Hussman Weekly Market Comment: Oil and Red Ink
From earlier this week.
Similarly, before the housing crisis, it might have been tempting to shrug off mortgage defaults as relatively isolated events, since the price of housing had generally experienced a long upward trend over time. Indeed, historically, sustained declines in home prices could be shown to be very low probability events. But as the bubble continued, investors made little attempt to assess the probability of a debt crisis given that home prices had become detached from all reasonable metrics of income and ability to pay. Just as buy-and-hold investors assumed that the long-term return on stocks was constant at about 10%, despite the late 1990's valuation bubble, investors during the housing bubble kept looking at the "unconditional probability" P( credit crisis ) based on decades of normal housing valuations, when they should have recognized that the conditional probability P( credit crisis | extreme housing overvaluation and lax credit standards ) was probably higher. This turned out to be a profound oversight.
But that was evidently not a sufficient lesson. As soon as the surface appearance of the problem was covered up by an expensive and opaque band-aid of government bailouts and suspension of accounting transparency by the FASB, investors went right back to using those unconditional probability estimates. Indeed, until the spike in credit spreads that began a few weeks ago, the amount of additional yield investors demanded for taking credit risk had fallen back to the lows of 2007. We've had a major credit crisis, we have failed to restructure the debt underlying that crisis, and yet investors are approaching the market as if the debt has simply been made whole and we can continue along the former path.
Knowing that the cash flows from mortgage payments cannot possibly be adequate to service the original debt, that delinquencies continue to hit new records, and that there is an enormous overhang of nonperforming debt and unforeclosed homes - it seems utterly naive to assume that the problems we saw over a year ago have been adequately addressed.
What holds for oil also holds for red ink. Disasters contain information. It's no longer reasonable to apply previous risk estimates even after we've observed a major spill.
