http://hussmanfunds.com/wmc/wmc081013.htm
October 13, 2008
Four Magic Words: "We Are Providing Capital"
John P. Hussman, Ph.D.
This week's comment may be distributed freely without further permission
I want to begin this comment with three questions:
1) How many people do you know whose bank has failed and have had any difficulty recovering their deposited funds? Anyone?
2) Do you personally know anyone whose money market fund has “broken the buck” and has not received the full assurance of the government that their claims will be paid in full?
3) Have you yourself had any difficulty making any transaction (not tightly related to your personal credit rating) in any aspect of daily life such as credit card purchases, grocery, gas, shopping, or for any other purpose?
The point of these questions is certainly not to deny that credit – particularly commercial paper and interbank lending – is extraordinarily tight. These markets are quite short-term in nature; generally between overnight and 30-60 days, but they are also markets in which central banks are providing extraordinary amounts of liquidity to ease those constraints. Rather, the point of these questions is to to remind investors that upon reflection, virtually all of the panic that people have about the credit markets is borne of fearmongering, and not based on personal experience. This crisis has certainly caused major difficulties for the owners and employees of unsound institutions, but generally speaking, the customers have not been affected.
I have several assertions here. As a reputed “perma-bear” that has pointedly warned about the collapse that we're observing now (e.g. “A Who's Who of Awful Times to Invest” – July 16, 2007), I hope these assertions will carry some weight.
The only thing we have to fear is the fearmongering of Wall Street itself
Look – a few weeks ago, there was a $700 billion pile of money on the table, but the only way for Wall Street and bureaucrats to get their paws on it was to scare the public out of its collective gourd. They succeeded, but created the psychology that the U.S. was on the verge of depression if the bailout wasn't passed. Having created that psychology, the crisis took on a life of its own.
I have argued since 2003 (e.g. “Freight Trains and Steep Curves”) that the U.S. financial system was pushing toward major credit difficulties. Earlier this year (“Which Inning of the Mortgage Crisis Are We In?”), I noted that the eye of the storm would pass just about where we are today. These difficulties were largely expected. In response, the badly reasoned and childish panic coming out of Wall Street analysts these days is an embarrassment to the investment profession.
Word to the wise - don't accept advice or analysis about this crisis from anyone who failed to anticipate it in the first place. The people warning about Depression now (or even talking about it casually on the financial channels) are the same reckless jackasses who told investors that stocks were cheap and “resilient” at the highs.
Stocks are now measurably undervalued
Investors will berate themselves for the panic they are now exhibiting. This, from an advisor that has adamantly argued for over a decade (with the exception of 2002-2003) that the stock market was strenuously overpriced and likely to deliver disappointing long-term returns. My impression is that investors who abandon properly diversified and carefully planned investments here, with the stock market already down by nearly half, will regret it as the emotionally panicked decision that wrecked their retirement prospects.
Long-term shareholders will recognize the following chart, which is an update of our 10-year total return projections for the S&P 500 Index ( standard methodology). The heavy line tracks actual 10-year total returns. Note that the total return for the past decade has been zero, right in the mid-range of what we projected at the time. The green, orange, yellow, and red lines represent the projected total returns for the S&P 500 assuming terminal valuation multiples of 20, 14 (average), 11 (median) and 7 times normalized earnings. Stocks are now at the same valuations that existed at the 1990 bear market low. Relative to 30-year Treasury yields, the S&P 500 is priced to deliver the highest excess return since the early 1980's.
Warren Buffett recently repeated some useful advice – “good investors are fearful when everyone else is greedy, and greedy when everyone else is fearful.” Though we continue to have put option coverage below nearly 90% of our stockholdings, we have covered our short call options, and have moved our put strikes lower. At present, those options provide significant (but not complete) defense against continued market losses without exerting a major drag on positive returns that appear increasingly likely. (With reference to the strategy articulated in the Prospectus, we are now in the yellow “Moderate” condition - favorable valuations but still unfavorable market action – where we gradually establish moderate exposure to market fluctuations on price weakness).
Four magic words will ease this crisis: “We are providing capital.”
The main problem in the U.S. financial system amounts to roughly 5% of the mortgage assets outstanding. Much of the panic can be traced to the wipeout of shareholder equity in highly leveraged institutions, but it's only a small percentage of the volume of loans in the financial system. Investors are now being quoted ridiculous dollar figures in the trillions and quadrillions (e.g. the total value of the U.S. housing stock, or the un-netted notional value of financial derivatives) as if these figures represent potential losses. The people spouting these figures are appealing to the worst impulses of a frightened public that doesn't fully understand the market mechanisms at work here.
