In his September 17th weekly market comment titled “Low Water Mark“, my favorite economist, John Hussman writes:

“As of Friday, [ed.: 9/14/12] our estimates of prospective return/risk for the S&P 500 have dropped to the single lowest point we’ve observed in a century of data. There is no way to view this as something other than a warning, but it’s also a warning that I don’t want to overstate. This is an extreme data point, but there has been no abrupt change; no sudden event; no major catalyst. We are no more defensive today than we were a week ago, because conditions have been in the most negative 0.5% of the data for months. This is just the most negative return/risk estimate we’ve seen. It is what it is.

Since we estimate prospective return/risk on a blended horizon of 2-weeks to 18 months, we are not making a statement about the very long-term, but only about intermediate-term horizons (prospective long-term returns have certainly been worse at some points, such as 2000). As always, our estimates represent the average historical outcome that is associated with a given set of conditions, and they don’t ensure that any particular instance will match that average. So while present conditions have been followed by extraordinarily poor market outcomes on average, there’s no assurance that this instance can’t diverge from typical outcomes. Investors should ignore my concerns here if they believe that the proper way to invest is to bet that this time is different.”

….

“Last week, we observed a syndrome of evidence that matches only a handful of market extremes in history, including August-December 1972, August 1987, April-July 1998, July 1999, and March 2000, and April-July 2007. Investors with a good sense of market history will recognize all of those instances as points from which subsequent outcomes were steeply negative, even if stocks held up or advanced moderately over the short-run. With regard to the potential for steeply negative outcomes, we find that when we look across history, conditions similar to the present have been “enriched” with steep declines – another way of saying that the negative tail of the distribution is very fat here.

For example, if we break our estimates of prospective market return/risk into five quintiles or “buckets”, present estimates are clearly in the most negative bucket. Historically, 31% of instances in that worst bucket have been followed by a market decline of at least 10% over the following 6 month period, while 41% of all 10% market declines (occurring within a 6-month period) have started from instances in that bucket. In other words, while the lowest quintile captures 20% of the historical data, that bucket captures 10% market corrections more than twice as often as one would expect if those 10% declines were randomly distributed across market conditions. Similarly, the periods in the lowest quintile of prospective return/risk capture 45% of all 15% market declines that have occurred within a 6-month window, 54% of all 20% market declines, 69% of all 30% declines, and 87% of all declines of 35% or more (what would commonly be considered “crashes”).
In short, saying that our estimates of prospective return/risk are negative does not indicate that the market will or must plunge. Rather, it says that the average outcome has been quite negative, and the likelihood of extreme “tail events” is vastly enriched compared with more typical conditions throughout history.”

This is somewhat in conflict with my last post about Tom Demark’s short-term bullish call of 1478 on the S&P 500 before the November election.  Of course, Demark makes a very short-term call while Hussman is speaking of ‘intermediate’ returns of up to 18 months.

Regardless, I’m not finding anything of value to invest in at the moment, which leaves me around 47% in cash (15% gold, 32% stocks).

My excerpts from the Hussman Funds’ Weekly Market Comment (6/28/10):

[bold emphasis mine]

Based on evidence that has always and only been observed during or immediately prior to U.S. recessions, the U.S. economy appears headed into a second leg of an unusually challenging downturn.

..the U.S. economy is most probably either in, or immediately entering a second phase of contraction. Of course, the evidence could be incorrect in this instance, but the broader economic context provides no strong basis for ignoring the present warning in the hope of a contrary outcome. Indeed, if anything, credit conditions suggest that we should allow for outcomes that are more challenging than we have typically observed in the post-war period.

..following systemic banking crises, the duration of housing price declines has averaged roughly six years, while the downturn in equity prices has averaged about 3.4 years. On average, unemployment rises for almost 5 years. If we mark the beginning of this crisis in early 2008 with the collapse of Bear Stearns, it seems rather hopeful to view the March 2009 market low as a durable “V” bottom for the stock market, and to expect a sustained economic expansion to happily pick up where last year’s massive dose of “stimulus” spending now trails off. The average adjustment periods following major credit strains would place a stock market low closer to mid-2011, a peak in unemployment near the end of 2012 and a trough in housing perhaps by 2014. Given currently elevated equity valuations, widening credit spreads, deteriorating market internals, and the rapidly increasing risk of fresh economic weakness, there is little in the current data to rule out these extended time frames.

