Chart of the Month
 |
| Hussman, August 6, 2012 |
Even though the economy added 163,000 new jobs in July, the year-over-year
change in non-farm job growth fell under 1.4% this month. This is significant, because ten out of the
last ten recessions have followed this breakdown. This isn’t to say that the trend couldn’t change
this time around, but as we have recently pointed out most indicators are
flashing amber.
Investment Committee
Outlook
At the onset of this month’s investment
committee meeting I posed the following question to the members,
“Does anyone have a single reason to be bullish on stocks”?
No response.
Then after about 10 or 15 seconds
our most senior committee member said, “Dave, at this time I can’t think of a
single reason to be optimistic (emphasis
added)”.
Almost in perfect unison, each
committee member agreed with his assessment.
Performance Based
Funds Are Underperforming
The US stock market year-to-date
has made professional money managers look foolish (DP included). In today’s Wall Street Journal an article
outlined just how badly the macro-performance based investment strategy has
underperformed the S&P 500 Index so far this year. The average return of performance-based
funds is in the red nearly 5% year-to-date, and in most cases underperforming
the benchmark by over 15%.
This begs the question, “Why are
professional money managers underperforming the market by such a wide margin”. From our perspective, equity markets in the
short run rarely reflect the impacts of geopolitical and economic events, because
speculators dominate when uncertainty is high.
Prudent long-term investment policy is achieved through a disciplined
process of risk management, not chasing stock market returns. Large market drawdowns can destroy portfolio
values that can take decades to recover.
We believe that in times when risk and uncertainty is most prevalent,
protecting a portfolio’s capital base is far more important that speculation.
More QE?
As I pointed out last month, we
realize that our underperformance over the last two and half months has been
excruciatingly painful, but the geopolitical risks in Europe and the impact it
is causing on the global economy and corporate profits are far too great to
ignore. It is no secret that the global
economic situation has deteriorated rapidly, and in response, central banks
around the world have lowered borrowing costs to historic lows, and the ECB and
the FOMC have pledged massive quantitative easing if the economic situation
continues to worsen. As a result of
these promises, the equity markets in the US have been trading near the highs
of the year ignoring the high probabilities of another recession.
Will another round of QE work?
The purpose of quantitative easing
is to reduce the borrowing costs of consumers, corporations and central
governments. In the United States the yield on the 10-year Treasury
bond is around 1.5 – 1.6%, which is at a historic low. This strategy enables central bankers to
print money or use existing assets from their balance sheet to purchase various
types of debt securities; usually treasuries, agencies, or mortgage backed
securities to lower borrowing costs.
Since the financial crisis began
back in 2008 the FOMC has initiated two rounds of QE. The first round in 2008 was successful in
lowering overall borrowing costs, and stabilizing the fear in equity markets. The overall economy did improve, but then
softened again in the middle of the 2010.
Once again the FOMC came to the rescue, but QE2 did not have nearly the effectiveness
in jump starting the economy. We are once
again dealing with an economy staring at the brink of recession, but borrowing
costs are already at historic lows, and the equity markets are near the highs
of the year. How much effect will
another round of QE3 have on lowering
borrowing costs, and stimulating asset growth? I dare say, little to none. Coupled with the fiscal cliff at the end of
the year, corporate profits slowing, and a massive health care burden bestowed
on small business, the effectiveness of QE3 will be mostly ineffective. The real solution lies in public
policy. Our elected officials need to address
the real fiscal problems of the country, and cease to assume the FOMC and
monetary policy is going to solve the economic woes of the US and abroad.
In Europe, the ECB led by Mario
Draghi is trying to gain support to purchase the sovereign debt of Italy and
Spain, where their borrowing costs are near 6.0% and 7.0% respectively. We agree this will certainly assist in
lowering the already skyrocketing cost of debt. Unfortunately, Europe is already in a
downward spiral with high unemployment, austerity measures, and a slowing
demand for its goods and services. If
the ECB is allowed to buy the sovereign debt of its ailing economies this will
only be a short-term solution and prolong the problem. I have already stated the problem in Europe
is solvency not liquidity, and the ECB cannot solve the
deep-rooted political and social issues that face the European nations. Needless to say, the only possible solution
is for politician and its citizens to agree to change thousands of years of
cultural differences, and to allow the more fiscally stronger governments
(Germany) to control the weaker ones (Italy and Spain) in exchange for capital. I believe this is asking too much.
Why Hedge?
In a meeting last week one of our
clients, whom I have a great deal of respect for, made the comment that I have
been pessimistic for nearly three years, and asked the question (rightfully
so), “why do we continue to use derivatives and options to hedge the
portfolio”. Instead of giving a
complicated quantitative answer, I posed this same question to our investment
committee. Below are some of their
responses.
1.
“The
Great Depression - September 1929 – November 1929 the stock market lost 40%,
and didn’t bottom until July 1932 loosing 89% in just three years. It took nearly twenty-five years to recover
the losses that where experienced in just four short months.”
2.
Stock market
sell-offs are explosive and occur in a relatively short amount of time, and can
take years and even decades to recover.
In short, when storm clouds are above, seek shelter”.
3.
“Based on experience,
I would much rather underperform the market to the upside, and preserve capital
when the market sells-off”
4.
“Some
investors decide to index or buy the S&P 500, when the market is rising,
which can be a profitable strategy.
Though, if you decided to index in 1999, and not protect capital when
the warning signs became apparent of two immanent recession, today you have
made exactly nothing on your investment, and if you paid mutual fund fees or
ETF fees you would have lost on average 1.5% per year for 13 years”.
5.
“Preservation
of capital in times of uncertainty, allows you to buy when everybody else is
selling.”
6.
“I am not
interested in speculation, when history and forecasting probabilities are
suggesting economic or political unrest I choose to protect my capital
investment”.
7.
“Are
you more afraid of missing out on upside returns, or losing hard earned capital. I choose to keep what I have already earned…there
will always be another opportunity to make money”.
8.
“If
Warren Buffet’s Berkshire Hathaway is sitting on $40 Billion of cash (50% of
their portfolio), I might take a closer look at using derivatives rather than
being out of the market and the opportunity cost of not getting paid any
dividend while I wait”.
