Hussman’s extreme risk syndrome present again

John Hussman does the best long-term statistical analysis of the broad equity market, bar none. He has identified a set of four conditions that has appeared at or just before significant tops in the stock market:

Overbought: S&P 500 within 3% of its upper Bollinger bands, at least 7% above its 52-week smoothing, and over 50% above its 4-year low

Overbullish: Investors Intelligence sentiment survey shows bulls above 52% and bears below 27%

Overvalued: Shiller P/E above 18 (it’s currently 23)

Rising yields: 10-year Treasury yields above their level of 6-months earlier.

This condition also appeared in 1929 (followed by a crash and 20 year bear market in real terms) and 1964 (stocks peaked in ’66 before going down 80% in real terms over the next 16 years). When stocks are overbought and overvalued, treasuries have fallen, and most investors are bullish, it is to your great advantage to eliminate market risk (sell your stocks or hedge them).

Why not sell German bonds?

The German 30 year bond is yielding 2.8%:

The US 30 year bond is yielding the same:

Yahoo Finance

There is no margin of safety in Germany debt against the strong likelihood that the country will be forced (by Merkel and other banker tools) to absorb the losses of the rest of Europe.

Of course, there is no margin in safety in US bonds either at this price, certainly not enough to compensate for the probability of trillion dollar deficits forever. I expect yields to stay low through this cyclical bear market, but not much beyond that. Bonds will continue to be a good short at times when they are overbought, and we may be approaching such a time.

Analysts and institutions: stocks “extremely cheap” despite 1.7% yields after 80% rally. Hussman & Prechter: another crash likely.

Bloomberg today gives a tour of the bull camp, which believes in a V-shaped recovery and soon-to-be record S&P earnings:

Even after the biggest rally since the 1930s, U.S. stocks remain the cheapest in two decades as the economy improves…

…Income is beating analysts’ estimates by 22 percent in the first quarter, making investors even more bullish that the rally will continue after the index climbed 80 percent since March 2009. While bears say the economy’s recovery is too weak for earnings to keep up the momentum, Fisher Investments and BlackRock Inc. are snapping up companies whose results are most tied to economic expansion.

“The stock market is incredibly inexpensive,” said Kevin Rendino, who manages $11 billion in Plainsboro, New Jersey, for BlackRock, the world’s largest asset manager. “I don’t know how the bears can argue against how well corporations are doing.”

S&P 500 companies may earn $85.96 a share in the next year, according to data from equity analysts compiled by Bloomberg. That compares with the index’s record combined profits of $89.93 a share from the prior 12 months in September 2007, when the S&P 500 was 19 percent higher than today.

Those figures would be for operating earnings, not the bottom line. In recent years it has been increasingly common to simply call operating earnings “earnings” and to imply that multiples on this figure should be compared to historic multiples on the bottom line. Ken Fisher, readers may recall, was running obnoxious video web ads through 2007-2008 touting a continued rally just before stocks fell off a cliff. His equity management firm makes the most money if people are all-in, all the time, as it collects fees as a percent of assets.

Record Pace

The earnings upgrades come as income beats Wall Street estimates at the fastest rate ever for the third time in four quarters. More than 80 percent of the 173 companies in the S&P 500 that reported results have topped estimates, compared with 79.5 percent in the third quarter and 72.3 percent in the three- month period before that, Bloomberg data show.

It is impressive how companies have protected themselves since the downturn began, but the way they have done this is by simply cutting costs, hence the stubborn 9.5% (headline U-3) or 17% (U-6) unemployment rate.

David Rosenberg, as usual, is the cooler head in the room:

Alternate Valuation

David Rosenberg, chief economist of Gluskin Sheff & Associates Inc., says U.S. stocks are poised for losses because they’ve become too expensive. The S&P 500 is valued at 22.1 times annual earnings from the past 10 years, according to inflation-adjusted data since 1871 tracked by Yale University Professor Robert Shiller.