In recent months, I have finessed this issue by encouraging investors to carefully examine their risk exposures. I’m not sure that finesse is helpful any longer. The probabilities are becoming too high to use gentle wording. Though I usually confine my views to statements about probability and “average” behavior, this becomes fruitless when every outcome associated with the data is negative, with no counterexamples. Put bluntly, I believe that the economy is again turning lower, and that there is a reasonable likelihood that the U.S. stock market will ultimately violate its March 2009 lows before the current adjustment cycle is complete. At present, the best argument against this outcome is that it is unthinkable. Unfortunately, once policy makers have squandered public confidence, the market does not care whether the outcomes it produces are unthinkable. Unthinkability is not evidence.

Based on our standard valuation methods, the S&P 500 Index would have to drop to about 500 to match historical post-war points of secular undervaluation, such as June 1950, September 1974, and July 1982. We do not have to contemplate outcomes such as April 1932 (when the S&P 500 dropped to just 2.8 times its pre-Depression earnings peak) to allow for the possibility of further market difficulty in the coming years. Even strictly post-war data is sufficient to establish that the lows we observed in March 2009 did not represent anything close to generational undervaluation. We face real, structural economic problems that will not go away easily, and it is important to avoid the delusion that the average valuations typical of the recent bubble period represent sustainable norms.

{comments on holding Gold right now}

From an inflation standpoint, is important to recognize the distinction between what occurs during a credit crisis and what occurs afterward. Credit strains typically create a nearly frantic demand for government liabilities that are considered default-free (even if they are subject to inflation risk). This raises the marginal utility of government liabilities relative to the marginal utility of goods and services. That’s an economist’s way of saying that interest rates drop and deflation pressures take hold. Commodity price declines are also common, which is a word of caution to investors accumulating gold here, who may experience a roller-coaster shortly.

In bonds, the Market Climate last week was characterized by moderately unfavorable yield levels and favorable yield pressures. Credit spreads continue to widen, and we’ve observed a flattening of the yield curve due to a flight-to-safety in default free instruments. This may seem like an odd outcome, given that the growing issuance of Treasury and Fed liabilities is gradually setting us up for a difficult inflationary period beginning in the second half of this decade, but it is a strong regularity that “default-free” beats “inflation prone” during periods of crisis. For that same reason, we have to be careful about concluding that the growth of government liabilities will quickly translate into continued appreciation in precious metals and other commodities. Again, the historical regularity is for commodities to decline, though with a lag, once credit difficulties emerge. My weekly comments on this front might be less redundant if there were more subtlety to the issue, but it is subtle enough to recognize that the long-term inflationary implications of current monetary and fiscal policies will not necessarily translate into negative short-term outcomes for the Treasury market, nor persistently positive short-term outcomes for commodities.

[Commentary]
I currently own no stocks, and the momentum system has me in long-term treasury bonds, which agrees with above.  Also agrees with my commentary on Gold.

I do plan on purchasing two new stocks tomorrow, which are too cheap to ignore and are already visiting their March 2009 lows.

via John Hussman weekly commentary

Greek Debt and Backward Induction

On Sunday, the IMF approved its 30 billion portion of the 110 billion euro bailout package for Greece – the remaining funds to come from the European Union. The reason for all of this cooperation, of course, is that Greece has enormous debt that is owed in the euro, a currency that it cannot devalue. For many years, Greece has allowed government spending and wage agreements to grow rapidly, thanks to ability to borrow in euros as if it were little different from Germany or France. Unfortunately, the Greek economy faces a debt burden that its economy is now unable to service. If Greece were not part of the European Monetary Union and its debt was denominated in drachmas, it would be able to satisfy its debts by devaluing its currency, essentially making Greek goods, services and wages worth less in terms of foreign goods, services, wages and currencies. In other words, it could alter the relative price of Greek labor and output, imposing extreme cuts in government spending, and without inducing what amounts to an internal deflation. Since this is not possible, keeping Greece as part of the European Monetary Union requires it to impose extreme austerity toward its own citizens, which has predictably led to strikes and rioting. Greek debt problems also predictably imply problems for the European banks that have lent to the country.

