HOW LONG CAN THE DELUSION LAST?

The stock market is at extreme valuations only seen in 1929, 2000, and 2007. It is being propped up by the belief that Bernanke’s QEternity can permanently keep stock valuations valued 50% higher than historical relationships would predict. Is this time different? The answer to this question reveals whether you are a delusionist or realist.

Hussman’s article is long and filled with charts, so I’ll pick out the key takeaways.

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.

In any event, I continue to believe that it is plausible to  expect the S&P 500 to lose 40-55% of its value over the completion of the  present cycle, and suspect that whatever further gains the market enjoys from  this point will be surrendered in the first few complacent weeks following the  market’s peak. That’s how it works. If all of this seems like hyperbole, please  recall my similar concern at the 2007 peak (see Fair Value – 40% Off),  and the negative 10-year return projections – even on best-case assumptions –  that we correctly estimated for the S&P 500 in 2000. These numbers relate to the striking gap  between present valuation levels and normal historical precedent, not to  personal opinion.

Leash the Dogma 

John P. Hussman, Ph.D.     

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.

Below is what the actual data look like, depending on  exactly how the proposed relationship is stated.

The first chart shows the relationship between the  unemployment rate and the most recent year-over-year inflation rate. The  relationship isn’t even downward sloping, but more importantly, it’s  extraordinarily noisy. The clean curves presented in textbooks are so much more  convenient.

The next chart is what people have in mind when they think  of low unemployment causing inflation, and high unemployment as causing  deflation. The chart shows the unemployment rate versus the CPI inflation rate  one year later. Again, the relationship slopes the wrong way, but is in any  case an insignificant relationship lost in a cloud of noise.

Of course, one might argue that the Phillips curve is best  stated as a relationship between the unemployment rate and the change in the inflation rate over the  following year. This one at least gets the sign of the relationship right, but  that relationship is again insignificant relative to the surrounding noise.

The next chart is what people have in mind when they think  of reducing unemployment by allowing higher inflation. It shows the  relationship between the CPI inflation rate, and the unemployment rate in the following year. If one believes that  raising inflation is a way of lowering unemployment, the data is completely  unsupportive. In the real world, inflationary periods often feature economic  and speculative imbalances that are followed by recession and higher unemployment.

Without torturing every permutation of this relationship,  suffice it to say that the foregoing clouds of noise and weak relationships  show up in every other statement of the inflation-unemployment tradeoff,  regardless of whether one uses levels, changes, trailing data, subsequent data,  CPI inflation, core inflation, or mixtures of all of these.

What’s perplexing about this entire inflation-unemployment  argument is that the original “Phillips Curve” proposed by A.W. Phillips in  1958 was a relationship between unemployment and wage inflation, based on century of data where Britain was on the  gold standard and general price inflation was virtually non-existent. So the  Phillips curve is actually a relationship between unemployment and real wage inflation.

The resulting  relationship can be stated very simply: wages  rise, relative to other prices, when unemployment is low and labor is scarce;  wages fall, relative to other prices, when unemployment is high and labor is  abundant. The chart below nicely illustrates this relationship in U.S.  data. It relates current unemployment  to subsequent real wage inflation.

Unfortunately, even the true Phillips curve is emphatically not a relationship that can be manipulated to  create jobs or lower the unemployment rate. The natural response of  policy-makers and economists has been to ignore Phillips’ original formulation  and torture the data instead. This torture usually takes the form of an  “expectations augmented” Phillips Curve. This is the notion that various levels  of inflation get built into expectations, causing the Phillips Curve to shift  up and down over time, but retaining a “short-run” tradeoff that can be  manipulated.

The concept of a “natural rate of unemployment” is  closely related – the basic idea is that the Phillips Curve shifts up and down  over time, but can still be manipulated by clever policy makers with compassion  and vision. The red lines give some idea of the proposed torture to the data.

Even these short-run “Phillips Curves” are overwhelmed by  noise unless one draws so many that every few consecutive points represent a  separate little Phillips Curve – and half of them would slope the wrong way.  When one compares this mess with the true Phillips Curve – an unambiguous relationship between unemployment  and real wage inflation, it’s evident  that these alternate formulations are an effort to bend the evidence to support  an interventionist dogma.

