Weekly Market Comment
by John Hussman
17 February 2014

Excerpts:

Following a moderate decline from its recent highs, the market experienced a “reflex” advance last week. As I noted in the February 3 comment, “Even the shallow 3% retreat from the market’s all-time highs may be enough to prompt a reflexive ‘buy-the-dip’ response in the context of extreme bullish sentiment here, as the S&P 500 bounced off of a widely monitored and steeply ascending trendline last week that connects several short-term market lows over the past year. Regardless, the potential for short-term gains is overwhelmed by the risk of deep cyclical and secular losses.”

Needless to say, our concerns are little changed by the last week’s advance, and with this low-volume reflex rally in place, we may observe a much deeper and uncorrected loss if the prior resolutions of severely overvalued, overbought, overbullish, rising-yield conditions are an indication.

We would dismiss historical analogs like this if the recent market peak did not feature the “full catastrophe” of textbook speculative features – particularly the same syndrome of extreme overvalued, overbought, overbullish, rising-yield conditions observed (prior to the past year) only at major market peaks in 2007, 2000, 1987, 1972, and 1929. The main temptation to ignore this concern is that similarly extreme conditions emerged in both February and May 2013 without consequence. Less extreme variants of this syndrome have also emerged periodically in the past few years (these variants also capture 1937 and a few other bull market peaks, as well as the April 2011 peak after which the market briefly retreated by nearly 20%). Overall, my view continues to be that the consequences of the more recent instances have not been avoided, but merely deferred – and those consequences will be worse for it."

Regardless of the patterns that have emerged in recent months, it’s important to recognize that the implications of extremely overvalued, overbought, overbullish conditions are not necessarily immediate. In 2000, the March high was followed by a series of retreats and recoveries, with a marginal new high in total-return terms as late as September 2000 before the market lost half of its value. In 2007, the August high was followed by an initial retreat and recovery into a very marginal final peak in October 2007 before the market lost half of its value. In 1972-73, an initial decline of nearly 20% from the market peak was followed by an advance in October 1973 that brought the S&P 500 and Dow Industrials within 7% of their highs before completing a near-50% market loss. In contrast, the reflex advances from the 1987 and 1929 peaks were rather short-lived, and were followed by steep losses within a span of weeks. Market cycles often display regularities, but investors should never conclude that they follow precise rules.

Jim Grant - Stocks are set for a big fall, thanks to the Fed
By Matthew J. Belvedere - CNBC's "Squawk Box"
Monday, 24 Feb 2014

James Grant, Founder & Editor of Grant's Interest Rate Observer, shares his perspective on the role of central bankers.

The Federal Reserve's massive bond buying and near-zero-interest-rate monetary policy has set up the stock market for a big fall, said Jim Grant, founder and editor of Grant's Interest Rate Observer.

"My fear is because that interest rates are suppressed, therefore earnings are inflated," he told CNBC's "Squawk Box" on Monday. "So when rates go up … the 'hall of mirrors' is shattered and we look at each other and see what actually is real rather than what the Fed wants us to believe."

If it were up to him, Grant said, the Fed would not have intervened at the time of the 2008 financial crisis because the markets and wages should have been given a chance to hit rock bottom.

"What happens in a capitalist economy when there is not intervention?" he asked. "Prices get low enough to invite buyers to come in and seize that value."

Besides artificially increases stocks, Grant said that Fed intervention has been counterproductive to economic growth. "We have been living through a very persuasive demonstration of futility of intervention to solve a recession."

"It is now year six of this 'monetary improv' … [and] we're making it up as we go along," he added.

Using a baseball metaphor, Grant said: "We don't know exactly day-to-day where the strike zone is … how many strikes you get … nor what the distance is from home plate to first."

"Sometimes they change the rules after the game is over," he added.

February 20, 2014, 3:52 pm

Every time Janet L. Yellen, the chairwoman of the Federal Reserve, testifies in Congress, she can expect some senators to scoff and representatives to question.

But Washington’s critics pale next to Wall Street’s.

Since the financial crisis, the Fed has engaged in an aggressive stimulus campaign, which has helped lift stock and bond markets, greatly enriching Wall Street in the process. Even so, a surprisingly large number of investors and bankers remain deeply skeptical — and even angry — about what the Fed is doing.

