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The Hook: Mr. Hussman'r reply to Mr. Marks


giofranchi
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Mr. Hussman’s reply to Mr. Marks: sorry to say this, but I am with Mr. Hussman!

 

The “hook” today is the dramatically elevated, deficit-induced level of profit margins. While the complete faith of investors in the Federal Reserve may prove to be the hook for ordinary investors, it’s not enough to draw in more careful observers. The real hook, in my view, is the absence of a bubble in any individual sector, and instead a bubble in profit margins across the entire corporate sector. That is the hook that serves to keep investors and traders thinking that everything is going to be all right.

 

As economist David Rosenberg has noted, if recent decades have taught investors anything, it is that every time the Federal Reserve drives interest rates to negative levels after inflation, it creates a bubble that subsequently bursts. As part of this painful learning experience, investors have become at least somewhat practiced in identifying bubbles within individual sectors – technology, housing, and debt, for example. The problem, in my view, is that the present bubble is systemic – with short-term interest rates at zero, the prospective returns of nearly every asset class, looking out over a 5-7 year horizon, is also close to zero. Equity investors, in particular, don’t see it because part of this bubble is captured in profit margins rather than in prices (unless one uses cyclically-adjusted earnings, which make the overvaluation more evident). But the result is the same – stock prices are dramatically elevated on the basis of the long-term stream of cash flows that investors can actually expect to receive over time. It may make investors feel better that current profit margins are elevated enough to make price/earnings ratios seem “reasonable.” But then, that’s the hook.

 

giofranchi

 

“As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.” - John Maynard Keynes

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This is one of the better letters from Hussman.

 

The key issue is the level of profit margins going forward compared to the past. Hussman is betting that profit margins revert around the 6% level. I have absolutely no doubt that profit margins are mean reverting but think the mean they would be reverting would be higher than in the past. This is sort of like the old rule of dividend yield for stocks should be higher than the bond yields since stocks are risky. This used to be a good indicator for when stocks are getting overvalued. Anyone following it would have been out of stocks for about 55 years from the mid 1950s till about march 2009. The point being, big macro calls could turn out to be wrong for very long periods of time, far longer than the investment horizon of most people. I agree stocks are pretty highly valued, just not as much as Hussman thinks or as certain as he seems to be that they would come crashing down.

 

Vinod

 

 

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This used to be a good indicator for when stocks are getting overvalued. Anyone following it would have been out of stocks for about 55 years from the mid 1950s till about march 2009. The point being, big macro calls could turn out to be wrong for very long periods of time, far longer than the investment horizon of most people.

 

That’s why I am always in the game. I just try and let the prudence with which I do business grow, as the prudence with which others do business shrinks. And vice versa.  :)

 

giofranchi

 

“As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.” - John Maynard Keynes

 

 

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Jeremy Grantham has made the same point about profit margins mean reverting. However I have always had a problem with this argument and the reason is that I don't understand why profit margins are so high to begin with. My basic answer is that profit margins are high because productivity gains have not gone to labour due to the demise of unions and strong competitive pressures from countries like China. This happened I think in the beginning of the Industrial Revolution as people moved from rural areas to cities. In the long run wages get bid up and as they do profit margins erode.

 

I am not confident of any of this though and don't think anyone really has a good answer as to what is going on.

 

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Sorry to say, but I don't know why these ratios have to mean revert.  Eventually, maybe, but not necessarily within most people's investment horizons.  The S&P profits are so global nowadays, how do you calculate that vs. the GDP of US, and expect it to mean revert to levels prevalent in the 70's or even 80's prior to Berlin Wall fell and China being integrated into the world?  Maybe all it shows is that S&P companies are earning more abroad than ever.  Consider it the fruits of globalization, maybe.  2000 was the peak of Pax Americana, today less so, but clearly more so than the 70's and 80's?  When you think of the earnings of a Coke, JNJ, BA, IBM, etc., etc., they are all benefiting tremendously from being part of "brand America".  Even financials gets a piece of the action in the form of foreigners financing US assets at a cheaper rate than otherwise possible.

 

Not to say they will all be sustain at this level forever, 2008 clearly showed the cracks, but think about the geopolitical context underwhich the corporate profits / US GDP will mean revert to the 70's.  Within most people's investment horizon, what probability do you really assign of that happennig?  And that's the event you are hedging for?  I guess in '09 it was precisely that, therefore Hussman had great returns, but now?

 

 

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