Outside the Box: Notes to the FOMC

Janet Yellen, the new Fed chair, has her admirers and her detractors. One unabashed admirer is my good friend David Zervos, Jefferies’ chief market strategist, who during the past several months has taken to hollering “Dammit Janet, I love you!” He was at it again yesterday:

Last week was certainly a week for the lovers. Q’s broke to new cyclical highs, spoos moved to within just a few points of all time record highs, and Friday was St. Valentine’s day! It was all about LOVE, LOVE and LOVE! But for those folks still hiding out in the HATER camp – those who probably spent Friday evening watching Blue Valentine, War of the Roses or Scenes from Marriage – last week must have felt more like a St Valentine’s day massacre. These folks, and their econometrically deceitful overlay charts of 1927-1929 vs 2012-2014, were shredded by our new goddess of pleasure, beauty, love and of course easy money – Janet “Aphrodite” Yellen. She gave the haters a taste of the Hippolyos treatment!! And once again it was a triumph of love over hate!!

Janet delivered the perfect message for markets. Her focus on underemployment was unquestionable. Her commitment to eradicate joblessness via the power of monetary policy was also unwavering. And for anyone who thought she would be hawkish, or even middle of the road, this speech was a wake up call. The reality is that we are dealing with a die-hard Keynesian dove! It’s really not that complicated.

That said some folks seem to think the rally was mostly a function of the data. Weak ISM, payrolls, retail sales and IP were apparently the drivers of a 5 percent rally off the lows. Pullease!! That is preposterous. The reality is the market was jittery (and downright freaky) into the Fed chairmanship transition. Risk was pared back by folks who began to incorrectly price in a surprise from Janet! And leverage induced illiquidity created an overshoot to the downside. Weak hands sold, and all the usual haters came out of their bunkers to once again warn of impending doom. But as per the norm, their day in the sun was short-lived. The dust has settled and the haters lost again! Love is in the air my friends, and we owe a great deal of thanks to our new goddess of easy money. Dammit Janet, I love you! Good luck trading.

Take note of this phrase: “the new Goddess of Easy Money.” It is now in the lexicon. I wonder how many virgins will be sacrificed to this new deity. (Just kidding, Janet!)

Now, David is not above having a bit of fun in his always-entertaining commentaries, but for a somewhat more substantial take on the opening of the Yellen era, I suggest we turn to John Hussman. I wouldn’t call John a Yellen detractor, exactly, but he is certainly inclined to take the Fed down a notch or three. Check out these zingers:

While we all would like to see greater job creation and economic growth, there is little demonstrated cause-and-effect relationship between the Fed’s actions and the outcomes it seeks, other than provoking speculation in risk-assets by depriving investors of safe yield….

[T]he “dual mandate” of the Federal Reserve is much like charging the National Weather Service to balance the frequency of sunshine versus rainfall….

The FOMC should be slow to conclude that monetary policy is what ended the credit crisis…. The philosophy seems to be “If an unprecedented amount of ineffective intervention is not sufficient, one must always do more.”

At present, U.S. equity valuations are about double their norms, based on historically reliable measures.

The primary beneficiary of QE has been equity prices, where valuations are strenuously elevated. QE essentially robs the elderly and risk-averse of income, and encourages a speculative reach for yield.

I think John would agree with me that the current economic theory driving our monetary policy is both inadequate and outdated. Is it any wonder that he concludes that monetary policy as it is practiced today is simply part of the problem? It is as if we are trying to fly a 747 using the knowledge and skills we learned while driving a car, and all the while looking in the rearview mirror. (Do those things have rearview mirrors?)

You can find John’s “Weekly Market Comment” and other valuable analysis at the Hussman Funds website.

This weekend I will be writing about some of the recent analysis concerning income inequality. I’ve actually been thinking a lot about it in conjunction with the rise of the Age of Transformation. I think about it a lot, most personally in terms of my own seven kids. I’m not so concerned about income inequality as I am about income opportunity. It seems to me that we have an education system that was designed to meet the needs of the US and the Second Industrial Revolution that was grown atop the industrial British Empire.

We are simply not preparing most of our children for the challenges that lie ahead. Many of course are going to do quite well, but that will be in spite of the educational process, not because of it. The complete higher-academic and bureaucratic capture of the educational process is as much at the root of income inequality as the other usual suspects are. There is more than one cause, and another root is the manipulation of capitalism and free markets by vested interests.

But that’s all too serious, because now it’s time to hit the send button and think hard about an Italian dinner and the Miami Heat being in town. Even if Lebron James is on the other team, he is simply a pleasure to watch. Lebron, you should’ve come to Dallas to play with Dirk!

Your getting ready to sit courtside analyst,

John Mauldin, Editor
Outside the Box[email protected]

Notes to the FOMC

John P. Hussman, Ph.D.

The following are a few observations regarding Dr. Yellen’s testimony to Congress. The objective is to broaden the discourse with alternative views and evidence, not to disparage FOMC members. We should all hope that Dr. Yellen does well in what can be expected to be a challenging position in the coming years.

1. While we all would like to see greater job creation and economic growth, there is little demonstrated cause-and-effect relationship between the Fed’s actions and the outcomes it seeks, other than provoking speculation in risk-assets by depriving investors of safe yield. That’s essentially the same M.O. that got us into the housing crisis: yield-starved investors plowing money into mortgage-backed securities, and Wall Street scrambling to create “product” by lending to anyone with a pulse. To suggest that fresh economic weakness might justify further efforts at quantitative easing is to assume a cause-and-effect link that is unreliable, if evident at all, and to overlook the already elevated risks.

