The following is the commentary for John Hussman, president of the Hussman Trust, for the week of June 28. For the full archive of Mr. Hussman's commentary, please click here.
Based on evidence that has always and only been observed during or immediately prior to U.S. recessions, the U.S. economy appears headed into a second leg of an unusually challenging downturn.
A few weeks ago, I noted that our recession warning composite was on the brink of a signal that has always and only occurred during or immediately prior to U.S. recessions, the last signal being the warning I reported in the November 12, 2007 weekly comment Expecting A Recession. While the set of criteria I noted then would still require a decline in the ISM Purchasing Managers Index to 54 or less to complete a recession warning, what prompts my immediate concern is that the growth rate of the ECRI Weekly Leading Index has now declined to -6.9%. The WLI growth rate has historically demonstrated a strong correlation with the ISM Purchasing Managers Index, with the correlation being highest at a lead time of 13 weeks.
Taking the growth rate of the WLI as a single indicator, the only instance when a level of -6.9% was not associated with an actual recession was a single observation in 1988. But as I've long noted, recession evidence is best taken as a syndrome of multiple conditions, including the behavior of the yield curve, credit spreads, stock prices, and employment growth. Given that the WLI growth rate leads the PMI by about 13 weeks, I substituted the WLI growth rate for the PMI criterion in condition 4 of our recession warning composite. As you can see, the results are nearly identical, and not surprisingly, are slightly more timely than using the PMI. The blue line indicates recession warning signals from the composite of indicators, while the red blocks indicate official U.S. recessions as identified by the National Bureau of Economic Research.
The blue spike at the right of the graph indicates that the U.S. economy is most probably either in, or immediately entering a second phase of contraction. Of course, the evidence could be incorrect in this instance, but the broader economic context provides no strong basis for ignoring the present warning in the hope of a contrary outcome. Indeed, if anything, credit conditions suggest that we should allow for outcomes that are more challenging than we have typically observed in the post-war period.
Unthinkability is Not Evidence
One of the greatest risks to investors here is the temptation to form investment expectations based on the behavior of the U.S. stock market and economy over the past three or four decades. The credit strains and deleveraging risks we currently observe are, from that context, wildly "out of sample." To form valid expectations of how the economic and financial situation is likely to resolve, it's necessary to consider data sets that share similar characteristics. Fortunately, the U.S. has not observed a systemic banking crisis of the recent magnitude since the Great Depression. Unfortunately, that also means that we have to broaden our data set in ways that investors currently don't seem to be contemplating.
On this front, perhaps the best single reference is a somewhat academic book on economic history with the intentionally sardonic title, This Time Is Different, by economists Kenneth Rogoff (Harvard) and Carmen Reinhart (University of Maryland). The book presents lessons from a massive analysis of world economic history, including recent data from industrialized nations, as well as evidence dating to twelfth-century China and medieval Europe. Reinhart and Rogoff observe that the outcomes of systemic credit crises have shown an astonishing similarity both across different countries and across different centuries. These lessons are not available to investors who restrict their attention to the past three or four decades of U.S. data.
Reinhart and Rogoff observe that following systemic banking crises, the duration of housing price declines has averaged roughly six years, while the downturn in equity prices has averaged about 3.4 years. On average, unemployment rises for almost 5 years. If we mark the beginning of this crisis in early 2008 with the collapse of Bear Stearns, it seems rather hopeful to view the March 2009 market low as a durable "V" bottom for the stock market, and to expect a sustained economic expansion to happily pick up where last year's massive dose of "stimulus" spending now trails off. The average adjustment periods following major credit strains would place a stock market low closer to mid-2011, a peak in unemployment near the end of 2012 and a trough in housing perhaps by 2014. Given currently elevated equity valuations, widening credit spreads, deteriorating market internals, and the rapidly increasing risk of fresh economic weakness, there is little in the current data to rule out these extended time frames.
In recent months, I have finessed this issue by encouraging investors to carefully examine their risk exposures. I'm not sure that finesse is helpful any longer. The probabilities are becoming too high to use gentle wording. Though I usually confine my views to statements about probability and "average" behavior, this becomes fruitless when every outcome associated with the data is negative, with no counterexamples. Put bluntly, I believe that the economy is again turning lower, and that there is a reasonable likelihood that the U.S. stock market will ultimately violate its March 2009 lows before the current adjustment cycle is complete. At present, the best argument against this outcome is that it is unthinkable. Unfortunately, once policy makers have squandered public confidence, the market does not care whether the outcomes it produces are unthinkable. Unthinkability is not evidence.
Moreover, from a valuation standpoint, a further market trough would not even be "out of sample" in post-war data. Based on our standard valuation methods, the S&P 500 Index would have to drop to about 500 to match historical post-war points of secular undervaluation, such as June 1950, September 1974, and July 1982. We do not have to contemplate outcomes such as April 1932 (when the S&P 500 dropped to just 2.8 times its pre-Depression earnings peak) to allow for the possibility of further market difficulty in the coming years. Even strictly post-war data is sufficient to establish that the lows we observed in March 2009 did not represent anything close to generational undervaluation. We face real, structural economic problems that will not go away easily, and it is important to avoid the delusion that the average valuations typical of the recent bubble period represent sustainable norms.
Our policy makers have spent their ammunition in the attempt to bail out bondholders and to create an entirely deficit-financed appearance of economic strength. It would be better to allow insolvent, non-sovereign debt to default (including long-term Fannie and Freddie obligations, and obligations to bank bondholders), and to instead use public funds to take receivership of failing institutions and to defend customers and depositors from the effects. Restructuring is probably a more useful word, but in any case, the key element is that those who actually made the loans, not the public, should absorb the loss. Restructuring means simply that the payment terms are rewritten to reflect the lower amount that will delivered over time. I can't emphasize this point often enough - "failure" of a financial institution means only that the bondholders don't receive 100 cents on the dollar plus interest. Failure is only a problem when it requires piecemeal liquidation, as occurred in the case of Lehman. This is not necessary when appropriate regulators can take receivership of insolvent bank and non-bank institutions (as the new financial regulatory bill now provides).
My greatest concern is that these new receivership powers will not be implemented because the Fed and the Treasury are both in bed with major Wall Street and banking institutions. Yet there is no effective alternative. Having squandered trillions in an empty confidence-building exercise, it will be nearly impossible for those same policies to build confidence again in the increasingly likely event that the economy turns lower and defaults pick up again. The best approach will still be to allow bad debt to go bad, let the bondholders lose, and defend the customers by taking whole-bank receivership (as the FDIC does seamlessly nearly every week with failing institutions). Almost undoubtedly, however, our policy makers will choose to defend bondholders again, pushing our government debt to a level that is so untenably high that little recourse will remain but to suppress the real obligation through long-term inflation (though as noted below, the near-term effects of credit crises are almost invariably deflationary at first).
Though Reinhart and Rogoff published This Time is Different in early 2009, extending the analysis they provided in a January 2008 NBER working paper (13761), the book accurately foreshadowed the recent debt crisis in European countries, noting "As of this writing, it remains to be seen whether the global surge in financial sector turbulence will lead to a similar outcome in the sovereign default cycle. The precedent, however, appears discouraging on that score. A sharp rise in sovereign defaults in the current global financial environment would hardly be surprising."
It is interesting that despite the apparent stabilization of the Euro in recent weeks, the stabilization more reflects sudden concerns about the U.S. dollar than improvement of European debt conditions. Notice that relative to the Swiss Franc, for example, the Euro continues to plunge to fresh lows.
