On Hussman and Global Housing Bubbles
July 10, 2010
We are at a cross-road in terms of global financial markets and economies – and fund manager john Hussman provides a very useful framework to help one chart a path through the morass of "expert" opinions and uncertainty
- This "rent, not own" market being driven by technical traders. the plethora of support and resistance levels for the market being cited by analysts is unprecedented and a move above 1100 (the "death cross") could trigger a sharp short-covering rally or a move below 1040 (and particularly a move below 3792.89 in the Dow transports index) could cause mayhem.
- The key though is the sustainability of the moves – and a more concrete trend is only likely to develop if it finds support in economic leading indicators (i.e. the ECRI) , initial jobless claims or corporate earnings guidance.
- The S&P is still about 40% overvalued on the basis of normalized earnings. The "stocks are cheap" assessments are based on flawed measures like price to forward operating earnings estimates – which actually said the market was 40% undervalued just prior to the 2007 top!
- Operating earnings exclude a host of "recurring non-recurring charges" which often large and related to the core businesses of the companies. Additionally, forecasted earnings are typically higher than trailing 12-month earnings.
- The historical average p/e ratio is 15 based on trailing earnings – the comparable norm for forward operating earnings is 12 and was 6 at the 1982 and 1974 market lows.
- Current forward earnings estimates also assume profit margins (which are highly cyclical) that are nearly 50% higher than their historical average - a level they briefly only reached in 2007.
- Based on their composite indicators of economic activity, they think a double-dip recession over the next several quarters is likely –these same indicators pointed to recessions in October 2000 and November 2007! However, deep market losses usually precede forecasts of recessions.
- The astute credit analyst Meredith Whitney thinks that a double-dip in housing is highly likely as non-performing mortgage loans on bank balance sheets have doubled in the last year, as customers have not paid their mortgages while they ostensibly wait for better modification programmes. However, banks are now accelerating their foreclosures which are likely to lead to another 20% drop in house prices.
- The U.S. over the last decade or so, "has squandered its productive capital resources in the pursuit of bubbles" – the real domestic private investment is lower today than 12 years ago – and much of that has been destroyed in speculative real estate activity.
- Unless the U.S. refocuses its efforts on providing incentives for research and development, accumulating productive (and not speculative) capital and maintain adequate educational and human capital, the real wages of U.S. workers will eventually slide towards those of developing countries.
- History has not dealt kindly with economies which have the generated high profits, weak wage gains and low capital accumulation – eventually leading to high taxation, regulatory intervention and, in some cases, revolution.
- This situation has been temporarily resolved over the last few decades, by allowing consumers to borrow excessively to maintain living standards while corporations have continued to ostensibly book strong profits.
- However, corporate profits have been increasingly dominated by the financial sector and "reported operating earnings" have been substantially above what has been delivered to shareholders in terms of dividends, increases in book value or share repurchases in excess of grants to insiders.
- This is largely due to operating profits not including "extraordinary charges" due to credit losses or bad investments and the distribution of profits to corporate insiders through the issuance of stocks and options. Stocks are not cheap as an investment class based on how much cash-flow that is deliverable to shareholders.
- They remain tightly hedged as the market continues to have unfavourable valuations and unfavourable market actions. in addition, the recent clearing of oversold conditions typically opens the potential for vertical declines. They also see a 30% correction in gold as deflation concerns emerge.
Hussman is spot-on in his observation that market are still significantly overvalued based on almost any long term measure. the key question is whether it gets even more overvalued or suffers a sharp downturn , and the key here is what the market expects the economy to do over the second-half of this year. i expect the economy to continue to surprise on the downside leading to sharp falls in the market going into the 3rd quarter GDP release in end-October and the u.s. mid-term elections in early November. This is likely to spur a second major quantitative easing (qe2) programme, and if the economy actually dips in the 3rd quarter, a second fiscal package is likely to be rolled out subsequently. Markets could have a sharp rally on the back of this event into 2011.
meanwhile, continue to add U.S. treasury bonds (preferably 30 year zero coupons – there is a convenient way to do this through a PIMCO ETF - ZROZ), long dollar (I have closed out my long euro position) and short global equity markets for a small trading position (through inverse ETFs – I have done this through the ETF SDS for the S&P and EEV for emerging markets).
Hussman’s observations on what went wrong in the U.S. (and much of the developed world) are also very insightful and similar observations have been made by other thoughtful analysts (Andrew Smithers has also made the point of continuously overstated U.S. corporate profits in his recent book). Regarding financial profits, I came across a fascinating comment from the hedge fund manager Eric Sprott – "of the 986 bank holding companies in the U.S. last year, a total of 980 of them lost money. And that’s even after all the government bailouts the sector received. Is this robust banking recovery? Not a chance. However, the remaining six banks, all of which are "too big to fail", did manage to earn a combined $51 billion in 2009 (not on their own strength but thanks to taxpayer’s bailouts and government handouts in terms of zero interest rates and purchases of risky assets), sending their stocks soaring as a result".
On global housing bubbles
the economist has updated their quarterly chart on global property markets and depict australia as the most overvalued market (based on price to rent ratio compared to long term averages), followed by Hong Kong! in terms of rate of price increases in recent quarters, Singapore takes the mantle of being the "frothiest" market. It’s important to keep Jeremy Grantham’s dictum in mind when thinking about buying property (or not selling investment property) in the bubble cities – bubbles eventually always correct, and a bubble which does not do so would be a first in the history of markets! This is the closet one can get to a fundamental theorem in markets- and this applies irrespective of "race, colour or creed"!
While we are on the subject of property, i add excerpts from a fascinating piece written by martin wolf recently in the ft on the land cycle:
Those who do not learn from history are condemned to repeat it. This applies not least to the immense financial and economic crisis into which the world has fallen. so what lay behind it? The answer is the credit-fuelled property cycle. The people of the U.S., U.K., Spain and Ireland became feverish speculators in land. Today, the toxic waste poisons the entire world economy.
This system creates calamitous political incentives. in a world in which people have borrowed heavily to own a location, they are desperate to enjoy land price rises and, still more, to prevent price falls. Thus we see a bizarre spectacle: newspapers hail upward moves in the price of a place to live – the most basic of all amenities. Particularly in the U.K., they welcome the creation of artificial scarcity of land, via a ludicrously restrictive regime of planning controls. This is the most important way in which wealth is transferred from the un-propertied young to the propertied old. The rigged land market is the biggest single cause of this calamity.
The opportunity for speculation in land both fuels – and is fuelled by – the credit cycle, which has, yet again destabilized the economy. In a superb new jeremiad, the journalist Fred Harrison argues that this cycle – with a duration of 18 years – was predictable and, by him at least, predicted. In essence, he notes, buyers rent property from bankers, in return for a gamble on the upside. A host of agents gains fees from arranging, packaging and distributing the fruits of such highly speculative transactions. in the long upswing (the most recent one lasted 11 years in the U.K.), they all become rich together, as credit and debt explode upwards. Then, when the collapse comes, recent borrowers, the financial institutions and taxpayers suffer huge losses. this is no more than a giant pyramid selling scheme and one whose dire consequences we have seen again and again. it is ultimately, as Mr Harrison argues, a ruinous way of running our affairs".
This observation applies to most other countries as well – so don’t believe all the media hype and anecdotal stories on why property is (and always is!) the best investment – yes there are periods when it makes absolute sense to buy property – but patience and disciplined valuation analysis will keep you out of trouble and still provide meaningful upside over time!
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