Hussman Weekly Market Comment: No Margin of Safety, No Room for Error

Over the past 10 years, the S&P 500 has achieved a total return, including dividends, averaging -0.03% annually. Over the past 13 years, the total return for the S&P 500 has averaged just 3.23%. Why have stocks performed so poorly? One word. Valuation. If investors take nothing else from these commentaries, there are two primary lessons that should be clear. First, the poor market returns that investors have achieved for more than a decade were entirely predictable during the late 1990's, based on the historical relationship between valuations and subsequent returns. Second, from current valuations, the similarly poor returns that investors are likely to achieve over the coming 5-7 year period are also predictable based on the same evidence.

While we regularly emphasize that valuation is not particularly useful as a timing tool, we know of no factor with a better record in setting expectations for long-term market returns. We spend a great deal of time discussing market conditions, economic policy, investor sentiment, and other factors in these weekly comments. But it is critical to recognize that these factors simply modify the short-term course that market returns take over periods of perhaps 1-2 years. They do not significantly affect the long-term course of market returns. Once valuations become unusually rich, disappointing long-term returns become baked in the cake.

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Citing "imminent funding pressures" in the global banking system, the IMF released a report last week suggesting the potential for a fresh round of bank stress. The primary focus of concern was the European banking system, due to "relatively greater pressure in European banking systems from both sovereign risks and wholesale funding strains," but the IMF indicated that U.S. banks may also need to raise additional capital "to reverse recent deleveraging trends, and possibly to comply with U.S. regulatory reforms." The IMF warned that "Conditions in the global financial system now have the potential of jumping from benign to crisis mode very rapidly."

It will come as no surprise that we agree, but at least for now, investors evidently could not care less. Had investors been correct in ignoring the ultimately disastrous risks of the dot-com bubble, the tech bubble, the housing bubble, and the overleveraging of U.S. financial institutions that preceded the recent credit crisis, we would concede that the market's wisdom on these issues should take precedence over our own concerns. But in our view, those disasters were predictable. Likewise, as noted above, the persistent willingness of investors to misprice stocks is exactly why they have gone nowhere for over a decade. We'd love to be bulls, scampering happily about. But that would be helped if stocks were priced appropriately and if there was not a large anvil suspended on a fraying string overhead.

Forensic Asia Report: ASIA CRISES - FUTURE THREAT

Found via Claire Barnes.

This report, on Asia’s corporate health, is the first ForensicAsia publication to go to press. Forthright and broad in scope, we believe it sets the tone for future reports from Forensic Asia Limited that will take a robust and – above all – an independent look at the inner workings and machinations of companies listed on stockmarkets the length and breadth of the Asia region.

More bull: Apollo Asia Fund - the manager's report for 3Q2010

At the time of writing, modern retail accounts for 30% of the securities held. The shops operated by our companies comprise supermarkets, hypermarkets, general merchandise stores, pharmacies, health food and convenience stores, and are broadly spread from greater China through Southeast Asia to India. These businesses have long-term pricing power (margins in any given quarter may be squeezed), and they are typically supplier-funded, so that rising inflation requires no new capital. A fair percentage of their sales are staples, so footfall is resilient. One pays for such merits: the current-year PE for the portfolio is 13.8, and for our retailers ranges to almost twice that. At present we hold no fashion or luxury-goods retailers.

Low-end consumer finance represents another 9%. Like the retailers, these benefit from supportive demographics and urbanisation trends throughout Southeast Asia - but they are much more vulnerable to changes in government policy. Looking at the mess caused by excessive debt and bank failures in the west, it is understandable that Asian central banks should consider preemptive braking. The lack of current growth makes these stocks unfashionable: current-year PEs range from 8 to 11 on our estimates (although earnings could of course be battered by NPLs in the event of renewed recession), and net dividend yields are 5-6%.

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Given the concerns we expressed earlier in the year on the importance of energy, we now have no airline exposure, and no companies whose own operations seem particularly energy-intensive. However, the portfolio does have significant exposure to automobiles (parts manufacture, distribution, testing), and a high general dependence on the continuation of business as usual. (We'd be happy to reduce that dependence if we could, as the risks for the global economy seem extremely high.)

Meanwhile, with interest rates trivial globally, it is easy to make the case that the earnings yields on equities are attractive, and that equities may hold their value in case of inflation, while real returns on cash would be indisputably negative. Against this stands the voice of experience (and statistical analysis), that when equities have had such a strong bull run, and are as highly valued as they are now, the subsequent returns are usually disappointing. But the party can go on for a long time.

