John Hussman

Market Commentary by John Hussman

Below, I summarize my takeaways from the weekly market commentary by John Hussman. I like his letters because they’re extremely detailed, and never shirk from arithmetic. Below, I summarize the letters that I have read. I have skipped the ones that didn’t contain any new lessons for me.

ToDo (someday): recreate charts show on 5/9/16 letter.

5/16/16 – Blowing Bubbles: QE and the Iron Laws

Iron Law of Equilibrium assumes that base money will stay base money until it is retired by the Fed. BUT, someone has to hold it at every moment in time, and nobody is comfortable holding much of it if there are decent alternatives available. And so, people look for something to hold, and the first stop is Treasury bills. So now, as the holders of the monetary base try to get rid of their hot potato by purchasing Treasury bills, driving down their yields, and this reach-for-yield stops when investors become indifferent between zero-interest cash and low-yielding T-bills.

Leading economic indicators are already weak, but this would matter more if the stock market were to decline by even a few %age points.

5/9/16 – Latent Risk and Critical Points

Substantial market declines are often preceded by a combination of (a) internal dispersion–relatively large number of new-high and new-low stocks, and (b) leadership reversal–statistics shift from a majority of new highs to new lows within a small number of trading sessions. This is like a substance going through a phase transition, with particles choosing between two phases, and as the transition approaches a critical point, clusters beginning to choose sides and effecting their neighbors.

4/18/16 – Permanently High Plateaus Have Poor Procedures

The Fed Model is wholly an artifact based on a single period 1980-1997–equity valuations and bond yields were tightly linked during the associated disinflationary period. If you look at the entire inflation-deflation cycle of 1972-1997, the relation is actually inverse.

5/18/15 – The “New Era” in an Old Story

Main charge against Market Capitalization/GDP is that the GDP doesn’t include the income of U.S. income generated overseas and does include the income of foreign companies (which presumably are not listed on the U.S. markets). To adjust for this, Hussman uses GVA (gross value added)–GDP is essentially (GVA – sales taxes + subsidies), and adjusts that for foreign profits to get a more reflective measure. GVA can be found in Federal Reserve Z.1 Flow of Funds statistics. All in all, Hussman comes up with Adjusted GVA, which is Domestic GVA * (1 + ROW profits)/(domestic profits). This relationship–Market Capitalization/(Adjusted GVA) is better correlated to the S&P returns, but does lead to materially different results that the basic market cap/GDP statistic. I am not sure why Hussman didn’t simply scale the GDP accordingly, but otherwise, interesting point and well-taken.

4/20/15 – Profit Margins – Is the Ladder Starting to Snap?

Most historically reliable valuation measures are those that adjust for cyclical variation of profit margins.

Economic difficulties tend to emerge first in financial variables (interest rates, credit spreads, industrial commodity prices), followed by retail sales and survey measures of new orders and order backlogs, followed by production measures, followed by personal income, followed by new claims for unemployment, and generally confirmed much later by payroll data.

3/23/15 – Eating Our Seed Corn – The causes of U.S. economic stagnation, and the way forward

U.S. corporate profits are at elevated level, and this is largely a mirror image of  unusually large deficits in the household and the government sectors. This can be found from the Kalecki equation, which goes as follows:

Profits – Dividends = (Investment – Foreign Savings) – Household Savings – Government Savings

We know that household and government deficits have been financing company profits, but recently (in the past 4 years), foreign savings (Exports – Imports, i.e the inverse of U.S. current account balance) have been strong, financing Investment, which in turn has supported the U.S. profits. Recently, household and the government have been saving, and absent the influx of foreign saving, Profits would have come lower.

3/5/15 – Plan to Exit Stocks Within the Next 8 Years? Exit Now.

We should all remember what happens when Fed eases aggressively in an environment of risk-averse investor preference: nothing. The Fed began cutting rates on 3/11/30, two years before the market bottomed. Fed cut rates on 1/3/01 as the two-year bear market began and kept cutting through the decline. Fed cut the rates on 9/18/07, before markets reached the top and again, kept cutting through the decline. All in all, Fed actions always need to be analyzed through the lens of market internals.

1/9/15 – Expect a Decade of 1.7% Portfolio Returns from a Conventional Asset Mix

On monetary policy: when Fed, as one imagines, “pumps money into the economy”, it is not as is imagined “creates money out of thin air”. What it does, is that it purchases an already existing government liability (a Treasury) and pays for it with a different government liability (currency). This doesn’t automatically return in more spending because the person who sold the Treasury was already inclined to hold that liability as a store of value as opposed to as a means of payment. The monetary operation simply changes the form of that store of value from a bond to a currency unit. Thus, every liability of the Fed is backed by an asset.

This is different from an act of Congress, which when it enacts an act of spending, and if the spending is deficit financed, truly creates a a new liability (not backed by anything).

1/2/15 – Market Action Suggests Abrupt Slowing in Global Economic Activity

Widening credit spreads, deteriorating market internals, plunging commodity prices and collapsing yield on Treasury debt, taken together comprise a market action that is associated with signs of potential economic strains. In case of a real economic strain this is followed by new orders and production components of regional purchasing managers indices and Fed surveys, followed by real sales, followed by real production, followed by real income, followed by new claims for unemployment, followed by payroll employment data, followed by unemployment rate (reflects what was happening in the economy 4-5 months ago).

12/15/14 – A Sensible Proposal and a New Adjective

The strongest average return/risk profile is associated with favorable valuation and and an already favorable market action. Added on the letter on 11/11/16 – “By the time value investors are all in, trend followers are out, and they have to pry stock away from committed value investors–which means when market action begins to improve, market prices move sharply higher. Conversely, at market tops, value investors are all out and trend followers are all in, and when they attempt to exit, the prices have to decline significantly–until the skittish value investors are willing to absorb the shares being offered.”

12/08/14 – Peaking Process

ST interest rates are a well-behaved function of the size of the monetary base (currency and bank reserves) relative to nominal GDP (known as “liquidity preference curve”).

A lot of the trillion $s of leveraged loan are held by the U.S. banks in form of “participating shares”, something FDIC doesn’t like.

12/01/14 – Hard-Won Lessons and the Bird in the Hand

Signals provided by market internals, credit spread etc. are informative about risk-seeking/risk-aversion, regardless of the particular economic context. U.S. recessions show up like this–

• Slowdown in real sales and consumption
• then Production (and others sensitive measures of activity such as material prices)
• then Personal incomes and Employment (a certain lagging indicator and details what happened 4-6 months ago)

A similar letter (FY15 annual letter dated 2/18/16) states that U.S. recessions are signaled by a combination of (even though appearance of individual items is not sufficient to signal this) the following:

1. At first in financial metrics: falling stock prices, widening credit spreads, modest spread between long-term and short-term interest rates (flattish yield curve)
2. Next it begins to show up in “Order surplus”: new orders + backlogs – inventories
3. Next, if the economic downturn is broad, “coincident” measures of supply and demand such as ISM PMI declining below 50 and real retail sales slowdown show up
4. Real incomes slow shortly after
5. Last to move are employment indicators: beginning with initial claims for unemployment, next payroll job growth and finally the duration of unemployment

11/03/14 – Losing Velocity: QE and the Massive Speculative Carry Trade

There’s no clear link between short-term rates and quarterly change in GDP–in fact Alan Gelb showed that productivity of real investment (incremental output/unit of capital) is highly and positively correlated with real interest rates, and though it’s a stretch to deduce a casual link, the data seems to caution against manipulations.

QE is really a way by which central bankers change the mix of government liabilities that the public is forced to hold–away from bonds, and towards currency and bank reserves (see here). This change in mix of government liabilities does not impact economic growth or inflation (which arises because of supply constraints or exogenous shocks that reduce supply, coupled with large governmental deficits being used to finance consumption and transfer payments).

10/27/14 – Fast, Furious and Prone of Failure

“Fast, furious, prone-to-failure” advances generally feature lower trading volume than observed during the previous decline, with concentration of buying on speculative and heavily-shorted names. 1929, 1972, 1987, 2000 and 2007 episodes all featured (1) overvalued, over bullish, overwrought conditions (rich valuations, lopsided bullish sentiment, uncorrected and overextended ST action), (2) subtle breakdown in market internals across various securities, (3) an initial “air-pocket” type selloff to an oversold ST low, (4) a “fast, furious, prone-to-failure” hot squeeze, and (5) a continued pairing of rich valuations and dispersion in market internals, resulting in a (a) crash, or (b) pro-longed bear-market decline.

10/20/14 – On the Tendency of Large Market Losses to Occur in Succession

Large down days tend to cluster (my note: there’s more wisdom in this statement than is apparent at first).

10/13/14 – Air-Pockets, Free-Falls, and Crashes

Market action is narrowing in a classic pattern that reflects the effort of investors to reduce risk around the edge of their portfolios, in what proves to be an ill-founded belief that a falling tide will not lower all ships.

Duration of assets should be matched with the anticipated horizon of spending needs (/liabilities). The estimated duration of the S&P index is about 50, 10-yr Treasury has a duration of 9 years and of course, cash has zero duration. A passive investor expecting the average date of spending of about 15 years should match that with an asset portfolio of similar duration, which could be 20% – 50% – 25% mix of stocks, bonds and cash. The challenge here is that prospective nominal returns for the next 15 years of all such portfolio mixes is less than 2%.

10/06/14 – Dancing Without a Floor

We do not rely on a severe market decline as a precursor to encourage a constructive position. We will shift our stance when our measures of valuation and market action shift materially, EVEN IF valuations remain above historical norms.

09/22/14 – The Ponzi Economy

Statistics says that the U.S. productivity growth has been +2.1% since 1999, which may make one feel not so bad about the declining labor force participation, but U.S. measures of productivity growth is heavily influenced by U.S. imports and foreign labor outsourcing, as subtracting imports from GDP does not adequately correct for their impact on the final output, yet foreign labor is not counted in the denominator, so measured output per U.S. worker decreases.

Deteriorating market internals –

• Breadth (avg. stock is lower even though indices are higher)
• More declines than advances despite index highs
• Weak small cap stocks
• “Hindenburg” signal  – both new highs and new lows exceeded 2.5% of the issues traded (not useful by itself, but useful when combined with other signals)
• NYSE Advance-Decline line vs. the S&P 500
• Majority of new highs shifting to majority of new lows within a small number of trading sessions

All of this is useful when this happens within a few weeks of it each other. Also, it is not simply the extent of any of the signals, but rather the uniformity of the divergences that contains information that investor risk preferences are subtly shifting toward risk aversion.

08/18/14 – Dimes on Black and Dynamite on Red

Cracks are becoming visible in form of visible breakdowns in market internals such as small cap stocks, HY bond prices, market breadth and other areas, but it’s not clear that investors’ risk preference has shifted durably. Galbraith reminded us that 1929 crash did not have any observable catalysts (markets crashed first, and economic strains emerged later).

07/28/14 – Yes, This Is An Equity Bubble

Equity losses are just losses even when if prices fall in half, but credit strains can cause a chain of bankruptcies when the holders are each highly leveraged. Ratio of non-financial stocks as a % of GDP is 1.35 vs. a pre-bubble historical norm of about 0.55 and an extreme at the 2000 peak of 1.54 (my note: perhaps Russell 2000 would be a better candidate here vs. S&P 500 as S&P is much more likely to have global cos.). Dow has gone 709 days without a 10% correction, one of the 7 longest spans on record.

07/21/14 – Optimism vs. Arithmetic

Investment relies on arithmetic of expected cash flows whereas speculation relies much less on calculation than on psychology, particularly of two forms–(a)expected change in sponsorship (the pool for which begins to tap out as bullish sentiment becomes heavy, unless it begins to draw in new sponsors), and (b) expected change in risk aversion.

07/14/14 – Ockham’s Razor and Market Cycle

Market is overvalued as calculated by multiple metrics and actual subsequent 10-year returns correlate strongly with the following models.

• Forward Operating Earnings Model [08/02/10]
• Profit-Margin Adjusted CAPE Model [05/05/14]
• Dividend Model [03/18/13]
• Shiller P/E/ Model [03/18/13]
• Market Cap / GDP Model [03/18/13]
• Revenue Model
• Tobin’s Q Model (my note: looks like a relative outlier)

06/02/14 – Markets Peaks are a Process

Stock market peaks are a process, not an event or an instant. In context of a full market cycle, the process seems fairly brief, and in real-time it can seem endless.

2012 Wine Country Conference

I was listening to the speak presentations at the 2012 Wine Country Conference, and one of the points that John Hussman made was about stable and unstable equilibrium, and how valuation is the end game of the stable equilibrium, and the market can exist in an unstable equilibrium for a while. Thinking of a security’s value as implied by valuation as the stable equilibrium version of the value is a very neat way to thinking of the security on the value spectrum. This para is rather vague, and I implore you to see this video for a better explanation from a much smarter person.

11/12/07 – Expecting a Recession

The 4-indicator Recession Warning Composite I defined several years ago used the following definitions:

1. Widening credit spreads: An increase over the past 6 months in either the spread between
   1. commercial paper and 3-month Treasury yields, or between
   2. Dow Corporate Bond Index yield and 10-year Treasury yields.
2. Moderate or flat yield curve: 10-year Treasury yield no more than 2.5% above 3-month Treasury yields (this doesn’t create a strong risk of recession in and of itself).
3. Falling stock prices: S&P 500 below its level of 6 months earlier. Again, this is not terribly unusual by itself, which is why people say that market declines have called 11 of the past 6 recessions, but falling stock prices are very important as part of the broader syndrome.
4. Weak ISM Purchasing Managers Index:
   1. PMI below 50, or
   2. PMI below 54, plus NFP employment growth 1.3% below last yr, or NFP unemployment rate 0.4% from its 12-mo low.

Confirming Indicators are as follows:

1. Sudden widening in “consumer confidence spread”
2. Low or -ve real interest rate (3-mo T-bill vs. CPI)
3. Falling factory CUR (>80% to <80% is the most typical)
4. Slowing growth in employment/ hours worked