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John Hussman: Banks Pass Stress Test - Regulators Fail Ethics Test

From my blog, Scott's Investments:


John Hussman's Weekly Market Comment for May 11th is now available.  He has some strong words regarding the ethics of the 'stress test', bailouts, bondholders, and the bureaucrats who perpetrated them:

Our regulators want confidence. And they're willing to fudge the numbers to get it. If there wasn't a freight train of additional mortgage defaults coming, perhaps confidence building would be a good thing. As matters stand, encouraging confidence is equivalent to encouraging investors to throw good money after bad.....

Over the past few weeks, I've heard a number of analysts suggesting that the bailouts aren't so bad because �we owe this money to ourselves,� and that in terms of present value, they are neutral for society as a whole. What's fascinating about these arguments is that they entirely miss the ethical and distributional effects of the bailouts. This isn't something that would be missed if the Treasury was to borrow a trillion dollars and then hand it over to a fur-coated pimp standing on a street corner in lower Manhattan, but it somehow escapes concern when the recipients are in the offices above the ground floor. It's amazing how quickly capitalists turn into socialists when they stand to lose money.

Here's the situation. A variety of investors provided capital to financial companies, with which they made irresponsible loans and took excessive risks. These activities resulted in real losses, which have largely wiped out the shareholder equity of the companies. But behind that shareholder equity is bondholder money, and so much of it that neither depositors of the institution nor the public ever need to take a penny of losses. Citigroup, for example, has $2 trillion in assets, but also has $600 billion owed to its own bondholders. From an ethical perspective, the lenders who took the risk to finance the activities of these companies are the ones that should directly bear the cost of the losses.

We can always compensate those who we believe lost unfairly, were cheated, or whom we otherwise believe that there is a social interest in compensating. But those decisions should emphatically be made through the political process by our elected officials, not by the arbitrary decisions of bureaucrats that continue to erode the Constitutional separation of powers....

Notice that by bailing out the financial companies, there is a massive crowding out of private investment, because for every dollar of losses that should have been wiped off the ledger, we are forced to retain and service two dollars of overall debt � the debt securities owed by the financial companies to their bondholders continue to exist, and we now have an equal amount of new debt issued by the Treasury. The rescued bank debt is a drain on the public because it has to be serviced through a combination of higher interest rates to borrowers, and lower deposit rates to savers. Meanwhile, the Treasury debt is also a drain, because except for some income from the Treasury's holdings of preferred stock, the debt has to be serviced from tax receipts.

The bailout is not something �neutral� that cancels itself out, but instead amounts to a transfer of trillions of dollars of purchasing power directly and indirectly from those who didn't finance reckless mortgage loans to those who did. Farewell to the projects, innovation, research, investment, and growth that might have been financed by the savings and retained earnings of good stewards of capital. Those funds are being diverted to the careless stewards who now stand to be made whole.

In short, these bailouts are emphatically not neutral to society as a whole, because they damage incentives and divert productive resources into hands that have proven themselves to be reckless and incapable. To believe that the bailouts are just money we owe to ourselves is to overlook serious ethical implications, as well as distributional and incentive effects....

As of last week, the Market Climate for stocks was characterized by modest overvaluation on virtually every measure that does not assume a return to record 2007 profit margins. Most likely, stocks are priced to deliver total returns in the area of about 8% over the coming decade, which is not hostile valuation, but is certainly not strongly compelling, particularly in an extremely overbought and uncorrected market. Market action remains quite good on the breadth front, but remains fairly tepid from the standpoint of volume sponsorship. Still, we are at the point where stocks could take on something of a speculative life of their own, and we would be forced to meet further advances with incremental removal of the short call side of our hedge. That would allow the market to �take us out� of our hedge in the event of a continued advance (allowing corresponding losses on a retreat back to current levels), but without removing our downside coverage against the significant possibility of a steeper retreat.

The stress here is on �incremental.� My impression remains that the market will be in a very wide 25-35% trading range for quite some time (note also that a 25% loss approximately wipes out a 35% gain, and vice versa). Even if we have entered a sustainable bull market (which I doubt, but cannot rule out), the historical tendency after similar early advances has been for the market to pull back by 7-12% before continuing higher. It's true that stocks have generally done well a full year after an 8-week market rally of 25% or more, but of the seven previous 8-week rallies in the market since 1900, the average dividend yield on stocks at the end of those 8-week rallies was still 6.6%, the median yield was 5.9%, and no instance was below 4.4% (presently, the yield on the S&P 500 is 2.6%). Two of those advances were off the 1932 lows, when the P/E ratio of the S&P 500 on normalized earnings was just over 5 after the advance. One was off the 1982 low, when the yield on the S&P 500 was still 5.1% after the rally, and the normalized P/E was less than 9.