The bailout package for Greece should keep it from having to tap the open market for capital for about 18 months. Yet it is hard to look at the possible trajectories of Greek output, deficits and debt without concluding that a debt restructuring will ultimately be necessary – meaning that owners of Greek debt are likely to receive only a portion of face value. What European leaders seem to be attempting is to buy Greece more time, essentially to smooth the potential amount of this restructuring and its impact on the banking system, perhaps three or four years from today when, hopefully, Greece has smaller deficits and the ability to operate without new borrowing.

While this is a hopeful scenario, backward induction is not kind to it. In Game Theory, there’s a technique called “backward induction” that is often used to identify the likely outcome of a game that is repeated again and again for multiple periods. Essentially, you evaluate what would be the best move for each player that would be optimal in the very last period, then assuming those moves, you evaluate what the optimal moves would be in the next-to-last period, and so on to the beginning of the game.

Put yourself in the position of a holder of Greek government debt a few years out, just prior to a probable default. Anticipating a default, you would liquidate the bonds to a level that reflects the likelihood of incomplete recovery. Working backward, and given the anticipated recovery projected by a variety of ratings services and economists, one would require an estimated annual coupon approaching 20% in order to accept the default risk. For European governments and the IMF to accept a yield of only 5% is to implicitly provide the remainder as a non-recourse subsidy. Even then, investors are unlikely to be willing to roll over existing debt when it matures – the May 19th roll-over is the first date Europe hopes to get past using bailout funds. In the event Greece fails to bring its budget significantly into balance, ongoing membership as one of the euro-zone countries implies ongoing subsidies from other countries, many of which are also running substantial deficits. This would eventually be intolerable. If investors are at all forward looking, the window of relief about Greece (and the euro more generally) is likely to be much shorter than 18 months.

Still, for Greece, it appears that the IMF and EU will provide the funding for the May 19th rollover of Greece’s debt, so there’s some legitimate potential for short-term relief. The larger problem is that Portugal and Spain are also running untenable deficits (think of Greece as the Bear Stearns of Euro-area countries). European officials deny the possibility of contagion that might call for additional bailouts, but my impression is that Greece is the focus because its debt is the closest to rollover. The attempt to cast Greece as unique is a bit strained – Christine LaGarde, the French finance minister suggested last week “Greece was a special case because it reported special numbers, provided funny statistics.”

In other words, Greece gets the bailout because it had the most misleading accounting?

The bottom line is that 1) aid from other European nations is the only thing that may prevent the markets from provoking an immediate default through an unwillingness to roll-over existing debt; 2) the aid to Greece is likely to turn out to be a non-recourse subsidy, throwing good money after bad and inducing higher inflationary pressures several years out than are already likely; 3) Greece appears unlikely to remain among euro-zone countries over the long-term; and 4) the backward induction of investors about these concerns may provoke weakened confidence about sovereign debt in the euro-area more generally.

Despite the potential for a short burst of relief, the broader concern about deficits in the euro-area make it unlikely that global investors will be appeased by a large bailout of Greece, or will go forward on the assumption that all is back to normal once that happens.

Lending information source: https://www.sambla.se/samla-lan/

Restructure, Restructure

Looking at the current state of the world economy, the underlying reality remains little changed: there is more debt outstanding than is capable of being properly serviced. It’s certainly possible to issue government debt in order to bail out one borrower or another (and prevent their bondholders from taking a loss). However, this means that for every dollar of bad debt that should have been wiped off the books, the world economy is left with two – the initial dollar of debt that has been bailed out and must continue to be serviced, and an additional dollar of government debt that was issued to execute the bailout.

Notice also that the capital that is used to provide the bailout goes from the hands of savers into the hands of bondholders who made bad investments. We are not only allocating global savings to governments. We are further allocating global savings precisely to those who were the worst stewards of the world’s capital. From a productivity standpoint, this is a nightmare. New investment capital, properly allocated, is almost invariably more productive than existing investment, and is undoubtedly more productive than past bad investment. By effectively re-capitalizing bad stewards of capital, at the expense of good investments that could otherwise occur, the policy of bailouts does violence to long-term prospects for growth. Looking out to a future population that will increasingly rely on the productivity of a smaller set of younger workers (and foreign labor) in order to provide for an aging demographic, this is not a luxury that our nation or the world can afford.

