John Hussman: Fed-Induced Speculation Does Not Create Wealth

Includes: DIA, IWM, QQQ, SPY
by: John Hussman

Excerpt from the Hussman Funds' Weekly Market Comment 3/24/14:

In recent years, by starving investors of all sources of safe return, the Federal Reserve has successfully engineered an enormous upward shift in the short-run tolerance of investors to accept risk. Unfortunately, there is no reason to believe that human nature has changed as a result, nor is there reason to believe that the long-run, full-cycle tolerance of investors to accept risk has changed. In the short run – the advancing half of the full cycle – the tolerance for financial risk can be effectively rewarded, regardless of valuation, so long as prices are advancing and valuations are becoming progressively more extreme. These episodes typically end when historically identifiable syndromes of excessive speculation appear (the most extreme version we identify emerged as early as February 2013, and again in May, December, and today). Over the complete market cycle, the tolerance for risk can be rewarded only by the delivery of cash flows that are reasonable in comparison to price paid for the investment, coupled with the absence of significant downward adjustments in valuations over time.

The same speculative pressures that have rewarded short-run risk tolerance in recent years have done so only by removing the potential rewards available for maintaining investment positions and risk-tolerance over the longer-run. The arithmetic is simple – the higher the price one pays for a claim to some stream of future cash flows, the lower the long-run return that an investor will achieve. For a review of current valuations and prospective market returns, see the March 10 comment: It is Informed Optimism to Wait For the Rain.

Fed-induced speculation does not create wealth. It only changes the profile of returns over time. It redistributes wealth away from investors who are enticed to buy at rich valuations and hold the bag, and redistributes wealth toward the handful of investors both fortunate and wise enough to sell at rich valuations and wait for better opportunities. There won’t be many, because rising prices also encourage overconfidence in a permanent ascent. Few investors are capable of enduring the discomfort of being on the sidelines for very long if a speculative market proceeds further without them.


It’s certainly true that even the most extreme variant of overvalued, overbought, overbullish, rising yield conditions we define – which previously appeared at the 1929, 1972, 1987, 2000, 2007 peaks – has emerged several times in the past year without consequence (February, March and December 2013, and again at present). In my view, the consequences have been deferred, not avoided, by faith in the Fed. Yet even thoughtful voices within the FOMC itself are increasingly concerned about the distortions that monetary policy has created.

Fed Governor (and FOMC voting member) Richard Fisher recently observed, “I fear that we are feeding imbalances similar to those that played a role in the run-up to the financial crisis. With its massive asset purchases, the Fed is distorting financial markets and creating incentives for managers and market players to take increasing risk, some of which may result in tears. And all this is happening in uncharted territory. We have aided creation of massive excess bank reserves without a clear plan for how to drain them when the time comes.” Last week, he added that the Fed’s policy of quantitative easing has “overstayed its welcome” and that the Fed has “exhausted the efficacy” of the policy.

Likewise, Fed Governor Charles Plosser appeared on CNBC last week saying “A lot of the shocks that we’ve faced, certainly in the United States, have had lasting effects on the economy. We’re not going to close that gap, and to keep thinking we’re going to do that means we overplay our hand in terms of policy. I am very worried about the potential for unintended consequences of all of this action. Expectations of what central banks can do and should do have risen to unhealthy highs.” Plosser added, “We are not the panacea, we are not the silver bullet for all the economic challenges that the world faces. Under many policy rules – and I’m a very big fan of systematic rule-like behavior on the part of monetary policy making – it will not be long before we are no longer bound by the zero bound. That is, these rules will call for higher rates.”


Based on valuation methods that have maintained a near-90% correlation with actual subsequent market returns not only historically but also in recent decades, we presently estimate 10-year nominal total returns for the S&P 500 Index averaging just 2.3% annually. It is worth remembering that these same methods indicated the likelihood of 10-year S&P 500 total returns averaging 10-12% annually in late-2008 and early-2009 (our 2009 insistence on stress-testing against Depression-era data was not based on valuation concerns). Moreover, our current estimates of prospective S&P 500 total returns are negative on every horizon shorter than about 7 years. Meanwhile, corporate bond yields and spreads are near record lows, Treasury bill yields are near zero, and the 10-year Treasury bond yield is just over 2.7%. Our friend James Montier at GMO correctly calls this a “hideous opportunity set.”

To give an indication of how hideous the opportunity set of both short- and long-horizon investors has become as a result of quantitative easing and Fed-induced speculation, the chart below shows the estimated return of a balanced portfolio that assumes an allocation of 20% in Treasury bills, 20% in corporate bonds, 20% in Treasury bonds, and 40% in the S&P 500. We currently estimate that the prospective 10-year return on such a balanced portfolio is now at the lowest level in history, at just over 2% annually. The process of driving security prices higher and prospective long-term returns lower has been greatly satisfying over the short-run. The future will be a mirror image, as it was following other historic speculative episodes.


Reminiscences of a misidentified permabear

In October 2008, after the market had plunged by more than 40%, our valuation measures indicated a clear shift to undervaluation. The challenge that emerged was not that valuations were rich, but that measures of what we call “early improvement in market action” which were quite reliable in post-war data were whipsawed like mad in the final months of 2008, as they were in the Depression-era. I leave everything I’ve written online – right, wrong, or neutral – and you can see us walk into that challenge in real-time by reviewing my rather constructive October 20, 2008 comment Why Warren Buffett is Right and Why Nobody Cares (note the section on early improvement in market action).

Measured from the market’s peak to trough, we came out of the 2007-2009 collapse virtually unscathed, but we were certainly whipsawed in late-2008. The similarity of that market action to Depression-era outcomes, coupled with what I viewed as misguided policy actions, forced a stress-testing decision that I still view as a necessary and fiduciary response. The resulting ensemble methods address that "two data sets" challenge, and we've validated them in data from market cycles across history. Taking our present methods to that period (without training them on that data), sufficient improvement in market internals did not emerge until early 2009. The market conditions required to navigate both Depression-era data and post-war data are simply more demanding than in post-war data alone. Of course, in real-time we were working to address that "two data sets" problem, and those methods were not available to us.

It’s quite easy in hindsight to assert that my insistence on stress-testing every aspect of our approach was unnecessary given improved valuations during the crisis. But it’s important to recognize that during the Depression, valuations similar to those of 2008 and 2009 were followed by an additional two-thirds loss of the market’s value. As for whipsaws, the Dow followed the initial 1929 crash by advancing fully 48% between November 13, 1929 and April 17, 1930, and then losing more than 80% of its value from there.