Hussman update:
Sunday April 21, 2002 : Hotline Update
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"There can be little doubt that prospects have brightened."
- Alan Greenspan, April 17, 2002
"We have yet to see any significant evidence of a rebound in economic activity in the United States."
- Scott Davis, CFO, United Parcel Service, April 18, 2002
Frankly, given the terrible record of consensus economic forecasts, particularly those of central bankers, I'm more inclined to go with the observations of the people who actually ship the packages.
In recent weeks, I've noted my concern regarding the Dow Transportation average, emphasizing its failure to confirm the recent high in the Dow Industrials (an observation noted by a few other analysts, most notably Richard Russell of www.dowtheoryletters.com). At the risk of seeming quaint, archaic, and out of touch with the New Economy, I take this nonconfirmation seriously. At this point, the evidence suggests that the recent firming in economic activity represents little more than inventory rebuilding, rather than final demand.
Indeed, as noted in the latest issue of Hussman Investment Research & Insight, the gaping U.S. current account deficit provides strong reason to believe that consumption and investment will grow substantially slower than in the typical economic rebound. Historically, economic recoveries have started with a substantial surplus in the U.S. current account (essentially, a trade surplus). This means that the U.S. was producing enough to satisfy its own domestic consumption and investment needs, with enough left over to make net exports abroad. In this kind of situation, there is a great deal of room for consumption and investment to soar, while the current account moves from surplus (exporting goods and services on balance) to deficit (net imports from abroad). There is no question that the most powerful and prolonged U.S. expansions and investment booms have been largely fueled by the ability to import goods, services and capital from foreign countries, which shows up as an increasing current account deficit. The problem here is that we already have a monster deficit. The probability of consumption and investment growing sustainably faster than GDP (as it did for most of the past decade) is nearly zero.
I also believe that the U.S. housing market is in a bubble. Greenspan suggested on Wednesday that the relative illiquidity of housing made it immune to bubbles, which is absurd. The valuations that produce a bubble are always determined by the transactions between the marginal buyer and the marginal seller, not by the ease or difficulty of turning over the entire stock. So long as existing owners define their wealth by the prices determined by the marginal buyers and sellers, the impact of a bubble in housing prices is no different from the impact of a bubble in equities.
I noted in Research & Insight that weakness in the dollar would be the first sign that foreigners might be starting to pull back on sending capital to the U.S. Last week, the dollar broke recent support, hard. This is a dangerous sign, in my estimation. Moreover, lumber futures also broke hard last week, which is of further concern regarding housing. When divergent market action starts telling stories that nobody wants to hear, it's often worth paying attention. As always, this is not a forecast so much as an indication to be alert. It is worth watching for any persistence in these divergences, and for other confirmations such as fresh weakness in the stock prices of homebuilding companies.
We continue to hear comments by analysts on CNBC, in SmartMoney, and elsewhere about "money on the sidelines" that has to "come into the market" due to low T-bill yields. This is like saying that apples are bigger when they are made of grapefruit - a statement that is neither true nor false, but simply reflects a completely invalid view of the world.
In equilibrium, the desired ownership of every security must exactly equal the outstanding supply, or the price of the security changes until it does. Suppose that there are 1000 units of a security that we call "cash", and 100 units of a security that we call "stock." Now, suppose that the people with the cash decide that they would rather hold stocks, so they try to "put their money into the market." Well, urgent demand for stocks might very well cause stock prices to rise, but this is because the eagerness to buy exceeds the eagerness to sell. Some people who held cash will now hold stock, and some people who held stock will now hold cash. After the trades take place, there will still be 1000 units of cash outstanding and 100 units of stocks outstanding. There will still be identically the same amount of "cash on the sidelines" as there was before. The size of the cash position itself is neither bullish nor bearish.
Look. If people decide that cash at current yields is not interesting, cash becomes a hot potato. Since, in equilibrium, all securities including outstanding cash must be held, we require either the return on cash to increase, or the competing return on other investments to fall. Now, if demand is urgent for alternatives to cash, stock and bond prices may increase, lowering their prospective future returns (since prices and returns move inversely), reducing their attractiveness relative to cash, and restoring equilibrium. But there is still the same amount of cash as there was before.
In short, the argument that there is "enormous cash on the sidelines" is incoherent. The proper way to frame this argument, if you want to make it, is to argue that short-term interest rates are too low to create equilibrium in the short-term money markets.
Now if you believe this, the least plausible implication is that stock prices must rise. To argue for an increase in stock prices, one requires the additional assumption that stocks are currently priced to deliver an attractive rate of return - something which we've argued endlessly against. At present, there are three far more plausible ways to bring the money markets into equilibrium (if you assume they are not).
1) An increase in bond prices (i.e. a decline in long-term interest rates). This is another way of saying that people would be more comfortable with low money-market yields if the yield curve was flatter at the long end.
2) An increase in short term interest rates - remember that market yields on T-bills and commercial paper are but not actually determined by the Fed, and often move opposite to Fed-controlled rates. If investors don't want to hold cash at current low interest rates, the simple solution is to demand higher yields. This isn't happening yet, which suggests that there is still enough risk aversion that investors are comfortable holding safe cash.
3) An acceleration of inflation. If cash is a hot potato and nobody really wants to hold it at current yields, there is a tendency for cash to lose value relative to goods. That's another way of saying that inflation rises.
In short, whatever money is on the sidelines will, by virtue of equilibrium, stay on the sidelines, though possibly in the hands of somebody else. If investors are dissatisfied with low returns on cash, the most plausible outcomes would be inflation and an increase in short term interest rates, which would naturally flatten in the yield curve. If investors were really aggressive in their distaste for cash holdings, the yield curve might even flatten by long-term rates falling (bond prices rising). In practice, when money creation is excessive, we tend to see inflation, rising short term interest rates, a flattening yield curve, and a falling dollar all happening in tandem, which is the market's way of screaming that the Fed is too loose.
But at current stock valuations, the last way that disequilibrium in the money markets would express itself would be a rally in stocks. In any event, there would still be the same amount of cash on the sidelines, but the profile of prices and yields in other markets would be sufficient to make people comfortable holding that cash. Those who argue that "money on the sidelines" must shift "into" the stock market are not simply making a statement that is true or false. They're talking complete gibberish.
At present, we remain defensive based on the current unfavorable profile of valuations and trend uniformity. As I've noted in recent weeks, we have no forecast regarding how long trend uniformity will remain negative, but until and unless it improves (which could be in a week or could be in a year), we'll remain defensive. We are fully hedged at present.
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