“Failure” and “restructuring” mean only that bondholders don’t get 100 cents on the dollar. We can continue to bail out the poor stewards of capital who voluntarily made bad, unproductive investments, and waste our future productivity in order to make those lenders whole, or we can turn the debate toward deciding the best strategies for restructuring existing debt.

John Hussman describes for us in simple terms the difference between EBIT, EBITDA and the investor “Owner Earnings” which should be the real evaluation cash flow for a business:

Just for Kids: Let’s start a lemonade stand!

By John P. Hussman, Ph.D.

OK, boys and girls. It’s been pretty hot out lately. So we’re going to start our own lemonade stand!

What? Jimmy, Sally, and Bobby all have lemonade stands just on your block alone? See, this is why I’m a professional money manager and you’re not even out of middle school. I only have two words for you: Global Warming. It’s a New Era. That’s all you need to know. Now go and borrow $100 from your Mom.

… I’ll wait.

Got it? Great. Now you’re deeply in debt, far beyond your ability to earn income, in an industry ridiculously overburdened with capacity. Hey, we haven’t been at this more than 30 seconds and you’re already qualified to run a telecom company! See how much you’ve learned already?

Now let’s go public. Go to your Dad and offer to sell him your business for $100. We’ll still have to pay Mom back, but Dad will have a claim on everything else.

… I’ll wait.

Holy smoke, you’re a natural. Alright now. Let’s take that $200 of investor money to buy some stuff: a lemonade stand, pitchers, spoons and ice buckets. Since the lemonade stand is cheap, you’ll have to spend another $10 a week to fix it as it “depreciates,” but we’ll deal with that later.

You’ll also have to pay for some other things before we show a profit. The lemonade mix and paper cups will be part of your “cost of goods sold.” Since you’ve got a credit rating of about F-, Mom wants $10 a week “interest” on her loan. Finally, there’s the big kid. For every dollar of profit, you’ve got to give him 40 cents or he’ll give you a wedgie until you cry “Uncle.” We’ll just call him the Uncle.

You’re off to a great start! In the first week, you’ve sold $50 of lemonade. Subtract off $20 as “cost of goods sold” and the $10 that you’ve stuffed into your pocket as “selling, general and administrative expenses.” Congratulations, you’ve earned $20 in “EBITDA” – earnings before interest, taxes, depreciation and amortization. Now subtract that $10 of depreciation, and you have $10 in “EBIT,” otherwise known as “earnings from operations.” Call CNBC. Also, make sure to buy the lemonade mix and cups with an IOU and don’t replace the depreciation, so when Dad looks into your cash register, he’ll actually see $40 in “cash flow from operations,” underscoring the “quality” of your earnings. Sweet.

But let’s take a closer look at what Dad can actually claim if you actually intend to stay in business. $50 revenue, minus $20 cost of goods sold, minus $10 administrative expense, minus $10 interest, minus $10 to replace depreciation, gives $0 in “net earnings.” The good news is that you don’t owe anything to the Uncle.

Hmmm. Which number should you report to Dad? $20 of EBITDA or $0 of net earnings? Hmmm.

Wait. Even better. Let’s classify the lemonade mix and cups as an “investment.” We can also underdepreciate the lemonade stand. And we’ll write both off as “extraordinary losses.” After all, the stand wouldn’t have worn down had it not been for the existence of time, and our investment in lemonade mix and cups would have survived had it not been for the existence of customers. That leaves us with EBITDA and operating earnings equal to $40. Yes, that’s much better.

Week two. Unfortunately, the novelty of lemonade has worn off in the neighborhood, and it’s a little cooler out too. As it turns out, you’ll only be able to take in $25 a week in revenue from now on. Now we’ve got $10 in cost of goods sold, $10 in administrative costs, $10 of interest costs… Oops! We can’t even make our interest payment, much less replace depreciation. And nobody wants to buy a used lemonade stand. Suddenly, Dad’s investment is worthless, and we’ve got to default on our debt to Mom.