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).

Though one can show a very high correlation between the level of the monetary base and the level of the S&P 500 since 2008, the  fact is that two reasonably diagonal lines will almost always be correlated  more than 90%. The rule is simple – if two lines run diagonally without a great  deal of intervening variation relative to that trend, the correlation will  always be nearly perfect, whether or not there is any mechanistic relationship  between them at all. If you have a four-year old child, I can nearly guarantee  that over the past four years, the correlation between the level of the S&P  500 and the height of your child has been over 90%. Heck, since the end of  2008, the correlation between the S&P 500 and a diagonal line has been 95%.

In my view, most of the response to quantitative easing reflects psychological factors rather than mechanistic ones. Certainly the scale of  QE has been enormous, and suppressed short-term interest rates have undoubtedly  motivated a reach-for-yield in more speculative assets. But it remains true  that the amount of credit market debt in the U.S. is roughly 19 times the  current size of the monetary base (with an average maturity of about 5-6 years),  while the value of U.S. equities is easily over 6 times the monetary base. So  quantitative easing effectively relies on the extent to which investors shun  zero-interest cash amounting to less than 3.9% of that available portfolio. In  any environment where low-interest but liquid and non-volatile securities  become desirable as even a small part of investor portfolios, quantitative  easing is likely to lose its presumed ability to “support” financial markets.

The other psychological contributors to the recent success  of quantitative easing are the sheer novelty of QE, as well as the  misattribution of the 2009 market rebound to monetary policy instead of the  more logical, immediate, and salient factor – the abandonment of  “mark-to-market” rules by the Financial Accounting Standards Board. In our  view, the crisis ended on precisely March 16, 2009 (see The Grand Superstition),  and had little to do with monetary policy.

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 truth is that Fed policy has the capacity to do enormous  damage by adding fuel to asset price bubbles when investors are already  inclined to take risk, yet has very little power to “support” asset prices when  investors are inclined to avoid risk (see Following the Fed to 50%  Flops). The confidence that the Fed can, in all circumstances, drive asset  prices higher is largely psychological – mostly due to misattributing the 2009  recovery to monetary policy instead of the move to end “mark to market”  accounting. Yet even to the extent that stocks have been driven higher, there  is very little evidence that the “wealth effect” on jobs and economic activity  has been large. This is something that the Fed should have understood years ago.

So let’s go to the data and examine the “wealth effect.”

The chart below presents the most generous interpretation of  the “wealth effect” that we can identify in the data. There is clearly a  positive relationship between stock market changes and changes in real GDP over  the same and subsequent year (after that, the relationship becomes negative and  much of the temporary gain is lost). The relationship explains about 18% of the  historical variation in real GDP growth rates. But notice the effect size.  Essentially, each 1% change in the S&P 500 is associated with a temporary  change of about .05% in GDP growth over the following two years, reversing  after that point. So if correlation was causality, and dollars were doughnuts,  the best-case scenario for QE –  assuming that the correlation could be perfectly manipulated – is that driving  stock prices up by 50% might help to generate a temporary increase in GDP  growth of about 2.5% over what it might have been otherwise. Of course, to the  extent that the increase in asset values was artificial, the opposite  contraction could then also be expected.

When we look more carefully at the relationship between  stock prices and GDP, an additional problem emerges. Specifically, this  relationship cannot be usefully manipulated, as all of the correlation between stock market changes and economic  growth is captured in periods where stocks were rebounding from prior lows.

See, stock market troughs tend to precede economic troughs  by a few months, and stock market recoveries from those troughs tend to precede subsequent economic recovery. It turns out  that the entire relationship between  stock price changes and economic changes is captured by the 30% of historical periods  when stocks were at least 10% below their prior two-year highs. If one excludes  these periods, the relationship between stock market gains and economic gains in  the other 70% of the data vanishes completely.

So the Fed is attempting to exploit an already weak relationship  between stock prices and economic growth, with the further complication that  nearly all of this relationship is due to the co-cyclicality of stock prices  and GDP, rather than being a true wealth effect. Friedman and Modigliani were  right – consumers spend based on their assessment of their lifetime “permanent  income,” not based on temporary fluctuations in volatile asset prices.

