Bubble, Crash, Bubble, Crash, Bubble...
by John P. Hussman, Ph.D., Hussman Funds
"Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion."
Federal Reserve Chairman Ben Bernanke, Washington Post 11/4/2010
Last week, the Federal Reserve confirmed its intention to engage in a second round of "quantitative easing" - purchasing about $600 billion of U.S. Treasury debt over the coming months, in addition to about $250 billion that it already planned to purchase to replace various Fannie Mae and Freddie Mac securities as they mature.
While the announcement of QE2 itself was met with a rather mixed market reaction on Wednesday, the markets launched into a speculative rampage in response to an Op-Ed piece by Bernanke that was published Thursday morning in the Washington Post. In it, Bernanke suggested that QE2 would help the economy essentially by propping up the stock market, corporate bonds, and other types of risky securities, resulting in a "virtuous circle" of economic activity. Conspicuously absent was any suggestion that the banking system was even an object of the Fed's policy at all. Indeed, Bernanke observed "Our earlier use of this policy approach had little effect on the amount of currency in circulation or on other broad measures of the money supply, such as bank deposits."
Given that interest rates are already quite depressed, Bernanke seems to be grasping at straws in justifying QE2 on the basis further slight reductions in yields. As for Bernanke's case for creating wealth effects via the stock market, one might look at this logic and conclude that while it may or may not be valid, the argument is at least the subject of reasonable debate. But that would not be true. Rather, these are undoubtedly among the most ignorant remarks ever made by a central banker.
Let's do the math.
Historically, a 1% increase in the S&P 500 has been associated with a corresponding change in GDP of 0.042% in the same year, 0.035% the next year, and has negative correlations with GDP growth thereafter (sufficient to eliminate any effect on the long-run level of GDP). Now, even if one assumes - counter to reasonable analysis - that the GDP changes are caused by the stock market changes (rather than stocks responding to the economy), the potential benefit to the economy of even a 10% market advance would be to increment GDP growth by less than half of one percent for a two year period.
Now, as of last week, the total capitalization of the U.S. stock market was at about the same as the level as nominal GDP ($14.7 trillion). So a market advance of say, 10% - again, even assuming that stock prices cause GDP - would result in $1.47 trillion of market value, and a cumulative but temporary increment to GDP that works out to $11.3 billion dollars divided over two years. Moreover, even if profits as a share of GDP were to hold at a record high of 8%, and these profits were entirely deliverable to shareholders, the resulting one-time benefit to corporate shareholders would amount to a lump sum of $904 million dollars. In effect, Ben Bernanke is arguing that investors should value a one-time payout of $904 million dollars at $1.47 trillion. Virtuous circle indeed.
One of the main reasons that stock market fluctuations have such a limited impact on real output is because investors correctly perceive these fluctuations as impermanent - particularly when they are detached from proportional changes in long-term fundamentals. Recall that the primary source of the recent financial crisis was excessive debt expansion, consumption, and speculative housing investment. Consumers observed persistently rising home prices, and inferred that they were "wealthy" enough to shift their consumption forward by borrowing against that perceived "wealth." A key to this dynamic was the fact that U.S. home prices had never experienced a sustained decline during the post-war period, so the increases in housing wealth were indeed viewed as permanent. As Milton Friedman and Franco Modigliani demonstrated decades ago, consumers consider their "permanent income" - not transitory year-to-year fluctuations - when they make their consumption decisions.
Rising home prices were further promoted by a combination of lax credit standards, perverse incentives for loan origination, a weak regulatory environment, and a Federal Reserve that sat so firmly on short-term interest rates that investors felt forced to reach for yield by purchasing whatever form of slice-and-dice mortgage obligation the financial engineers could dream up. Rising home values provoked more debt origination, and even higher prices. What seemed like a "virtuous circle" was ultimately nothing but an overpriced speculative bubble with devastating consequences.
Bubble, Crash, Bubble, Crash, Bubble ...