Many of them say the central bank’s policies are causing harm — and they are confident that Ms. Yellen, who succeeded Ben S. Bernanke as chief this month and is extending his policies, will fail spectacularly. “I don’t really like the Fed very much,” said Jeffrey E. Gundlach, chief executive of DoubleLine, an investment firm. “I wish the Fed were not manipulating the market the way it is.”

In many ways, the Fed bashing, which remains widespread and undimmed five years after the crisis, is not surprising. Financiers have always weighed in on the economic policy questions of the day. And it is in character for certain top Wall Street figures to believe they are smarter than the government employees who have the actual job of fighting unemployment.

Yet, to hear the Fed’s critics tell it, their antipathy toward the central bank is not motivated by a reflexive opposition to government intervention, but by a desire to end the big booms and busts that have hurt the economy in recent
decades.

Some of them have backed progressive causes, and assert that the Fed’s policies are widening the divide between the rich and poor. “It does seem that in spite of all the rhetoric you hear, it is not stopping the polarization of wealth,” Mr. Gundlach said.

The Fed’s critics have gotten some of their biggest predictions wrong. The central bank’s stimulus did not create inflation or debase the dollar. The Fed’s supporters on Wall Street credit it with taking bold actions after the crisis that, they say, averted a terrible slump that would have made life far harder for people on lower incomes. The Fed itself has acknowledged that its easy money policies have costs as well as benefits. Fed officials have made it clear that they are on the lookout for new dangers like excessive speculation in the markets.  “I believe I am a sensible central banker and these are unusual times,” Ms. Yellen said in Congress this month.

Still, the detractors say that the Fed has learned little, and seems doomed to commit the same mistakes as in the past 30 years.  “My guess is that the Fed will play its usual game till we’re in good old-fashioned bubble territory,” said Jeremy Grantham, co-founder of GMO, an investment firm. He took umbrage at Ms. Yellen’s recent arguments in Congress for why the stock market is not particularly overvalued. “Either she is ignorant about the markets,” he said, “or on the other hand she is cynical and she is manipulating the market.”

One theory unites the faultfinders — and it conveniently allows them to keep issuing warnings even as the economy shows signs of strength. The critics contend the Fed’s near-zero interest rates and huge bond-buying programs have acted a lot like steroids, creating an artificial recovery that could wane as the Fed removes the stimulus. “This is the drug that masks the symptoms rather than treats the disease,” said Todd Harrison, a former hedge fund manager and the chief executive of Minyanville, an online financial media company.

One reason that low interest rates cannot create a lasting recovery, the critics said, is that cheap borrowing costs do very little when so many people are already heavily indebted. In this climate, according to the Fed’s opponents, it is wrongheaded, and perhaps futile, for the central bank to encourage people to take out more loans.

“Trying to solve an indebtedness problem by getting further into debt only compounds the problems,” said Lacy H. Hunt, chief economist of Hoisington Investment Management. “You have to clear the debt.”

Many of the Fed bashers promote alternative policies that can sound harsh.  They argue that the economy would have bounced back more robustly since the financial crisis if the central bank had done less, because, they assert, capitalism works best when it is allowed to purge itself of uneconomic activity. “The economy might have snapped back a lot more strongly,” Mr. Grantham said. By intervening less, he added, the Fed “would have broken the back of moral hazard, just as Volcker did when he broke inflation,” referring to Paul A. Volcker, a former Fed chairman who pursued tough policies in the 1980s.

Though there are many Fed baiters on Wall Street, most of the financial industry has a generally favorable view of the central bank. And the Fed’s supporters shudder when they hear their peers calling on it to do less.

The Fed’s sympathizers say that it would have risked a bigger banking collapse and a depression if it had not opened the floodgates after the crisis. Short of entirely changing the way in which the global banking system operates, which simply wasn’t going to happen, there was not much else the Fed could do to keep things afloat, they say.

“The Fed has been doing what it can to stabilize this inherently unstable system, but we are still left with the system,” Tony Crescenzi, a portfolio manager at Pimco, said. In addition, defenders of the Fed argue that its policies can foster the economic conditions that enable a lightening of the country’s debt load that is not dangerously jarring. Ray Dalio, founder of Bridgewater Associates, a hedge fund, calls this a “beautiful deleveraging.”

But James S. Chanos, of Kynikos Associates, a hedge fund, asserts that an important measurement of debt is actually higher than it was before the crisis. “That beautiful deleveraging has not happened,” he said. “We are more leveraged as a society than we were in 2007 at the onset of the financial crisis.”

