“For as long as I can remember, veteran businessmen and  investors – I among them – have been warning about the dangers of irrational  stock speculation and hammering away at the theme that stock certificates are  deeds of ownership and not betting slips… The professional investor has no  choice but to sit by quietly while the mob has its day, until the enthusiasm or  panic of the speculators and non-professionals has been spent. He is not  impatient, nor is he even in a very great hurry, for he is an investor, not a  gambler or a speculator. The seeds of any bust are inherent in any boom that  outstrips the pace of whatever solid factors gave it its impetus in the first  place. There are no safeguards that can protect the emotional investor from  himself.” – J. Paul Getty

Another fact filled truthful warning from John Hussman. We might be in the midst of a blow-off top that will take the markets to marginal new highs, but the hangover will be epic and ten years from now, the stock market will be no higher than it is today. If you are too lazy to read the whole article, these two paragraphs will provide the insight you need to take away from this post:

On a diverse set of reliable fundamentals, we now estimate a  10-year nominal total return for the S&P 500 of just 2.6% annually. Put  another way, stocks are likely to achieve zero risk premium over 10-year  Treasuries in the coming decade, despite having about five times the duration, volatility and drawdown risks. The  entirety of that total return can be expected to arrive in the form of dividends,  leaving the S&P 500 below its current level a decade from now. This would  be a less depressing conclusion if I didn’t correctly say the same thing in  2000, and if even simple versions these valuation methods didn’t have a nearly  90% correlation with subsequent 10-year returns (see Investment, Speculation,  Valuation, and Tinker Bell).  

The failure of investors to learn from experience isn’t just  an inconvenience – the constant misallocation of capital resulting from these  speculative episodes is gradually destroying our nation’s economic potential  for long-term growth and job creation. We measure our standard of living by the  amount of output that an individual is able to command for a given amount of work. We measure our productivity by  the amount that an individual is able to produce for a given amount of work. Over time, these two must go hand in hand. Policies  that misallocate savings away from productive investment and toward  unproductive speculation are the same policies that do long-term violence to  our nation’s standard of living. Although the members of the Federal Reserve  undoubtedly mean well, their actions are at the center of the assault.

Bernanke has solved nothing. The economy has been terminally damaged by his actions. Accounting fraud does not change the fact that Wall Street banks, Fannie Mae, Freddie Mac, the Federal Reserve, and our local, state and federal governments are effectively bankrupt and insolvent. Throwing freshly printed pieces of paper at a debt problem is as mind boggling as it is insane. Enjoy the show while it lasts.

Did Monetary Policy Cause the Recovery? 

John P. Hussman, Ph.D.      

As investors, we should be aware that the current Shiller  P/E of 24.8 (S&P 500 divided by the 10-year average of inflation adjusted  earnings) is now above every historical instance prior   to the bubble period since the late-1990’s, save for the final weeks approaching the 1929 peak. We should also be aware that overvaluation alone in the late-1990’s did not stop the  market from reaching even higher levels as new-era speculation culminated in the 2000 bubble  peak.

It’s fine, and quite accurate to say that valuations are  not as frenzied as they were at the 2000 extreme (a comparison that fell from the  lips of Robert Shiller himself last week), provided that one also recognizes  that the hypervaluation in 2000 has been followed by a period that included  two separate market losses in excess of 50%, and a nominal total return from  2000 until today averaging just 3.2% annually. Even that weak 13-year return has been  achieved only thanks to distortions  that have again driven present valuations  to temporary and historically untenable extremes.

Put simply, the past 13 years have chronicled the journey of valuations – from hypervaluation to levels that still exceed every pre-bubble precedent other than a few weeks in 1929. If by  2023, stock valuations complete this journey not by moving to undervaluation, but simply  by touching pre-bubble norms, we estimate that the S&P 500 will have achieved a nominal total return of only about 2.6% annually between now and then.

What usually distinguishes an overvalued market that continues to advance  from an overvalued market that drops like a rock is the quality of market  internals and related measures that capture the preference of investors to seek  risk. On that front, our views on near-term return/risk prospects  are very mixed at present. On one hand, our primary measures of market  internals remain unfavorable but approaching borderline, while price action appears  overbought on nearly every measure. On the other hand, bullish sentiment has  eased back modestly, and investors continue to celebrate the likelihood that  the Fed will defer any tapering decision this month. More on short-term considerations below.

