Authored by Mohamed El-Erian, originally posted at Project Syndicate,
The United States’ reputation for sound economic policymaking took a beating in 2013. Some of this was warranted; some of it was not. And now a related distorted narrative – one that in 2014 could needlessly undermine policies that are key to improving America’s economic recovery – is gaining traction.
The 2008 global financial crisis left the US economy mired in a low-level equilibrium, characterized by sluggish job creation, persistently high long-term and youth unemployment, and growing inequalities of income, wealth, and opportunity. Many Americans started 2013 with high hopes that congressional leaders would overcome, even if only partly, the polarization and political dysfunction that had slowed recovery.
Expectations of less political turbulence were enhanced at the start of 2013 by a bipartisan agreement that avoided the so-called fiscal cliff (though at the last minute and with much rancor) and a deal reached later in January to raise the debt ceiling (albeit temporarily). With expectations of less political brinkmanship and lower policy uncertainty ahead, consensus projections foresaw faster, more inclusive economic growth.
In turn, faster growth was expected to revitalize the labor market, counteract worsening income inequality, mollify concerns about debt and deficit levels, and enable the Federal Reserve to start normalizing monetary policy in an orderly fashion. It would also facilitate a return by Congress to more normal economic governance – whether passing an annual budget, something not accomplished in four years, or finally taking steps to enhance rather than impede growth and job creation.
But optimism foundered over the course of 2013, and frustration soared.
Growth has again fallen short of expectations. With another year of uneven job creation, the problems associated with long-term and youth unemployment have become more deeply embedded in the economy’s structure. Inequalities remain too high, and continue to grow. Congressional paralysis has reached levels unparalleled in recent history. And, again, lawmakers have not enacted an annual budget.
This is not to say that there has been no economic or financial progress in 2013. After all, economic growth, while unnecessarily held below potential by Congress (and vulnerable to decline if Congress is not careful), has again outpaced that of Europe. The budget deficit has fallen markedly, while companies and households, too, have continued to strengthen their balance sheets. Many segments of the equities market have bounced back strongly, with price indexes hitting record highs. And Americans are on the verge of obtaining much better access to health care.
What is frustrating is that the country could have – and should have – done a lot better. Recognizing this, Americans are not hesitant to blame a Congress that seems more eager to manufacture problems than to enable the economy to reach its considerable potential.
Rather than building on some of the fledgling bipartisanship from earlier in the year, Congress decided to produce a mid-year government-financing drama. Even immigration reform – a bipartisan pro-growth issue with considerable support from much of American society – has languished unnecessarily. More broadly, Congress took no significant action to avoid headwinds that impose a drag on growth and discourage companies and individuals from investing in their future.
According to a survey based on data from the Office of the Clerk of the US House of Representatives, the current 113th Congress has delivered the lowest legislative activity “since at least 1947, when the data collection began.” And Americans know it. According to Gallop, the 9% approval rating for Congress is the lowest level in the survey’s 39-year history.
Partisan polarization in Congress has also undermined the executive branch, unduly blocking government appointments – including routine and essentially uncontroversial ones – and placing unwarranted obstacles in the way of implementing even the most sensible and seemingly bipartisan legislative proposals. The resulting sense of political drift and dysfunction has been exacerbated by the poor rollout of the Affordable Care Act (Obamacare) – a massive, avoidable distraction that has been allowed to cast doubt on this landmark initiative.
Yes, 2013 was not a good year for public-sector decision-making, especially given that most of the slippages were “own goals.” In the process, the US damaged the reputation for effective economic management that it had earned during the global financial crisis, when bold and timely measures prevented a period of reckless private risk-taking and financial leverage from ending in Great Depression II. The Congress-imposed government shutdown and near-default in October were particularly harmful to the country’s global standing.
As a result, the popular narrative is shifting to the danger of “government failure.” More and more Americans are being led to forget how, just a few years ago, a united US government reacted decisively to “market failures” and thus helped to avoid a global economic meltdown that would have devastated millions of lives and undermined future generations’ prospects. Now, as the pendulum swings back, it risks overshooting the optimal combination of private and public activity and ending up at a simplistic view of government as the problem and the private sector as the solution. If this occurs, the outlook for faster, more inclusive growth would be weakened further.
Government has a long pro-growth to-do list heading into 2014. The top priorities include modernizing the country’s transport and energy infrastructure, reforming an underperforming education system, improving the labor market, bringing order to an overly-fragmented fiscal structure, enhancing the provision of public goods, and safeguarding America’s interests abroad.
It is tempting for politicians and analysts to overplay simple narratives that place the blame entirely on one side or the other. The truth is more nuanced and complex. America is in desperate need of a Congress that encourages, rather than impedes, better partnerships between the public and private sectors. Constantly pitting one side against the other may make for entertaining roundtables on cable television and energizing political rallies. But it comes at the cost of undermining an economy that could – and therefore should – be performing much better.
US Gets Involved In Another Foreign Conflict, Will Support French Troops In Central African Republic
One of the underreported stories from last week, noted here previously, was that quietly, on the day in which French unemployment soared to a new 16 year high, French president Hollande did what every true Keynesian in his position would do and dispatched troops to the Central African Republic due to a "duty to intervene" and stop the "alarming, frightening massacres" taking place there. There were no YouTube clips available to justify said massacres yet: we assume they are being produced currently. A few days later the fighting has begun with Reuters reporting that French troops fought gunmen in Bangui, the capital of Central African Republic, on Monday as they searched for weapons in an operation to disarm rival Muslim and Christian fighters responsible for hundreds of killings since last week. Shooting erupted near the airport in the morning after gunmen refused to hand over their weapons, and French forces later came under attack by former rebels in the city centre. France said it was prepared to use force if fighters rejected calls to disarm or return to barracks. Paris boosted its military presence to 1,600 troops at the weekend as waves of religious violence swept its former colony.
That's not news. The news is that the US is once again getting involved in yet another foreign conflict. Also from Reuters:
- PENTAGON CONSIDERING REQUESTS FOR U.S. MILITARY SUPPORT TO FRENCH AND AFRICAN UNION FORCES IN CENTRAL AFRICAN REPUBLIC - U.S. OFFICIAL
- U.S. MILITARY LIKELY TO PROVIDE SOME LOGISTICAL SUPPORT -OFFICIAL
Some additional detail from the WSJ:
The U.S. will airlift African Union forces to the Central African Republic as part of an effort to aid French troops who are in the country to put down rising violence, defense officials said.
Defense Secretary Chuck Hagel authorized the deployment of the U.S. transport planes and pilots Sunday night, responding to a request for assistance from France. The planes will be used to carry troops from Burundi to the Central African Republic, where France has deployed 1,600 troops to try to quell rising violence.
Fighting has increased in the Central African Republic since March when a rebel group seized power. The rebel leader, Michel Djotodia, named himself president.
Turmoil has escalated in recent days, claiming 400 lives and prompting the French intervention. On Monday, French soldiers began disarming fighters in the Central African Republic.
And yet something is different about the C.A.R. - drones. From IBTimes:
Drones were deployed over the Democratic Republic of the Congo on Tuesday, marking the first time the United Nations has used unmanned surveillance aircraft in its peacekeeping efforts. A fleet of five unarmed drones will help U.N. troops monitor the vast Central African country of 66 million people, which has been plagued by violent militias for decades.