All of the above applies equally to the unemployment rate.  In general, each 2% variation in GDP from trend-growth is accompanied by a 1% move  in the unemployment rate in the opposite direction (a regularity known as Okun’s Law). Nearly all of the  relationship between stock prices and changes in the unemployment rate, like  GDP, are captured in the 30% of periods where stock prices were depressed by at  least 10% relative to their two-year highs. There is simply no evidence in the  historical record that stock market changes and unemployment changes are  related outside of those periods of recovery.

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.

As former Fed Chairman Paul Volcker recently observed:

“I know that it is fashionable to talk about a “dual  mandate” — that policy should be directed toward the two objectives of price  stability and full employment. Fashionable or not, I find that mandate both  operationally confusing and ultimately illusory: operationally confusing in  breeding incessant debate in the Fed and the markets about which way should  policy lean month-to-month or quarter-to-quarter with minute inspection of  every passing statistic; illusory in the sense it implies a trade-off between  economic growth and price stability, a concept that I thought had long ago been  refuted not just by Nobel prize winners but by experience.

“The Federal Reserve, after all, has only one basic  instrument so far as economic management is concerned—managing the supply of  money and liquidity. Asked to do too much—for example, to accommodate misguided  fiscal policies, to deal with structural imbalances, or to square continuously  the hypothetical circles of stability, growth, and full employment—it will  inevitably fall short. If in the process of trying it loses sight of its basic  responsibility for price stability, a matter that is within its range of  influence, then those other goals will be beyond reach.”

The Fed, very simply, is pushing on a string. It is a dogmatic  effort that is unsupported by historical evidence. Even to the extent that the  Fed’s efforts have “worked” in driving stock valuations higher, much of this  effect is due to psychological, rather than mechanistic, relationships. In the  words of Zorba the Greek, the “full catastrophe” of economic life here is  driven by dogma and superstition. This will end very badly.

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.

On the basis of a wide variety of historically reliable  fundamentals, we currently estimate 10-year S&P 500 nominal total returns  of just 2.5% annually. Notably, the Shiller P/E (S&P 500 divided by the  10-year average of inflation-adjusted earnings) is now at 25. Prior to the  late-1990’s bubble, the only time the Shiller P/E was higher was during three  weeks in 1929 that accompanied the extreme peak of the market before stocks  crashed. Meanwhile, the price/revenue ratio of the S&P 500 is presently 1.6  – a level that is double its pre-bubble norm, and even further above levels  historically associated with bear market lows.

We observe similar extremes in other reliable measures that  aren’t dominated by cyclical movements in profit margins. The apparently “reasonable”  market valuations based on margin-sensitive fundamentals (e.g. forward  operating earnings) implicitly assume that all of history can now be ignored: profit  margins will no longer be highly cyclical; margins will no longer vary as the mirror  image of deficits in combined household and government savings (see Taking Distortion at Face  Value); and they will instead permanently remain more than 70% above their historical norm.

Aside from the fact that we can fully explain the present surplus of corporate profits as the  mirror image of deficits in the household and government sectors, the other  reason to focus on normalized earnings, cyclically-adjusted earnings, revenues,  and other “smooth” fundamentals is simple: they are strikingly accurate guides across  history. Another such measure is the ratio of stock market capitalization to  nominal GDP, based on Federal Reserve Z.1 Flow of Funds data. Again, the present  multiple is about double the historical pre-bubble norm.

While the valuation of the S&P 500 Index itself was  higher in 2000, it’s notable that the overvaluation of the S&P 500 was  skewed in 2000 by extreme overvaluation in very large-capitalization stocks,  while smaller capitalization stocks were much more reasonably valued. In  contrast, we have never in history observed the median stock as overvalued as we observe presently. Indeed, the  median price/revenue ratio of stocks in the S&P 500 now exceeds the 2000  peak. Likewise, as Damien Cleusix has observed, if we examine valuations by quartiles (25% of stocks in each  bin), the average price/revenue ratio of the two middle quartiles also exceeds  the 2000 extreme.

