Hussman - Shifting Policy at the Fed: Good for Long-Term Growth, Bad for Cyclical Bubbles

John P. Hussman, Ph.D.
Weekly Market Comment
March 31, 2014

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.
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With regard to the debt markets, leveraged loan issuance (loans to already highly indebted borrowers) reached $1.08 trillion in 2013, eclipsing the 2007 peak of $899 billion. The Financial Times reports that two-thirds of new leveraged loans are now covenant lite (lacking the normal protections that protect investors against a total loss in the event of default), compared with 29% at the 2007 peak. European covenant lite loan issuance has also increased above the 2007 bubble peak. This is an important area for regulatory oversight.
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Meanwhile, almost as if to put a time-stamp on the euphoria of the equity markets, IPO investors placed a $6 billion value on a video game app last week. Granted, IPO speculation is nowhere near what it was in the dot-com bubble, when one could issue an IPO worth more than the GDP of a small country even without any assets or operating history, as long as you called the company an “incubator.” Still, three-quarters of recent IPOs are companies with zero or negative earnings (the highest ratio since the 2000 bubble peak), and investors have long forgotten that neither positive earnings, rapid recent growth, or a seemingly “reasonable” price/earnings ratio are enough to properly value a long-lived security. As I warned at the 2000 and 2007 peaks, P/E multiples – taken at face value –implicitly assume that current earnings are representative of a very long-term stream of future cash flows.
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The same representativeness problem is evident in the equity market generally, where investors are (as in 2000 and 2007) valuing equities based on record earnings at cyclically extreme profit margins, without considering the likely long-term stream of more representative cash flows. There’s certainly a narrow group of stable blue-chip companies whose P/E ratios can be taken at face value. But that’s because they generate predictable, diversified, long-term revenue growth, and also experience low variation in profit margins across the economic cycle. Warren Buffett pays a great deal of attention to such companies. But looking at major stock indices like the S&P 500, Nasdaq and Russell 2000 as a whole, margin variation destroys the predictive usefulness of P/E ratios that fail to take these variations into account. Similarly, the “equity risk premium” models often cited by Chair Yellen and others perform terribly because they fail to capture broader variation in profit margins over the economic cycle. Even measures such as market capitalization / national income and Tobin’s Q have dramatically stronger correlations with actual subsequent market returns (particularly over 7-10 year horizons), and have been effective for a century, including recent decades.
The FOMC would do well to increase its oversight of areas where exposure leveraged loans, equity leverage, and credit default swaps could exert sizeable disruption. From a monetary policy standpoint, the effort to shift from a highly discretionary policy to a more rules-based regime is a welcome development… except for speculators banking on an endless supply of candy.