Economic growth will slow and stocks retreat as governments around the world reduce spending after supporting their economies through the worst recession since the 1930s, said Komal Sri-Kumar, who helps manage more than $100 billion as chief global strategist at TCW Group Inc. The U.S. budget shortfall may reach $1.6 trillion in the fiscal year ending Sept. 30, according to figures from the Washington-based Treasury Department.

“The correction is going to come,” Sri-Kumar said in an interview with Bloomberg Television in New York on April 21. “You now have a debt bubble growing in the sovereign side, and we’re slow to recognize how negative that could be.”

We are still in the thick of the largest credit bubble in history. Consumer and real estate debt has yet to be fully liquidated (and hasn’t even started in China), corporate indebtedness is the highest ever, and now government debt has reached the point of no return where default is inevitable.

Equity is the slice of the pie left over after all debts are serviced, so to say that it is cheap when it only yields 1.7% (in the case of S&P dividends) is insane. It is much safer to be a creditor of a business than an owner, so debt yields should be lower than equity yields. In today’s perverse investment climate, even 10-year treasuries of the US and Germany yield more than twice equities.

This extreme confidence in stocks and dismissal of risk considerations further indicates that this is a toppy environment, highly reminiscent of 2007.

John Hussman explores this theme a bit further in his latest market comment:

As of last week, our most comprehensive measure of market valuation reached a price-to-normalized earnings multiple of 19.1, exceeding the peaks of August 1987 (18.6) and December 1973 (18.3). Outside of the valuations achieved during the late 1990′s bubble and the approach to the 2007 market peak, the only other historical observation exceeding the current level of valuation was the extreme of 20.1 reached just prior to the 1929 crash. The corollary to this level of rich valuation is that our projection for 10-year total returns for the S&P 500 is now just 5.3% annually.

While a number of simple measures of valuation have also been useful over the years, even metrics such as price-to-peak earnings have been skewed by the unusual profit margins we observed at the 2007 peak, which were about 50% above the historical norm – reflecting the combination of booming and highly leveraged financial sector profits as well as wide margins in cyclical and commodity-oriented industries. Accordingly, using price-to-peak requires the additional assumption that the profit margins observed in 2007 will be sustained indefinitely. Our more comprehensive measures do not require such assumptions, and reflect both direct estimates of normalized earnings, and compound estimates derived from revenues, profit margins, book values, and return-on-equity.

That said, valuations have never been useful as an indicator of near-term market fluctuations – a shortcoming that has been amplified since the late 1990′s. The lesson that valuations are important to long-term investment outcomes is underscored by the fact that the S&P 500 has lagged Treasury bills over the past 13 years, including dividends. Yet the fact that these 13 years have included three successive approaches (2000, 2007, and today) to valuation peaks – at the very extremes of historical experience – is evidence that investors don’t appreciate the link between valuation and subsequent returns. So they will predictably experience steep losses and mediocre returns yet again. Ironically, before they do, it also means that investors who take valuations seriously (including us) can expect temporary periods of frustration.

I’ve long noted that the analysis of market action can help to overcome some of this frustration, as stocks have often provided good returns despite rich valuations so long as market internals were strong, and the environment was not yet characterized by a syndrome of overvalued, overbought, overbullish, and rising yield conditions. In hindsight, the stock market has followed this typical post-war pattern, and we clearly could have captured some portion of the market’s gains over the past year had I ignored the risk of a second wave of credit strains (which I remain concerned about, primarily over the coming months).

It is important to recognize, however, that even if we had approached the recent economic environment as a typical, run-of-the-mill postwar downturn, we would now be defensive again, as a result of the current overvalued, overbought, overbullish, rising yields syndrome. I do recognize that my credibility in sounding a cautious note would presently be stronger if I had ignored further credit risks and captured some of the past year’s gains. But the awful outcome of this same set of conditions, which we also observed in 2007, should provide enough credibility.

Hussman proceeds to offer a detailed statistical analysis of how valuation and market action impact risks and returns. Curious parties are encouraged to read his essay in its entirety.

