Sunday, December 09, 2007

Overbought in an Unfavorable Market Climate / Hussman

On his mission to inform and try to provide his much needed "anti spin" Hussman must feel very lonely. It´s amazing what nonsense you hear and read hour by hour on a daily basis from wall street finest. Thanks from Germany

Hussman muß sich auf seiner Mission ungefilterte Wahrheiten unters Volk zu bringen ziemlich einsam vorkommen. Es gibt meiner Meinung nach kaum einen der so beharrlich & gebetsmühlenartig seinen "Anti Spin" mit Fakten untermauert. Das ganze wird immer dann besonders gruselig wenn man sich die Kommentare der sog. anderen Experten vor Augen führt und diese Hussman´s Ausführungen gegenüber stellt. Besten Dank dafür aus Deutschland



Overbought in an Unfavorable Market Climate
Also, as I've frequently emphasized, monetary policy is not, and cannot be independent of fiscal policy. All the Fed does is to determine whether government liabilities take the form of Treasury bonds sold to the public, or currency and reserves held by the public directly or indirectly through the banking system. Monetary policy determines the mix (and even then only at the margin). Fiscal policy determines the total quantity of those government liabilities, most which are absorbed these days not by the Fed but by foreigners (in an amount many, many times what the Fed absorbs). If you want to worry about some entity that could have enormous impact on U.S. economic activity, ignore the Fed and focus on the real “maestros:” foreign purchasers of U.S. Treasuries, particularly China and Japan. ....

Again, the Federal Open Market Committee (FOMC) has “injected” only about $16 billion of “liquidity” into the U.S. banking system since March – all via short-term repos that are continually rolled over. Meanwhile, foreign investors (particularly China's central bank) have provided about $2 billion in fresh “liquidity” per day, mostly by purchasing U.S. securities (primarily Treasuries).

Liquidity and real investment
What has happened to this dough? This is the money that the U.S. uses to finance its own gross domestic investment (“real” investment such as factories, equipment, housing, etc). Indeed, all of the growth in U.S. gross domestic investment over the past decade has been financed by foreign capital inflows, since our government appears incapable of existing without spending away the domestic savings that would otherwise allow America to self-finance its growth*.

In the coming year or so, we'll probably see a narrowing of the massive trade and current account deficits that have accumulated in recent years. As I've noted before, every dollar of “improvement” we observe in the U.S. current account deficit is typically matched by a dollar of deterioration in gross domestic investment. That regularly happens during recessions, and it's likely to happen in this one (nothing in recent reports or market action materially changes the prospects of an oncoming U.S. economic downturn).

Recessions are generally due to a growing mismatch between what the economy produces and what is demanded. During those recessions, overinvestment stops, losses are taken, adjustments are made, and resources are reallocated, all of which help to eventually turn the economy around. It is these adjustments that require a long and variable lag. They are not primarily the result of “Fed liquidity.”

In any event, the overinvestment and excess inventory during this economic cycle has clearly been in the areas of housing, finance, and debt origination, so those are the areas that will bear the primary burden of adjustment. ....


Fast, furious, and prone to failure
As I noted last week, “The market has now cleared the oversold condition that it established a week ago. Stocks aren't overbought here, but overbought conditions in unfavorable Market Climates tend to be rare. The steepest bear market losses tend to follow immediately on the heels of such overbought conditions.”

Presently, the market has established just that profile. This is one of the very few situations in which I ever have a pointed view about likely market direction. Although the likely Fed rate cut (no opinion on 25 vs. 50) on Tuesday adds some uncertainty, and the market would most likely celebrate a 50-basis point cut, there is currently not much evidence that suggests that even such a rally would be sustained for long. In my view, the probable risks are skewed to the downside. I don't believe there is such a thing as the Fed getting “ahead of the curve.” LIBOR continues to be “sticky” in the face of multiple cuts in the Federal Funds rate, credit spreads continue to push toward new highs, and there is no reason to believe that minuscule volumes of Fed repos will have any effect in ameliorating credit risks.

Meanwhile, the Treasury “plan” to bail out homeowners (without bailing them out) is likely to be both very little and very late. Think of it as the equivalent of the FEMA response after hurricane Katrina. Barring an almost immediate freeze on foreclosures and interest rate resets, we are likely to observe a rash of delinquencies and the need for soaring loan loss reserves even over the next few months. All of this talk of Federal help feels good, but it will be next to impossible to coordinate Federal assistance quickly and equitably. On the other hand, freezing lenders ability to collect on bad loans will simply allow balance sheets to deteriorate without any actual financial solution to the problem

The problem is simple: people bought houses during a boom, at bubble prices that they couldn't actually afford. The money that was lent has already been dissipated to the sellers – the owners of the houses don't have it, and neither do the lenders. The excess money that homeowners can't actually afford to pay back will have to be written off institution by institution, lender by lender. Major loan losses are inevitable. To believe they are something less than inevitable is to stay at the party even as flames engulf the building, in hopes that water is on the way. The U.S. financial system is going to have a bad time with this – there will be major losses and major adjustments. Eventually we will work through it, but it is delusional to look for a bottom when the real losses haven't even started to emerge.

Thanks to Jim Borgman

Again, with regard to the stock market, my having any view at all relating to short-term market direction is very unusual, but I am particularly concerned because we now have overbought conditions in a negative Market Climate. The Fed may very well give the market an extra psychological boost next week with a 50 basis point cut, but a disappointing move or statement could prompt an unusually steep decline. As for market action, despite the standard “fast, furious” rebound from oversold conditions, there is no indication from the quality of market action that investors have adopted a robust willingness to speculate.

On the subject of multiple Fed rate cuts being bullish for stocks, it may be helpful to note that in those events that multiple Fed cuts helped the market, stocks had generally already experienced a bear market decline of 20-40% prior to the second rate cut, and the average P/E on the S&P 500 was typically below 14 and (generally less than 11). Stocks were largely poised to perform well anyway, generally by virtue of being sold off to depressed valuations. Even in the 1998 instance (which occurred at much richer valuations than previously), the S&P 500 had plunged about 20% prior to recovering.

Investors let mottos like “don't fight the Fed” and “it's a new economy” do their thinking for them in 2000-2002, while the S&P 500 lost half its value and the Nasdaq lost three-quarters. There's good reason to expect “motto-based investing” to be disappointing again. Keynes may have been right in saying “the market can remain irrational longer than you can remain solvent,” but provided you don't do things that endanger your solvency (like taking large net short positions), there's nothing wrong with avoiding risk in periods of market irrationality - particularly once market internals deteriorate measurably as they have now. Provably incorrect ideas are eventually proven incorrect. The beliefs that the Fed is “injecting massive liquidity” and that profit margins hold up despite economic softness are provably incorrect ideas.

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2 Comments:

Anonymous eh said...

J-M,

We saw the same thing just a few weeks ago when the markets rallied strongly, led by financials (!), before they later tanked. It has sort of the same feeling now; I have no idea how long it will continue...

I am a little bit suspicious about words like "overbought", because while on the one hand I tend to agree (from the point of view of fundamentals), but on the other you can be scared away from profitable trades if you decide not to take long positions.

eh

1:12 AM  
Blogger jmf said...

Moin Eh,

i have the the same feeling.

"but on the other you can be scared away from profitable trades if you decide not to take long positions."

That indeed is a major problem that i have still problems to deal with.

My general bearish view has put me out of several interesting long positions during the past view years.

1:20 AM  

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