"Such high-technology systems allow a better knowledge of what is happening on the ground, which allows a force to better do its job," said Hervé Ladsous, U.N. Under-Secretary-General for Peacekeeping Operations, according to the U.N. News Agency.
The new drone program marks another rare initiative for the U.N. It was originally approved by the Security Council in January, due in large part to the conflict in Goma. M23 surrendered last month, but ongoing peace talks in Uganda between the rebels and the Congolese government have reached an impasse over the wording of the final agreement.
Of course, someone must have benefited from the drone "surge." Indeed, someone did.
The drones for the Congo fleet were purchased from the electronics firm Selex ES, a unit of the Italian industrial and defense company Finmeccanica SpA (BIT:FNC). Deployment was originally planned for August, but a complicated procurement process delayed the launch until this week. If the drones prove effective, the U.N. may consider launching similar initiatives in other countries where peacekeeping operations are under way.
In other words, look for the C.A.R./Congo region to get drastically "destabilized" in the coming weeks, especially with both French and the US forced on the ground, and with hundreds of drones in the air repeating the bang up "peace intervention" job most recently achieved in Afghanistan. Why? Simple - because China has now been actively expanding its sphere of influence in Africa as we have been reporting over the past two years. Indeed as the map below which we posted first over a year ago shows, the Central African Republic is the only place that China does not have a major documented presence yet.
So the US (and the west) do the only thing they can: find a pretext to land a military force in order to stake a claim on what they believe are their critical strategic interests before Chinese moneyed-interests decide to do the same.
A month ago, the Bank of England's Cunliffe dismissed UK realtors' fears of a central bank-driven bubble in housing, by stating confidently that "it is not a boom or a bubble. It is a market correction, albeit a fairly quick one." But now, the man really in charge of the liquidity pedal, the BoE head Mark Carney has proclaimed:
- BOE'S CARNEY SAYS CONCERNED ABOUT POTENTIAL DEVELOPMENTS IN UK HOUSING MARKET
- BOE'S CARNEY: WANTS TO AVOID HOUSING MARKET MOVING TO 'WARP SPEED'
In the speech at the New York Economic Club, Carney went on note that this BoE-created bubble could be popped by raising capital requirements against the housing sector if need be; but we suspect the faster way to pop the momentum-chasing hot-money frenzy will be to pass the foreign homebuyers' capital gains tax.
So, it would appear, that unlike his brethren in the US, Carney is able to see bubbles - and it seems is capable and ready to react to them...
While Newport Beach Lamborghini dealerships may be engaging in marketing gimmicks such as exchanging the 'explosively volatile' Bitcoins for Teslas; the true Bitcoinaires opt for something more internally combustible...
The quarterly Flow of Funds report by the Fed has been released and the latest household net worth numbers are out. While not nearly quite as dramatic as last quarter's wholesale dataset revision, which saw all of America suddenly worth $3 trillion more primarily due to a change of how "pension entitlements" (formerly "pension reserves") are calculated (more more in the full breakdown from September), with the resulting total net worth rising to a total of $74.8 trillion, according to the just released data, in the third quarter, US housholds, or rather a very tiny subset of them, saw their net worth rise once again, this time to $77.3 trillion from a revised $75.3 trillion.
The reason for this increase, and why we say a "subset" is because virtually all of the net worth increase was the result of a $1.5 trillion bounce in financial assets (read: capital markets) to a new all time high of $63.9 trillion. As most know by know, the bulk of the exposure to this asset class is held by the ultra wealthy, particularly in the form of Corporate Equities, the category which rose by the single largest amount in the quarter, or $600 billion. Away from financial assets, the remainder, or $500 billion of the increase, was due to a rise in real estate values to $21.6 trillion, still over $3 trillion lower than the all time high for the category reached in Q4 2006.
Curiously enough, the ongoing increase in assets, and thus net worth, continues without any comparable increase in liabilities, as total household debt rose by a minuscule $116 billion, of which the $71 billion increase in consumer credit (read student and car loans) was the biggest offset to net worth growth.
This is how the US household balance sheet looked like at September 30, 2013:
This is how this chart looked last quarter:
Finally, putting it all together, when looking at the assets and liabilities of the US household on a very simplified basis, recall what Citigroup pointed out recently: "the rich hold assets, the poor have debt."
ETF Outlook for the week ...
Submitted by Simon Black of Sovereign Man blog,
Mohamed Bouazizi. It’s not a name that means much to most people. But you’ll recall his story.
Frustrated with the absurd amount of regulation and corruption that prevented him from being able to put food on the table for his family, Bouazizi was the 26-year old Tunisian fruit merchant that set himself on fire in 2011.
In doing so, all the pent up frustration across the Middle East and North Africa erupted all at once; the entire region immediately plunged into multi-year revolution which became known as the Arab Spring that has since toppled a number of governments.
Like individual people, societies have their own breaking points. They build up anger and frustration for years… sometimes decades. Then all it takes is one spark. One catalyst. And it all becomes unglued.
Just yesterday, a 33-year old Indian man got hit by the proverbial bus in Singapore’s Little India neighborhood. That was the catalyst. What transpired for the next several hours was a full blown riot… the first of its kind since 1969.
Several hundred rioters stormed the streets. They started off smashing the up the bus that was still on the corner of Hampshire Road and Race Course Road. Then they started throwing objects at the ambulance staff who were unsuccessful in extracting the man in time to save his life.
By the end of the evening, an angry mob had lit five police vehicles on fire, plus the ambulance, leaving the streets in a towering inferno.
The government immediately went into damage control mode trying to explain what happened. But the explanation is really quite simple.
Singapore has had years of tensions building. The wealth gap is growing like crazy. Wealthy people are becoming ultra-wealthy, while the majority of folks see the cost of living rise at an alarming rate.
Strong ideological and ethnic differences are boiling over. And backlash against immigrants, especially from certain countries, is becoming an acute and obvious problem.
These issues are commonplace. Ideological differences. The wealth gap and economic uncertainty. Immigration challenges.
They’re the same issues, for example, that have plunged much of Europe into turmoil, including the rise of a blatantly fascist political party in Greece.
And these same issues exist, in abundance, in the Land of the Free… where a number of serious ideological divides are becoming obvious social chasms.
Printing money with wanton abandon. Racking up the greatest debt burden in the history of the world. Doling out wasteful and offensively incompetent social welfare programs at the expense of the middle class. Brazenly spying on your own citizens. These are not actions without consequences.
And if it can happen in Singapore - one of the safest, most stable countries on the planet, it can happen anywhere. Even in a sterile American suburb.
While the second-derivative hopers and primary budget surplus believers cling to the faith that Stournaras talking about recovery is enough to bring the depressing Greek nation out of its slumber, the fact is that Greek deflation has never been worse. However, it gets worse... as a recent study by CFR finds that countries are most at risk of defaulting the year they turn a positive primary budget - meaning they are no longer reliant on their creditors. Simply put, the Greek government has far less incentive to pay, and far more negotiating leverage with, its creditors once it no longer needs to borrow from them to keep the country running - this makes it more likely, rather than less, that Greece will default sometime next year. Beggars, once again, become choosers.
Less worse un-growth and Hope deflating...
Things are looking up in Greece – that’s what Greek ministers have been telling the world of late, pointing to the substantial and rapidly improving primary budget surplus the country is generating. Yet the country’s creditors should beware of Greeks bearing surpluses.