Here is how he rather bluntly sums up the current environment:

As of last week, the Market Climate in stocks remained characterized by an overvalued, overbought, overbullish, rising-yields syndrome that has historically produced periods of marginal new highs, slight declines, and yet further marginal highs, followed somewhat unpredictably by nearly vertical drops. I’ve often accompanied the description of this syndrome with the word “excruciating,” because the apparent resiliency of the market and the celebration of each fresh high, can make it difficult to maintain a defensive stance. Interestingly, the analysts at Nautilus Capital recently noted that the most closely correlated periods in market history to this one were the advances of 1929 and 2007. While exact replication of those advances would allow for a couple more weeks of further strength, we’ve generally found it dangerous to expect history to do more than rhyme. These hostile syndromes have a tendency to erase weeks of upside progress in a few days.

I have to agree with this assessment as well as that of Robert Prechter that this spring offers perhaps the greatest short-selling opportunity in history.

Earnings check: quietly revising down

Here’s a snapshot from the latest S&P 500 earnings file (paste the following link into your browser or google “S&P 500 earnings” for the whole Excel file:



















The average estimate for 2009 earnings is now under $40 (for a PE of 27 using today’s price), since Q3 and Q4 have been revised way down from earlier this year. Now analysts think Q4 could only come in $1 better than Q1, which was horrible.

These numbers make you wonder if accountants used up all of their tricks to boost the bottom line in Q2. The reality of shrinking sales and margins can’t be hidden forever.

The estimates for 2010 and 2011 earnings are now $45 and $61, respectively, and 2009 dividends are projected at $22 (back to 2005 levels from $28 in 2008, for a piddling 2% yield). Even if profits recover as projected, the market will have to maintain the current extreme multiple in order to deliver gains over the next two years. We are already trading at 18X 2011 earnings! The PE at the peak in 2007 was 19, and look at where that got us.

My own take on earnings is that we will be lucky to see $30 in 2010 or 2011 for that matter. The debt overhang remains, and underlying asset values are so much lower than they were 12 months ago that another huge round of write-offs is needed, which will directly hit the bottom line. Households are digging in, and banks are still pulling in credit. The consumer economy is not coming back, and corporate America will take years to adjust.

Stock prices are so far from fundamental support of any kind that this market has to be counted among the greatest bubbles of all time. Many observers understand that this is a bubble, and are wondering what it will take to bring prices back in touch with reality. My answer is nothing — the market will simply turn with social mood, which has no master but god. The facts are always there, but traders aren’t always in the mood to check.


A toppy-looking week

Well, the reflation trade has managed to hold on for a few more days and even reached new heights, but the case for a pullback is looking that much better. Precious metals, non-dollar and non-yen currencies, oil and treasury yields have all benefited from what looks like a fairly extreme fear of inflation.

At 3.83%, the 10-year note, and certainly the 5-year at 2.83%, are even approaching levels at which they may be attractive buy-and-hold instruments. In a couple of years, we may look back at this sell-off as a great chance to lock in some respectable yields for a long bout of deflation. These bonds will at the very least vastly outperform the stock market or real estate.

I would be surprised if today’s sell-off in the mid-range of the yield curve doesn’t start to lure people back into longer maturity notes.


Today’s “gap and crap” in the stock market can also be taken as a sign of a top, which would coincide perfectly with a bottom in bonds and turnaround in the dollar. Euro and pound bullishness had been holding at well over 90% by early this week, as had that for precious metals. Silver’s two strong pullbacks from the $16 level were encouraging, as were the nosedives in the euro and pound.

From this juncture, I am still more enthusiastic about the prospects for the dollar, bonds and related commodity shorts than I am about stock market shorts, since the sentiment in the later has not reached the same levels of broad consensus. That said, it would be surprising if we don’t at least stop making new highs for a few weeks, if not fall well under 900 in the S&P.

Still a deflationist, huh?

Why am I so sure that we are stuck in deflation? Simple: the inflation we have experienced for the last 40+ years in the US and most of the world is less related to money printing, digital or otherwise, than credit issuance. This was a great credit bubble, during which families and corporations forgot all the lessons of irresponsible borrowing thanks to compromised central banks that provided cheap money and the promise of bailouts to the bankers who would otherwise be on the hook for extending worse and worse loans.