Examining various historically useful fundamentals, the  S&P 500 price/revenue ratio of 1.6 is now twice its pre-bubble historical norm of about 0.8. For perspective,  it’s worth noting that the 1987 peak occurred at a price/revenue ratio of less  than 1.0 and neither the 1965 secular valuation peak, nor the 1972 peak (before  stocks dropped in half) breached even 1.3. Also, take care to note that the price/revenue  multiple is twice the historical median – not twice the level where bear markets have typically ended. No, the price/revenue ratio is closer to three times that level.

Broadening our view to a larger set of historically reliable  measures that are actually well-correlated with subsequent market returns, we arrive at identical conclusions. For  example, the market value of non-financial stocks to GDP (based on Z.1  flow-of-funds data from the Federal Reserve) presently works out to about 1.24.  This is twice the pre-bubble norm,  well above the 2007 peak, and already at late-1999 levels.

On a diverse set of reliable fundamentals, we now estimate a  10-year nominal total return for the S&P 500 of just 2.6% annually. Put  another way, stocks are likely to achieve zero risk premium over 10-year  Treasuries in the coming decade, despite having about five times the duration, volatility and drawdown risks. The  entirety of that total return can be expected to arrive in the form of dividends,  leaving the S&P 500 below its current level a decade from now. This would  be a less depressing conclusion if I didn’t correctly say the same thing in  2000, and if even simple versions these valuation methods didn’t have a nearly  90% correlation with subsequent 10-year returns (see Investment, Speculation,  Valuation, and Tinker Bell).

The failure of investors to learn from experience isn’t just  an inconvenience – the constant misallocation of capital resulting from these  speculative episodes is gradually destroying our nation’s economic potential  for long-term growth and job creation. We measure our standard of living by the  amount of output that an individual is able to command for a given amount of work. We measure our productivity by  the amount that an individual is able to produce for a given amount of work. Over time, these two must go hand in hand. Policies  that misallocate savings away from productive investment and toward  unproductive speculation are the same policies that do long-term violence to  our nation’s standard of living. Although the members of the Federal Reserve  undoubtedly mean well, their actions are at the center of the assault.

Did Monetary Policy Cause the Recovery?

We can quite reliably estimate the long-term returns that  stocks are likely to deliver over a 7-10 year horizon. Still, valuations often  have less direct effect over shorter portions of the market cycle. The present  situation is complicated by the fact that while valuations are extreme from a  historical standpoint, investors are tied to a narrative that assumes a  cause-and-effect link between monetary policy and market direction. The “follow  the Fed” narrative certainly did not prevent the market from losing half of its  value during the 2000-2002 and 2007-2009 plunges, despite aggressive monetary  easing in both instances, but what matters in the short-run is not the truth of  that narrative, but the perception that it is true.

Since about 2010,  normal economic relationships have taken a back seat to ever  larger monetary policy interventions. The correlation between reliable leading  measures of economic activity and subsequent job growth and GDP has dropped not  just to zero but to negative levels (see When Economic Data is  Worse Than Useless). Similarly, extreme overvalued, overbought, overbullish  syndromes, which throughout history have been closely followed by severe  losses, have instead been followed by further speculative gains. The question is whether this reflects a permanent change in economic dynamics, or a temporary overconfidence about the effectiveness of monetary policy.

To address this question, a  proper understanding of the credit crisis is essential. Much of the present faith in monetary policy derives from the belief that it was the central factor in ending the banking crisis during what is often called the Great Recession. On careful analysis, however, the clearest and most immediate event  that ended the banking crisis was not monetary policy, but the abandonment  of mark-to-market accounting by the Financial Accounting Standards Board on  March 16, 2009, in response to Congressional pressure by the House Committee on  Financial Services on March  12, 2009. The change to the accounting rule FAS 157 removed the risk of  widespread bank insolvency by eliminating the need for banks to make their  losses transparent. No mark-to-market losses, no need for added capital, no need for regulatory intervention, recievership, or even bailouts. Misattributing the recovery to monetary policy has contributed  to a faith in its effectiveness that cannot even withstand  scrutiny of the 2000-2002 and 2007-2009 recessions, and the accompanying market  plunges. This faith is already wavering, but the loss of this faith will be one of the most painful aspects of the completion of the present market cycle.