A primary budget surplus is a surplus of revenue over expenditure which ignores interest payments due on outstanding debt. Its relevance is that the government can fund the country’s ongoing expenditure without needing to borrow more money; the need for borrowing arises only from the need to pay interest to holders of existing debt. But the Greek government has far less incentive to pay, and far more negotiating leverage with, its creditors once it no longer needs to borrow from them to keep the country running.
This makes it more likely, rather than less, that Greece will default sometime next year. As today’s Geo-Graphic shows, countries that have been in similar positions have done precisely this – defaulted just as their primary balance turned positive.
The upshot is that 2014 is shaping up to be a contentious one for Greece and its official-sector lenders, who are now Greece’s primary creditors. If so, yields on other stressed Eurozone country bonds (Portugal, Cyprus, Spain, and Italy) will bear the brunt of the collateral damage.
The Obamacare enrollment portal is the gift that keeps on giving endless examples of government incompetence. The latest comes from Bloomberg which informs us that "there’s no way to tell how many people who think they’ve signed up for health insurance through the U.S. exchange actually have, after about 1 in 4 enrollments sent to insurers from the federal website had garbled included incomplete information." Still that particular glitch was not enough to prevent Obama from taking full credit for a "fixed" website after somehow the White House managed to calculate that sign ups soared to 100,000 people, and have taken off since the "fix."
[T]he acknowledgment suggests consumers need to be vigilant about their health plan purchases. Letters from insurers confirming coverage can take a week or more, and the Obama administration now says people should call their companies if they aren’t contacted within that time.
With repairs to the front end of healthcare.gov leading to a spurt of 29,000 new enrollments in the first two days of December, U.S. officials are now focusing on what happens after customers select a plan on the website. Enrollment isn’t complete until consumers make their first payment, which is due Dec. 31 for insurance coverage that will begin on Jan. 1.
“It’s time for people to move toward locking in coverage and paying for it,” said Joel Ario, a consultant with Manatt Health Solutions, in a telephone interview. Insurers will face “a tall challenge” trying to resolve enrollment errors as the time shortens before coverage begins Jan. 1, he said.
The Centers For Medicaid & Medicare Services, which runs the federal health website, doesn’t have “precise numbers” on how many of the enrollment forms called 834s have been sent to insurers or how many have errors, Julie Bataille, an agency spokeswoman, said during a Dec. 6 conference call.
One aspect where Obamacare is working, is where the government decided to bypass the healthcare.gov 500 million lines of code monstrocity entirely and allow consumers to enroll directly with state insurance companies.
A project the government began two weeks ago with 16 insurance companies in three states -- Texas, Florida and Ohio - - to allow them to enroll people directly into health plans, bypassing healthcare.gov, has improved the working relationship among the government’s technicians and those at the companies, said a person familiar with the work who asked not to be identified because the information is private. The new cooperation has helped to resolve issues with the data transfers, the person said.
Alas, the bulk of the enrollment problems remain when using the central portal:
“In general our 834 files have been pretty good,” said Kathleen Oestreich, CEO of Meritus, a Tempe, Arizona, startup insurer funded by government loans. The company has seen only one “orphan” member, she said -- a person who called and said they hadn’t received an enrollment notice even though they had picked Meritus as their insurer.
More troubling are “ghosts” -- people whose files never reach their insurers, Robert Laszewski, an insurance industry consultant, said. It’s unclear how many people may fall into that category or how companies will identify or reach them.
“If they enroll 500,000 people and 25,000 of them walk into the doctor’s office and nobody knows who they are, that’s a problem,” he said in a phone interview.
It is indeed. And it is just the start, because while the enrollment process of Obamacare will (one hopes) eventually be fixed, that will merely unleash all new, and far more disturbing problemsn. Such as the deductible sticker shock that is about to be unleashed upon Americans in need of medical aid, especially those who choose the cheaper "bronze" plan. The WSJ reports:
As enrollment picks up on the HealthCare.gov website, many people with modest incomes are encountering a troubling element of the federal health law: deductibles so steep they may not be able to afford the portion of medical expenses that insurance doesn't cover. The average individual deductible for what is called a bronze plan on the exchange—the lowest-priced coverage—is $5,081 a year, according to a new report on insurance offerings in 34 of the 36 states that rely on the federally run online marketplace.
That is 42% higher than the average deductible of $3,589 for an individually purchased plan in 2013 before much of the federal law took effect, according to HealthPocket Inc., a company that compares health-insurance plans for consumers. A deductible is the annual amount people must spend on health care before their insurer starts making payments.
The health law makes tax credits available to help cover insurance premiums for people with annual income up to four times the poverty level, or $45,960 for an individual. In addition, "cost-sharing" subsidies to help pay deductibles are available to people who earn up to 2.5 times the poverty level, or about $28,725 for an individual, in the exchange's silver policies. As enrollment picks up on HealthCare.gov, many people with modest incomes are encountering a troubling element: deductibles so steep they may not be able to afford the portion of medical expenses that insurance doesn't cover.
But those limits will leave hundreds of thousands or more people with a difficult trade-off: They can pay significantly higher premiums for the exchange's silver, gold and platinum policies, which have lower deductibles, or gamble they won't need much health care and choose a cheaper bronze plan. Moreover, the cost-sharing subsidies for deductibles don't apply to the bronze policies.
That means some sick or injured people may avoid treatment so they don't rack up high bills their insurance won't cover, according to consumer activists, insurance brokers and public-policy analysts—subverting one of the health law's goals, which is to ensure more people receive needed health care. Hospitals, meantime, are bracing for a rise in unpaid bills from bronze-plan policyholders, said industry officials and public-policy analysts.
Ah: central planning, also known in the now-defunct USSR as the where "whatever can go wrong, will." As Obama (and soon the Fed) are learning first hand...
As the country's leaders search the world for funding, and in spite of the seemingly acquiescent removal of barriers from the government buildings by the police, the situation in Ukraine appears to growing more out of control:
- *UKRAINE'S TOP PROSECUTOR SAYS PROTESTS VIOLATE LAW
- *PROTESTS ENTAIL 'SEVERE CRIMINAL RESPONSIBILITY:' PROSECUTOR
- ARMED MASKED MEN SEIZE KIEV PARTY HEADQUARTERS OF JAILED OPPOSITION LEADER YULIA TYMOSHENKO-EYEWITNESS
- TYMOSHENKO PARTY SPOKESWOMAN SAYS RAIDERS TOOK COMPUTER SERVER, BLAMES POLICE; POLICE DENY INVOLVEMENT
As we warned previously, the nation's funding situation remains "precarious" and headlines will crow of consiliatory discussions, this action appears to be anything but - as perhaps the Ukrainian elite fear the same kind of "success" that the people's coup in Thailand appears to be having. Ukraine's CDS has reached its highest in 4 years.
In state polls last night in India the opposition party won a stunning upset in areas that hold about 200 million people.
The victories for the Janata Party are a challenge to the Singh party going into May 14 elections and underscore the unhappiness that exists within India over the heavy handed role the state plays in the economy.
If investors believe there can be an aggressive mandate won in next year’s elections that can re-ignite Asia’s other billion populous countries, you could see greater moves in the markets.
No tsunami or earthquake but Entergy's Arkansas nuclear facility is offline...
