PhD portfolio manager John Hussman advises investors to “run” rather than walk away from “market conditions among the most negative 1 percent of observations on record.” In a letter to shareholders published Monday, the data-crunching former finance professor and head of the eponymous Hussman Funds issued his latest warning about “overvalued, overbought, overbullish markets.”
Hussman advises investors to ask themselves “what portion of your portfolio do you expect (or even hope) to sell before the next major market downturn ensues? Almost by definition, that portion of your portfolio is speculative in the sense that you do not intend to carry it through the full market cycle...With respect to those speculative holdings, and when to part with them, my own view is straightforward. Run, don’t walk.”
Hussman’s dim view of stock market returns in the coming decade, and the next six to 18 months particularly, is based on a view of market metrics he believes investors have not (yet) come to share. For example, he criticizes Wall Street’s infatuation with current, low price-to-earnings multiples.
But he says these market multiples are misleading because they are based on record profit margins “about 50-70 percent above historical norms.” Normalizing the data, however, for average profits might yield P/E multiples that are closer to bull market peaks. He said the situation may be compared to the P/E environment just prior to the Lehman crisis in 2008, when the non-normalized S&P 500 appeared to be trading at only 15 times earnings.
Hussman also questions the reliability of bank earnings specifically, saying two important drivers this quarter create a false impression of bank performance. One driver, reduction of reserves against future loan losses, has been treated as a positive contributor to earnings. So, for example, “a decline in loan loss reserves was the source of about one-third of the earnings reported by Citigroup.”
The other driver is called debt value adjustment. Hussman writes: “You might recall that as a result of European credit strains last year, investors sold off the bonds of major banks. In the world of bank accounting, the debt was therefore cheaper to retire, so — I am not making this up — the decline in the value of the bonds was booked as earnings.” In other words, banks report that they are doing well, while their true condition deteriorates.
Hussman also analyzes monetary policy, and provides a frightening chart on something called “liquidity preference.” The analysis is somewhat technical, but the upshot is that the Fed can only maintain its bloated balance sheet, without rapid inflation, only so long as “people (and banks) are willing to sit on idle, low or zero-interest money balances.” That willingness to accept near zero interest obtains only under conditions of credit crisis.
Citing Tyler Durden’s critique of Fed policy as "CTRL+P" (because of its propensity to print money), Hussman warns that expanding the monetary base is as easy as pushing “print,” but getting out of our predicament promises to be a “disruptive nightmare.”
Specifically, Hussman warns that moving back up from zero rates just to the level of a 0.25 percent 3-month T-bill will require fully reversing QE2, while 2 percent rates imply a balance sheet contraction of over 50 percent in order to avoid inflation.
Aside from inflation worries, climbing out of our current monetary hole risks the danger of Fed insolvency. “The Fed already has a balance sheet leveraged more than 50-to-1 against its own capital. So upward interest rate pressure would begin to induce capital losses on the Treasury securities the Fed has accumulated at low yields,” Hussman warns.