Seeking Alpha
, Hussman Funds (654 clicks)
Profile| Send Message|
( followers)  

Excerpt from fund manager John Hussman's weekly essay on the US market:

The stock market is currently more committed to "historically implausible themes" than at any time since the bubble peak in 2000... For example, Lowry's notes "The rally in big-caps has been deceptively narrow. As of Thursday's close, with the DJ Average within just a few points of a new all-time high, none of the 30 components rose to new all-time highs. Further, 63.3% of the components showed losses of -20% or more from their individual all-time highs, and 43.3% showed losses of -40% or more. As of Thursday's close, 5.7% of domestic common stocks rose to new 52-week highs, while 26.7% already show losses of -20% or more. A concern for the future is that this degree of selectivity has typically been found near major market tops..."

On one hand, substantial market breaks often occur within about 6 months of oncoming recessions, and it's possible that we're within that window. On the other hand, we can't rule out the possibility that investors will run with the existing "theme" for a while longer...

Of all the hopes that investors have at present, the strongest ones are centered on the Federal Reserve and its probable decisions regarding the Federal Funds rate. This obsession with the Fed comes at the expense of attention that should be focused on profit margins, normalized valuations, market internals, credit spreads, fiscal policy and the U.S. current account. In hopes of refocusing attention on factors that matter, my hope is that the following bit will further explain why the Fed is, in my view, irrelevant...

The "Federal Open Market Committee" (FOMC) is responsible for making "open market" purchases and sales, generally of U.S. Treasury securities, in order to affect the quantity of reserves (and currency) in the banking system... In principle, the FOMC lowers the Fed Funds rate by buying securities (primarily U.S. Treasuries) on the "open market."

There's no question that the Fed's open market operations determine the total supply of currency and bank reserves (the "monetary base"), but that's a power of little practical effect.

There are three problems with putting a lot of faith in the Fed's activities to significantly influence the economy, to "determine interest rates," or even to control inflation:

1) Foreign holdings of U.S. Treasuries swamp the holdings of the Fed by almost 3-to-1... Buying and selling of U.S. Treasuries by foreigners (particularly foreign central banks) swamps the impact of the Fed by more than 10-to-1.


2) Although the Fed can vary the monetary base, those fluctuations have virtually no effect on bank reserves. In the past 15 years, every single dollar of growth in the monetary base has been withdrawn from the banking system in the form of currency... To get a feel for this, since 1995, the monetary base has grown by nearly $400 billion. Meanwhile, the total amount of bank reserves has actually declined by $15 billion -- from $58 billion to the current $43 billion. That's right. The total amount of bank reserves in the U.S. banking system is just $43 billion, and that's all the FOMC is responsible for controlling. In an economy with a GDP of $13 trillion and a public debt of over $8 trillion, the Fed Funds rate is based on $43 billion of dough.

3) Since bank reserves are only required on checking deposits, which are a small fraction of the sources from which banks can lend, influencing the amount of reserves in the U.S. banking system has no effect on the volume of lending in the U.S. banking system...

The Fed is a lot like a little boy who waves his arms whenever he hears music playing, so people come to believe he's actually conducting the band... Put into perspective, the Fed's operations are relatively minuscule and are overwhelmed by the impact of foreign transactions in U.S. Treasuries. Meanwhile, there is no longer any material link between the quantity of bank lending and the bank reserves that the Fed controls. It's perfectly reasonable for investors to carefully monitor inflation, broad interest rate trends, and economic growth. However, except for the shortest duration interest rates, there's no mechanism by which Fed actions have a dominant effect on these. The Fed may have a psychological effect by dictating where it thinks short-term interest rates should be, but the whole effect requires that people believe the Fed is in control. In truth, the Emperor has no clothes.

Read more John Hussman weekly essay excerpts on Seeking Alpha.

Source: John Hussman: Undressing the Fed