The longer the Fed fuels borrowing, the worse things are becoming, the critics say. Mark Spitznagel, founder of Universa Investments, a hedge fund that profited during the 2008 crash, argues that by holding down interest rates, the Fed encourages companies to take up unhealthy habits, like borrowing to fund purchases of their own shares. “That’s outrageous behavior,” he said. “The Fed has entirely forced people to do this.”

It has come to the point where the Fed’s detractors wonder whether it has fallen victim to a school of thought that can only resort to easy money policies. “Sometimes you get a groupthink around a base assumption,” David Einhorn, president of Greenlight Capital, a hedge fund, said in 2012. “We’ve reached that point here with monetary policy.” Mr. Einhorn contends that the extremely low interest rates on savings are actually depriving people of income that could substantially bolster the wider economy.

The Fed’s supporters roll their eyes when Wall Street rushes to the defense of savers. Such remarks, they say, stem from ignorance about how the economy works during periods of adjustment. Mike Konczal, a fellow at the Roosevelt Institute, points out that John Maynard Keynes noted during the Great Depression that financiers expected unrealistically high returns on their capital. Testifying in Congress this month, Ms. Yellen herself said, “The rate of the return savers can expect really depends on the health of the economy.”

Still, many of the critics expect they will be proved right when, as they predict,
the Fed’s policies lose their power. When that happens, a big loss of confidence will occur, which will roil the markets and the economy, they forecast. “They’ve gotten themselves boxed into a corner,” Mr. Gundlach said.

Mr. Grantham said that he thought the Fed’s largess would drive stocks so high that they will become vulnerable to even the slightest nudge.
“We all feel like old-fashioned gramophone records,” he said. “It is the same
old game and we keep saying the same old things.”

Guy Haselmann
ScotiaBank

Markets have been unwelcoming and volatile since Janet Yellen’s swearing-in ceremony on Monday morning.  She should not take it personally as market agita is the result of a confluence of factors.  Certainly, the FOMC deserves a large portion of the blame as years of ‘pedal to the metal’ strategy demolished the ability of the Fed to know what the market’s reaction function would be once they eased off the accelerator.  Few should be surprised that there were a number of risk-seeking investors who were waiting for ‘tapering’ as the catalyst to reduce risk and to remove capital from a few EM countries.

To be fair, some of the troubles that have arisen in EM countries are isolated country-specific problems, but few should dispute that capital outflows have occurred due to ‘tapering’; thus, exacerbating their challenges.  

A quick reminder is in order.  One main goal of the extraordinary measures of Fed policies (QE and ZIRP) was to lift asset prices. In this regard, the Fed was successful as the S&P rose 160% above its 2009 low (from 676 to 1848).  The S&P is also coming off of a 32% year and posted double digit gains in 4 of the last 5 years.  Credit spreads have had an equally impressive surge.  Junk bond yields (oops, they are called ‘high-yield’) have declined more than 1500 basis points from 2009 spread levels.

Despite recent market weakness, the S&P is only 5.2% below all-time high prices; yet, investor worry seems quite substantial.  Part of the reason is due to the speed of the descent (5%+ in three weeks).  However, the magnitude (not speed) of the decline is quite small given the enormous gains in recent years; and therefore, it will not prevent the Fed from continuing its tapering path.

The drop in the 10 year yield to 2.65% should actually provide further encouragement and cover for further QE withdrawal.  The hurdle to ‘taper the taper’ (i.e. pause) is exceptionally high.

There is only one way that the lofty asset price levels could have been maintained and that was for enough economic growth to be generated in order for the economic fundamentals to justify the prices.  For too long, investors have given the Fed the benefit of the doubt that its policies would be able to achieve this outcome; consequently, they loaded-up on risk assets.  They believed that if the economy should falter, the Fed would merely react by staying accommodative until economic activity improved.  The ‘Fed put’, clearly, resulted in wide-spread moral hazard and investor complacency.  

The shift to ‘tapering’ when the global economy appears under strain now leaves investors in a quandary.  The fact that investors have begun to question the effectiveness of further asset purchases and whether much more can be provided without causing financial instability has roiled investor mindsets. The most recent Fed Minutes have unveiled these as valid concerns.   The impact of ‘tapering’ along with the challenges exposed in China (Trust securities), Japan (Abenomics and imported energy costs), and EM countries (capital outflows and interest rate hikes) are forming a toxic mix for risk-assets.

