depression until two years after the worst point in the crisis in the 1930s; and why it took decades, not months, quarters or even years, for the complete transition to the next sustainable economic expansion and bull market.>

Ding ding ding, we have a winner. I've been reading newspapers from the late 20's and the 1930's and you don't see them saying, " life sucks, we are in a depression"... All the talk is about the recovery around the corner, this government program is going to help us, blah blah blah. It was a decade of green shoots, hope and no change.

To compare this mess to our previous recessions is a very false comparison. This is by far the worst mess since the depression. Also remember that we did have blips of positive growth during the depression, there was a "double dip" so to speak, but it was all one big mess that ended in tens of millions of people around the world killing each other. Let's hope this depression doesn't end the same way.

2009 Nov 30 09:17 AM

[TheFounder]

I agree with this article with one exception. It is still possible that the fed will be able to trade depression for very high inflation over a long period of say 5-7 years.

Not that it makes a huge difference for most people, as it is extremely 'depressing' to live with 10-15% inflation. Point is, that the current market price may be the equivalend of falling back to March 09 levels, but adjusted for several years of high inflation and nominal GDP growth.

2009 Nov 30 09:33 AM

[Roger Knights]

"As Gluskin Sheff chief economist David Rosenberg noted last week, “Even if the recession is over, the historical record shows that downturns induced by asset deflation and credit contraction are different than a garden-variety recession ..."

I agree, and I've come up with a phrase that puts this whole argument in a nutshell: "It's the debt, dummy." I encourage others who like it to use it, to get their point across.

2009 Nov 30 11:16 AM

[fwi]

Great article. What we find ourselves in has always been a depression--a necessary deflation of asset values. Now that the Feds are trying to change the depression into something else by artificially publicizing private debts (mortgage reworking), we will have to wait for the inevitable asset normalizing. Recessions are simply tightening of money, recessions are ended with reducing the cost of money. Obviously that is not the case now, with the Fed rate at essentially 0%.

I wish that the ineptitude of this government would just get out of the way, let the guys who made bad bets and bought too much whatever accept the consequences, instead of asking the taxpayers to accept them for them.

2009 Nov 30 11:32 AM

[Davewmart]

A fine analysis.
But just to tone down any irrational exuberance people may feel on reading it, three additional factors which differ from those of the US in the 20's need considering:
Demographics are far worse - instead of the ratios of workers to dependents getting better or remaining constant, they are far now getting much worse.
Entitlements - they won't get paid. When it is your pension you are going to be upset.
Promises now exceed the ability to redeem them.
Oil - growth was based on cheap oil.
Even the official IEA now says that in OECD we won't be able to have as much oil as in the past, and the price is going to go up:
anz.theoildrum.com/nod...

This is still politically-directed bs, and oil supplies to the West and Japan are going to sink a long way, and rising prices will cut short any recovery.

Have a good day!

2009 Nov 30 11:39 AM

[bartpr]

we dont know where the cape or q ratio will finally bottom. this recesion should not be compared to the depression for the following reasons. 40% of the banks were allowed to fail. interest rates were maintained high because we were still on the gold std and other countries were off and pulling out our gold in mass. dollar was overvalued. prices and wages were maintained at high levels. no one could afford to buy becuase of the high prices and the high wages reduced profits. the tariff wars killed our trading partners.

lets look at the pluses, even in an overvalued market. the yield cuve is maxed out. market have not corrected big time until the yield curve inverts. shorts greater than long... leading indicators have recently come off a bottom. give them time to continue up.

2009 Nov 30 06:13 PM

[FB5000]

Utterly ridiculous. Hussman is discredited as a source.

An 80% probability. Really? How can anyone be so precise?

And this statement "the historical record shows that downturns induced by asset deflation and credit contraction are different than a garden-variety recession induced by Fed tightening and excessive manufacturing inventories since the former typically induce a secular shift in behavior and attitudes towards debt, asset allocation, savings, discretionary spending and homeownership. The latter fades more quickly"

There are no datapoints upon which to base any sort of conclusion like this.

As to over or undervaluation. In the long run - earnings drive markets. And what we know as a fact is that earnings have held up very well, companies have added significant operating leverage and developed large amounts of cash. S&P earnings in 2010 are probably going to be around $75. You can figure out what that is in terms of forward PE. But it does not equal overvaluation.

Comanies have done very well. Operating leverage will lead to impressive earnings growth in the absence of major top line growth.