We will continue this cycle until we catch on. The problem isn't only that the Fed is treating the symptoms instead of the disease. Rather, by irresponsibly promoting reckless speculation, misallocation of capital, moral hazard (careless lending without repercussions), and illusory "wealth effects," the Fed has become the disease.
Alan Greenspan contributed to the late-1990's market bubble by his embrace of the notion that 100 million lemmings leaping off of a cliff into the ocean can't be wrong. Beyond a single bit of rhetorical lip service to the effect of "how do we know when irrational exuberance has unduly escalated asset values," Greenspan aggressively accommodated that bubble. Once it crashed, the Fed sat on short-term interest rates in a way that directly contributed to the housing bubble. Back in July, 2003, I published a perspective called Freight Trains and Steep Curves, which is a reminder that that the recent credit crisis did not emerge out of the blue:
"What is not so obvious is the extent to which the U.S. economy and financial markets are betting on the continuation of unusually low short-term interest rates and a steep yield curve. This doesn't necessarily resolve into immediate risks, but it could profoundly affect the path that the economy and financial markets take during the next few years, by making the unwinding of debt much more abrupt... So the real question is this: why is anybody willing to hold this low interest rate paper if the borrowers issuing it are so vulnerable to default risk? That's the secret. The borrowers don't actually issue it directly. Instead, much of the worst credit risk in the U.S. financial system is actually swapped into instruments that end up being partially backed by the U.S. government . These are held by investors precisely because they piggyback on the good faith and credit of Uncle Sam... tolerated by the financial system because the debt has been swapped out through financial intermediaries, so investors get to hold relatively safe instruments like bank deposits and Fannie Mae securities. This mountain of debt in the U.S. financial system - tied to short-term interest rates - is ultimately and perhaps somewhat inadvertently backed by the U.S. government."
It is difficult to interpret Bernanke's defense of QE2 as anything else but an attempt to replace the recent bubble with yet another - to drive already overvalued risky assets to further overvaluation in hopes that consumers will view the "wealth" as permanent. The problem here is that unlike housing, which consumers had viewed as immune from major price declines, investors have observed two separate stock market plunges of over 50% each, within the past decade alone. While investors have obviously demonstrated an aptitude for ignoring risk over short periods of time, it is a simple fact that raising the price of a risky asset comes at the sacrifice of lower long-term returns, except when there is a proportional increase in the long-term stream cash flows that can be expected from the security.
As a result of Bernanke's actions, investors now own higher priced securities that can be expected to deliver commensurately lower long-term returns, leaving their lifetime "wealth" unaffected, but exposing them to enormous risk of price declines over the intermediate (2-5 year) horizon. This is not a basis on which consumers are likely to shift their spending patterns. What Bernanke doesn't seem to absorb is that stocks are nothing but a claim on a long-term stream of cash flows that investors expect to be delivered over time. Propping up the price of stocks changes the distribution of long-term investment returns, but it doesn't materially affect the cash flows. This reckless policy has done nothing but to promote further overvaluation of already overvalued assets. The current Shiller P/E above 22 has historically been associated with subsequent total returns in the S&P 500 of less than 5% annually, on average, over every investment horizon shorter than a decade.
With no permanent effect on wealth, and no ability to materially shift incentives for productive investment, research, development or infrastructure (as fiscal policy might), the economic impact of QE2 is likely to be weak or even counterproductive, because it doesn't relax any constraints that are binding in the first place. Interest rates are already low. There is already well over a trillion in idle reserves in the banking system. Businesses and consumers, rationally, are trying to reduce their indebtedness rather than expand it, because the basis for their previous borrowing (the expectation of ever rising home prices and the hope of raising return on equity indefinitely through leverage) turned out to be misguided. The Fed can't fix that, although Bernanke is clearly trying to promote a similarly misguided assessment of consumer "wealth."
