Monday, May 24, 2010

Hussman takes the Ponzi out of Mr Market

John Hussman's weekly Market Comment blog must be read from time to time, but not all the time, because his world moves glacially, not in squalls. His thinking and analysis is for the big picture. If Guambat had any funds to park, he'd park them with Mr. Hussman. Unfortunately, Guambat failed the parking part of the driving test.

Guambat was delighted with the way Hussman put the right finger on the right button when he discussed the illusion behind the illusive of Mr Market, when he talked recently about taking the Ponzl out of Mr Market.
The basic problem is that Greece has insufficient economic growth, enormous deficits (nearly 14% of GDP), a heavy existing debt burden as a proportion of GDP (over 120%), accruing at high interest rates (about 8%), payable in a currency that it is unable to devalue.

This creates a violation of what economists call the "transversality" or "no-Ponzi" condition. In order to credibly pay debt off, the debt has to have a well-defined present value (technically, the present value of the future debt should vanish if you look far enough into the future).

Without the transversality condition, the price of a security can be anything investors like.

However arbitrary that price is, investors may be able to keep the asset on an upward path for some period of time, but the price will gradually bear less and less relation to the actual cash flows that will be delivered. At some point, the only reason to hold the asset will be the expectation of selling it to somebody else, even though it won't be delivering enough payments to justify the price.

Transversality forces the price of the asset to be equal to the value of the discounted cash flows.

It's not enough for a borrower to keep the payments up over the short term, and it's not enough for price of an asset to be on an upward track for a while - over time, securities actually have to be able to deliver enough cash flows to justify the price that investors pay.

When investors abandon this requirement (as they did with dot-com and technology stocks during the runup to the market peak in 2000), the price they pay stops having any relationship with the stream of cash flows that will be delivered to them over time.

An increasingly large portion of the asset price represents real money that is being paid for a "phantom asset" in the distant future, that bears no cash flows, and yet gets assigned positive value because investors assume they'll be able to sell it to a greater fool.

Mr Market is inhabited by investments and Ponzis alike; things that are investments today can become Ponzis tomorrow. Be sure you know what's in your portfolio at all times, and what it is you're chasing.

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Blogger Jack said...


Solid thinking here. Hussman's comments are addressed to sovereign debt, though what he describes is exactly what happened to housing markets here, there and everywhere. The real estate bubble was just as silly as the dot-com stock market. Ain't no free lunches out there. Happens to us all.


25 May 2010 at 1:47:00 am GMT+10  
Anonymous little john said...

solid thinking for sure, but i would note that an abandonement of transversality (i must've slept too much in econ101 cuz this is a new word to me) is too elegant an explanation for bubble markets. Though I couldn't prove it one way or the other, I reckon for every hot dollar chasing the next incremental sucker in a bubble market, there were far more dollars who just plain got their future cash flows out wrong, and had to later revise their projections when groupthink shifted.

It's a lot easier to convince yourself of fantastic cash flow growth than it is to convince yourself that there's a bigger idiot around the corner. Of course the bigger idiot argument sounds much better after the fact.

23 June 2010 at 1:56:00 pm GMT+10  

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