Hard-Negative

John P. Huss­man, Ph.D., Huss­man Funds

With the excep­tion of extreme mar­ket con­di­tions (see Warn­ing– Exam­ine All Risk Expo­sures , and Extreme Con­di­tions and Typ­i­cal Out­comes ), I try not to wave my arms around about near-term mar­ket risks, but I think it's impor­tant to cut straight to the chase here. The present mar­ket envi­ron­ment war­rants unusual con­cern, in my view. Based on a wide vari­ety of evi­dence and its typ­i­cal mar­ket impli­ca­tions over an ensem­ble of dozens of sub­sets of his­tor­i­cal data, the expected return/risk pro­file of the stock mar­ket has shifted to hard-negative. This places us in a tightly defen­sive posi­tion. This isn't really a fore­cast in the sense that shifts in the evi­dence even over a period of a few weeks could move us to adjust our invest­ment stance, but here and now we observe con­di­tions that have often pro­duced abrupt crash-like plunges. This com­bi­na­tion of evi­dence includes ele­vated val­u­a­tions, over­bull­ish sen­ti­ment, mar­ket inter­nals best char­ac­ter­ized as a "whip­saw trap" on the basis of typ­i­cal follow-through, height­ened credit strains, and clear evi­dence (on reli­able forward-looking indi­ca­tors) of oncom­ing reces­sion, among other factors.

As always, we try to align our invest­ment posi­tions with the evi­dence we observe. If the evi­dence soft­ens, our hedges will soften. While the quick­est route to a mod­est expo­sure to mar­ket fluc­tu­a­tions (per­haps 20–30%) would be a clear improve­ment in mar­ket inter­nals — which could jus­tify a less defen­sive stance even in the face of reces­sion risks and rich val­u­a­tions — the most likely route to a sig­nif­i­cant invest­ment expo­sure would be a decline to much lower prices and cor­re­spond­ingly higher prospec­tive returns. Presently, avoid­ance of major mar­ket losses takes prece­dence in our analysis.

On a val­u­a­tion front, we esti­mate that the S&P 500 is likely to achieve an aver­age total return over the com­ing decade of about 4.8% annu­ally. This is cer­tainly bet­ter than the pro­jected returns that we have observed over much of the past decade, but then, the past decade has pro­duced vir­tu­ally no total return for equity investors at all. An expected total return of 4.8% is also clearly bet­ter than is presently avail­able on Trea­sury bills, which are priced to return a sin­gle basis point of inter­est annu­ally, and is also bet­ter than the sub-2% yield avail­able on 10-year Trea­sury debt.

The prob­lem is that the dura­tion of a 10-year Trea­sury bond is only about 7 years, which is not only the weighted aver­age time it takes to receive the future stream of pay­ments, but also con­ve­niently mea­sures the expected per­cent­age change in the bond price for a 1% change in long-term return. For stocks, the "dura­tion" math­e­mat­i­cally works out to be roughly the price/dividend ratio, which is about 45 for the S&P 500. Put sim­ply, in order to achieve a given increase in long-term expected return, stocks would have to suf­fer about 6 times the price decline that bonds would expe­ri­ence. Stocks may very well out­per­form Trea­sury bonds over the com­ing decade, but for investors who have any sen­si­tiv­ity to price volatil­ity, that is likely to be a small com­fort in the next few years. We esti­mate that the S&P 500 would have to trade at about the 800 level in order to achieve 10-year prospec­tive returns of 10% annu­ally. Impor­tantly, even a mag­i­cal "fix" out of Europe would do noth­ing to change that algebra.

On the sen­ti­ment front, Investors Intel­li­gence reports that the per­cent­age of advi­sory bears dropped below 30% last week, which has his­tor­i­cally resulted in unre­ward­ing mar­ket out­comes when val­u­a­tions have been ele­vated even to a lesser extent than they are today. Thom­son Reuters reports that neg­a­tive earn­ings pre-announcements are exceed­ing pos­i­tive ones by the largest ratio since mid-2001. Investors have eagerly accepted for­ward oper­at­ing earn­ings as a basis for val­u­a­tion assess­ments, with­out account­ing for the fact that those earn­ings expec­ta­tions assume profit mar­gins about 50% above their his­tor­i­cal norms. Unfor­tu­nately, profit mar­gins are highly vul­ner­a­ble to eco­nomic weak­ness, and we are begin­ning to observe that reg­u­lar­ity here.