For the sake of completeness, I should also note that  virtually every “overvalued, overbought, overbullish” syndrome we define is on  red alert. I hesitate a bit on this point, because in contrast to nearly a  century of market history where these syndromes were reliably associated with  deep losses, the emergence of these syndromes since late-2011 has repeatedly  been followed by yet further speculation (see the chart in The Road to Easy Street).  My impression remains that this is not a permanent change in market dynamics,  but simply reflects an anvil that has not yet dropped. So these  syndromes have admittedly done us no favors in the more recent period. Still,  it remains our job, and our discipline, to view market action within its full  historical context.

Among the many largely equivalent ways to define an  overvalued, overbought, overbullish syndrome, the blue bars on the following  chart present one of the many we observe at present: Shiller P/E anywhere above  18 (overvalued), S&P 500 at a 5-year high and at least 8% over its 40-week  smoothing (overbought), with bullish sentiment greater than 50% and bearish sentiment  less than 20% based on Investors  Intelligence figures (overbullish). Notice that we did not observe this particular variant in 2000 because bearish sentiment never fell below 20% in that year.  Also, while sentiment data was not available in 1929, we can impute sentiment  reasonably on the basis of past price movements. Using imputed sentiment, we  can also include 1929 in the set of instances here.

Notice that we’ve observed three instances this year – in May,  in August, and today. Given the lack of follow-through from recent syndromes,  we have to at least allow for the  possibility of a further blowoff, as the seduction of quantitative easing has  encouraged investors to ignore these conditions. On the economy, the best we  can say is that while some widely-followed Fed surveys and Purchasing Managers  indices  have improved modestly in recent  months, the most recent rolling correlation between these measures and actual economic  outcomes (employment growth, industrial production) has become even more  negative at the same time (see When Economic Data is  Worse than Useless). Again, my impression is that this is not a permanent  change in economic dynamics, but a temporary effect of distortions from  quantitative easing, but it does force us take a more agnostic view of the  economy than we might otherwise have.

In any event, I continue to believe that it is plausible to  expect the S&P 500 to lose 40-55% of its value over the completion of the  present cycle, and suspect that whatever further gains the market enjoys from  this point will be surrendered in the first few complacent weeks following the  market’s peak. That’s how it works. If all of this seems like hyperbole, please  recall my similar concern at the 2007 peak (see Fair Value – 40% Off),  and the negative 10-year return projections – even on best-case assumptions –  that we correctly estimated for the S&P 500 in 2000. These numbers relate to the striking gap  between present valuation levels and normal historical precedent, not to  personal opinion.

None of our own challenges in this decidedly unfinished  half-cycle relate to our consistent ability to correctly assess long-term  investment prospects. We may yet see some amount of further short-term speculation,  but already for the median stock, the long-term investment outlook has never  been worse.

The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Only comments in the Fund Notes section relate specifically to the Hussman Funds and the investment positions of the Funds.

Fund Notes

As of last week, Strategic Growth Fund remained fully  hedged, with a “staggered strike” position that raises the strike prices of its  index put options somewhat closer to present market conditions. With the  resurgence of multiple “overvalued, overbought, overbullish” syndromes on a  wide range of criteria, we have no basis to speculate on a further short-term  blowoff here, even though we can’t rule it out. My impression is that even very  short-term measures are stretched, so some amount of retreat in overbought  conditions and overbullish sentiment might encourage a modest position in index  call options as a constructive hedge against any climax in the recent  speculative run (though remaining well-hedged otherwise due to longer-horizon  concerns). We’ll let the evidence drive our discipline. For now, we remain  defensive. Meanwhile, Strategic International remains fully hedged. Strategic  Dividend Value remains hedged at about 50% of the value of its stock holdings.  In Strategic Total Return, we clipped our precious metals holdings back to  about 5% of assets early last week, also taking the duration of the Fund below  6 years (meaning that a 100 basis point move in interest rates would be  expected to impact Fund value by less than 6% on the basis of bond price  fluctuations). The Fund presently holds about 4% of assets in utility shares.