John Hussman: Little Dutch Boy

Includes: DIA, QQQ, SPY
by: John Hussman

Excerpt from the Hussman Funds' Weekly Market Comment (11/19/12):

In the Mary Mapes Dodge book titled Hans Brinker, there is a fictional story within the story of a little Dutch boy who, on his way to school, notices a hole in the dyke. Having nothing else to fix the leak, he plugs the hole with his finger and stays there through the night until workers come to repair it. We are now into the fourth year of efforts to print trillions of little Dutch boys out of dollars and euros in order to stop a tide from crashing through a fundamentally damaged dyke. All of this has bought time, but no workers have arrived, and no real repairs have been done.

The holes seem only loosely related: non-performing mortgages, widespread unemployment, massive U.S. budget deficits, a “fiscal cliff” sideshow, inadequate European bank capital, European currency strains, a surge of non-performing loans in China, and unexpected economic softness in Asia and global trade more generally. All of this gives the impression that these problems can simply be addressed one-by-one. The truth is that they are all intimately related to a single central issue, which is the utter unwillingness of politicians around the globe to accept and proceed with the inevitable restructuring of bad debt, and their preference to defend the bondholders of a fundamentally rotted financial system.


Ultimately, three outcomes would improve the global economy more durably. The first would be a process of debt restructuring that might be highly disruptive over the intermediate-term, but would exert the costs of bad debt on the holders of that debt rather than the general public. My expectation is that a large portion of the European banking system will be restructured in the next few years – meaning receivership, a wipeout of equity value, a writedown of liabilities to bondholders, and an eventual recapitalization as the restructured entities are sold back to private ownership. It isn’t clear that Spain or Italy will be forced to default, as long as Germany, Finland, and other relatively strong countries depart from the euro and allow the ECB to monetize as it pleases. Greece is a basket case in that it seems likely to default again regardless of whether the euro remains intact. In the U.S., efforts to create standardized, marketable mechanisms to restructure mortgage debt (e.g. debt-equity swaps such as marketable property appreciation rights in return for principal reductions) remain long overdue.


A second beneficial outcome would be a realignment of the prices of financial assets to more adequately reflect risk, to provide an incentive to save, and to raise the bar on rates of return – so that investments with strong prospective returns are funded while those with low prospective returns are not. Probably nothing in the past 15 years has been as damaging to the interests of the global economy as the constant distortion of the financial markets by central banks, which has encouraged bubble after bubble, elevating speculation over the thoughtful allocation of scarce capital toward productive uses.

Finally, we need innovation in new industries that have large employment effects. During periods of economic weakness, a common belief seems to emerge that the government can simply “get the economy moving again” through appropriately large spending packages – as if the economy is nothing but a single consumer purchasing a single good, and all that is required is to boost demand back to the prior level. In fact, however, recessions are periods where the mix of goods and services demanded becomes out of line with the mix of goods and services that the economy had previously produced. While fiscal subsidies can help to ease the transition by supporting normal cyclical consumption demand, the sources of mismatched supply – the objects of excessive optimism and misallocation such as dot-com ventures, speculative housing, various financial services, obsolete products, brick-and-mortar stores – generally don’t come back. What brings economies back to long-term growth is the introduction of desirable new products and services that previously did not exist. This has been true throughout history, where the introduction of new products and industries - cars, radio, television, airlines, telecommunications, restaurant chains, electronics, appliances, computers, software, biotechnology, the internet, medical devices, and a succession of other innovations have been the hallmarks of long-term economic growth. Fiscal policies are part of the environment, but their effect should not be overstated.


All of this will change, and despite major challenges over the intermediate-term, there is no reason to lose long-term optimism for the U.S. or the global economy. The problem is that in our view, long-term assets are priced in a way that ignores the prospect for significant disruptions, and allows for inadequate return even in the event that the long-term works out very well. So we do have long-term optimism for the global economy, but also believe that financial assets are mispriced even if that long-term optimism is entirely correct. In bonds, yields-to-maturity remain near record lows. In stocks, valuations only appear tolerable because profit margins remain about 70% above long-term norms, largely because of low savings rates coupled with massive federal deficits (see Too Little to Lock In for the accounting relationships).