The reported comments of Messrs. Buffett, Munger and Gates on their short China trip were doubtless intended mainly for their domestic hosts, but brought to mind those of Barton Biggs in late 1993 ('tuned in, overfed, and maximum bullish'). Then, just as we thought a crazy market could not get much sillier, American asset allocators supercharged the punch. Now, quantitative easing by developed nations is causing new waves of funds to flow to Asia, and doubtless a new generation to fall for the sirens' tales. There are sound stories too: of secular progress, and the absence of certain problems prevalent in the west - overindebtedness, excessive pension liabilities, etc. These merits are striking, and well articulated by brokers. But Asia's internal problems (inflation, energy security, water security, pollution, overdependence on construction...) are also becoming more significant.

These are not the sort of markets in which we excel - indeed we frequently underperform, having a tendency to worry too early about the risks, while lacking the confidence or imagination to find ways of profiting when they crystallise. Suggestions are very welcome. However, investors wishing to participate fully may prefer to switch horses.

Video: Jim Grant Says Quantitative Easing Is Just Money Printing

Link to: Grant Says Quantitative Easing Is Just Money Printing

The Boeckh Investment Letter - Government Policy and the Markets: Prepare For Some Big Changes

When markets don’t perform the way politicians want, you can count on them to bypass, manipulate or manage these markets. All too frequently these attempts are motivated by short-term political needs where appearances take priority over substance. Currently market distortions in housing, credit and the financial system are huge and dangerously unstable. We are now beginning to pay the price. There is a critical shortage of political will to tackle the underlying problems and band-aid solutions will likely keep us lurching from one crisis to the next over the coming years.

As we discussed in The Great Reflation the steady increase in credit during the debt supercycle hid a multitude of sins. Distortions in both the domestic and global economy grew virtually unchecked behind a veil of prosperity. Such a facade was supported by the expansion of private debt relative to income or GDP–choose your yardstick. The distinction between wealth and credit became clear in the aftermath of the financial crisis. Peering behind the veil reveals an ugly, distorted picture: unsupportable private debt levels, spiraling public sector debt, massive trade imbalances with the accumulation of reserve assets of a few countries, and a flawed international monetary system. All of these issues imply economic stagnation and high structural unemployment in the U.S. and other developed countries.

Planet Money: How Four Drinking Buddies Saved Brazil

Found via The Corner of Berkshire & Fairfax (I think via Tariq).

Brazil is booming, but for most of the 20th century it was an economic mess.

For a while, inflation was so high that grocery stores were raising their prices every day. Shoppers would run ahead of the guy changing the price tags, so they could pay the previous day's price.

A series of leaders tried and failed to stop inflation. One guy instituted a price freeze. Another froze peoples' bank accounts. None of it worked.

Then, the government brought in in four economists who had been talking to each other for years about how to fix Brazil's inflation problem. Their solution: Create a currency that doesn't exist. No coins, no bills.

Macroeconomics after the Crisis: Time to Deal with the Pretense-of-Knowledge Syndrome - By Ricardo J. Caballero

Found via the Mises Institute.

The root cause of the poor state of affairs in the field of macroeconomics lies in a fundamental tension in academic macroeconomics between the enormous complexity of its subject and the micro-theory-like precision to which we aspire.

This tension is not new. The old institutional school concluded that the task was impossible and hence not worth formalizing in mathematical terms (for example, Samuels, 1987, and references therein). Narrative was the chosen tool, as no mathematical model could capture the richness of the world that is to be explained. However, this approach did not solve the conundrum; it merely postponed it. The modern core of macroeconomics swung the pendulum to the other extreme, and has specialized in quantitative mathematical formalizations of a precise but largely irrelevant world. This approach has not solved the conundrum either. I wish the solution was to be found somewhere in between these polar opposites, but it is not clear what “in between” means for a range that has a framework based on verbal discussions of the real world on one end and one based on quantitative analysis of an “alternative” world, on the other.

The periphery of macroeconomics has much to offer in terms of specific insights and mechanisms, but to fulfill the ambition of the core we need to change the paradigm to go from these insights on the parts to the behavior of the whole. It is not about embedding these into some version of the canonical real business cycle model. It is, among other things, about capturing complex interactions and the confusion that they can generate.

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The challenges are big, but macroeconomists can no longer continue playing internal games. The alternative of leaving all the important stuff to the “policy”-types and informal commentators cannot be the right approach. I do not have the answer. But I suspect that whatever the solution ultimately is, we will accelerate our convergence to it, and reduce the damage we do along the transition, if we focus on reducing the extent of our pretense-of-knowledge syndrome.

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Related previous post: F.A. Hayek's 1974 Nobel Speech: The Pretence of Knowledge

Warren Buffett Interview from Fortune's Most Powerful Women Summit

Link

Kyle Bass from the Barefoot Economic Summit

James Grant Interview About Financial Rules Overhaul

Thanks to Will for bringing this to my attention.

Sept. 30 (Bloomberg) - James Grant, editor of Grant's Interest Rate Observer, talks about the overhaul of U.S. financial regulation. Grant also discusses Federal Reserve monetary policy. He talks with Pimm Fox on Bloomberg Television's "Taking Stock."