John Hussman: A Financial Panic Is Fully Avoidable

Excerpt from the Hussman Funds' Weekly Market Comment (4/7/08) referring, in part, to the House and Senate's inquiries into the Fed's involvement on JPMorgan's (JPM) deal to buy out Bear Stearns (BSC):

... SEC Chairman Cox is right – Bear Stearns' customers and counterparties were never at risk of loss. Major U.S. financial companies have enough capital (shareholder equity and bondholder debt) to provide a cushion in the event of substantial writeoffs, without customers or counterparties being at risk of loss in the event of outright bankruptcy. The only instance where there would be a question would be if the book value of the failing company was negative after entirely zeroing out all shareholder equity and bondholder debt. That was not the case for Bear Stearns.

As I said a couple of weeks ago, if we keep on believing that the default of Bear Stearns bonds ("bankruptcy") would have caused a global financial crash, then I expect that we are in for a global financial crash anyway. Not because there is any true risk to customers and counterparties, but because investors are misinformed about how the financial markets work, and they will panic as foreclosures and writedowns inevitably soar in the months ahead. A financial panic is fully avoidable if Wall Street and the media stop propagating the utterly false belief that a Bear Stearns bankruptcy would have led to a “chain reaction” of financial losses. While we might very well see some over-leveraged firms go bankrupt, with substantial losses to their own stockholders and bondholders, the customers and counterparties are generally not at risk if there is enough stockholders equity and bondholder capital to eat through without leaving the remaining book value negative. Bankruptcy or no bankruptcy, the underlying book of assets and liabilities can be transferred quickly. The only question is how much the bondholders come away with. That "chain reaction" theory is just utterly irresponsible fearmongering.

Look. I would welcome lower stock market valuations because they would increase prospective long-term returns enough to accept a significant amount of market risk, but I have no desire to see the financial markets in distress. The U.S. economy will get through this, but the credit problems are not over. Even if they were, the U.S. stock market would still be vulnerable because the valuations of recent years have been based on unsustainably high profit margins. Unfortunately, profit margins are cyclical, and competitive forces bring them down over time. So even if investors are inclined to celebrate the Fed's intervention over the near term, it does not alter the broader risk to stock market values.

In short, stocks are still vulnerable, but there is no need for an outright financial panic, and no need to misuse public funds to benefit the bondholders of individual companies. I am very concerned that investors and even Congress have swallowed the “chain reaction” theory hook, line and sinker. The fact that they have makes me more concerned about crash risk, not less. In any event, it is wishful to believe that a $30 billion misuse of public funds has suddenly put problems of mortgage foreclosures, profit margin risks, rich valuations, and an oncoming (not outgoing) recession behind us.

Market Climate

As of last week, the Market Climate in stocks was characterized by unfavorable valuations and still unfavorable market action, holding the Strategic Growth Fund to a fully hedged investment stance. Market action has been relatively good even in the face of poor employment numbers and upward revisions in job losses. Moreover, new claims for unemployment shot above 400,000 last week, as is characteristic of early recessions...

While we are willing to lift a moderate portion of our short calls if the recent improvement in market action broadens further, my guess (and it's presently only a guess) is that the market may be vulnerable to a steep break here. From the fact that I have an opinion on market direction, you can immediately infer that the market is either a) overbought in an unfavorable Market Climate, or b) oversold in a favorable Market Climate. At present, of course, the answer is a). Such conditions don't guarantee a market slide, but the average outcomes are not good. We are hedged and defensive here.