2. In this context, the “dual mandate” of the Federal Reserve is much like charging the National Weather Service to balance the frequency of sunshine versus rainfall. If Congress was to require the Federal Reserve to change itself into a butterfly, it would not be the fault of the Federal Reserve to miss that objective. Moreover, what is absent from nearly every reference to the dual mandate is the phrase “long run” that is repeatedly included in that mandate. It seems probable that the cyclical response to economic weakness following the 2000-2001 recession – suppressing safe yields in a way that encouraged yield-seeking and housing speculation – was largely responsible for present, much longer-term difficulties.

3. The FOMC should be slow to conclude that monetary policy is what ended the credit crisis. The main concern during that period was the risk of widespread bank insolvency, resulting from asset losses that were wiping out the razor-thin capital levels at banks. In the first weeks of March 2009, in response to Congressional pressure, the Financial Accounting Standards Board changed accounting standards (FAS 157) to allow “significant judgment” in the valuation of assets, instead of valuing them at market prices. That change coincided precisely with the low in the financial markets and the turn in leading economic measures. By overestimating the impact of its actions, the FOMC may underestimate the risks. The philosophy seems to be “If an unprecedented amount of ineffective intervention is not sufficient, one must always do more.”

4. At present, excess reserves in the U.S. banking system amount to $2.4 trillion – more than double the total amount of demand deposits in the U.S. banking system, far more than all commercial and industrial loans combined, and 25% of total deposits in U.S. banks. Short term interest rates have averaged less than 10 basis points since late-2009, when the Fed’s balance sheet $2 trillion smaller. Based on the tight relationship between monetary base / nominal GDP and short-term interest rates, it is evident that even an immediate and persistent reduction in the Federal Reserve’s balance sheet of $20-25 billion per month would be unlikely to result in even 1% Treasury bill rates until 2020, absent much higher interest on reserves. The FOMC has done what it can – probably too much. A focus on the potential risks of equity leverage (where NYSE margin debt has surged to a record and the highest ratio of GDP in history aside from the March 2000 market peak), covenant lite lending, and other speculative outcomes should be high on the priorities of the FOMC.

5. Dr. Yellen suggests that equity valuations are not “in bubble territory, or outside of normal historical ranges.” The historical record begs to differ on this. The first chart below reviews a variety of reliable valuation measures relative to their historical norms. The second shows the relationship of these measures with actual subsequent 10-year equity returns. With regard to alternate measures of valuation such as price/unadjusted forward operating earnings, or various “equity risk premium” models, it would be appropriate for the FOMC to estimate the relationship between those measures and actual subsequent market returns. Having done this, the spoiler alert is that these methods do not perform very well. In contrast, the correlation between the measures below and actual subsequent 7-10 year equity returns approaches 90%. At present, U.S. equity valuations are about double their norms, based on historically reliable measures.

The chart below shows how these measures are related with actual subsequent 10-year total returns in the S&P 500. The specific calculations are detailed in a variety of prior weekly comments (the price / revenue and Tobin’s Q models are straightforward variants of the others).

6. Finally, when confronted with the difficulties that quantitative easing has posed for individuals on fixed incomes, Dr. Yellen asserted that interest rates are low not only because of Fed policy, but because of generally lackluster economic conditions. This argument is difficult to support, because there is an extraordinarily close relationship between the level of short-term interest rates and quantity of monetary base per dollar of nominal GDP (see the chart below). With regard to long-term interest rates, it’s notable that the 10-year Treasury yield is actually higher than when QE2 was initiated in 2010, and is also higher than the weighted average yield at which the Federal Reserve has accumulated its holdings. In order to restore even 1% Treasury bill yields without paying enormous interest on reserves, the Fed would not only have to taper its purchases, but actively contract its balance sheet by more than $1.5 trillion.

The primary beneficiary of QE has been equity prices, where valuations are strenuously elevated. QE essentially robs the elderly and risk-averse of income, and encourages a speculative reach for yield. Importantly, one should not equate elevated stock prices with aggregate “wealth” (as higher current prices are associated with lower future returns, but little change in long-term cash flows or final purchasing power). Rather, the effect of QE is to give investors the illusion that they are wealthier than they really are. It is certainly possible for any individual investor to realize wealth from an overvalued security by selling it, but this requires another investor to buy that overvalued security. The wealth of the seller is obtained by redistributing that wealth from the buyer. The constant hope is to encourage a trickle-down effect on spending that, in any event, is unsupported by a century of economic evidence.

The risks of continuing the recent policy course have accelerated far beyond the potential for benefit. The Fed is right to wind it down, and as it does so, the FOMC should focus on addressing the potential fallout from speculative losses that to a large degree are now unavoidable. Ultimately, the U.S. economy will be best served by a return to capital markets that allocate scarce savings toward productive investment rather than speculative activity. The transition to that environment will pose cyclical challenges, but is well worth achieving if the U.S. economy is to escape the grip of what is now more than 15 years of Fed-enabled capital misallocation.

Like Outside the Box?
Sign up today and get each new issue delivered free to your inbox.
It’s your opportunity to get the news John Mauldin thinks matters most to your finances.

© 2013 Mauldin Economics. All Rights Reserved.
Outside the Box is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.MauldinEconomics.com.
Please write to [email protected] to inform us of any reproductions, including when and where copy will be reproduced. You must keep the letter intact, from introduction to disclaimers. If you would like to quote brief portions only, please reference www.MauldinEconomics.com.
To subscribe to John Mauldin’s e-letter, please click here: http://www.mauldineconomics.com/subscribe
To change your email address, please click here: http://www.mauldineconomics.com/change-address

Outside the Box and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA, SIPC, through which securities may be offered . MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop.