Sunday, August 05, 2007

Strong economic optimism (... is a contrary indicator) / Hussman

Glad to hear that his fund just hits a new ATH. I especially like the comment from the past that Milken has said via James Grant. This sums it all up..... Click on the headline to read the entire report.

Freut mich besonders das sein Fonds gerade jetzt auf einem Allzeithoch steht. Der Kommentar von Milken aus dem Jahr 1989 via James Grant ist kaum zu toppen. Dieser Satz beschreibt treffend was am Markt momentan los ist und was in den letzten Jahren abgegangen ist....Klickt bitte auf die Überschrift um den kompletten Bericht zu lesen.
The way to wealth in a bull market is debt. The way to oblivion in a bear market is also debt, and nobody rings a bell. Easy access to credit facilitates the marginal transaction. It enlarges the gross national product, expands the debt industry, and creates the rationale for a future relaxation of lending standards. It hefts up prosperity by its bootstraps and makes it something more than it would otherwise be. It produces stupendous fees and underwriting commissions for investment bankers. Good ideas become bad ideas through a competitive process of “Can you top this?” But when the cycle turns, the process must swing into reverse. Marginal transactions, financed by debt, must be unwound through foreclosure or bankruptcy. Asset values, propped up by debt, must fall, and thereby reduce other asset values in a chain reaction.”

- James Grant (“Michael Milken, Wikipedia Meet Sewell Avery” 1989)
Strong economic optimism (... is a contrary indicator)
Despite credit concerns, Wall Street remains exuberant about economic prospects. Last week brought a 6-year high in consumer confidence, evidently supporting the idea that the consumer remains strong and the economic expansion remains intact.
Unfortunately, if you examine the data, you'll quickly discover that consumer confidence is a lagging indicator, well explained by past movements in GDP, employment, and capacity utilization. Worse, for the stock market, it's a contrary indicator (especially when it is well above the "future expectations" component of the same survey). This is a fact that we've had the good fortune of exploiting over time, not only in early 2000 when new highs in consumer confidence supported a defensive position, but conversely in the early 1990's, when new lows in consumer confidence supported a leveraged position in stocks (prompting that “lonely raging bull” comment in the L.A. Times).

It is no less true that high levels of economic optimism are regularly observed at the peaks of foreign economic expansions. That shouldn't be suprising. It's the very nature of a peak that it can't be produced except by unusual optimism.

The uncertainty in the economic outlook is not only that the U.S. economy appears increasingly vulnerable, but also that tensions with China are markedly increasing. Last week, the House Banking Committee - frustrated with a record current account deficit and the depressed value of the Chinese yuan - passed a measure that would provide for countervailing duties on goods from countries that manipulate their currencies. The Senate Finance Committee passed a separate measure. The increasing concerns over the toxicity of imported consumer products - tootpaste, children's toys, fish, tires, pet food - are almost certain to lower the political barriers to more stringent trade legislation as well.

Maybe it's just anectodal, but I've increasingly heard the media using the phrase "Communist China" in recent weeks, rather than simply "China." Unfortunately, as a result of accumulated deficits from military spending and irresponsible U.S. fiscal policy, China owns a substantial portion of the float in U.S. Treasury securities. Indeed, nearly all of the growth in U.S. gross domestic investment since 1998 has been financed with foreign capital inflows. Combining these ingredients is a lot like watching a small child play with a chemistry set - you don't know exactly what's going to happen, but you can almost count on a trip to the emergency room.
Another useful contrary indicator is the mutual fund cash/assets ratio, which just hit a fresh low of 3.5%. Since cash levels tend to fluctuate with Treasury bill yields, Norm Fosback of the Institute for Econometric Research noted that the relationship to subsequent market returns is significantly improved by factoring out the effect of interest rates, which I've done in the chart below. Adjusted for interest rates, mutual fund cash levels are the lowest level, relative to assets, on record. This is another sign of extreme bullishness about the prospects for the stock market and the economy. Unfortunately, such extreme bullishness has historically been well correlated with subsequent weakness.

Still, I continue to believe that it's too early to form any strong expectation of an oncoming recession. The evidence is certainly increasing, given that credit spreads have now blown wider, and the growth rate of employment is edging closer to the levels that typically indicate imminent recession risk (1% year-over-year or 0.5% over a 6-month period). The ISM Purchasing Managers Index also shifted lower, though still above the 50 level. While readings below 50 on the PMI are not sufficient indicators of recession risk in themselves, their usefulness is substantially magnified when they occur in the context of slow employment growth, a flat yield curve, rising credit spreads and flat or declining stock prices.
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