- *ENTERGY: ARKANSAS NUCLEAR ONE OFFLINE AFTER TRANSFORMER FIRE
- *ENTERGY SAYS UNIT 2 OFFLINE, UNIT 1 REMAINS ONLINE
Reassuringly, Entergy explains there was "no damage to the actual nuclear reactor," for now.
Authorities are responding to a fire that was reported Monday morning at an Entergy auxiliary transformer at Arkansas Nuclear One Unit Two in Russellville, company spokesman Mike Bowling said.
The blaze started about 7:50 a.m. after there was a "fault in the transformer that resulted in the fire," Bowling said.
The facility's Unit Two is offline, but Unit One is still online, Bowling said. No injuries have been reported, and the fire has been contained.
The auxiliary transformer is an electrical device that transfers energy and is not a nuclear portion of the plant, Bowling said.
The London Fire Department and Entergy's onsite responders are working the scene.
Arkansas Department of Emergency Management spokesman Tommy Jackson said that the fire was not extinguished within the 15 minutes of detection.
"The auxiliary transformer exploded in Unit Two, and there was fire within the protected area," he said.
Gov. Mike Beebe said after a speech Monday at the Arkansas Electric Cooperatives Directors' Winter Conference in Little Rock that he had been briefed on the fire and that there was "no damage to the actual nuclear reactor."
First, delayed Bill auctions due to "technical glitches"... Now the first POMO of the day delayed by 15 minutes. Is Central Planning proving to be a touch problematic, or is this merely a slight disturbance in the farce?
The good news is that if the Fed screws it up with POMO #1, there is always POMO #2 at 1 pm.
Amazing move when you consider the slower growth paradigm and structural deadlock on key economic developments like allowing foreign multinationals access to their local consumer.
The move in India comes despite a currency that should continue to have current account pressure in 2014 but may have settled into a trading range between 58 and 62.
Today’s AM fix was USD 1,228.50, EUR 895.60 and GBP 749.95 per ounce.
Friday’s AM fix was USD 1,230.75, EUR 900.59 and GBP 752.38 per ounce.
Gold rose $4.56 or 0.4% Friday, closing at $1,229.06/oz. Silver climbed $0.11 or 0.6% closing at $19.44/oz. Platinum fell $3.25, or 0.2%, to $1,354.74/oz and palladium dropped $0.64 or 0.1%, to $731.50/oz. Gold and silver were down 1.7% and 2.6% for the week respectively.
Gold was flat on Monday after volatile trading last week led to slight losses. Very tentative signs of improving U.S. economic growth kept prices in the red as technical and momentum traders remain negative on gold.
On Friday, gold closed with a decline of nearly 2% for the week, as traders had to wade through a week of mostly upbeat economic numbers, including a stronger-than-expected U.S. jobs report for November on Friday. Short-covering by traders and physical demand offered some support.
More speculative market participants and traders continue to fret over whether the United States will begin tapering its $20 billion a week debt monetisation programme. Also, stronger equities is attracting hot money flows from those seeking to make quick capital gains. This tends to end on tears as late comers to the party buy at record highs.
Chinese gold bullion demand remains voracious and will likely pick up after the recent price falls and ahead of Chinese New Year. October saw China's second highest month for gold imports ever, according to Hong Kong customs data.
China imported 148 tons in October, the second highest recorded level. The record was in March 2013 when China imported 224 tons. October marked China's 26th consecutive month of being a substantial net gold importer.
These numbers are solely demand that is going through Hong Kong. There are also sizeable shipments directly to China from Australia, the UK, the U.S. and South Africa. There may also be exports from elsewhere in Africa that is not showing up in the data.
Meanwhile, the SPDR Gold Trust, the world's largest gold exchange-traded fund, said its holdings fell 3 tonnes to 835.71 tonnes on Friday as gold continues to flow from west to east.
Another bullish contrarian indicator is the fact that hedge funds raised their bearish bets in U.S. gold futures and options close to a 7 and a 1/2 year high in the week to December 3, data from the Commodity Futures Trading Commission (CFTC) showed Friday. Speculators turned silver into a net short position for the first time since late June.
What Are Bail-Ins?
A bail-in is when regulators or governments have statutory powers to restructure the liabilities of a distressed financial institution and impose losses on both bondholders & depositors.
Simply stated, a bank bail-in is an attempt to resolve and restructure a bank as a going concern, by creating additional bank capital (recapitalisation) via forced conversion of the bank’s creditors’ claims (potentially bonds and deposits) into newly created share capital (common shares of the bank).
The bail-in is undertaken by a regulatory authority that is vested with powers to execute a previously agreed bailin plan in a very short space of time, possibly over a weekend, so as to keep the bank functioning, and to preserve financial stability as far as possible.
To understand what the bail-in concept of a troubled bank is, it is important to understand what a bank balance sheet is, and what the balance sheet consists of. Simply put, a bank’s balance sheet consists of sources of financing and uses of this financing. At a high level, the sources are shareholders’ equity (shares) and the bank’s liabilities, which consist of lending to the bank by bondholders (bonds) and lending to the bank by depositors (deposits).
The shareholders are the bank’s owners, while the bondholders and depositors are the bank’s creditors. These components constitute the bank’s capital, and in total are known as its capital structure. The bank then lends out and invests its liabilities and refers to them as assets.
Previously, during bank bail-outs, when a bank was failing and the government stepped in, the losses were absorbed by the sovereign states and the risk was transferred to the taxpayer. In a bail-in, during the resolution of the problematic bank, the risk is pushed back to the bank’s shareholders and creditors.
In a bank’s capital structure, the various sources of financing exist in a hierarchy of claims. This is both a hierarchy for repayment when the bank is a going concern, and also in liquidation. Debt resides at the top of the hierarchy for repayment, since bondholders get repaid ahead of equity holders. In a liquidation, the company’s assets are sold and proceeds are paid to senior creditors, subordinated creditors, and then shareholders, in that specific order. If senior creditors take a hit, subordinated creditors get nothing, nor do shareholders, who get wiped out. If subordinated creditors take a hit, shareholders are wiped out.
There is normally a stratum of seniority within debt holders, for example, from top to bottom, running from super senior debt, to senior debt, to subordinated debt, then to junior debt. Senior debt can include secured and unsecured bonds, depositors, and in some cases wholesale money market borrowing. Secured bonds are ‘backed’ by specific assets or collateral and rank higher in the repayment hierarchy than unsecured bonds. Below debt in the hierarchy sits equity, such as preferred equity, and at the bottom, common equity (shares).
In a direct bail-in regime, as proposed by the Financial Stability Board and associated monetary authorities, there is also a hierarchy of first to be bailed-in (converted to bank shares), but it differs from the liquidation creditor hierarchy since in a bail-in, shareholders do not get wiped out, they get diluted. The more the bank’s assets are impaired, the more categories of bank liabilities get converted to shares.
This impacts the shareholders since their shareholdings become diluted as entities who were previously creditors become shareholders. So a bail-in differs from a liquidation in that although creditors take a loss, existing shareholders survive but own less of the overall share capital.
In Cyprus, bondholders (including senior bond holders) and depositors over €100,000 were bailed-in. Their money was seized, and in return they were given shares in the problematic banks, thereby becoming shareholders of these struggling banks.