To a large extent, the Fed has assumed the role of creating financial bubbles because we have allowed it. The proper role of the Federal Reserve, and where its actions can be clearly effective, is to provide liquidity to the banking system in periods of financial stress or constraint, by replacing Treasury bonds held by the public with currency and bank reserves. But to expect the Fed to somehow bring about full employment is misguided. To believe that changing the mix of government liabilities in the economy (monetary policy) is a more important determinant of inflation than the total quantity of those liabilities (fiscal policy) is equally misguided. Historically, and across the world, the primary driver of inflation has always been expansion in unproductive government spending (think of Germany paying striking workers in the early 1920s, or the massive increase in Federal spending in the 1960s that resulted in large deficits and eventually inflation in the 1970s). But unproductive fiscal policies are long-run inflationary regardless of how they are financed, because they distort the tradeoff between growing government liabilities and scarce goods and services.
We are betting on the wrong horse. When the Fed acts outside of the role of liquidity provision, it does more harm than good. Worse, we have somehow accepted a situation where the Fed's actions are increasingly independent of our democratically elected government. Bernanke's unsound leadership has placed the nation's economic stability on two pillars: inflated asset prices, and actions that - in Bernanke's own words - should be "correctly viewed as an end run around the authority of the legislature" (see below).
The right horse is ourselves, and the ability of our elected representatives to create an economic environment that encourages productive investment, research, development, infrastructure, and education, while avoiding policies that promote speculation, discourage work, or defend reckless lenders from experiencing losses on bad investments.
Out of control: The distinction between monetary policy and fiscal policy
A decade ago, Bernanke gave a speech titled “Japanese Monetary Policy – A Case of Self-Induced Paralysis?” where he encouraged the Bank of Japan to pursue “substantial currency depreciation,” “maintaining the zero interest rate policy for the indefinite future,” “stating an inflation target of, say, 3-4 percent,” and if necessary, that “the BOJ expand its open market operations to a wider range of assets, such as long-term government bonds or corporate bonds.” Bernanke is essentially operating from this playbook, despite the fact that it has done Japan no good at all.
Some may argue that the first round of QE in the U.S. was effective, but to the extent it had an effect on the economy, that effect had nothing to do with monetary policy. What the Fed really accomplished during the first round of QE was the unlegislated grant of the government's full faith and credit to Fannie Mae and Freddie Mac. As I noted last week, the public would have viewed Fannie and Freddie securities as indistinguishable from Treasury debt if Congress had explicitly guaranteed them, but Bernanke decided to substitute his own will for that of the public.
Bernanke's 1999 speech included a very disturbing paragraph, particularly in light of what the Fed did by purchasing $1.5 trillion of these agency securities.
“In thinking about nonstandard open-market operations, it is useful to separate those that have some fiscal component from those that do not. By a fiscal component I mean some implicit subsidy, which would arise, for example, if the BOJ purchased nonperforming bank loans at face value (this is of course equivalent to a fiscal bailout of the banks, financed by the central bank). This sort of money-financed “gift” to the private sector would expand aggregate demand for the same reasons that any money-financed transfer does. Although such operations are perfectly sensible from the standpoint of economic theory, I doubt very much that we will see anything like this in Japan, if only because it is more straightforward for the Diet to vote subsidies or tax cuts directly. Nonstandard open-market operations with a fiscal component, even if legal, would be correctly viewed as an end run around the authority of the legislature, and so are better left in the realm of theoretical curiosities.”
Yet this is precisely what the Fed did with Fannie Mae and Freddie Mac a year ago. Bernanke understands this. He simply does not want the public or Congress to recognize it.
Given that fiscal authority is enumerated by the Constitution as the sole right of Congress, and spending is prohibited by the Constitution without explicit appropriation, it seems clear - regardless of how the Federal Reserve Act is written - that monetary operations involving anything but Treasury securities contain unconstitutional “fiscal component,” unless they involve repurchase agreements that would make the Fed whole even if the underlying securities were to fail. It is doubtful that when Congress drafted the Federal Reserve Act to allow the use of mortgage-backed securities, it ever dreamed that the Fed would purchase these securities outright when the issuer was insolvent. Until this issue is clarified in legislation, Bernanke will continue to see it as “perfectly sensible” for the Fed to make “money financed gifts” that substitute his own personal discretion for those of a democracy.
