Extinction Burst

From a long-term investment standpoint, the stock market remains obscenely overvalued, with the most historically-reliable measures we identify presently consistent with zero 10-12 year S&P 500 nominal total returns, and negative expected real returns on both horizons.

From a cyclical standpoint, I continue to expect that the completion of the current market cycle will likely take the S&P 500 down by about 40-55% from present levels; an outcome that would not be an outlier or worst-case scenario, but instead a rather run-of-the-mill cycle completion from present valuations. If you are a historically-informed investor who is optimistic enough to reject the idea that the financial markets are forever doomed to extreme valuations and dismal long-term returns, you should be rooting for this cycle to be completed. If you are a passive investor, you should at least align your current exposure with your investment horizon and your tolerance for cyclical risk, which we expect to be similar to what we anticipated in 2000-2002 and 2007-2009. For more data and detail on these views, see The Next Big Short: The Third Crest of a Rolling Tsunami, and Rarefied Air: Valuations and Subsequent Market Returns.

From an economic standpoint, recall that economic deterioration typically follows a well-defined sequence, with weakness in what I call the “order surplus” (new orders + backlogs - inventories) followed by deterioration in industrial production (which retreated again last month) and by real retail sales (which have declined for two consecutive months), then real personal income (which is the next measure to watch here), and typically followed only then by weakness in employment indicators. Nothing in recent weeks has changed our assessment of an imminent likelihood of recession, though as I’ve regularly noted, the immediacy of that expectation would be deferred if our measures of market internals improve significantly. Though employment is a lagging indicator, we would still watch for an increase in weekly unemployment claims above roughly 330,000, a decline in aggregate weekly hours over a 3-month period, and an increase in the unemployment rate to about 5.3% or higher to confirm the actual start of a recession.

From a near-term standpoint, given a well-defined top formation extending back to 2014, and a strenuously overbought advance that has now carried the market to the arc of that formation, my sense is that the preceding paragraphs would be most satisfying if I were to say that all evidence supports expectations of an immediate collapse, and that crash risk is our most pressing concern (as it was just a few weeks ago). Frankly, that outcome would still serve us best. But like last week, our near-term outlook actually remains fairly neutral. That near-term outlook would shift to a hard-negative view at about the 1975 level on the S&P 500, which is where the full weight of market action would pile to the downside again. I also continue to view the 1820 level as a potential crash threshold.

At present, our most reliable measures of market internals remain mixed, though several trend-sensitive components have improved, encouraged by a tag-team of central bankers easing monetary policy (or backing away from further tightening) in the U.S., Europe, and Japan. If the recent advance fails spectacularly, that will be just fine with us. Still, in the near-term, we shouldn’t rely on that by ratcheting-up a hard-negative outlook on every further market advance. Fortunately, option premiums are rather cheap here, so one can defend against a vertical market decline without relying on stop-loss orders (which, as one might recall from 1987, are extremely difficult to execute in practice during a market collapse). A neutral near-term outlook is sufficient here, particularly since nearby safety nets can be established inexpensively. The S&P 500 is only 3-4% above the level that would shift us to a hard-negative outlook, and less than 12% above the level that would amplify concerns about a vertical collapse or “crash.”

To summarize, on the basis of valuation measures we find most strongly correlated with actual subsequent market returns across history, we presently estimate zero nominal total returns for the S&P 500 over the coming 10-12 year period, with negative real returns on both horizons. We expect that the completion of the current market cycle is likely to take the S&P 500 down by about 40-55%, which would not be a worst-case scenario but a historicallyrun-of-the-mill outcome given present valuations. As for the near-term, an initial market loss of even 3-4% to the downside will put us back in a hard-negative outlook, but given recent improvement in several trend-sensitive components of market internals, our near-term outlook is fairly neutral, without any particular reliance on market direction.

Extinction Burst

In behavioral psychology, a “reinforcer” is anything that increases the likelihood of a given behavior. Reducing an undesirable behavior usually involves two steps: a) “extinction,” where the reinforcement for the existing behavior is removed, and; b) “substitution,” where another behavior is introduced that hopefully satisfies the underlying need in a more desirable and effective way.

Now, when a given behavior stops being reinforced, one might expect the behavior to be abandoned. Instead, and particularly when no substitute behavior is available, you’ll actually see an initial “extinction burst” - a nearly frantic increase in the frequency and the intensity of the behavior.