Usually, only bonds with a conversion option, called convertible bonds, ever have the potential for getting converted into equity. However, there is another class of convertible bonds called contingent convertible bonds that can be converted into equity depending on particular outcomes or scenarios.
Given that the bail-in regime can force bondholders and depositors to be converted into shareholders, a new thinking is evolving in which unsecured bonds and bank deposits should now be viewed as contingent capital.
This is really the crux of the Cyprus template as proposed by international monetary authorities , i.e. that depositors internationally now have to think of their uninsured deposits as liable to potentially being confiscated and transformed into bank shares.
Bank depositors have traditionally viewed their bank deposits as 100% secure, with an inalienable right to have their deposits returned in full. However, this has never been the case in legal terms. A bank depositor is just an unsecured creditor of the bank.
In other words, the depositor is a lender who has loaned their deposit to the bank. If the bank became insolvent, depositors would have to line up with the other creditors in the hierarchy of claims and wait to see if their money was returned.
In light of the above hierarchy and the essential unsecured creditor nature of bank deposits, it’s useful to look at some formal definitions of bail-ins as applied to Systematically Important Financial Institutions (SIFIs).
A 2012 IMF Staff Paper defined a bail-in as:
A statutory power to restructure the liabilities of a distressed SIFI by converting and/or writing down unsecured debt on a “going concern basis.” In bail-in, the concerned SIFI remains open and its existence as an on-going legal entity is maintained. The idea is to eliminate insolvency risk by restoring a distressed financial institution to viability through the restructuring of its liabilities and without having to inject public funds….The aim is to have a private-sector solution as an alternative to government-funded rescues of SIFIs.
The Systematically Important Financial Institution concept is similar to the Too Big To Fail (TBTF) doctrine which was used to bail-out a number of large international banks during the financial crisis in 2008. The ‘TBTF’ concept maintains that when a financial institution is so big and interconnected into an economy that if it failed it would be disastrous to that economy, then it has to be supported by the relevant government or authority.
In October 2012, in a speech to the International Association of Depositor Insurers (IADI) annual conference, Paul Tucker, a deputy governor of the Bank of England, explained the central bank view on bail-ins:
“The central principle running through this whole endeavour is that after equity is exhausted, losses should fall next on uninsured debt holders, in the order they would take losses in a standard bankruptcy or liquidation process. Although all resolution strategies have that effect, it is the particular focus of what has come to be called ‘bail-in’. I should perhaps say that bail-in isn’t about identifying a special type of bond that can be written down or converted. ‘Bail-in’ is a verb not a noun. It’s about giving the authorities the tools, the powers, to affect a restructuring of the capital and liabilities of a bank that isn’t toxic all the way through.”
For large institutions, there are two main approaches to a bail-in, the first being ‘single point of entry resolution’ where the bail-in occurs in the holding company at the top of the group, and the second being ‘multiple point of entry resolution’ where, given that a banking group may be operating across lots of regions
Who Is Driving The Bail-In Regime?
It is revealing to examine the genesis and evolution of the centrally planned bail-in regime as discussed by central banks and international policymakers, since it highlights that the planning and preparation for a global bank “Bail-In Regime” has been on-going internationally at a high level for a number of years now, primarily under the auspices of the Financial Stability Board (FSB).
The Financial Stability Board emerged from the Financial Stability Forum (FSF), which was a group of finance ministries, central bankers and international financial bodies, founded in 1999 after discussions among Finance Ministers and Central Bank Governors of the G7 countries. The FSF facilitated discussion and co-operation on supervision and surveillance of financial institutions, transactions and events. The FSF was managed by a small secretariat housed at the Bank for International Settlements in Basel, Switzerland.
The FSB was officially founded at a Group of Twenty Finance Ministers and Central Bankers (G20) meeting in London in April 2009. The FSB coordinates national and supra-national regulatory and supervisory bodies on financial sector stability.
The FSB’s first chairman was Mario Draghi, current President of the European Central Bank, while its current chairman is Mark Carney, Governor of the Bank of England.
FSB members now include monetary authorities and security market regulators from the US, the UK, Canada, Australia, France, Italy, the Netherlands, Germany, Switzerland, Japan, Hong Kong, Singapore, Brazil, Russia, India, China and South Africa, as well as the European Commission, IMF, OECD, World Bank, and the Bank for International Settlements (BIS).
The Key Attributes Of A Bail-In Regime
In October 2011, the Financial Stability Board (FSB) published a seminal report on the bail-in regime titled “Key Attributes of Effective Resolution Regimes for Financial Institutions”. 8
This report set out a high-level framework for responding to and resolving failures at banks and other financial institutions, and was officially endorsed by the G20 at a summit in Cannes in November 2011 “as the international standard for resolution regime”.
The intent is to “allow authorities to resolve financial institutions in an orderly manner without taxpayer exposure to loss from solvency support, while maintaining continuity of their vital economic functions”. Essentially this means addressing the funding of firms in resolution, as well as recovery and resolution planning.
The Key Attributes include a number of noteworthy pronouncements on an effective resolution regime such as:
• Allocating losses to firm owners (shareholders) and unsecured and uninsured creditors in a manner that respects the hierarchy of claims.
• Not relying on public solvency support and not creating an expectation that such support will be available.
• Where covered by schemes and arrangements, protecting depositors that are covered by such schemes and arrangements, and ensuring the rapid return of segregated client assets.
The inclusion of Financial Market Infrastructures means that large parts of the global financial system is susceptible to bail-in and could potentially be bailed-in.
The scope of this planned bail-in regime for participating countries is not just limited to large domestic banks. In addition to these “systemically significant or critical” financial institutions, the scope also applies to two further categories of institutions, a) Global SIFIs, in other words, cross-border banks which happen to be incorporated domestically in a country that is implementing the bail-in regime, and b) ”Financial Market Infrastructures (FMIs)”, such as clearing houses.
The inclusion of Financial Market Infrastructures in potential bail-ins is in itself a major departure.
The FSB defines these market infrastructures to include multilateral securities and derivatives clearing and settlement systems, and a whole host of exchange and transaction systems, such as payment systems, central securities depositories, and trade depositories. This would mean that an unsecured creditor claim to, for example, a clearing house institution, or to a stock exchange, could in theory be affected if such an institution needed to be bailed-in.
As Paul Tucker phrased it at the IADI conference: “resolution isn’t just about banks, and so we are planning to elaborate on how the Key Attributes should be applied to, for example, central counterparties, insurers, and the client assets held by prime brokers, custodians and others.”
The inclusion of Financial Market Infrastructures means that large parts of the global financial system is susceptible to bail-in and could potentially be bailed-in
According to the FSB report, the implementation of the bail-ins should be undertaken by a resolution authority in each country with statutory resolution powers to enforce bail-ins.
These powers would include powers to:
• Override rights of shareholders of the firm in resolution.
• Transfer or sell assets and liabilities, legal rights and obligations, including deposit liabilities and ownership in shares to a solvent third party.
• Carry out bail-in within resolution.
• Impose a moratorium with a suspension of payments to unsecured creditors.
• Effect the closure and orderly wind down (liquidation) of the whole or part of a failing firm with timely payout or transfer of insured deposits.
Following on from the release of the FSB Key Attributes report in 2011, it became apparent that national monetary authorities and regulators had been actively working for some time on national bail-in preparedness and their own versions of the Key Attributes.
