Excerpt from the Hussman Funds' Weekly Market Comment (3/31/14):
In the face of financial markets that we view as steeply overvalued as a result of yield-seeking by investors, an important development in the financial markets in recent months is the gradual recognition by the Federal Reserve that, in the words of several FOMC members, the policy of quantitative easing has “overstayed its welcome”, and that the Fed has attempted to “overplay its hand.” As FOMC member Richard Fisher has observed, the Fed is “distorting financial markets and creating incentives for managers and market players to take increasing risk.” Member Charles Evans – correctly in our view – openly warns “I am very worried about the potential for unintended consequences of all this action.” Esther George concurred last week “these policy settings also contain risk in the long run to financial stability.” FOMC member James Bullard observed that the Fed has set “a high bar” for moving away from tapering QE. Charles Evans and Naranya Kocherlakota, in contrast, remain dovish as ever. Among the moderates, Sandra Pianalto indicated that the first step to unwinding the Fed’s balance sheet would likely be to stop reinvesting the proceeds of maturing Treasury and mortgage debt held by the Fed.
The key observation here is that the Fed is wisely and palpably moving away from the idea that more QE is automatically better for the economy, and has started to correctly question the effectiveness of QE, as well as its potential to worsen economic risks rather than remove them.
We continue to believe that the financial crisis was ended not by QE, but instead by the March 2009 decision by the Financial Accounting Standards Board to relieve banks of the need to mark distressed assets to market, allowing “significant judgment” instead. Though QE undoubtedly helped the mortgage market to recover, nearly a century of economic history had long rendered a verdict on broader hopes for QE even before the policy began. Both theory and evidence reject the idea of a useful “wealth effect” from stock market valuations to consumer spending.
As Milton Friedman and Franco Modigliani demonstrated decades ago, consumers do not alter spending in response to variations in volatile forms of income, but instead consume based on their assessment of their probable “permanent income” over the long-term. Until 2008, variations in home values did exhibit a wealth effect, but that was because those variations were fairly smooth and unidirectional. Equity prices are anything but smooth or permanent. To offer an idea of “effect sizes,” a 40% increase in the value of the stock market would be associated with a short-lived (roughly 2-year) boost to GDP of about 2%, and a short-lived reduction in the rate of unemployment of about 1%. Needless to say, any subsequent market loss would be accompanied by similar, though also short-lived, downside risk to the economy.
Small fourth-quarter revisions for GDP and other economic statistics were released last week. Broadly speaking, we continue to observe GDP, real final sales and other economic measures hovering at growth rates that typically delineate the border between expansion and recession. With inventory accumulation the primary driver of growth in gross domestic investment, and households carrying more debt as a ratio of disposable income than at any time in history (supported only in the near-term by suppressed interest costs), we don’t observe a great deal of pent-up economic demand in the system save for the possibility of a weather-related bounce.
As I’ve noted in recent months, the correlation between historically useful leading economic measures and actual economic activity has been disrupted a great deal by quantitative easing in recent years. This has made economic projections much more difficult. So while we observe borderline economic activity, any expectation of an economic downturn would require much stronger evidence on a diverse range of measures, including equity price weakness, widening credit spreads (both on a 6-month lookback), a drop in year-over-year payroll growth below about 1.3%, and further softening in a range of national and regional Fed surveys and purchasing managers indices. As a rule, when the noise increases relative to the signal, the best information is obtained by looking for uniform shifts across several imperfectly correlated measures. We don’t yet observe that sort of uniformity.
Meanwhile, the latest economic data provide no optimism on the outlook for profit margins over the completion of the present market cycle or over the longer-term. From our perspective, the central economic relationships we’ve described previously continue to hold in current, real-world data – see The Coming Retreat in Corporate Earnings. Keep in mind, however, that some of these relationships are exerted with a lag of several quarters and are not immediate.
One of the central views underlying our investment approach is that the expected return and risk of the market varies based on observable conditions, particularly valuations, market action, sentiment, interest rates, and other factors. For an overview of these principles, see Aligning Market Exposure with the Expected Return/Risk Profile.
I have a “permabear” reputation with those not familiar with our experience in the years prior to 2009. The fact is that even our defensiveness in the late-1990’s bubble was easily vindicated by the 2000-2002 plunge, after which we shifted to a positive stance in early 2003, and then largely avoided the 2007-2009 collapse (which wiped out the entire total return of the S&P 500 – in excess of Treasury bill returns – all the way back to June 1995). Our present defensiveness is easiest to dismiss by ignoring the reason for the unique challenges we’ve faced in this particular cycle: the awkward transition resulting from my 2009 insistence on stress-testing our methods against Depression-era outcomes. For those who understand that narrative, I’ll note that my confidence in our approach is rooted in a century of market history, including how both our pre-2009 and present methods (had they been in hand) would have navigated the current market cycle in the absence of that stress-testing.
Suffice it to say that I believe that transition is behind us. Our defensiveness in recent months is not something that we are inclined to “fix,” because the objective data would have encouraged the identical defensiveness at only a small handful of similar points, including the 1929, 1972, 1987, 2000 and 2007 peaks, as well as a less extreme peak in 2011 (which still resulted in a near-20% market loss before another round of QE restored the speculative pitch).
Even the most hostile set of market conditions we identify include periods of advancing prices, and even the most favorable set of market conditions we identify include periods of declining prices. It is only over repeated instances over the course of the market cycle that we expect the average market behavior in these market conditions to dominate the random day-to-day and week-to-week noise.