A good friend recently suggested that I name my next dog John Hussman, considering how often I send around blips from Dr. Hussman’s weekly commentary. Great idea except I’ve already negotiated this one with Jill years ago – the next pup in our house will be a Bulldog named Benjamin Graham. Hope Ben can get along with Stella okay. She is definitely more of a momentum investor!
Despite the harassment, I decided to take the risk and share another except from Hussman Funds Weekly Market Comment. We’ll explore this one in detail as there is a lot of meat here. Be forewarned – this turned out to be quite a lengthy post. So here is a quick summary of the material to follow:
- Deja Vu All Over Again
- Europe’s Banks
- The Fallacy of Forward Earnings
- Bad Estimates
- Setting the Record Straight
- Bottom Line – Too Much Leverage
“Last week, the financial markets mounted a striking shift back to the “risk-on” trade, as investor concerns about a recession were abandoned, and Wall Street came to believe that Europe will easily contain its banking problems. Accordingly, downside protection was largely discarded (as reflected by a plunge in the CBOE volatility index), price-volume action reflected eager short-covering, and investor interest shifted strongly away from defensive sectors to speculative ones. For defensive investors, it was admittedly a difficult week, as the markets suddenly became convinced that no defense was needed, and treated defensive investments accordingly.
“From my perspective, Wall Street’s “relief” about the economy, and its willingness to set aside recession concerns, is a mistake born of confusion between leading indicators and lagging ones. Leading evidence is not only clear, but on a statistical basis is essentially certain that the U.S. economy, and indeed, the global economy, faces an oncoming recession. As Lakshman Achuthan notes on the basis of ECRI’s own (and historically reliable) set of indicators, “We’ve entered a vicious cycle, and it’s too late: a recession can’t be averted.” Likewise, lagging evidence is largely clear that the economy was not yet in a recession as of, say, August or September. The error that investors are inviting here is to treat lagging indicators as if they are leading ones.”
Here is a picture of the most recent picture from ECRI. The interview with Lakshman Achuthan Hussman refers to is available here. We think an important point lost on the consensus is the frequency of recessions. John Mauldin has discussed this at length as well. The bottom line is that during an extended deleveraging process, economic volatility is higher than “normal” which means recessions are more frequent than “normal” when you are dragging along at “stall speed.” More frequent recessions, more volatile economic growth . . . higher risk premiums, lower equity prices. We’d also recommend taking a moment to read this interview, available at GuruFocus, with Fairfax CEO, Prem Watsa to get a feel for the possibilities here. “That second leg can be vicious, and we might well be entering that second stage.”
Deja Vu All Over Again
“The simple fact is that the measures that we use to identify recession risk tend to operate with a lead of a few months. Those few months are often critical, in the sense that the markets can often suffer deep and abrupt losses before coincident and lagging evidence demonstrates actual economic weakness. As a result, there is sometimes a “denial” phase between the point where the leading evidence locks onto a recession track, and the point where the coincident evidence confirms it. We saw exactly that sort of pattern prior to the last recession. While the recession evidence was in by November 2007 (see Expecting A Recession), the economy enjoyed two additional months of payroll job growth, and new claims for unemployment trended higher in a choppy and indecisive way until well into 2008. Even after Bear Stearns failed in March 2008, the market briefly staged a rally that put it within about 10% of its bull market high”
In addition to the economic similarities, here’s a look at the current set-up is from a technical standpoint, compliments of The Chart Store:
“At present, the S&P 500 is again just 10% below the high it set before the recent market downturn began. In my view, the likelihood is very thin that the economy will avoid a recession, that Greece will avoid default, or that Europe will deal seamlessly with the financial strains of a banking system that is more than twice as leveraged as the U.S. banking system was before the 2008-2009 crisis.”
Here’s a great illustration of the extent of Europe’s problems in one concise chart. Per the folks at Credit Writedowns, “The size of the largest four banking institutions in France, for example, represents over 300 percent of the country’s GDP.”