Download our Bail-In Guide: Protecting your Savings In The Coming Bail-In Era(11 pages)
Back in February, Fed governor Jeremy Stein warned of overheating (read: bubble conditions) in credit markets. Nobody cared. A few months later, while observing among other things the ongoing credit bubble, none other than the central banks' central bank said the "central banks must head for the exit and stop trying to spur a global economic recovery" and that the "monetary kool-aid party is over." It wasn't, and naturally nobody cared either - as we would find out a few months later the party would go on as it turned out banks have no other choice but to keep the kool-aid flowing. Then over the weekend, just in case, the BIS tried once again, this time "sounding the alarm over record sales of PIK Junk Bonds" combining what it said previously together with Jeremy Stein's warnings (of course, nobody would care this time either).
Record sales of high-yield payment-in-kind bonds are triggering uneasiness among international regulators concerned that investors may suffer losses when central banks tighten monetary policy.
Issuance of the notes, which give borrowers the option to repay interest with more debt, more than doubled this year to $16.5 billion from $6.5 billion in 2012, according to data compiled by Bloomberg. About 30 percent of issuers before the 2008 financial crisis have since defaulted, the Bank for International Settlements said in its quarterly review.
Companies are taking advantage of investor demand for riskier debt as central bank stimulus measures suppress interest rates and defaults approach historic lows. The average yield on junk-rated corporate bonds fell to a record 5.94 percent worldwide in May, Bank of America Merrill Lynch index data show, while global default rates dropped to 2.8 percent in October from 3.2 percent a year earlier, according to a Moody’s Investors Service report.
“Low interest rates on benchmark bonds have driven investors to search for yield by extending credit on progressively looser terms to firms in the riskier part of the spectrum,” according to the report from the Basel-based BIS. “This can facilitate refinancing and keep troubled borrowers afloat. Its sustainability will no doubt be tested by the eventual normalisation of the monetary policy stance.”
Warning, shmarning: the truth is that as long as the Fed continues pushing everyone into the riskiest assets (so essentially forever), the demand for High Yield, aka Junk Bonds will rise. Although technically, "High Yield" is no longer the appropriate name for the riskiest credit issuance since the average coupon has declined to where Investment Grade used to trade in the years before the New Normal. It is therefore only appropriate that as part and parcel of this record high yield bond issuance surge levering the riskiest companies to the gills with low interest debt, that there is also a scramble between underwriters to become as competitive as possible. And, sure enough, as Bloomberg Brief reports, "the underwriting fees disclosed to Bloomberg on U.S. junk bond deals average 1.276 percent for the year to date, the lowest since our records began. The prior low was set in 2008, when fees averaged 1.4 percent." 2008... that was when the last credit bubble burst on unprecedented demand for junk bonds: we are confident the bubble apologists will find some other metric with which to convince everyone that reality, and the Fed's Stein, have it all wrong.
In the meantime, this is what a real bubble, if not so much in underwriting fees, looks like.
And by underwriter:
Finally, as a courtesy reminder what happened the last time the credit bubble hit such epic proportions, here again is the BIS:
The trend towards riskier credit was fairly general. It spurred, for example, the market for payment-in-kind notes. …This rise occurred despite evidence of the riskiness of payment-inkind notes: Roughly one third of their pre-crisis issuers defaulted between 2008 and mid-2013.
China Exports inspire a short term rally but let’s keep enthusiasm at a minimum and understand the big picture.
China’s weekend trade numbers were overall very positive on the headline as Exports came in at +12.7% vs. estimated 7% and exceeding the previous month print of +7.6%.
BUT….note that the comps on the export data are not too difficult coming off a softer China and global economy for the yearend of 2012.
Also note that for China to really prime the global commodities pump and grow at +10-11% levels, they will need to be exporting a lot more and that is just not in the cards.
Global trade is down and will remain in a down trend. Chinese imports and consumption growth can be a pleasant surprise but will not move the needle in the next 2-3 years in a meaningful way to drive the entire asset class.
by John Hussman, Hussman Funds
Our estimate of prospective 10-year nominal S&P 500 total returns has eroded to just 2.3%, suggesting that equities are likely to underperform even the relatively low returns available on 10-year Treasury bonds in the coming decade. Those estimates have had a correlation of over 85% with subsequent 10-year S&P 500 total returns since 1940, and a higher correlation with subsequent returns more recently. We don’t rely on any single estimation method, and some are more complex discounting models, but a number of very good shorthand methods with similar historical reliability are reviewed in the Valuation section of Investment, Speculation, Valuation, and Tinker Bell. Note that these same valuation measures were quite favorable in 2009, and gave us sufficient room to shift to a constructive stance after the 2000-2002 bear market plunge, while warning of overvaluation at the 2000, 2007 and present instances. Despite other considerations that have been unique to this cycle, our valuation measures haven’t missed a beat.
As a side-note, it’s easy enough to evaluate the all of these methods versus actual subsequent equity returns in a century of historical data. One can demonstrate their reliability against alternatives such as the Fed Model, “equity risk premium” models, and forward-operating P/E ratios (see An Open Letter to the Fed: Recognizing the Valuation Bubble in Equities), as well as measures that use NIPA profits (where a rather egregious bit of analysis that I addressed months ago continues to stagger about like the living dead). Analysts who don’t show their data, and more importantly, don’t demonstrate that their valuation methods are tightly correlated with actual subsequent market returns over the next several years, are simply purveyors of noise. When you realize that the errors of the Fed Model in explaining actual subsequent market returns (in excess of bonds) are 86% correlated with the profit margins that existed at the time of the forecast, it should be clear that the model is not capturing regularities that ought to be captured.
Examining extreme market peaks across history, you’ll usually observe three things: a) the most historically reliable valuation measures will have modestly underestimated the advance over the preceding 10-years, b) those same valuation measures will be projecting dismal subsequent market returns, and c) those valuation measures will be proven right. The converse is generally true at extreme market troughs (see The Siren’s Song of the Unfinished Half-Cycle for a historical graph that illustrates these regularities). The reason for this is that any market extreme is the endpoint of an unfinished half-cycle. So not surprisingly, when we examine projections from a decade ago, or calculate a 13+year estimate from the 2000 peak, the S&P 500 has briefly outperformed those estimates by several percent annually. These “overshoots” are likely to be corrected in the completion of the full market cycle.
The stock market is presently at valuations where not only cyclical but secular bear markets have started. A secular bear period comprises a series of cyclical bull-bear periods where valuations gradually work their way lower at each successive cyclical trough. The past 13 years of paltry overall total returns for the S&P 500 have unfortunately corrected very little of the excess in 2000, largely thanks to yet another round of Fed-enabled speculation. We should have learned how these episodes end. At least in 2000 investors had not seen that ending, and even in 2007, the point had not been driven home. There is no excuse today, at least not if one distinguishes between measures that have provided reliable guidance about actual subsequent market returns over the past century, and those that – despite their popular appeal – have not. Though valuations for the S&P 500 are not as rich as 2000 on most measures, valuations for the median stock actually exceed the 2000 peak. From the standpoint of a century of market history, equity valuations are obscene.
