John Hussman: Leash The Dogma

by: John Hussman

Excerpt from the Hussman Funds' Weekly Market Comment 11/4/13:

It’s fascinating to hear central bankers talk about the economy, because in the span of a few seconds they can say so many things that simply aren’t supported by the evidence. For anyone planning to watch the confirmation hearings for the next Fed Chair, the evidence below is provided as something of a leash to restrain the attacking dogma.

There’s a lot of ground to cover this week – the Phillips Curve, quantitative easing, the Fed's bloated balance sheet, the “wealth effect,” the misguided "dual mandate," and the largely unrecognized bubble in stock prices. We have a Federal Reserve relentlessly pursuing a “trickle down” monetary policy that has weak economic effects, thin historical support, and ominous implications for future investment outcomes and the stability of the financial markets. So let’s get started.

The Phillips Curve

Consider first the notion of the “inflation-unemployment tradeoff” – the so-called Phillips Curve. Part of the reason that investors fall for this idea so easily is that many of them learned it from a nicely drawn diagram in some economics textbook. Like the one below. The idea is that as the unemployment rate rises, inflation falls, and as unemployment falls, inflation rises. The belief in this tradeoff has become so dogmatic that economists often comment about how we might intentionally target a higher rate of inflation in order to bring the unemployment rate down. Nice, clean diagrams lend themselves to such simplistic and dogmatic thinking.


Quantitative Easing

The same sort of dogma can be found in other discussions of monetary policy and its presumed effectiveness. For example, quantitative easing essentially proposes that rapid increases in the monetary base can achieve reductions in the unemployment rate. But when we examine the data, we find very little to support this view, regardless of whether the relationship is posed in terms of growth rates, levels, changes, coincident changes, or subsequent changes in unemployment.

Of course, quantitative easing has had an enormous effect on the stock market in recent years. That’s not because there is any historical relationship between changes in the monetary base and the stock market prior to 2008. Indeed, in data prior to 2008, the correlation between growth in the monetary base and returns in the S&P 500 during the same year is almost exactly zero (slightly negative, actually), while the pre-2008 correlation between growth in the monetary base and returns in the S&P 500 over the following year is also almost exactly zero (again slightly negative).


The Fed's Balance Sheet

A brief update on the bloated condition of the Federal Reserve’s balance sheet. At present, the Fed holds $3.84 trillion in assets, with capital of just $54.86 billion, putting the Fed at 70-to-1 leverage against its stated capital. Given the relatively long maturity of Fed asset holdings, even a 20 basis point increase in interest rates effectively wipes out the Fed’s capital. With the present 10-year Treasury yield already above the weighted average yield at which the Fed established its holdings, this is not a negligible consideration.

Notice though, that after the 0.25% interest that the Fed pays banks to hold their reserves idle, the Fed still turns over more than 2% in interest annually to the Treasury from its debt holdings. At an estimated portfolio duration of about 8 years, it actually takes an increase in interest rates of about 0.25% annually for capital losses to wipe out interest earnings, thereby turning monetary policy into fiscal policy by creating net losses to the Treasury. Essentially, to the extent that the Fed eventually closes its holdings at a net loss, it would be as if the Treasury borrowed at a higher interest rate than it otherwise might have.

The main concern is that the more the Fed’s balance sheet expands, the more likely it is that the exit will be problematic. Already, a normalization of Treasury bill yields to even 0.25% would require a balance sheet contraction of over $1 trillion, or additional payments to the banking system approaching $10 billion annually in order to keep reserves idle. Such payments would predictably become politically contentious very quickly. Considering how glorious the expansion of the Fed’s balance sheet has been for investors, we should not be surprised if the eventual normalization turns out to be equally inglorious.


The Wealth Effect

Regardless of whether or not the faith of investors in quantitative easing is based on misattribution and superstition, hasn't the perception of its effectiveness been behind the recent advance in stock prices? The answer in the short run is an emphatic “yes.” There is no question – and we have no argument – that quantitative easing has been the primary driver of what we view as a dangerously speculative advance in equities.

Indeed, the whole point of quantitative easing, if one listens to Ben Bernanke, appears to rely on a belief that higher securities prices will make investors feel wealthier and will go out and spend, thereby creating economic demand and encouraging job creation. In effect, the Fed is pursuing what my friend John Mauldin calls “trickle-down monetary policy” – the idea that if the Fed can make the rich richer, the benefits will drizzle down to the unwashed masses. And so, Fed policy has relentlessly sought to create what is now the widest U.S. income distribution since 1929, just before the Great Depression.


The Dual Mandate

To some extent, one can’t blame the Fed for the weakness of recent economic progress, despite the massive financial distortions it has created. The dual mandate to pursue “stable prices” consistent with “maximum employment” asks the Fed to pursue employment outcomes that are poorly related to its instruments. That mandate is a relic of a long-discredited dogma that the Phillips Curve applies to general prices instead of real wages, and that the relationship can be manipulated. Unfortunately, Ben Bernanke and Janet Yellen still appear to believe this.


Stock Valuations – an unrecognized bubble

Recently, as part of his book promotion tour, Alan Greenspan has hit the media circuit. His remarks include the assertion that stocks are still attractively valued, based on his estimate of the “equity risk premium.” See Investment, Speculation, Valuation, and Tinker Bell for a full discussion of the Fed Model, “equity risk premium” calculations, and a variety of far more reliable valuation methods that are tightly associated with subsequent S&P 500 total returns.

The simple fact is that on metrics that have been reliable throughout history, and even over the past decade, stock market valuations are obscene. Importantly, these same valuation metrics were quite optimistic about prospective market returns at the 2009 low.

As a side-note, one should not confuse the message with the messenger here. It’s no secret that my insistence on stress-testing our return/risk estimation methods against Depression-era data resulted in missed returns in the interim (2009-early 2010), but none of that reflects our valuation metrics, which indicated prospective 10-year S&P 500 total returns in excess of 10% annually at the time. The real concern in 2009 was that even after similar valuations were observed during the Depression, the stock market still went on to lose two-thirds of its value. So I’m quite open to criticism about my insistence on stress-testing (which I still believe was a fiduciary obligation given the events at the time). But one should be careful in concluding that this removes the ominous implications of present valuations.