As credit got cheaper and easier to obtain, people relied more and more on it for everything from houses to cars to clothing purchases and even vacations. With easy credit, prices levitated across the economy until we reached the point where we could just not make debt any easier to get. After 105% loan-to-value, neg-am, teaser rate, no-doc loans, what else could be possibly be done to lure more people to borrow?

Debt is now a burden without a reward

Without the continued expansion of credit, there was no reason for prices to keep going up, but after 2005, without prices going up, there was no reason to borrow. Just like a light switch, in 2006-2007, debt became a burden without a reward, and ever since then the magic of leverage has been working in reverse to the tune of tens of trillions of dollars in lost equity.

Creating a few trillion dollars and simply giving it to banks with (still!) massively upside-down balance sheets does nothing to get the inflation ball rolling again. If the money were dropped from helicopters or spent into circulation by the government hiring tens of millions of people (as in the highly-socialist Weimar Republic, where the government owned factories) or, as is more likely here, in a truly massive war effort like the inflationary WW1 and WW2, we would soon have inflation. But nothing that we have seen so far is remotely capable of spurring inflation until asset prices and incomes have so collapsed that most of the bad debt (tens of trillions) is liquidated through bankruptcy.

Without the bailouts, we would already be most of the way through this recession, as in the short depression in the US after WW1, in which the government did very little except lower taxes. Assets like bank deposits and car factories would be finding their way into responsible hands, where they could be put to productive use. The surviving prudent banks would be lending to the surviving prudent manufacturers and prudent families, who would be acquiring assets from the foolish, who henceforth would be much less foolish. This natural process is exactly how the west achieved such fantastic real growth in incomes, technology and quality of life in the period from the 19th century to WW1.

At the rate we are going, prepare for many years of high unemployment (we’re at 16.4% now) and weak corporate earnings, as the prudent are taxed to prop up the foolish and cynical. This is not a formula for rising prices or a better standard of living. This is a formula for political, moral and economic decline.

This is not the kind of process that societies just can just stop on a dime. Nations can’t be expected to just have epiphanies, throw the bums out and install better governments. The baddies are so in control of the nation’s press, schools and political apparatus that events must run their course, over many generations, unto total collapse. Just ask the French of the 18th century or the Russians and Chinese of the mid-20th. The west has been on this course for nearly 100 years now, since a great civilization was dashed to pieces in the fields and forests of Europe and collectivism gained a foothold.

90 day T-bill rate drops to 0.23%. What’s next, negative yields?

This is a serious panic. Bloomberg informs us that rates haven’t been this low since 1954.

Click image for sharper view. Source: Bloomberg

Yields can go negative if people are desperate enough for a safe haven. In deflation negative nominal yields can be positive real yields. CPI went slightly negative in August. Expect significant price drops in everything over the next couple of years — including your own labor!

The long end of the curve still has plenty of room to come down. The 10-year should be 2% before long, and the 30-year could fall under 3%.  Anyone who thinks that lower yields are good for stocks needs to explain this:

30-year Treasury yield in blue, S&P 500 in red:

Click image for sharper view. Source: Yahoo! Finance

Welcome to the deflationary depression of the 2000s. Got cash?

Resolving a difference of opinion: Treasuries rally as stocks tank

Mama said there’d be days like this (30-year Treasury yields in blue, S&P 500 in red):

Click for sharper image. Source: Yahoo! Finance

Today’s action showed much a higher standard deviation move for Treasuries than stocks, and it may be a sign of things to come, as there has been a very strong correlation of Treasury yields with stock prices (inverse correlation of bond and stock prices) for the past couple of years:

Click for sharper image. Source: Yahoo! Finance

Note the divergence for the last month or so. Bond traders haven’t been feeling the same relief as stock market participants since July’s mini-panic. I’ve heard it said that the bond market has a Wharton MBA and the stock market has a masters from a South Florida community college. My money says the stock market chokes and comes down with bond yields right through the July and March lows in a long series of moves like today’s.