I fully understand that investors would like to believe 13 years after the 2000 bubble peak (during which time the S&P 500 has achieved annual total returns of scarcely 3% annually) it should be impossible that stocks could be in yet another valuation bubble. Explaining this unfortunate situation to my 17-year old daughter, she quotes Flannery O’Connor – “The truth does not change according to our ability to stomach it.” The S&P 500 was priced in 2000 to achieve what we estimated to be negative total returns over the following decade, and the market did exactly that. But today, a few years past that 10-year mark, the 3% annual total return of the market since 2000 has been achieved only by restoring historically severe valuations. Again, present valuations are less severe than in 2000 for the S&P 500 as a whole, but are actually more severe for the median stock. In 2000, small capitalization stocks were much better valued than larger ones, though that didn’t prevent them from losing a large portion of their value in the bear market that followed.
What we observe today is very broad based overvaluation across asset classes and individual securities. This is why measures that extend beyond the S&P 500 – like the market capitalization of equities / GDP (based on Federal Reserve Z.1 Flow of Funds data) are worse than in 2007 and are approaching the records seen in 2000. It’s why the median price/revenue ratio for S&P 500 stocks is now higher than at the 2000 peak (and is nearly as high if one uses enterprise value/revenue instead of price/revenue). It’s why Value Line now reports the lowest median 3-5 year appreciation potential among all of the stocks it covers – lower than 2000 and 2007, and every point back to the 1960’s.
Since 2012, a combination of enthusiasm, superstition and blind faith in quantitative easing has clearly allowed the market to climb a speculative parabola even in the face of extreme overvalued, overbought, overbullish conditions that have historically resolved much more quickly. I continue to believe that this is not a reflection of any permanent change in market dynamics, but is instead a temporary reprieve from consequences that will be even worse for the wait.
The median is not the messenger
The knee-jerk reaction to the fact that the median stock is now more overvalued than in 2000, and that prospective 10-year S&P 500 returns are dismal, is to dispense with the evidence because of our own challenges since 2009. I cannot emphasize strongly enough that those challenges trace primarily to the stress-testing decision that I made in 2009, even though our existing methods had enjoyed an outstanding record at that point. Moreover, the methods that resulted would have outperformed our pre-2009 methods both in historical data and in the recent cycle, had they been available at the time. I fully accept that missed returns in the half-cycle since 2009 will keep me open to criticism until we prove all of this out over the completion of this cycle and future ones.
Meanwhile, however, I fear that investors are going to do themselves a terrible disservice if they ignore the objective evidence on the basis of our subjective miss, or if they fail to distinguish the past year – a sustained period of overvalued, overbought, overbullish conditions that have always resulted in subsequent collapses that wipe out a significant fraction of the market’s value – from that stress testing decision. Understanding this narrative admittedly doesn’t make the half-cycle since 2009 less disappointing, but we can evaluate the resulting methods in a century of market cycles across history, including the most recent ones. Our confidence in their ability to navigate the completion of this cycle, and those in the future, isn’t dimmed by the awkward transition that resulted from my insistence on stress-testing in 2009.
Everything looks easy in hindsight. At the end of every episode of “Deal or No Deal,” Howie Mandel asks the contestant to call out the numbers of the remaining unopened briefcases, to see whether the contestant had the million-dollar briefcase all along. It’s always fascinating that people judge whether a contestant “made a good deal” depending on how far they might have pushed their luck before losing everything. This is precisely what investors are doing here. They fear the regret of getting out with what is already a good deal because they might get more if they keep pushing their luck. One might get away with that strategy in a one-time game of “Deal or No Deal,” but in a repeated game, it’s a terrible approach. Investors should have discovered this during the 50% plunges following the 2000 and 2007 peaks, but they have again decided that “this time is different.”
Without the benefit of hindsight, one has to weigh the relevant evidence at hand. The simple reason for my stress-testing decision is that 2008-early 2009 outcomes were dramatically “out of sample” from the standpoint of the methods we had exhaustively tested only in post-war evidence since 1940. The economic and market outcomes were much more similar in scale to what was observed in Depression-era data. The same valuations we observed in early 2009 were followed, in the Depression, by a further two-thirds loss in the value of the stock market. Though the stock market corrected its 1929 plunge by briefly advancing nearly 50% in the early months of 1930, the gains were largely given back within three months, and the market went on to lose about 80% of its value from that 1930 post-crash high (more than 85% from the 1929 high).
In any event, we no longer face anything close to the valuations that existed in 2009. At that time, we could at least say that the prospective 10-year nominal total return for the S&P 500 exceeded 10% annually. Today, we estimate prospective S&P 500 total returns at just 2.3% annually for the coming decade. Stocks have already enjoyed a 5-year half-cycle that correlates most strongly – among all periods in history – with the advances preceding the 1929, 2000 and 2007 market peaks (no surprise – unbroken diagonal lines always correlate strongly). After sustained market advances, investors are inclined to look at market returns in the rear-view mirror, using phrases like “the market is paying X% a year” as if the past is prologue. Looking at the chart of the Dow Jones Industrial Average approaching the peak from which it was soon to lose seven-eighths of its value, does anyone believe that investors then were any less confident about an “unbreakable” market than investors are now?
Signs of a speculative peak
Last week, the percentage of bearish investment advisors plunged to just 14.3%, the lowest level in 25+ years. The Shiller P/E (the S&P 500 Index divided by the 10-year average of inflation-adjusted earnings) is now 25.4, and while we use the Shiller only as a readily-available shorthand for other measures, it is certainly better correlated with our actual valuation measures than alternatives like the Fed Model are. Looking over the historical record, the only other instance that bearish sentiment was this low while the Shiller P/E was over 19 was the exact peak of the S&P 500 in January 1973, before the market lost half its value. Looking at the overvalued, overbought, overbullish features that regularly define market peaks, there are only four instances in history when the Shiller P/E was over 19, the market was at a 5-year high, and bearish sentiment was anywhere below 18.5%. These instances were 1972, 1987, 2007, and today. The 2000 peak doesn’t appear because bearish sentiment never moved below 20% that year.
Among the litany of other classic features of a speculative bull market peak, margin debt on the NYSE has surged to the highest level in history, and at nearly 2.5% of GDP, exceeds all but two months in 2000 and 2007. The amount being borrowed to buy stocks on margin is now 26% the size of all commercial and industrial loans in the entire U.S. banking sector. As low-quality, high-risk borrowers rush to take advantage of the present speculative appetite, issuance of leveraged loans (particularly the junkier “covenant-lite” forms) has now hit a record high, already eclipsing the previous record in 2007 at the height of pre-crisis yield-seeking. New equity issuance is also running at the fastest pace since any point except the 2000 bubble peak. At the same time, Bloomberg reports that investors are plowing more into stock mutual funds than at any point since the 2000 bubble peak. Keep in mind how this works – every buyer is matched with a seller in equilibrium, so the same amount of stock is being sold by institutions and other non-retail investors. One doesn’t need to think long to answer who is likely to be the “smart money” in this trade, as the history of surges in retail participation provides a rather firm answer to that question.