Equally disturbing is that Bernanke apparently has no problem confusing fiscal policy with monetary policy when it suits him. In the same paper, Bernanke purports to explain why the central bank always has the ability to increase aggregate demand, even in a liquidity trap:
"The general argument that the monetary authorities can increase aggregate demand and prices, even if the nominal interest rate is zero, is as follows: Money, unlike other forms of government debt, pays zero interest and has infinite maturity. The monetary authorities can issue as much money as they like. Hence, if the price level were truly independent of money issuance, then the monetary authorities could use the money they create to acquire indefinite quantities of goods and assets. This is manifestly impossible in equilibrium. Therefore money issuance must ultimately raise the price level, even if nominal interest rates are bounded at zero. This is an elementary argument, but, as we will see, it is quite corrosive of claims of monetary impotence."
The only thing that is corroded here is Bernanke's economic reasoning. In this example, the central bank is not engaging in monetary policy, but fiscal policy. Creating government liabilities to acquire goods and assets, unless those assets are other government liabilities, is fiscal policy, pure and simple.
Valuations, risk and absolute returns
Last week, investors launched into a frantic scramble to own already overvalued speculative assets. Stocks with consistent revenues and stable balance sheets were palpably out of favor, while cyclical, commodity and financial stocks enjoyed "blowoff" advances. That skew in price behavior contributed to a pullback of about 2.8% in the Strategic Growth Fund, which is a roughly one-in-twelve event for the S&P 500, but for us was among our most challenging weeks since the inception of the Fund.
Investors have now chased risky assets to the point where their expected long-term returns are in the low single-digits across the board. Our projection for the total return of the S&P 500 over the coming decade is now less than 4.5% annually, and even that expected return is likely to be accompanied by an enormous degree of risk. Our projected S&P 500 total return for the coming 3-5 year period is close to zero, but it appears likely to be a very volatile trip around zero.
Keep in mind that the effective duration of the S&P 500 is now over 50, which implies two things. First, the sensitivity of stock prices to any rise in yield will be exaggerated here. Every 10 basis points of increase in yield (say, from the current 1.89% to 1.99%) implies a price decline of over 5%. Given that the historical norm of the S&P 500 yield is about twice the present level, it is clear that a significant reversion of expected returns from presently depressed levels would require a massive price adjustment.
Second, from an investment-horizon perspective, a duration of over 50 means that the more your investment horizon deviates from a 50-year period, the more sensitive your terminal wealth will be in response to transitory changes in prices. Passive investors with a 50-year horizon can expect their terminal wealth to be largely "immunized" from price fluctuations, since reinvested dividends would, at that horizon, largely offset price variations. The same is not true for investors with, say, a 10-year horizon, where the exact position of the market a decade from now will matter a great deal to their standard of living.
I recognize that I can be faulted for not treating the recent economic cycle as a typical post-war recession - I instead insisted on more stringent investment criteria that reflected post-credit crisis data from more similar historical periods. Moreover, I did not anticipate that investors would drive stocks to back to strenuous overvaluation over such a short period of time. But however one views what, in hindsight, has been an unnecessary aversion to risk over past 18 months, the fact is that the long-term projections from our valuation models have continued to be a reliable gauge of long-term investment merit for stocks regardless. At present, stocks are overvalued, and long-term return prospects are poor. Further market returns will likely come at the cost of subsequent losses over a 2-5 year period, which means that market risk is essentially speculative here.
As a side note, I should reiterate that both the level and the growth rate of index level S&P 500 dividends already reflect the impact of stock repurchases. Despite the frequently repeated argument that dividends do not matter anymore, they have remained a much stronger basis of valuation than investors wish to believe. Undoubtedly, investors would have been saved a great deal of grief over the past decade had they realized this, because the market's loss since 2000 was utterly predictable.