The simple fact is  that the belief in direct, reliable links between monetary policy and the economy – and even with the stock market – is contrary to the lessons from a century of history. Among the many things that are demonstrably not true – and can be demonstrated to be untrue even with simple scatterplots – are the notions that inflation and unemployment are negatively related over time (the actual correlation is close to zero and slightly positive), that higher inflation results in lower subsequent unemployment (the actual correlation is positive), that higher monetary growth results in subsequent employment gains (the correlation is almost exactly zero), and a wide range of similarly popular variants. Even “expectations augmented” variants turn out to be useless. Examining historical evidence would be  a useful exercise for Econ 101 students, who gain an unrealistic sense of cause and effect as the result of studying diagrams instead of data.

In regard to what is demonstrably true, it can easily be shown that unemployment has a significant inverse relationship with real, after-inflation wage growth. This is the true Phillips Curve, but reflects a simple scarcity relationship between available labor and its real price, but this relationship can’t be manipulated to create jobs (see Will the Real Phillips Curve Please Stand Up). It’s also true that changes in stock prices are mildly correlated with subsequent reductions in the unemployment rate and higher GDP growth. But the effect sizes are strikingly weak. A 1% increase in stock prices correlates with a transitory increase of only 0.03-0.05% in subsequent GDP, and a decline of only about 0.02% in the unemployment rate. So to use the stock market as a policy instrument, the Fed would have to move the stock market about 70% above fair value just to get 2.8% in transitory GDP growth, and a 1.4% decline in the unemployment rate. Guess what? The Fed has done exactly that. The scale of present financial disortion is enormous, and further distortions rely on the permanent belief that there is actually a mechanistic link between monetary policy and stock prices.

We know very well the mechanisms and actual historical  relationships between monetary policy and financial markets, and doubt that any  amount of quantitative easing will prevent a market slaughter in any  environment where investors find short-term liquidity desirable (QE only  “works” to the extent that zero-interest liquidity is treated as an undesirable  “hot potato”). Still, the novelty of quantitative easing, and the misattributed  belief that monetary policy ended the banking crisis, has created financial  distortions where perception-is-reality, at least for now. We believe that the  modifier “for now” will prove no more durable than it was during the tech  bubble or the housing bubble.

On Full-Cycle  Discipline

From a short-term perspective, the S&P 500 is pushing  its upper Bollinger bands at daily, weekly and monthly resolutions (two  standard deviations above the respective 20-period averages), which to say that  the recent advance looks stretched. At the same time, though our measures of  market internals still show internal divergence, there’s little question that  speculation has gathered some momentum. Specifically, monetary “tapering” is  likely to be taken off the table for a while, as the result of recent fiscal  wrangling, which requires us to allow for the possibility of a speculative  blowoff over a handful of weeks. Even if a speculative ramp occurs, it’s not at  all clear that speculators will actually be able to get out with much – the  first few days off the top are likely to wipe out months of gains in one fell  swoop – but again, we have to at least allow for an already reckless situation to become even more reckless over the short  run, as the crowd seems to have a bit in its teeth.

In any event, while the potential for further speculation  may warrant a bit of insurance (index call options have a useful contingent  profile), the most important consideration continues to be the complete cycle,  not the next few weeks. As in 2007, we’re back to a situation where fair value  is more than 40% below present levels, and I believe that it is essential to maintain a strong defense  overall.

If you picture a small child throwing a stone upward and out  over the edge of the Grand Canyon, you’ll get a general idea of the market  trajectory that we expect over the completion of this cycle.

With regard to catalysts, it’s a market truism that the  catalysts  become clear only after a bear market is well underway, but my  impression is that the primary factor contributing to market losses over the  remainder of this cycle will not be some abrupt crisis, but instead a persistent  and broadening loss of confidence –  not only in the ability of monetary policy to produce economic growth, but in  the prospects for economic growth itself. The predictable contraction in  corporate profit margins will certainly contribute, but remember that changes  in corporate profits typically follow changes in combined government and  household savings with a lag of 4-6 quarters, and most of the recent shift in  combined savings has only occurred since the third quarter of 2012.