As noted last week, we con­tinue to esti­mate a very high prob­a­bil­ity of oncom­ing reces­sion. While the eco­nomic out­look seems fairly benign based on a "flow of anec­dotes" approach (judg­ing eco­nomic prospects on the basis of pos­i­tive or neg­a­tive sur­prises in indi­vid­ual reports as they arrive), the out­look is actu­ally very unfa­vor­able based on a more reli­able ensem­ble of lead­ing indi­ca­tors of eco­nomic activ­ity (see Have We Avoided a Reces­sion? ).

That view is clearly shared by the Eco­nomic Cycle Research Insti­tute, where Lak­sh­man Achuthan noted on Bloomberg last week that "for­ward look­ing data since two months ago has remained weak, it's get­ting weaker, it's not turn­ing up. So, to my fel­low fore­cast­ers out there, I'd say they're roughly in two camps. There are those who say that the econ­omy is firm­ing and will con­tinue to firm into next year. We reject that. There's noth­ing there that sug­gests that at all. I think there's a larger camp that says we're going to mud­dle through; we're going to get this kind of slow growth, 'I'm not ter­ri­bly opti­mistic, but we're going to mud­dle through.' I would point out that that's never hap­pened. We never mud­dle through. A mar­ket econ­omy does not want to have a sta­tic state. It either accel­er­ates or it decel­er­ates, and these for­ward look­ing indi­ca­tors say decelerate."

Achuthan also noted that "the other half of the GDP report," gross domes­tic income or GDI (which tends to be the more accu­rate mea­sure of GDP) was up just 0.3% in the most recent quar­ter. The Fed­eral Reserve has observed that when GDP and GDI dif­fer, the GDP fig­ure tends to be revised toward GDI, not the other way around. Achuthan warned that the GDI fig­ures are "a big red reces­sion sig­nal." In response to the ques­tion "You had a reces­sion call, what hap­pened?," Achuthan sim­ply answered "It's happening."

It's impor­tant to be clear that the hard-negative con­di­tion of our ensem­bles here is based on observ­able data, and our expec­ta­tion for returns is based on mar­ket out­comes that have accom­pa­nied past obser­va­tions that fall into the same clas­si­fi­ca­tion "bucket" or "clus­ter" as we see today. The neg­a­tive aver­age return/risk pro­file asso­ci­ated with present con­di­tions is, of course, an aver­age, and this spe­cific instance might turn out dif­fer­ently. The prob­lem is that the aver­age is dom­i­nated by poor out­comes, some very steeply neg­a­tive, with a much smaller set of pos­i­tive out­comes. In any case, our mar­ket expec­ta­tions here are dri­ven by observ­able data, not by our views about what may or may not hap­pen in Europe. Of course, our con­cern about high reces­sion risk here is also dri­ven by observ­able data.

No Sugar Tonight

As for Europe, last week was essen­tially a con­fir­ma­tion of our impres­sions on a vari­ety of fronts. First, and prob­a­bly most impor­tant from (the stand­point of investor per­cep­tions) is that the new head of the ECB, Mario Draghi, is as com­mit­ted to the con­straints imposed by EU Treaties as clear-headed observers should expect (see Why the ECB Won't, and Shouldn't, Just Print ). Far from look­ing for clever "polit­i­cal cover" that would allow the ECB to ini­ti­ate mas­sive pur­chases of dis­tressed Euro­pean debt, Draghi said that he was "kind of sur­prised" that that oth­ers mis­in­ter­preted his phrase "other mea­sures might fol­low" as a sug­ges­tion that mas­sive ECB bond-buying would be allowed once a fis­cal union was more clearly estab­lished. To the con­trary, he rejected any sort of "grand bar­gain," say­ing "We have a Treaty, and Arti­cle 123 pro­hibits financ­ing of gov­ern­ments. It embod­ies the best tra­di­tion of the Bun­des­bank. We shouldn't try to cir­cum­vent the spirit of the treaty." He specif­i­cally warned against attempts to use "legal tricks" to cir­cum­vent the EU Treaties.