Our investment objective remains to outperform our benchmarks (the S&P 500 for the Strategic Growth Fund) over the complete bull-bear market cycle, with smaller periodic losses than a passive investment strategy. I certainly don't believe that our concern about potential losses should be any less pointed. Even though the S&P 500 is substantially below its 2007 peak, it is also strenuously overvalued once again. Still, I do recognize that outperforming an awful market cycle is only satisfying if the absolute returns are positive and well above risk-free alternatives. Given that our post-war data set now includes a full-blown credit crisis, I do believe that we can move forward with a focus on that broader data set, and that we can continue to achieve our objectives with the expectation of more significant absolute returns over time.
Over the shorter term, the challenge is that the investment environment is unfavorable here on the basis of postwar data alone. Valuations are steeply extended and short-term conditions are overbought and overbullish. Even if we were to establish a purely speculative exposure here, the question is "what would prompt us to get out?" Certainly, it would not be valuations, because stocks are already overvalued in the first place. Certainly, it would not be economic deterioration, because despite slight improvement, our own measures as well as the ECRI weekly leading index are still negative, and have not recovered sufficiently to remove the prospect of tepid growth (or in our view, even negative GDP growth). Overbought conditions or excessive sentiment would also not get us out, since we observe them already.
The only thing, then, that would get us out, would be outright price weakness. So essentially a speculative bet is equivalent to an expectation that the market will advance enough from current levels that we would still be selling at a higher level once prices weaken enough to signal an exit. This would indeed be a speculative bet. The current advance may very well go further over the near term, but I have little doubt that it will have a disruptive ending. We'll continue to focus on our investment objectives.
The behavior of the market in recent years has been largely unrepresentative of post-war history, and managing the risks has not been simple or obvious. Still, when we include the experience of recent years, I believe that post-war data includes enough examples of strength and stress in the markets and the economy that it will serve as a solid basis for setting expectations about risk and return as conditions change over time. I'll continue working carefully to achieve our investment objectives, with an emphasis on absolute returns.
Correlated and Compressed
In recent years, the average correlations among sectors and various asset classes have moved from about 30-40%, which is normal, to nearly 80% - meaning that the securities markets are moving in concert as if they are one single, giant security, driven largely by the anticipation of government interventions of one form or another.
The "dispersion" that remains has largely cut across quality lines - more stable companies with good balance sheets versus more speculative companies with high leverage. But while recent months have favored the speculative side of that distinction, it is important to recognize that the rush toward speculative assets has also compressed their risk premiums. This might not be a problem in a world where the risk premiums on all assets are driven to zero and just stay there, but it will become very hostile in the event that risk premiums normalize, because the most speculative assets (whose prices are most sensitive to changes in required returns) could decline dramatically relative to safer ones.
When long-term returns are compressed and the correlation of risky assets is nearly perfect, the ability to select stocks and manage risk serves a purpose only at the point that those conditions prove unsustainable. My impression is that we are near that point, but this is also a momentum-driven market where investors care little about anything but the size of the next cartoonish government intervention. We'll have some scope for accepting market risk if we observe some combination of improved economic fundamentals and a clearing of overvalued, overbought and overbullish conditions (without a major breakdown in market internals).
Employment Notes
As Lacy Hunt of Hoisington Management observed (via John Mauldin), "The October employment situation was dramatically weaker than the headline 159k increase in the payroll employment measure. The broader household employment fell 330k. The only reason that the unemployment rate held steady is that 254k dropped out of the labor force. The civilian labor force participation rate fell to a new low of 64.5%, indicating that people do not believe that jobs are available, but this serves to hold the unemployment rate down. In addition, the employment-to-population ratio fell to 58.3%, the lowest level in nearly 30 years. The most distressing aspect of this report is that the US economy lost another 124k full-time jobs, thus bringing the five-month loss to 1.1 million in this most critical of all employment categories."