Four magic words will ease this crisis: “We are providing capital.” Specifically, the Treasury should refrain from buying bad assets from financial institutions, and should instead provide capital directly . As I noted in You Can't Rescue the Financial System if You Can't Read a Balance Sheet, buying bad assets does nothing to improve the capital position of an institution unless the Treasury overpays for those assets.
In recent weeks, I've taken out full-page pieces (An Open Letter to the U.S. Congress Regarding the Current Financial Crisis) in the Washington Post and elsewhere. Though the second rescue bill was generally better than the first, I've continually argued that the most proper and effective form of government intervention in this crisis is to provide capital. In return, the government should receive not common stock, but either senior preferred stock bearing a relatively high rate of interest, or ideally, a novel sort of “super-bond” – it would be subordinate to customer claims, so it would be countable as a hybrid Tier II security for the purposes of capital requirements, but in the event of bankruptcy, it would be senior to all of the company's own bondholders. Virtually all of these financial institutions have bondholder liabilities that are more than adequate to absorb every dollar of loss on bad mortgage securities and other assets, without ever exposing customers to risk of loss. Taxpayers would bear very little risk by providing a capital cushion that sits ahead of the company's common stockholders (and ideally its bondholders), but behind the customers.
Property appreciation should be traded for mortgage reductions
The proper way to address homeowner distress is not for the government to buy troubled mortgages and simply reduce the principal. That idea is utterly insane. If that policy was enacted, every homeowner in America would have an incentive to immediately go delinquent on their mortgage. Rather, Congress should provide for a relatively modest alteration in bankruptcy laws, allowing judges to write down mortgage principal but at the same time provide the mortgage lender with what I'd call a “Property Appreciation Right” (PAR) that would give the lender a claim on some amount of future price appreciation of property owned by the borrower. In that way, the mortgage lender would have the prospect of being made whole over time, homeowners who have faithfully made payments on their own mortgages would not be discriminated against, and homeowners in trouble would surrender some future price appreciation for immediate reduction in their monthly payment burden.
The markets have endured credit-related “panics” before
I recognize that all of this is very scary – particularly the rate at which the market has declined. But it is important for investors to understand that the current selloff has all the quite standard markings of a “panic,” of the type that Charles Kindleberger described in Manias, Panics, and Crashes: a “seizure of credit in the system.” It is just mind-boggling to hear financial reporters and Wall Street “professionals” foaming at the mouth that the difficulties we are observing today are wholly new and unprecedented. We've seen these before.
Economist Stephen Roach wrote weeks ago that “The most important thing about financial panics is that they are all temporary. They either die of exhaustion or are overwhelmed by the heavy artillery of government policies.” That fact is worth remembering here.
Look – if your asset allocation is wrong (e.g. if you are relying on the market to recover quickly, at the risk of intolerable losses and changes to your plans if it doesn't), then your asset allocation is wrong, and you should immediately start to make changes so you can get it right. Don't put money that you need to meet short-duration obligations at the mercy of long-term investments, regardless of the market's valuation.
In contrast, if your asset allocation is consistent with your risk tolerance, you're diversified, and you have a “full cycle” investment horizon, stick with your discipline. If your exposure to risk is small, a panic is a good time to increase it gradually on depressed prices. That is what good investors do. The bad investors are the ones that establish leverage at tops and are forced to sell at bottoms. Those investors unfortunately exist, and their behavior can amplify movements in both directions, but a disciplined, gradual, diversified strategy should allow for that.
In a market economy, profits are the compensation that people earn for providing scarce resources. One of the scarcest resources here and now is the willingness to accept risk – the willingness to put a bid out at a low price so that someone can actually sell. You don't exhaust your whole risk budget, or even the majority of it, but you move gradually, in steps – the scarier and more volatile the market, the smaller the size of the trades and the bigger the discounts you require. In short, a good investor provides scarce resources – liquidity, risk bearing and (if you're a good investment analyst) information, when those resources are in furious demand.
Notes to shareholders
Last week, I posted the following special notes in the “Fund News” section of the Hussman Funds website in order to provide additional information about financial conditions and our day-to-day activities. These are reprinted here for informational purposes.
