Wednesday, 4 January 2012

John Hussman: "The Right Kind of Hope"

Some snippets from his latest weekly newsletter:

With 10-year Treasury yields below 2%, 30-year yields below 3%, corporate bond yields below 4%, and S&P 500 projected 10-year total returns below 5%, we presently have one of the worst menus of prospective return that long-term investors have ever faced. The outcome of this situation will not be surprisingly pleasant for any sustained period of time, but promises to be difficult, volatile, and unrewarding. The proper response is to accept risk in proportion to the compensation available for taking that risk. Presently, that compensation is very thin. This will change, and much better opportunities to accept risk will emerge. The key is for investors to avoid the allure of excessive short-term speculation in a market that promises - bends to its knees, stares straight into investors' eyes, and promises - to treat them terribly over the long-term.

Again, we enter the year with great hope. But our hope is not for continued speculation and the maintenance of rich valuations (that only look reasonable because long-term cyclical profit margins are at a short-term peak about 50% above their historical norms). At present, we have a situation where saving is discouraged by desperately low interest rates, where unproductive uses of capital are not discouraged because the bar is so low, and where central banks recklessly facilitate economic stagnation by bridging the gap between a puddle of unrewarding savings and a mountain of unproductive speculations. So our hope this year is for a return to a proper investment opportunity set - where saving is encouraged and rewarded by sufficiently high prospective returns, and the cost of capital is high enough to discourage high-risk, low-return investments and unsustainable fiscal deficits. The longer policy makers wait to begin the orderly restructuring of bad debt and overleveraged financial institutions, the greater the risk of a disorderly restructuring.

Meanwhile, the European Central Bank is more tapped out than we suspect investors recognize. The balance sheet of the ECB now stands at about $3.55 trillion (2.73 trillion euros), compared with EU GDP of about $16 trillion. This puts the European monetary base at about 22% of EU GDP, which is even greater relative to the economy than the Fed's balance sheet ($2.97 trillion on $15 trillion of GDP as of December 28, which works out to 21 cents for every dollar of GDP). Forget the "zero bound" - given the bloated size of the ECB balance sheet, combined with the lack of credible safe-havens in Europe, distrust of the banking system, and an apparent aversion to cash-stuffed mattresses, German 3-month debt is now sporting a yield of -0.17%, which means that investors pay the German government for holding their money.

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