Productivity is good, rates are low, the yield curve is steep. Inflation is very low. Yes lending is down but think of it. It is down from the days when you get 100% of a property without proof of income. Is that a bad thing? And while money is not easy to get - it can be got. Banks are doing their job. They are assessing risks. Overall this is a net positive.

People are driving themselves nuts trying to be the next genius to predict the next disaster Witness the unholy rush to label Dubai the next "black swan" disaster. Bove today says banks will need to raise capital if capital requirements are raised - no kidding - do you think? And what is the likelihood of that. About zero. Especially when banks are doing very well. Whitney says banks are in trouble. Give it a rest Meredith. You and Elain Garzarelli had your little 15 minutes of fame. The spotlight is elsewhere now. Get over it.

Get a grip. I feel sorry for you if you can't. And don't listen to this garbage. The mere fact that all these "pundits" cannot bring themselves to bless the rally means that it is the place to be.

That's all.

2009 Dec 01 01:36 AM

[FB5000]

Rosenberg is another one. Utter garbage. He has very little understanding of operating leverage. He wonders how you can get 10% profit growth in a 2 to 3% growth economy.

Do the math.

If profit is 10% say 100 out of 1000 and costs decline by 2% from 900 to 882 and revenue increases by 1% from 1000 to 1010 I can get profit growth of about 30% from 100 to 128. If I cut back on my investment I can juice free cash flow. This is the environment we are in right now. This is what better companies are doing. This is why US equities are attractive. Because they are demonstrating the capacity to grow eranings in a tough environment.


On Nov 30 11:16 AM Roger Knights wrote:

> "As Gluskin Sheff chief economist David Rosenberg noted last week,
> “Even if the recession is over, the historical record shows that
> downturns induced by asset deflation and credit contraction are different
> than a garden-variety recession ..."
>
> I agree, and I've come up with a phrase that puts this whole argument
> in a nutshell: "It's the debt, dummy." I encourage others who like
> it to use it, to get their point across.

2009 Dec 01 01:48 AM

[advalorem]

Can anyone compare any time period to present, given a Fed printing non-stop business-model; and zero borrowing costs for many financial institutions and the impacts of carry-trade?

2009 Dec 01 11:06 AM

[David Van Knapp]

Has anyone compiled a "box score" of the accuracy of predictions of Hussman, Kass, Roubini, Rosenberg (who am I leaving out?) over the past year? Each one has gotten one or two highly publicized things correct (as to direction AND approximate time), but overall my impression is that their near-daily predictions have been very bad. It's a shame that so many people follow them...people have lost their shirts during this rally by following their recommendations. I read some other comments on SA today where people stated they went short at the end of yesterday or today "because they just couldn't help it." Even after acknowledging that they've done it multiple times throughout this rally and gotten burned every time. It's so sad, like a gambling addiction. Self-inflicted impoverishment.

2009 Dec 01 08:17 PM

[Old Trader]

David,

I don't recall ever running across anything like that (the "box score" that you mentioned), but it sure would be interesting. Fwiw, I would consider people like Hussman and Kass in a somewhat different category than the others you mention, since both actually run money, rather than functioning purely as commentators, strategists, etc.

As an aside, I had the pleasure of actually meeting Hussman, back in October, at the IFTA annual conference in Chicago, where he was one of the presenters. I was a bit surprised to learn they rebalance their 2 funds on a weekly basis, based off of what their models are suggesting.


On Dec 01 08:17 PM David Van Knapp wrote:

> Has anyone compiled a "box score" of the accuracy of predictions
> of Hussman, Kass, Roubini, Rosenberg (who am I leaving out?) over
> the past year? Each one has gotten one or two highly publicized things
> correct (as to direction AND approximate time), but overall my impression
> is that their near-daily predictions have been very bad. It's a shame
> that so many people follow them...people have lost their shirts during
> this rally by following their recommendations. I read some other
> comments on SA today where people stated they went short at the end
> of yesterday or today "because they just couldn't help it." Even
> after acknowledging that they've done it multiple times throughout
> this rally and gotten burned every time. It's so sad, like a gambling
> addiction. Self-inflicted impoverishment.

2009 Dec 01 08:39 PM

[spald_fr]

On Dec 01 08:39 PM Old Trader wrote:


Wow, OT, following you around the board leads me to Hussman, who apparently has a set.

2009 Dec 01 08:59 PM