Hussman - Red Pill, Blue Pill

by John Hussman
January 5, 2015

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:
“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. In an environment where market internals and credit spreads are deteriorating, betting on risky assets is extraordinarily dangerous and subject to abrupt air-pockets, free-falls and crashes – the “sudden reassessments of market valuation” that Tenebrarum correctly recognizes. That’s what we presently observe, and it demands the red pill that makes one conscious of the painful reality of the present situation. But those conditions may change, and in that case, the immediacy of our concerns should ease accordingly.

There is one main lesson that should be drawn from our own experience in recent years – and it is a lesson that can be demonstrated across every bubble-crash cycle in history. In an environment where internals and credit spreads uniformly convey risk-seeking preferences, the market may be severely overvalued, but pointed expectations about impending losses are best deferred. That doesn’t mean swallowing the blue pill whole or living in the untethered world of speculative fantasy. It would surely require insurance or some other safety-net at current valuations, but there is a tendency for overvalued markets to become more overvalued in that environment. For now, we view the market as vulnerable to vertical losses. That risk will change with market conditions, and we will take that evidence as it emerges.

I’ll repeat emphatically what I noted a few weeks ago. The set of market conditions that we observe at present are supportive for steep losses to emerge because present conditions join compressed risk premiums with a measurable shift toward risk-aversion by investors. If further speculation is to emerge – and this is borne out even in data from recent years – that speculation is likely to be supported by a measurable shift toward risk-seeking that can also be inferred from the behavior of observable market internals. We need not hope for a major market decline, nor do we need to dread a major resumption of speculation. Each of these will manifest because conditions are supportive for them to manifest. As the Buddha said, “This is, because that is. This is not, because that is not.”