Consider central bankers. For the past several years, global central banks have pursued increasingly deranged monetary policies, creating massive distortions in financial markets. It’s easy to point to these effects on the financial markets, as Bernanke, Kuroda, Draghi and other central bankers have emphasized, as evidence that central bank policy is “working.”

Unfortunately, that’s not how one measures the impact of monetary policy on the real economy. The correct approach is to compare how the economy has actually done versus how it would have been expected to do with and without those interventions. Specifically, you estimate the trajectory of output, employment, and other variables using past values of a) only non-monetary variables like output and employment, and b) both non-monetary variables and monetary ones (typically using a statistical method known as "vector autoregression" or VAR). What we, and others, have found, is that all of this deranged monetary policy has raised the level of GDP, industrial production, and employment bybarely 1% from what would have been expected in the absence of these interventions.

On January 29, a week after insisting that a move to negative rates was not under consideration, Bank of Japan Governor Harohiko Kuroda announced a rate cut to -0.1%. On February 18 he reiterated that the BOJ was prepared to ease further. He wavered on that stance at the end of February, but shifted again last week, saying that a move to even deeper negative rates was possible. Meanwhile, facing economic erosion in Europe, Mario Draghi came out on February 15 saying “we will not hesitate to act.” He followed on March 10 with his “bazooka” including a rate cut to -0.4%, an increase in the pace of QE, and a broadening of ECB purchases to include investment-grade, non-bank corporate bonds. On Wednesday, Janet Yellen announced that the expected pace of Fed rate hikes this year was likely to be slower than expected, as a result of weak global economic conditions and widening credit spreads.

Aside from a one or two-day knee-jerk response, these moves have had very little sustained impact on the equity markets. Japan’s Nikkei index is down about 5% since the day after Kuroda’s rate-cut announcement. The Dow Jones EuroStoxx Index is also down since the day after Draghi’s bazooka. One suspects that the response of the S&P 500 to Yellen’s dovishness will be similarly short-lived, though we need not rely on that. Given the continued sequence of erosion in economic measures, central bankers continue to point to the financial markets as evidence that their policies are “working.” Now even those effects have become unreliable.

The press conferences following central bank moves increasingly sound like real people have been replaced with “bots,” mechanically retrieving phrases to make a historically extreme monetary stance sound prudent and to simultaneously encourage speculation. Every phrase has to be weighed individually, so one observes a halting, almost rambling quality to the remarks. Consider this response by Janet Yellen to the first question in the press conference following the Fed’s dovish monetary policy statement on Wednesday:

“So, you have seen a shift, uh, this time, in most participants assessments of the appropriate path for policy, and as I tried to indicate, I think that largely reflects a somewhat slower projected path for global growth, for growth in the global economy outside the United States, um, and for some tightening in credit conditions in the form of an increase in spreads, and, um, those changes in financial conditions and in, uh, the path of the global economy have, uh, induced, uh changes in the assessment of individual participants in what path is appropriate to achieve our objectives, so that’s what you, uh, see, that’s what you see. Now I guess you asked me also, what would we need to see, um, to continue raising rates, and I think it’s worth pointing out here that, um, the committee, most participants do continue to um, envision that if economic developments unfold as they expect, that further increases in the federal funds rate will prove appropriate over time, um, most participants anticipate that uh, and, uh, that the pace will be gradual.”

- Janet Yellen, March 16, 2016 press conference following FOMC meeting

This sudden escalation of dovish pronouncements by central bankers isn’t sound monetary policy, being conducted based on demonstrated cause-and-effect relationships between policy tools and the real economy. No, this is an extinction burst. Central bankers are behaving like lab rats frantically pressing a bar in hope that more food pellets will come out of the chute. They ain’t comin’.

The model in policy-maker’s heads

What do policy-makers hope to achieve with all this untethered monetary intervention? Consider the most basic economic model taught in Econ 101.

Output (Y) = Consumption © + Investment (I) + Government (G)

Foreign trade is ignored for simplification. Now, if Consumption is assumed to be proportional to output (so C = c*Y where c is the fraction of income that people consume), we have

Y = cY + I + G


Y = (I + G) * {1/(1-c)}

Look at the term in brackets. If people spend 75% of their income on consumption, they save (1-c) or 25%. That bracketed term would be {1/(1-.75)} or 4.0. So the model would say that increasing investment or government spending will have a “multiplier effect” on output of $4 of new output for every dollar of new investment or government spending. Alternatively, if you could get people to spend 80% of their income instead of 75%, you could increase the multiplier to 5.0.