Notably, the restric­tion in Arti­cle 123 specif­i­cally pro­hibits the ECB from "any financ­ing of the pub­lic sector's oblig­a­tions vis-a-vis third par­ties" — this does not sim­ply restrict the ECB from buy­ing debt directly (which could be cir­cum­vented by buy­ing dis­tressed debt on the open mar­ket). Rather, it is a restric­tion against using the ECB as a fund­ing mech­a­nism for pub­lic sec­tor oblig­a­tions. Read Draghi's lips: the ECB will not be ini­ti­at­ing mas­sive pur­chases of dis­tressed Euro­pean debt unless and until the EU Treaties them­selves are explic­itly changed.

It is still a good thing that 26 of the 27 EU mem­bers appear will­ing to agree to greater fis­cal union, but that sort of pact, out­side of EU Treaty changes, will not be suf­fi­cient to trig­ger ECB bond buy­ing in any event. Britain vetoed the idea of an EU Treaty change, with Prime Min­is­ter David Cameron say­ing "We're not in the euro and I'm glad we're not in the euro. We're never going to join the euro. We're never going to give up this kind of sov­er­eignty that these coun­tries are hav­ing to give up in order to have a fis­cal union."

The key point here is that the ECB should not be expected to buy dis­tressed Euro­pean debt any­time in the near future. In order to achieve that end, par­tic­u­larly with Germany's con­sent, Europe requires not only an agree­ment on fis­cal union among euro-area mem­bers, but explicit EU Treaty amend­ments includ­ing changes in the ECB's restric­tions and man­date. More­over, an agree­ment on fis­cal union isn't just a mat­ter of putting nice words on paper — it has to be cred­i­ble in order for Ger­many to go along. Oth­er­wise, mas­sive ECB buy­ing of dis­tressed Euro­pean debt would effec­tively con­sti­tute a per­ma­nent cre­ation of new euros that would never be undone. While open mar­ket oper­a­tions that tem­porar­ily cre­ate new cur­rency are often not infla­tion­ary, per­ma­nent cre­ation of new cur­rency to finance gov­ern­ment deficit spend­ing is entirely a dif­fer­ent matter.

On the ques­tion of cred­i­bil­ity, there is also a prob­lem in cre­at­ing an effec­tive enforce­ment mech­a­nism for the fis­cal union. Sup­pose a gov­ern­ment is, in fact, run­ning actual deficits greater than 3% of GDP, or "struc­tural" deficits greater than 0.5%, which is the desired max­i­mum. It will be impos­si­ble, at that point, to cred­i­bly say, "Uh oh, you're run­ning larger deficits than are allowed — there­fore, you're going to have to pay a penalty, which will effec­tively drive you into larger deficits. Oth­er­wise, you're going to lose your vote in the EU, which will accel­er­ate the risk of your dis­or­derly depar­ture from the union."

If the mar­kets want more flex­i­ble bond buy­ing from the ECB, the best route would be for EU mem­bers to agree to explicit changes to EU Treaties, and to restrict var­i­ous pro­vi­sions that Britain finds objec­tion­able, so that they apply only to the 17 EU mem­bers whose cur­rency is the euro. That said, while an explicit fis­cal union would give the ECB greater flex­i­bil­ity, my impres­sion is that we will still never see the ECB embark­ing on "big bazooka" pur­chases of dis­tressed Euro­pean debt, pre­cisely because the very fact that the debt is dis­tressed would intro­duce a ques­tion about whether the debt would be repaid; there­fore a ques­tion about the ECB's abil­ity to reverse the pur­chases; there­fore a ques­tion about the cred­i­bil­ity of the ECB; and there­fore a ques­tion about the cred­i­bil­ity of the euro itself.