The Fallacy of Forward Earnings
“While many Wall Street analysts continue to view stocks as cheap on the basis of forward operating earnings (which reflect expectations of a continued economic expansion and the maintenance of record profit margins indefinitely), the use of forward P/E multiples is a valid shorthand for discounted cash flow valuation only when profit margins reflect a level that is actually likely to be sustained over several decades. Even then, the benchmarks typically applied to forward operating earnings are actually based on historical norms for price-to-trailing net earnings.”
Here’s one of the problems with “forward earnings” in a nutshell. We will discuss the second momentarily. For now, suffice it to say that profits are extremely high and have always reverted to trend historically. Perhaps this time is different, but it never has been, so we’d caution those betting it is. In fact, if indeed this time is different, we’d suggest that the major trend change ahead is best signaled by the Occupy Wall Street movement. The largest driver of profit margins today is clearly employment – meaning there is very little of it. The share of profits making its way to corporate balance sheets rather than their employees has been increasing for a generation. The result is record income inequality at home and abroad. This is precisely why we have America’s next generation unemployed and sitting outside the Financial District as if it were Tahrir Square. Again, my bet is that if indeed “this time is different,” the difference will not be in favor of profit margins, as the pendulum is likely to swing back towards labor over time. I suspect that income inequality across the globe does not end well for any of us. This is definitely something worth monitoring.
“Investors should recognize that P/E multiples are simply a crude shorthand for legitimate valuation calculations (specifically, the careful discounting of a whole stream of future cash expected to be delivered into investor’s hands over time). P/E multiples subsume a whole set of assumptions regarding the entire future path of growth rates, profit margins, return on invested capital, and other factors. The common practice of valuing the stock market based on “forward operating earnings times arbitrary P/E multiple” is not only misguided – it’s an utterly disappointing display of Wall Street’s willingness to dumb-down the investment process. As investors have discovered through more than a decade of zero returns, the constant abandonment of intellectual effort comes at a cost over the long-term.”
The second issue with forward earnings multiples is simply that they are WRONG. The chart below, initially posted at The Big Picture shows S&P operating earnings (red line) and their 12-month forward forecasts shifted ahead one year. Bottom line according to James Bianco, “If the economy goes into recession, earnings forecasts are not 10% to 12% too high. Instead they might be 20% to 40% too high. In other words, if the economy goes into recession, the earnings forecasts are horribly wrong.”
The second chart shows the difference between the forecasts and actual releases. The shaded areas highlight official recessions. Bianco notes, “Wall Street is one of the few places where practice does not make perfect. Notice that every subsequent recession sees larger earnings error rates than the previous recession. During the 1990/1991 recession, top-down forecasters (strategists) were too optimistic by 10%. Bottom-up forecasters (adding up the 500 company forecasts) were too optimistic by 25%. During the 2000/2001 recession, top-down forecasters were too optimistic by 25%. Bottom-up forecasters were too optimistic by 23%. During the 2007/2009 “Great Recession”, top-down forecasters were too optimistic by 39.6%. Bottom-up forecasters were too optimistic by 40%. Also notice the difference between the top-down and bottom-up forecasts. Current strategists are getting significantly worse at predicting earnings than their 1980s and 1990s counterparts.”
Consensus expectations, particularly bottom-up, are still wildly optimistic. Bulls continue to point to “excellent” company fundamentals to support their thesis, completely missing the fact that they are staring in the rear view mirror. Top down forecasts are less rosy but are yet to bake in recession which I think is a given at this point. Equity analysts rarely lower estimates, recommendations, etc. based on in-house forecasts. They wait until they are told by management, which by definition, is too late. Company fundamentals still appeared “excellent” in H1-08 as well. Until they didn’t. By the time management admits the economy has turned, we are typically closer to the recovery. According to research performed by Ned Davis, the S&P has actually declined historically when earnings expectations have been this lofty. The time to get bullish is only once consensus has baked in the drop in forward earnings. Not before.
