I received an email a few weeks ago stating "Hussman has been so
wrong I should stop quoting him."
Nonetheless here I go again, because I think Hussman has something important
to say. Please consider a few admittedly lengthy snips from his post today Pills
for Cognitive Dissonance in a Speculative Bubble.
Several years of persistent yield-seeking speculation
provoked by zero-interest rate monetary policies have created a fertile
ground for cognitive dissonance. On one hand, any observer with historical
perspective knows not only that the overvaluation from this kind of
speculation inevitably ends in tears, but also that the heavy issuance of new
speculative and low-quality securities during the bubble finances and enables
unproductive malinvestment that leaves the economy far worse off in the end.
On the other hand, prices have been advancing.
It’s difficult to entertain both of those facts at once. One must
simultaneously hold in mind reckless yield-seeking speculation,
hypervaluation that rivals the 1929 and 2000 equity market peaks (see Yes, This is an Equity
Bubble), zero interest rates, low prospective long-term returns all
around, and persistent malinvestment that poses increasing systemic risks for
the entire global economy, plus one fact that encourages us to forget it all:
prices have been going up. Cognitive dissonance tempts us to reconcile this
tension by ignoring one part of the story or another.
[From Yes, This is an Equity Bubble]
One would think the Federal Reserve would have learned from that catastrophe.
Instead, the Fed has spent the past several years intentionally trying to
revive the precise dynamic that produced it. As a consequence, speculative
yield-seeking has now driven the most historically reliable measures of
equity valuation to more than double their pre-bubble norms. Meanwhile, as
investors reach for yield in lower-quality but higher-yielding debt
securities, leveraged loan volume (loans to already highly indebted
borrowers) has reached record highs, with the majority of that debt as
“covenant lite” issuance that lacks traditional protections in the event of
default. Junk bond issuance is also at a record high. Moreover, all of this
issuance is interconnected, as one of the primary uses of new debt issuance
is to finance the purchase of equities.
At present, the most historically reliable valuation measures are more than
100% above pre-bubble historical norms. Investors who dismiss present market
valuations by reflexively parroting the phrase “lower interest rates justify
higher valuations” haven’t thought carefully about the problem or done the
math, and that math is just basic arithmetic.
Make no mistake – this is an equity bubble, and a highly advanced one. On the
most historically reliable measures, it is easily beyond 1972 and 1987,
beyond 1929 and 2007, and is now within about 15% of the 2000 extreme. The
main difference between the current episode and that of 2000 is that the 2000
bubble was strikingly obvious in technology, whereas the present one is
diffused across all sectors in a way that makes valuations for most stocks
actually worse than in 2000.
[End Yes, This is an Equity Bubble - Back to Cognitive Dissonance]
Red Pill, Blue Pill
Probably the most interesting response to the cognitive dissonance provoked
by the present yield-seeking mania comes from Hugh Hendry at Eclectica (h/t ZeroHedge) who quite clearly recognizes the repulsive
long-term situation, but has embraced central-bank induced speculation out of
the necessity of self-preservation as a money manager. I would actually agree
with him here were it not for the fact that the behavior of market internals
and credit spreads doesn’t really recommend an outlook tied to the world of
illusion. That may change, and if it does, it would admit a greater range of
investment outlooks in the category of “constructive with a safety net.” Hendry’s
own struggle with the cognitive dissonance of this period is evident:
“There are times when an investor has no choice but to
behave as though he believes in things that don’t necessarily exist. For us,
that means being willing to be long risk assets in the full knowledge of two
things: that those assets may have no qualitative support; and second, that
this is all going to end painfully. The good news is that mankind clearly has
the ability to suspend rational judgment long and often."
“Remember the film The Matrix? Morpheus offered Neo the choice of two pills –
blue, to forget about the Matrix and continue to live in the world of
illusion, or red, to live in the painful world of reality… I have long
thought of myself as one of the enlightened. My much thumbed copy of
Kindelberger’s Manias, Panics and Crashes aided and abetted my thinking as I
correctly anticipated and monetised profits from the crisis of 2008 for
example. But it isn’t always good. Kindelberger has been absolutely
detrimental to my investment performance for the last six years and as a
result I have changed. I still believe that the attempt by central bankers to
prevent the private sector from deleveraging via a non-stop parade of asset
price bubbles will end in tears. But I no longer think that anyone can say
when."
“The economic truth of today no longer offers me much solace; I am taking the
blue pills now. In the long run we will come to rue the central bank actions
of today. But today there is no serious stimulus programme that our Disney
markets will not consider to be successful. Markets can be no more long term
than politics and we have no recourse but to put up with the environment that
gives us; the modern market is effectively Keynesian with an Austrian tail.”
Pater Tenebrarum offers a thoughtful (and respectful)
counterpoint in Hugh
Hendry and the “Blue Pill”:
“It seems possible that there is a catch. If no-one can
say when, then the ‘blue pill’ strategy has a major weakness. It means that
things could just as easily go haywire next week as next year. It should be
noted that the focus of Austrian business cycle theory is really on the boom,
its chief causes and effects, and the fact that instead of increasing prosperity,
it will lead to impoverishment in the long run. The major difference between
someone simply taking the blue pill and an ‘Austrian’ investor in the current
situation is probably that the latter attempts to incorporate all possible
outcomes in his strategy, instead of trusting that central bank
interventionism will continue to ‘work’ for investors.
“We believe that there is a grave danger associated with simply ‘taking the
blue pill.’ First of all, in the context of ‘risk assets,’ having faith in
central bank magic is most definitely not a contrarian position anymore –
less so than at any other time in the past six years. Contrarian views have
actually worked very well in treasury bonds and crude oil in 2014, so it
would also be quite wrong to state that ‘contrarianism no longer works’ as a
general proposition. The majority is of course always right during a strong
trend. However, there inevitably comes a time when a trend has lasted long
enough and gone far enough that the ranks of doubters have been thoroughly
thinned out and the majority ceases to be correct.
“We perceive a ‘greater tolerance for short term drawdowns’ as quite
dangerous in connection with risk assets at this juncture. In asset bubbles
there are usually a number of short term breakdowns that are immediately
followed by prices moving to new highs, a fact that greatly cements the
confidence of market participants – usually to the point where it becomes
fateful overconfidence. The main problem with this ‘tolerant’ approach is
that one simply cannot differentiate a run-of-the-mill short term correction
from a short term downturn that ends up heralding something far worse.
Initially, all corrections look similar… The initial downturn is never seen
as a cause for alarm. Sometimes this can however be followed by a decline so
swift that having a tolerance for drawdowns can end up leaving one with very
big losses in a very short time period.
“Such sudden reassessments of market valuation can rarely be tied to specific
fundamental developments. Rather, anything that is reported is all of a
sudden interpreted negatively and becomes a trigger for more selling, even
though similar news would have been shrugged off a few days or weeks earlier.
After all, nearly every economic news item can be interpreted in a number of
different ways, so that even superficially good news can become a problem (in
the current situation they could e.g. create fears of a faster tightening of
monetary policy).
“We will readily admit that one cannot know with certainty whether the bubble
in risk assets will become bigger. However, it seems to us that avoiding a
big drawdown may actually be more important than gunning for whatever gains
remain. One can of course endeavor to do both, but that inevitably limits
short term returns due to the cost of insuring against a potential calamity.”
My own view is that Hendry and Tenebrarum are both right –
only that the appropriate pill is conditional on the state of investor
preferences toward risk-seeking and risk-aversion – preferences that can be
largely inferred from observable market action.