All of this is a mixed situation – one where valuations and  long-run evidence are extremely clear, but where perception and sentiment may  dominate over the short-run. Our discipline remains to rely on the demonstrated  historical evidence, while allowing for some amount of further distortion.

Since 2000, we’ve made only two material changes to our  investment discipline – one resulted from stress-testing against Depression-era outcomes that I insisted on in  2009-early 2010 (despite the fact that our existing estimation methods had served admirably to  that point), and the other being a smaller hedging adaptation in 2012 (see Notes on An Extraordinary  Market Cycle). Our confidence in our discipline follows directly from  knowing exactly how our present methods have performed in market cycles across  history, including the Depression, including the cycle from 2000-2007, and including  the cycle from 2007 to the present. In hindsight, I would undoubtedly prefer to  have applied either our present  return/risk estimation methods or our pre-2009 methods over the complete course of  the most recent cycle, without the unfortunate and awkward transition that the credit  crisis provoked. We don’t have that luxury, but to understand the full story of the half-cycle since 2009, and to take either our pre-2009 or present methods to the data (the present ones also covering Depression-era outcomes) is  to understand why we adhere to our discipline without blinking. See Aligning Market Exposure with the Expected Return/Risk Profile for the general framework and a very simple illustration of this discipline. As I’ve noted before, history repeatedly teaches a  very coherent set of lessons:

1. Depressed  valuations are rewarded over the long-term;
2. Rich valuations  produce disappointment over the long-term;
3. Favorable  trend-following measures and market internals tend to be rewarded over the  shorter-term, but generally only while overvalued, overbought, overbullish  syndromes are absent;
4. Market losses  generally emerge from overvalued, overbought, overbullish syndromes, on  average, but sometimes with “unpleasant skew” where weeks or even months of  persistent marginal advances are wiped out in a handful of sessions. The losses  often become deep once the support of market internals is lost.
5. When a broken  speculative peak is joined by a weakening economy, the losses can become  disastrous.

Monetary conditions can be a modifier, but have historically  not prevented these basic tendencies from dominating over time. Investors who  are convinced that this time is different or that following the Fed is some  kind of “sure thing” are at liberty to forge their own path and test that  hypothesis on their own. We cannot do it for them, nor are we moved by any inclination  to do so.

It’s quite popular, at times like these, for people to quote  Keynes, saying “the market can remain irrational longer than you can remain  solvent,” but insolvency is the problem of debtors and those who speculate on  margin, not for those who simply await better opportunities. Keynes actually  made that comment because he was wiped out with a leveraged long position in a  plunging market.

From my standpoint, the more apt perspective is that of J.  Paul Getty (whom I also quoted in 2000, and at the May highs, a few percent  from current levels). Getty wrote:

“For as long as I can remember, veteran businessmen and  investors – I among them – have been warning about the dangers of irrational  stock speculation and hammering away at the theme that stock certificates are  deeds of ownership and not betting slips… The professional investor has no  choice but to sit by quietly while the mob has its day, until the enthusiasm or  panic of the speculators and non-professionals has been spent. He is not  impatient, nor is he even in a very great hurry, for he is an investor, not a  gambler or a speculator. The seeds of any bust are inherent in any boom that  outstrips the pace of whatever solid factors gave it its impetus in the first  place. There are no safeguards that can protect the emotional investor from  himself.”

The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Only comments in the Fund Notes section relate specifically to the Hussman Funds and the investment positions of the Funds.

Fund Notes

As of last week, Strategic Growth Fund remained  fully hedged, with a “staggered strike” position that places the strike prices  of its index put options moderately below present market levels. The Fund also  carries a small contingent call option position representing a small fraction  of 1% of assets, as slight insurance against the possibility of a further speculative  “blowoff” over the shorter-term. To be clear, we remain defensive overall. Meanwhile,  Strategic  International remains fully hedged, Strategic Dividend Value  is hedged at about 50% of the value of its stock holdings, and Strategic Total  Return carries a duration of just over 6 years (meaning that a 100 basis point  move in yields would be expected to impact the Fund by about 6% on the basis of  bond price fluctuations), with just over 8% of assets in precious metals shares  and a small position in utility shares.