Meanwhile, Value Line’s “Median 3-5 Year Appreciation Potential” for the stocks it covers is now the lowest since the 1960’s. Statistically, if one subtracts about 55% from the VLMAP, the result approximates the actual subsequent 4-year total return of the S&P 500. At a VLMAP of just 30%, the implication is a loss, in total return, of about -25% in the S&P 500 over the coming 4-year period. While my impression is that the market is likely to experience an even deeper interim loss, a 4-year overall market loss of -25%, followed by positive 9% average annual total returns for the S&P 500 over the subsequent 6-year period, would compound to produce a 10-year total return averaging 2.3%. That’s right in line with estimates from our own methods. Still, there is good news in that calculation: just because 10-year prospects are dismal at present doesn’t necessarily mean that investors will need to be defensive for the next 10 years. I expect that we’ll see much more attractive investment opportunities far sooner than that. In any event, when the books are closed on the next decade, we expect realized total returns on the S&P 500 to be even less than the depressed yield-to-maturity on 10-year Treasury bonds, with steep interim losses for stocks along the way.
On the subject of risk, aside from statistical measures like standard deviation, one of the ways to gauge potential price risk is to estimate what’s called “duration” – which is the sensitivity of price to a 100 basis point change in the rate used to discount future cash flows to present value. Duration is also a measure of the weighted-average date at which those discounted cash flows will be received. For a 10-year bond, duration stands at about 9 years at present (mostly influenced by the size of the lump-sum principal payment relative to the periodic interest payments), while the duration of the S&P 500 stands at about 50 years. Of course, 10-year bond yields are more volatile than the implied discount rate on equities (something that the Fed Model doesn’t contemplate because its users don’t even think in terms of long-term cash flows), but because equity durations are so high, stocks are likely to have several times the volatility and several times deeper drawdowns than bonds.
So passive buy-and-hold investors – who lock in a price and don’t alter their investment positions for a long period of time – should recognize that Treasury bonds are likely to outperform stocks over the coming decade, with substantially less risk. In my view, neither asset class is attractively priced, but in a world of zero returns on Treasury bills, our risk budget for passive investors would lean more toward bonds than equities here nonetheless.
All of this said, momentum and speculation continue to drive short-term outcomes, and valuation has very little near-term effect on that. It’s always problematic to gauge the endpoint of a parabolic advance, because very small changes in that endpoint can represent significant differences in price (see the chart above of the advance to the 1929 peak for a nice example of this). The gains tend to be surrendered very quickly after those peaks, though often with recovery attempts before severe losses follow. Any discussion about short-term market outcomes relies more on “impressions” and “tendencies” than reliable estimates. My impression is that the present advance remains consistent with a Sornette-type bubble that may have a bit of speculative reverie left in it.
The basic characteristic of a Sornette bubble is a “log periodic” pattern where market declines become progressively shallower and more frequent. I’ve described the investment behavior that drives this dynamic in terms of “increasingly immediate impulses to buy the dip.” What we’ve got now is a rather extreme version of this tendency, where nearly every pullback is seen as an opportunity.
We’ve been asked why the bubble appears to start in 2010 instead of at the 2009 low. The reason is that the advance from the 2009 low and into early 2010 was a legitimate non-bubble advance from a historically reasonable valuation to a historically elevated one. In the third-quarter of 2010, the Fed set a bubble in motion by encouraging the largely superstitious but – at least in the intermediate term – self-fulfilling belief in a central bank “backstop” against market risk. That’s when market dynamics shifted from investment to increasingly frantic speculation that has produced what are now historically obscene valuations.
We should not rely, but should allow for the tendency to buy every dip to move to an even more frantic pitch in the weeks ahead. In the chart below, I’ve enlarged the segment from recent months as a separate inset. Notice that log-periodic bubbles are “fractal” in that smaller segments are similar to larger segments. It will be important to watch for the emergence of fractal self-similarity at the smallest time-scales, which sometimes presents itself as increasing volatility even at 10-minute intervals (a characteristic I also noted at the 2007 peak, and again just before the market collapsed in 2008 – see Nervous Bunny). Remember, however, that this sort of fevered pitch is also terribly impermanent. We vividly recall the seeming “relentlessness” and “resilience” of the market approaching the 2000 and 2007 peaks. Investors must have felt nearly the same as prices approached their peak in 1929.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Only comments in the Fund Notes section relate specifically to the Hussman Funds and the investment positions of the Funds.
As of last week, Strategic Growth Fund remained fully hedged, with a “staggered strike” position that sets the strike prices of most of its index put options a few percent below present market levels. The Fund also carries a small position in index call options, still amounting to a fraction of one percent of Fund assets. A short-term speculative blowoff would bring those call options “in-the-money”, while a sideways or down market would result in a fraction of a percent in premium decay. Given the very well-defined speculative window that we believe is consistent with a blowoff, coupled with inability to rely on that sort of outcome in the presence of severely overvalued, overbought, overbullish conditions already, we view very small call option exposures as an appropriate contingency in the context of what otherwise remains a strongly defensive investment stance.
One of the most dangerous habits in the investment world is to phrase a past return as a future one, by adding the suffix “ing.” At market peaks, many investors don’t simply acknowledge that the market has returned X% annually over some recent period. Instead, they say that the market is returning X% annually (or worse, is “paying” X% annually). Likewise, at market bottoms, they say that the market is losing X% annually. The same practice extends to other asset classes like bonds, and to individual securities. This tendency to invest by hindsight leads investors to look at their portfolios and load them with asset classes and securities that seem to be “returning” or “paying” most. It is a recipe that leads investors to hold terribly aggressive portfolios at market peaks, and overly defensive portfolios at market lows. Whether or not readers own the Hussman Funds, my hope in these weekly comments is to discourage those tendencies, and encourage investors to evaluate their investments on a prospective basis.
I have no intention to discourage investors following a passive, disciplined buy-and-hold strategy from maintaining their discipline, provided that their allocations reasonably align the duration of their investments with the expected date that they’ll need the funds. At current interest rates, the duration of bonds is not much different from their maturity, since the terminal face value payment dominates the effect of interest payments. For example, a 10-year Treasury bond has a duration of about 9 years. By contrast, provided that dividends per share (which capture the effect of stock buybacks) grow fairly smoothly over time, and current dividends are more or less “representative,” the duration of stocks mathematically works out to be roughly the price/dividend ratio. So the effective duration of the S&P 500 presently works out to about 50 years. Passive investors who are indifferent to valuations and long-term prospective returns are still encouraged to reasonably align the total duration of their equity and bond exposures with the expected duration of their lifetime spending liabilities.
Strategic International remains fully hedged. Strategic Dividend Value is hedged at about 50% of the value of its stock holdings. In Strategic Total Return, we clipped the Fund’s duration back to about 3.5 years earlier in the week (meaning that a 100 basis point increase in interest rates would be expected to impact Fund value by about 3.5% on the basis of bond price fluctuations), while increasing the Fund’s holdings in precious metals shares to about 8% of Fund assets on price weakness in that sector. Our general view is that the Treasury yield curve is much steeper than we expect to endure, but against that, unfavorable yield pressures – on economic hopes that I see as unconvincing but exist in any event – may at least briefly lean against the tendency of the curve to normalize. Those two general considerations drive a moderate but not aggressive expected return/risk profile in bonds, and we are positioned accordingly.
Prospectuses for the Hussman Strategic Growth Fund, the Hussman Strategic Total Return Fund, the Hussman Strategic International Fund, and the Hussman Strategic Dividend Value Fund, as well as Fund reports and other information, are available by clicking “The Funds” menu button from any page of this website.
Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 reflect our standard valuation methodology, focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle (see for example Investment, Speculation, Valuation, and Tinker Bell, The Likely Range of Market Returns in the Coming Decade and Valuing the S&P 500 Using Forward Operating Earnings ).