But hey, we can still report $5 in EBITDA! Maybe nobody will notice.

Excerpts from The Two Essential Elements of Wealth Accumulation

How to make them work for you

Wealth is not acquired through addition. It is acquired through multiplication……According to statistical studies, two factors are most important in achieving wealth:

The number of years that an individual has been consistently saving and investing
The proportion of funds, on average, allocated to higher return investments such as stocks.

This does not mean that stocks should always be held regardless of price and risk levels. ….. Most have achieved their fortunes by compounding a moderate but consistent rate of return over a long period of time.There is a simple mathematical explanation for why these two factors are most important in building wealth:

Future Wealth = Current Wealth x (1+k)T

Where k is the annual rate of return earned on current wealth, and T is the number of years that wealth is allowed to compound in value.Wealth accumulation is exponential. At a 10% annual rate of return, $100 compounds to $259 over 10 years, and to $673 over 20 years. At a 15% annual rate of return, $100 compounds to $405 over 10 years, and to $1637 over 20 years. So both the rate of return, and the length of compounding have enormous leverage in creating future wealth.Simply stated, if your goal is to accumulate a significant amount of wealth during your lifetime, you must first save something, and then exercise some amount of control over one of two factors: your long-term rate of return, or the time horizon T over which you compound your wealth.

Increasing the long-term annual return

For most individuals, the best way to increase the annual return over time is to allocate a larger fraction of their funds, on average, to higher return types of investments such as stocks. The pitfall here is that stocks are not always priced to deliver high returns. Historically, the price/earnings ratio on the S&P 500 has averaged about 14. When the price/earnings ratio has approached 20, stocks have typically returned less than Treasury bills for as much as a decade or more.While it is not possible to avoid every downturn in the market, it is essential to defend capital when the Market Climate suggests a poor tradeoff of expected return to risk. …….Here’s why. Suppose that you earn 20% returns in three consecutive years. Clearly, your average annual return is 20%. But suppose that in the fourth year you lose 20%. The combined effect of lost value and lost time has a profound impact on your annualized return. If you do the math, you’ll find that for the overall 4 year period, the compound annual rate of return has dropped to just 8.43%.While risk-taking is essential to generate long-term returns, it is important to understand that market risk is typically rewarded much better in some Market Climates than in others.

Increasing the time horizon

The best way to increase the time horizon T over which you compound wealth is simply to start saving and investing as early and consistently as possible. Consider an investor earning a 10% long term rate of return. If the investor saves $2000 annually in a tax-deferred account (such as an IRA) for 10 years, and adds nothing for the next 20 years, the value of the portfolio at the end of 30 years will be $198,575. Although the investor committed a total of only $20,000, the account will have grown nearly tenfold.Now consider an investor who fails to start early. Suppose that the investor saves nothing during the first 10 years, and then attempts to make up for lost time by investing $2000 annually for each of the next 20 years. At the end of 30 years, the value of this portfolio will be just $114,550. The investor has committed a total of $40,000, twice as much as the first investor, but because the funds were not given as much time to compound, the investor retires with just over half as much wealth as the early bird. The higher the compound annual rate of return, or the greater the number of years to retirement, the more dramatic the effect that an early start will have on the ending wealth.

Some advice about saving

The key rule of saving is this. Don’t let your savings adjust to your spending needs. Let your spending adjust to your savings needs. It will help tremendously if you budget a certain amount of saving monthly, and make your investments first, as if you were paying a telephone bill. If you wait until all the bills are paid and all the spending is done, the result may be that you have nothing meaningful left to invest……..The best strategy to manage credit card debt is to minimize the number of cards you carry. But if you ever want to save, then start saving now. Make your monthly investments when you pay your other bills, and treat them as if they had a substantial late-payment penalty. The penalty for starting a savings program late really is enormous.

The bottom line

Financial security does not require extraordinary income or investment “home runs.” It requires, first and foremost, that you start saving and investing early, and add to your investments consistently.As for investment strategy, financial security requires avoiding large losses, particularly in environments that have been historically hostile to stocks. And it requires the willingness to take larger amounts of market risk in environments that have been historically friendly to stocks.