We've seen some the­o­ries that Europe intends to address the prob­lem through ECB lend­ing to banks, tak­ing dis­tressed debt as col­lat­eral, with the banks turn­ing around and buy­ing more dis­tressed debt. Apart from the fact that this would be the sort of "legal trick" that the ECB would be unwill­ing to facil­i­tate, this would imply an increase in bank lever­age ratios far beyond the 30–40 mul­ti­ples that already exist (which would be a dis­as­ter when tighter Basel III cap­i­tal require­ments kick in). In prac­tice, depos­i­tors would flee, and you would end up with a Euro­pean bank­ing sys­tem where bank bond­hold­ers, not the ECB, would be sub­ject to the losses, since the ECB's col­lat­eral claims would be senior. Like­wise, IMF loans are always highly con­di­tional, and are always senior claims.

As I noted last week, what investors really want isn't just for some­one to buy dis­tressed Euro­pean debt, but for some­one to buy that debt and will­ingly take a loss on it so the money doesn't ever actu­ally have to be repaid. This is a sol­vency issue — a short­fall between money owed and the resources to cred­i­bly repay it. There is no legal trick to get around that. Ulti­mately, you either have to restore cred­i­bil­ity, or you have to restruc­ture the claims through default or devaluation.

As for the knee-jerk enthu­si­asm of some ana­lysts over the prospect of not just one Euro­pean bailout fund, but two, it is help­ful to rec­og­nize that the Euro­pean Sta­bil­ity Mech­a­nism (ESM) is sim­ply the per­ma­nent, Treaty-blessed ver­sion of the Euro­pean Finan­cial Sta­bil­ity Facil­ity (EFSF). These are not two sep­a­rate pools of money, but are instead the presently oper­at­ing facil­ity and its even­tual per­ma­nent home, as the EFSF expires in 2013. There is a 1-year over­lap in the life of these two vehi­cles in order to facil­i­tate that trans­fer of respon­si­bil­ity. The guar­an­tee com­mit­ment of Euro­pean mem­ber states to the EFSF is 440 bil­lion euros (about one-third of that from Italy and Spain, which is ironic), which increases to 500 bil­lion euros in guar­an­tee com­mit­ments once the ESM is estab­lished. Again, these facil­i­ties are really one in the same.

I want to be clear — it is crit­i­cally impor­tant for the EU to estab­lish some sort of fis­cal unity, to pull Euro­pean mem­ber states off of the road toward insol­vency. In my view, an oncom­ing global reces­sion will be very hos­tile to the effort to bal­ance gov­ern­ment bud­gets, but greater fis­cal coör­di­na­tion is an impor­tant objec­tive if Europe's com­mon cur­rency is to survive.

The bot­tom line is that last week's events took a great deal more off the table than sugar-addicted investors may imme­di­ately appre­ci­ate. In effect, if a fis­cal union is achieved with­out treaty changes, the ECB is unlikely to act. But even if treaty changes are achieved, the ECB is unlikely to act force­fully unless those changes are cred­i­ble. Of course, if the changes are cred­i­ble, then force­ful actions will not be needed any­way. In any event, the prob­lem for bailout-hungry investors is that they will be deeply dis­ap­pointed if they expect Mario Draghi to turn into Ben Bernanke.

A cred­i­ble solu­tion for Europe: con­vert­ible debt

So what can Europe do to cred­i­bly address its credit strains, in a way that reduces the risk of a col­lapse of the Euro­pean mon­e­tary union? In my view, the most viable approach is for Euro­pean mem­ber states (par­tic­u­larly the dis­tressed ones) to begin writ­ing con­vert­ibil­ity clauses into their debt as it rolls over. Those con­vert­ibil­ity clauses would pro­vide that the debt could be con­verted, at the option of the issu­ing gov­ern­ment, into an equiv­a­lent amount of that country's legacy cur­rency (lira, pese­tas, etc).