The Jaws of Death

Today’s word to the wise comes from John Hussman’s weekly market comment:

Years ago, Larry Williams used to look for a situation he called the “Jaws of Death” – noting that when bond prices were weakening but stock prices were strengthening, the two differing trends opened a set of “jaws” that tended to snap shut, usually due to abrupt weakness in stocks. On that note, Bill Hester sent a chart over the weekend noting “I thought this was an interesting graph. The blue line is the 5-Yr Swap Spread, and the red line is the VIX. Credit investors are getting very nervous while equity investors are mostly whistling Dixie. It looks like a variation on the jaws of death that you’ve mentioned to me before….” Nothing like a good picture to complete the story (thanks Bill).

As Hussman notes, a compressed VIX in the face of rising Treasuries and an overbought market that has still not acknowledged the recession signals choppy waters ahead.

That crazy, crazy bond market: a call for sub-3% long bonds

All of a sudden, the bubbleheads seem to have caught on that the recession is worldwide and that this means lower demand for commodities. With the dollar rallying to boot, the (bad) idea of buying copper or oil as a dollar hedge is gone.

I predict that the dollar rally will strengthen the compression of Treasury yields at all ends of the curb, as the market perceives a lower currency risk. This is a sign of deflation: an increasing preference for cash. With the banking system on the verge of a collapse worse than the ’30s, people will have no choice but to buy Treasuries. These promises of an insolvent and unrepentant debtor are safer than cash in the bank (because its not really in the bank!).

This flight to safety will send short-term yields back under 1% (as they were in March), and traders will move out the yield curve to get ahead of the compression, driving long bonds to historic lows, likely well under 3%.

Talk about a conundrum.  The nation is already on the hook for $50+ trillion and is on track to run trillion dollar deficits to pay for wars, the Fannie and Freddie bailouts, baby boomers’ retirement and medical bills, growing unemployment payments, and the new New Deal that is being drawn up and fought over (Boone Pickens wants a piece). It is safe to say that the US will never have a balanced budget again and will default on its entitlement promises and outstanding loans within a generation.

In more than a few ways the coming depression is a gift for the government, not the least of which is the ability to keep the game going a bit longer by creating demand for its debt at ridiculously low rates. What choice do investors have to keep their money safe, when banks are broke, corporations are going broke, commodities are collapsing and real estate is toast, all over the world? (I would suggest gold, but even that should go still lower in this panic, as weaker hands are forced to sell anything with a bid).

But the 30-year T-bond under 3 percent? Preposterous, you say! Bond traders are the smartest, most wizened bunch out there. They don’t let just any bloke into that club. They know the long bond is all risk for no reward. But look at these startling illustrations of what the market has done at the past two turning points in the generation-long bond cycle: the 1940s and early 1980s:

Here first is a shot of yields as they made their last bottom, in the ’40s:

And here is CPI hitting double digits at the same time:

Next, yields topped out a quarter century ago like this:

Note how by 1982, CPI was 6% and dropping fast, but yields remained over 12%.  And how do you explain that second peak over 13% in 1984, when CPI had merely ticked up from under 3% to just over 4% ?

So it may seem crazy, but it is entirely possible (and given the banking crisis, likely) that long Treasury yields will fall to 60 year records in the face of horrible fundamentals. But once they get there, I expect them to turn up and keep going, as the government starts to default by Fed printing.

To all those who feel that the US debt just DESERVES to be shorted, I say wait. It will get more deserving.

Bullish on the biggest deadbeat’s debt

I have come around 180 degrees from last summer, and I’m bullish on long bonds now. The trend is clear over the past 12 months. The yields are moving with stocks.  The old correlation still holds, despite the dropping dollar and recently soaring commodities. The final flameout for the dollar is coming, but not just yet.

Dropping US, UK and Swiss government bond yields signal deflation and depression. I think they are a great speculation, particularly the Swiss bonds, since the country and currency are strongest.

Whatever you do, I wouldn’t buy one of those inverse bond funds, except for an inverse junk bond fund (such as RYIHX). In Depression #1, Treasuries soared and corporates were decimated.  And clearly, municipals are burnt toast. Sucks to be a government that can’t print money (sorry, Panama).

How to play it? I like 2010 calls on TLT.