Setting the Record Straight
One last point on valuation that drives me mad. This one is almost as popular as forward earnings. Take a look at the illustration below. If you can determine any relationship between the “earnings yield” on stocks and interest rates, please give me a call. Because outside of the brief period in history that an illusion of a relationship appeared – which happens to coincide with the time period that most investment managers in the business today have operated – there is no relationship between expected returns on stocks and expected returns on bonds. The consensus would also have you believe that as interest rates and inflation come down, PE’s should go up. Ask the folks in Japan how this has worked out for them. The fact is, today’s models worked great in an environment of increasing leverage. No one has thought to look at how they would perform as that leverage is unwound. The impact on economic growth, financial asset prices, inflation, etc. is profound and few have yet to grasp this change.
Consider a few simple examples to help illustrate why this is utter nonsense. First, suppose I am willing to sell you a quart of milk for $10 but offer you a gallon for $30. Does that mean the gallon is cheap or that it is a good buy at today’s price? If you answered yes, and you are a long-only investor, good luck. Alternatively, suppose you can buy a dollar today for 50 cents. Tomorrow, you pay two dollars for that same dollar. Is the level of the ten year treasury, or any interest rate for that matter, a significant determinant of how those investments work out for you? If you answered no, you are on your way to separating fact from fiction. Now please press mute on your remote control the next time you hear anyone comparing the yields on stocks to interest rates on bonds. Chances are anything else they have to say is not worth listening to.
Bottom Line – Too Much Leverage
“This is a good opportunity for investors to review their tolerance for significant losses. My impression is that this may be the best opportunity to reduce risk that investors are likely to see for a while.
“As of last week, the Market Climate in stocks remains negative, but has deteriorated significantly from the more benign negative levels that we’ve seen in recent weeks. Generally speaking, the worst market plunges tend to feature three things – overvaluation, negative market action, and a short-term overbought condition.”
A quick look at just how overbought this market is in the short term. As a general rule, overbought conditions should be sold in bear markets. In case you were wondering, this is a bear market.
“You rarely see the three together, because establishing that sort of condition requires a strong rally against both overvaluation and negative internals. That’s about where we are, though we can’t rule out a modest extension for a bit – mostly because advisory bearishness is reasonably elevated as of last week. That said, the drop in the CBOE volatility index late last week suggests an abandonment of bearish views, and more generally, just as early shifts toward advisory bullishness at the beginning of bull markets are often accurate and followed by further gains, early shifts toward advisory bearishness at the beginning of bear markets are also often accurate and followed by further losses. Overall, market conditions remain negative . . . “
Contrary to popular belief, the market is NOT cheap here. There are pockets of value if you look hard enough. But broadly speaking most major stock averages are not cheap. The chart below shows the S&P 500 trading at over 20x normalized earnings, relative to a long-term average closer to 16x. The current multiple is not that far off from where the market traded in the mid-60s prior to a bear market that lasted for almost two decades. You can feel comfortable hitting the mute button on your remote control whenever you hear someone claim that the next ten years look good for stocks, based solely on the fact that the last ten years were poor. Will they ever learn?
While many of our indicators are pointing to excessive pessimism, which may well be supportive of further rally, it is worth noting that AAII’s measure of Bullish Sentiment has rebounded sharply back to levels last seen in July, when all was still well in the world.
Putting it all together, the immediate future is not so bright for the buy-and-hold type today. While there are certainly values to be found in the large, multinational franchises that historically traded at premiums to the market, I am also growing concerned that this is more of a consensus belief today. Groupthink is dangerous. When everyone crowds into the same trade, the crowd is rarely right. One of the factors which made the 2008 crash so devastating was the forced liquidation driven by excessive leverage in the system. Once the crowd started selling, they all sold. We run from one side of the boat to the other, and back again. As they say, financial memory is notoriously short. But even we are surprised by speculators’ willingness to jump back on the leverage train after being so badly burned three short years ago. The amount of leverage in the system today is back at dangerous levels – it is declining, but prior market bottoms did not occur until these debts were entirely wiped out. I just hope this doesn’t mean that owners of risk assets and retirement plans get wiped out for the third time in ten years. Be careful out there.