While the crude little world above is an extreme abstraction from the real world, imposes no resource constraints whatsoever, and implies “multiplier effects” that are dramatically larger than we observe in practice, this model is essentially how most policy makers think about and justify their actions. Accordingly, what monetary authorities are quietly hoping to do is punish savings so violently, through negative interest rates and the like, that people will consume more (essentially increasing little c), or at least stimulate real investment so that attempts to save more (reductions in c) don’t result in economic contraction.

Unfortunately, we’ve observed in recent years that no amount of punishment actually reduces the desire of people to save. They simply look to save in different forms. This behavior has driven what is now the third equity bubble in 16 years, accompanied by a massive overhang of covenant-lite debt, and an increasing move to alternative forms of money such as precious metals. Meanwhile, aside from a mean-reverting rebound from the 2009 lows, real investment hasn’t responded strongly to low interest rates. Indeed, the growth rate of real U.S. gross domestic investment since 2000 has dropped to nearly one-quarter of the growth rate over the prior 50 years. That’s precisely why productivity and real incomes have stagnated.

Look, there’s one thing we know for certain in economics. The amount of saving in an economy must be precisely equal to the amount of real investment in the economy (factories, buildings, equipment, capital goods, and inventory). That’s not a theory. It’s an accounting identity.

Other things being equal, if people are trying to save a larger fraction of their income, and the level of investment doesn’t respond to low interest rates, income has to fall in order to bring saving and investment into equality. That’s the basic setup that Keynes explored in theGeneral Theory. But if policy-makers really believe that there’s a “savings glut,” punishing savings isn’t the only way out. There are many ways to encourage investment other than manipulating interest rates, and all kinds of spending can function as “investment” even if the GDP accounts classify them as government spending or consumption. That leaves a relatively straightforward road that’s rarely taken, which is to pursue fiscal policies targeted at increasing productive investment at every level of the economy.

Put simply, if people want to save a larger share of their income, and punishing savings doesn’t reduce that desire, and the whole world can’t rely on beggar-thy-neighbor policies to expand their own economies by increasing the trade deficits of others, then the only way to avoid global economic contraction and simultaneously raise the prospects for long-term growth is to expand productive investment at every level of the economy (including infrastructure investment, corporate investment tax incentives, workforce development credits, and other measures ideally tied to the creation of new jobs). Since investment isn’t responding materially to lower interest rates, you can’t do this through monetary policy. The only remaining option is to do it through fiscal means.

The problem with punishing saving in order to encourage more consumption is that it’s ineffective, and also leaves the economy with nothing to show for it. The wealth of a nation consists of its stock of real private investment (e.g. housing, capital goods, factories), real public investment (e.g. infrastructure), intangible intellectual capital (e.g. education, inventions, organizational knowledge and systems), and its endowment of basic resources such as land, energy, water, and the environment. In an open economy, one would include the net claims on foreigners. Everything else cancels out, because every security is an asset of the holder, but a liability of the issuer. If we want greater prosperity, it will come from expanding our productive capacity and defending our natural resources.

Monetary authorities have now become little more than lab rats on a frantic extinction burst. If there are no adults in the room among our policy-makers who are willing to pursue the appropriate substitute behavior - expanding productive investment through fiscal means - we’re going to have a deeper and more concerted global economic downturn than is already likely. I remain convinced that monetary authorities have already ensured a financial collapse in the coming years that is baked-in-the-cake as a result of obscene valuations. That outcome will unfold nearly regardless of economic prospects.

By encouraging acute financial distortions, enabling massive issuance of speculative-grade securities and stock buybacks at near-record valuations, and repeatedly diverting national savings toward speculative malinvestment, the concerted behavior of central banks is increasingly pushing the global economy toward financial crisis and depressed long-term growth. There is no hope for long-term economic prosperity if we place our faith in the monetary policies of deranged bankers and ivory tower college professors. All they can do is to buy interest-earning bonds and replace them with zero-interest paper. How ignorant must we be to believe that financial bubbles will carry us to prosperity without consequences, and how many collapses must we endure before we focus on strengthening our own legs?

The irony of economics is that when we pursue policies that encourage speculative malinvestment and make productive investment scarce, the pie gets smaller but a larger share of it goes to the owners of existing capital. The “rents” are always highest for those resources that are most scarce. If we really want more jobs, higher labor productivity, stronger growth, better real wages, a balanced income distribution, and a return to long-term economic prosperity, only an expansion of real productive investment - at every level of the economy - will do the job. Ever more deranged monetary policy wil not.

© Hussman Funds

© Hussman Funds

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