October 7, 2008: As noted in the latest weekly comment , in response to significant improvement in market valuations, the Strategic Growth Fund gradually establishes moderate exposure to market fluctuations on price declines (even while market action may still be unfavorable - see the Prospectus for details). This process can involve some discomfort, but is an intentional and necessary part of long-term, risk-managed, value-conscious investing. Currently, the majority of the Fund's portfolio remains hedged with put options. These hedges significantly mute but do not eliminate the impact of market fluctuations. As of 10/7/08, the Fund is 6.71% below the record level set a few weeks ago (the major indices lost nearly this amount on 10/7/08 alone). The price/peak-earnings multiple for the S&P 500 is now 11.7, which is the lowest level since the 1990 market trough
October 9, 2008 : The Strategic Growth Fund remains less than 10% from the record high set a few weeks ago. The current decline in the market has numerous historical precedents commonly referred to as "panics" - typically associated with short-lived liquidity crises as observed as early as 1907 and as recently as 1998. Nearly 90% of the stocks held by the Strategic Growth Fund continue to be hedged with put options, but we have intentionally lowered our strike prices in steps (about at-the-money as of Thursday's close). Our current hedge allows us to tolerate market weakness in a measured way (experiencing a fraction of the market's losses), while allowing for participation in advances. Market valuations have improved sharply. With the price/peak-earnings multiple now at 10.7, the S&P 500 currently appears priced to deliver favorable long-term returns.
Market Climate
As of last week, the Market Climate for stocks was characterized by favorable valuations and unfavorable market action. The Strategic Growth Fund continues to carry put option coverage for nearly 90% of its stock holdings, but we have moved our strike prices down in steps to take “intrinsic value” out, maintain significant but not complete downside protection, and also reduce the extent to which our hedges would restrain participation in subsequent market gains.
I strongly believe that investors will look at this period a few weeks from now and ask themselves “what the heck did we do that for?” Still, we can't rely on that outcome, so we do continue to carry some amount of put option coverage. Fortunately, even with very high implied volatilities, the market's actual volatility has exceeded what is priced into the options, allowing us to shift our strike prices and expirations in a way that has given us quite good protection in relation to the amount of upside potential that we've retained. At present, the Strategic Growth Fund down less than 10% from its record high, versus a drop of over 40% in the S&P 500 (I recognize that is little consolation, at least for the time being, but it is notable that we would require an advance of less than 11% to surpass our former high, while the S&P 500 would require an advance of about 70%).
As we emphasize in the Prospectus, the Strategic Growth Fund is equity growth fund, not a “bear” fund or a “market neutral” fund. Environments of favorable valuations are ones where we reduce the extent of our hedging – gradually, in a very measured way, but also intentionally. The Fund is behaving less like a fully hedged vehicle and has somewhat more sensitivity to market fluctuations because stocks are now priced at the most reasonable valuations in 18-25 years.
To a large extent, it is a gift that valuations have moved all the way to favorable levels, because it will allow us to have much more flexibility in our market exposure during the next market cycle than we had in the most recent one (which has now given up virtually all of the gains since the prior bear market low). In short, we are intentionally establishing a modest level of exposure to the market as it becomes increasingly undervalued, but we are also controlling our risk so that we can tolerate further market losses if they emerge.
In the June 30, 2008 Annual Report, I noted, “From the standpoint of discounted long-term cash flows, I currently believe that the S&P 500 Index remains priced to achieve relatively unsatisfactory returns over the coming 5-7 year period. However, substantial market weakness over a shorter period could reduce valuations to the level where expected long-term market returns would appear satisfactory or even compelling. At that point, the Fund is likely to accept a substantially greater level of market risk than it has in recent years. Thus, the defensiveness of the Fund's investment position in recent years should not be viewed as typical. Our exposure to market risk is generally proportional to the return that we can expect from such risk. So a more aggressive exposure to risk would, of course, be motivated by expectations of higher total returns over the complete market cycle.”
In bonds, the Market Climate last week was characterized by unfavorable yield levels and moderately favorable yield pressures. The Strategic Total Return Fund continues to carry a duration of about 2.5 years, mostly in short-maturity Treasury securities. The Fund also has about 12% of assets invested in precious metals shares, about 12% of assets in foreign currencies, and about 6% of assets in utility shares. That 30% of assets has induced some additional day-to-day volatility in the Fund, but all of these asset classes appear extremely oversold. Precious metals shares, in particular, are remarkably depressed relative to the metal itself – to the extent that gold prices could fall by half and gold stock prices would still be undervalued. A good amount of this behavior appears to be driven by forced liquidation in leveraged commodity hedge funds (so much for Malthusian arguments that commodity prices were no longer cyclical). Presently, the valuations in all of these holdings appear unusually favorable relative to what has been available in recent years.