The toxic brew, after several years of double digit portfolio gains, means that prudent investors and portfolio managers are well-advised to reduce risk (and stop justifying out-sized risk exposures by ‘fear of missing the upside’).

Risk positions have accumulated over several years, therefore three weeks of volatility (and the resulting minor correction) witnessed recently are probably only a small fraction (and indication) of what is yet to come.

Poor market liquidity will likely intensify capital flows and force transactions at sub-optimal prices. The most liquid instruments will start to command higher liquidity premiums.  Should global challenges deteriorate further or contagion advance, a meaningful reduction in growth and inflationary expectations are likely to arise.  This potential scenario may (be necessary to) propel Treasury prices higher and through the 2.5% yield on the 10-year note.

Bloomberg View - by Barry Ritholz, February 6, 2014

Not long ago, I was listening to former Federal Reserve Chairman Ben Bernanke discuss the central bank’s actions during and after the financial crisis. I came away very impressed with how thoughtful and intelligent the former head of Princeton’s economics department was. Combining a deep academic background in the Great Depression with outside-the-box thinking made him the perfect person to lead the Fed during this period.

There was one issue in particular that bothered me about his tenure, and it isn't a minor one. It is the Federal Open Market Committee's focus on the so-called wealth effect, and its corollary impact, the stock's reaction to Fed policy.

Let’s begin with a quick definition: The wealth effect is an economic theory that posits rising asset prices leads to beneficial effects in consumer sentiment, retail spending, along with corporate capital expenditure and hiring. It is based on a belief in a virtuous cycle that begins with equity prices. As they rise, investors and senior corporate managers begin to feel more secure and comfortable in their financial circumstances. This improvement in psychology releases the “animal spirits,” along with a commensurate increase in spending. Pretty soon thereafter, the entire economy is moving on the right direction.

But Fed policy makers seem to have gotten this precisely backward. Their premise is based upon a flawed statistical error, one that confuses correlation with causation. Building an entire thesis upon a flaw is likely to lead to poor results.

Why is the wealth effect a flawed theory?

Start with that correlation error: What actually occurs during periods where stock prices are rising? As Benjamin Graham observed, over the long term, markets act like a weighing machine -- valuing equities based on their cash flow and earnings. During periods of economic expansions, it is the rising fundamental economic activity that reflects the positive things wrongly attributed to the wealth effect. Companies can hire more and increase their capital spending. Competition for labor leads to rising wages. Employed, well-paid workers spend those wages on capital goods such as cars and houses, and discretionary items like entertainment and travel.

Oh, and along with all of these economic positives, the stock market is buoyed as well, by increasing profits and more buoyant psychology.

In other words, all of the same forces that drive a healthy economy, leading to happy consumers spending their plump paychecks, also drive equity markets higher. The Fed, though, seems to think that the stock-market tail is wagging the fundamental economic dog.

As we saw in the mid-2000s, it wasn't the wealth effect driven by rising home prices that led to greater economic activity, but rather access to cheap and widely available credit.

The flaw in this thesis is even more obvious when we consider the distribution of equity ownership in the U.S. The vast majority of employees and consumers have only modest investments in equities. When we look at 401(k)s, IRAs and other investment accounts, we see these are primarily held by the well-off. Ownership of equities is heavily concentrated in the hands of the wealthiest Americans. Start with the top 1 percent: They own about 40 percent of stocks (by value) in the U.S. The next 19 percent owns about 50 percent. That leaves the remaining four-fifths of American families holding less than a 10 percent stake in the stock market.

With so few people actually invested in the results of the stock market, how can it have such a broad effect on consumer spending? It doesn’t, unless the Fed wants to make the case that it is driven primarily by the trickle-down effect. I doubt they would want to do so for obvious political reasons.

Which leads to a Fed policy that has become overly concerned with the markets reaction to well, everything. Fed policy, FOMC member speeches, even FOMC minutes are obsessively considered in light of how markets will react to them. This is a terrible and unique Fed error. It makes for bad policy and worse governance in a democracy.

Some might perceive the wealth effect and the focus on market reactions to be two distinct issues. In reality, they are so closely intertwined that they are effectively two sides of the same coin.

The Fed must put to rest this flawed approach, and along with it a wealth of poor policy decisions.