Despite these concerns, for my part, I expect (and hope) that employment will, in fact, gradually improve as we move into 2011. Thus far, businesses have been able to squeeze the same output from a shrinking work force, resulting in large gains in measured productivity, but this dynamic seems largely played out. Even in a fresh economic contraction, which we don't rule out, the number of jobs lost per dollar of output lost is likely to be far more constrained than we saw in recent years. Conversely, increases in output will most likely trigger some pent-up demand for employment. All told, the employment market strikes me as less sensitive and vulnerable as the housing and financial markets do.
Market Climate
Just a note - the Hussman Funds generally make their annual capital gains distributions in the month of November. In the interest of minimizing short-term trading of the Funds, we do not announce the specific date of these distributions. No capital gains distribution is required for the Strategic Growth Fund. We estimate a distribution of just over 4% of NAV for the Strategic Total Return Fund (roughly two-thirds short-term and one-third long-term), and a distribution of less than 2% for the Strategic International Equity Fund.
As of last week, the Market Climate in stocks was characterized by strenuous overvaluation, coupled with overbought, overbullish conditions, and a paradoxical surge in 30-year Treasury yields, which are now near a 6-month high. Nearly 90% of stocks are now above their 20-day, 50-day and 200-day moving averages, which is an unusually overextended condition. Meanwhile, the CBOE volatility index (commonly viewed as a "fear index") dropped to 18.3%, joining elevated bullish sentiment in signaling broad investor complacency. Carl Swenlin of DecisionPoint keeps track of the ratio of Rydex bear and money market assets to the amount of assets in Rydex bull funds. Spike contractions in this ratio are typically followed by subsequent market declines, and last week's reading - like many technical measures - pierced the Bollinger band, which is by definition beyond a two-standard deviation outlier.
Still, none of this provides assurance that the market will retreat over the short-term. This is clearly a momentum driven market, and the potential for further momentum relates more to psychology than fundamentals or even observable risks. This feels a great deal like 2000 and 2007 in stocks, and early 2008 in the commodities market, but now as then, short-term overbought conditions did not necessarily resolve immediately into major plunges. We still have a condition that I characterize as "unpleasant skew," where the mode of the expected probability distribution is still slightly positive, while the mean of the probability distribution is negative, the right tail is truncated and the left tail is fat.
In English, the most probable outcome is a small further gain, but the average outcome is a loss, because there is a modest but clearly elevated probability of a steep decline.
The upward pressure on 30-year yields here is notable. Historically, the addition of rising yields to an overvalued, overbought, overbullish syndrome has often been associated with steep corrections or new bear markets within a very short period of time (typically a few weeks, following a further price advance averaging about 2%). So the behavior of interest rates across the board is worth watching. The Strategic Growth Fund is fully hedged - still with a staggered strike position but with our put strikes trailing a few percent below the current index in recognition of the market's momentum. The Strategic International Equity Fund is also well hedged, but with a net long exposure hovering near 10% of assets due to the greater dispersion of market conditions internationally.
In bonds, the Market Climate last week was characterized by unfavorable yield levels and neutral yield pressures. As noted above, despite the Fed's confirmation of QE2, upward yield pressures actually increased, led by a surge in 30-year Treasury yields. We clipped our 10-year Treasury holdings on price strength last week, as even a 30 basis point increase in yield would be sufficient to wipe out their advantage over Treasury bills. The Strategic Total Return Fund now has a duration of less than 1 year. Likewise, we clipped our precious metals holdings to only about 1% of assets on price strength.
What investors appear to want least at present are safe, short-term, default-free assets, in preference for risk assets that have been run up to the point that they are now priced to deliver little if any sustained investment advantage. We typically observe several opportunities a year to shift our positions in bonds, precious metals shares, and other asset classes. Here and now we have shifted decidedly to the defensive side. I don't expect we will remain in this position for an extended period of time, but we currently see the prospect for small positive returns as preferable to the likelihood of negative ones.
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