Fasten the Seat Belts?

John Hussman's Weekly Market Commentary is one of my must-reads. This week, he predicts substantial stock market volatility. His full piece, Buckle Up, is worth a read, but here are the noteworthy excerpts:

While the stock market is extremely compressed, which invites the typical “fast, furious, prone-to-failure” rallies to clear this condition, my larger concern is that market action and credit spreads are demonstrating very little investor confidence, risk-tolerance or commitment to stocks. Value investors know that stocks have been much cheaper at the end of lesser crises, and traders are still sellers on advances. My impression is that only prices that allow no room for error (what Ben Graham used to call a “margin of safety”) will be sufficient to prompt robust, committed buying from value investors. This will be a fine thing for investors who keep their heads, are already defensive, and have the capacity to add to their investment exposure on price weakness, but other investors are likely to be shaken out of long-term investments at awful prices. This need not happen in one fell swoop, and we need not observe the “final lows” anytime soon. The problem is that even to get a sustainable “bear market rally,” somebody has to be convinced that stocks are desirable holdings for more than a quick bounce.

and

Probably the most important long-term risk to perceived valuations here is that the deleveraging pressure we're observing is increasingly likely to cap future return-to-equity at a much lower level than was possible with extremely high levels of debt. This will make historical norms of price-to-book value and price-to-revenues increasingly relevant, while the recent history of peak-earnings (and perhaps even dividends) may be misleading because the recent peak in profit margins will be far more difficult to recover compared with past cycles.

and, most crucially,

The misguided policy response from Washington has focused almost exclusively on squandering public money and burdening our children with indebtedness in order to defend the bondholders of mismanaged financial institutions (blame Paulson and Geithner – I've got a lot of respect for our President, but he's been sold a load of garbage by banking insiders). Meanwhile, I suspect that the little tapes in Bernanke's head playing “we let the banks fail in the Great Depression” and “we let Lehman fail and look what happened” are so loud that he is making no distinction about the form of those failures. Simply letting an institution unravel is quite different from taking receivership, protecting the customers, keeping the institution intact, replacing management, properly taking the losses out of stockholder and bondholder capital, and issuing it back into private ownership at a later date. This is what it would mean for these banks to “fail.” Nobody is advocating an uncontrolled unraveling of major financial institutions or permanent nationalization as if we've suddenly become Venezuela.

Make no mistake. Buying up “troubled assets” will not materially ease this crisis, nor will it even improve the capital position of financial institutions (see You Can't Rescue the Financial System if You Can't Read a Balance Sheet). Homeowners will continue to default because their payment obligations have not been restructured to any meaningful extent. We are simply protecting the bondholders of mismanaged financial institutions, even though that bondholder capital is more than sufficient to cover the losses without harm to customers. Institutions that cannot survive without continual provision of public funds should be taken into receivership, their assets should be restructured to better ensure repayment, their stockholders should be wiped out, bondholders should take a major haircut, customer assets should (and will) be fully protected, and these institutions should be re-issued to the markets when the economy stabilizes.

The course of defending the bondholders of insolvent institutions is not sustainable. Do the math. The collateral behind private market debt is being marked down by easily 20-30%. That debt represents about 3.5 times GDP. That implies collateral losses on the order of 70-100% of GDP, which itself is $14 trillion. Unless Congress is actually willing to commit that amount of public funds to defend the bondholders of mismanaged financials so they can avoid any loss, this crisis simply cannot be addressed through bailouts. Bondholders have to take losses. Debt has to be restructured. There is no other option – but the markets are going to suffer interminably until our leaders figure that out.

Amen!