Undoubt­edly, this would tack a "con­ver­sion pre­mium" onto the bond yields of highly indebted coun­tries, essen­tially sub­sti­tut­ing for the default pre­mi­ums that investors tack on today. If a coun­try fol­lows (or adopts) a cred­i­ble fis­cal pol­icy, the con­ver­sion pre­mium would be rel­a­tively low, because investors would be con­fi­dent that the coun­try would remain in the euro-zone, and that no future con­ver­sion would occur. But if a coun­try pur­sues an unsound fis­cal course, the con­ver­sion pre­mium would rise, cre­at­ing an incen­tive for that coun­try to cor­rect its own fis­cal poli­cies, with­out the need for exter­nal pres­sure from other EU mem­ber coun­tries, and with far less fear of dis­or­derly default. If those efforts fail, the coun­try would con­vert the debt to its legacy cur­rency. Investors would rea­son­ably expect that in the event of con­ver­sion, the newly con­verted cur­ren­cies would most prob­a­bly depre­ci­ate, and they would reflect that risk in the prices they pay and yields they demand.

Keep in mind that the aver­age matu­rity of Euro-area debt is less than 7 years. Grad­u­ally intro­duc­ing debt with con­vert­ibil­ity clauses could pro­vide a sub­stan­tial "release-valve" for Europe within a fairly small num­ber of years. Rather than per­pet­u­at­ing a sys­tem of moral haz­ard, where indebted coun­tries become more indebted on the expec­ta­tion of even­tual bailouts by stronger EU mem­bers, intro­duc­ing con­vert­ible debt would place the costs and incen­tives for fis­cal reform squarely on each indi­vid­ual country.

Ide­ally, all of the present euro-zone mem­bers would achieve suf­fi­cient fis­cal cred­i­bil­ity to remain in the euro. Clearly, each coun­try would have an incen­tive to do so, with­out the need for ques­tion­able enforce­ment mech­a­nisms by other EU mem­bers. In this way, if the sys­tem can be saved, the sys­tem will be saved. Yet unlike the present arrange­ment, the entire EU will not be brought to its knees in the event that indi­vid­ual coun­tries fail to solve their bud­get difficulties.

Mar­ket Climate

As of last week, the Mar­ket Cli­mate for stocks was char­ac­ter­ized by an extremely unfa­vor­able ensem­ble of con­di­tions across val­u­a­tions, sen­ti­ment, eco­nomic fac­tors, and other con­di­tions. Cur­rent con­di­tions clus­ter with peri­ods such as May 1962, Octo­ber 1973, July 2001, and Decem­ber 2007, all which pro­duced 10–20% mar­ket losses in extremely short-order. Strate­gic Growth and Strate­gic Inter­na­tional are tightly hedged here. Strate­gic Total Return con­tin­ues to carry an aver­age dura­tion of about 3 years, with about 20% of assets in pre­cious met­als shares (where con­di­tions remain quite pos­i­tive on our mea­sures), and small single-digit posi­tions in util­ity shares and (non-euro) for­eign currencies.

That said, our invest­ment strat­egy is not based on fore­cast­ing spe­cific near-term mar­ket move­ments, but instead on accept­ing mar­ket risk in pro­por­tion to the expected return that has his­tor­i­cally accom­pa­nied sim­i­lar observ­able con­di­tions, on aver­age. As that evi­dence changes, our invest­ment stance will also change.

Impor­tantly, we don't look to "time" short-term move­ments or "catch" var­i­ous trends. My height­ened con­cerns here should not be taken as a spe­cific "pre­dic­tion" of com­ing mar­ket move­ments, but rather as a response to con­di­tions that have typ­i­cally been hos­tile. We are respond­ing to this observ­able data defen­sively, in a way that is most con­sis­tent with our long-term, full-cycle invest­ment objective.

Finally, I rec­og­nize that it is com­mon for invest­ment man­agers to posi­tion their port­fo­lios near year-end in hopes of window-dressing their port­fo­lios or bet­ting on a "Santa Claus" rally or other mild sea­sonal ten­den­cies. In gen­eral, these sea­sonal ten­den­cies are too weak to counter the other fac­tors that enter into our analy­sis, but in any case, we man­age the Funds with a focus on a spe­cific full-cycle invest­ment dis­ci­pline, not with a focus on tweak­ing our end-of-year hold­ings. So while year-end window-dressing activ­ity may or may not defer the unfa­vor­able pres­sures that we see in the data, we have no inten­tion of ignor­ing that evi­dence in hopes of catch­ing a wholly uncer­tain ride on Santa's sleigh. We'll con­tinue to fol­low our dis­ci­pline. For now, we remain broadly defensive.

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