Weekly Market Comments (click for full report)
September 21, 2015
by John P. Hussman, Ph.D.

*** Critical report for understanding Fed policy consequences *** [Lionscrest]

Last week, the Federal Reserve chose to do nothing to move short-term interest rates away from zero after nearly 6 years of extraordinary policy distortion. As detailed below, the inaction of the Fed, and the failure of the stock market to advance in response, follows the script that I detailed in February. Policy makers at the Fed actually appear to believe – contrary to historical evidence and contrary even to the recent experience of numerous countries around the world – that activist monetary policy has meaningful and reliable effects on subsequent economic activity. It’s lamentable that otherwise thoughtful policy makers, much less journalists who cover these actions, show no interest in how weak these correlations are in actual data, and seem incapable of operating even the most basic scatterplot. Despite the spew of projectile money creation around the world, the global economy is again deteriorating. The main defense of the Fed’s inaction seems to be that years of zero interest rate policy have been hopelessly ineffective, so continued zero interest rate policy is necessary.

As we’ve demonstrated previously, there’s no statistical evidence in the historical record to suggest that activist monetary policy has any relationship to actual subsequent economic activity (see The Beauty of Truth and the Beast of Dogma). Historically, monetary policy variables themselves can be largely predicted by previous changes in output, employment and inflation. That “systematic” component of monetary policy does have a weak correlation with subsequent economic changes. It’s unclear whether that’s purely incidental, or whether those systematic changes in monetary variables (such as short-term interest rates) are actually necessary for the weak effects that follow. I should be careful to note that monetary policy also seems to weakly influence confidence expressed in certain survey-based questionnaires. But that correlation emphatically does not translate into changes in actual output, income, or employment. Put simply, massive activist deviations from systematic monetary policy rules provide no observable economic benefit, but instead create fertile ground for speculative bubbles and crashes.

Despite its wild grandiosity, Fed intervention was not what ended the global financial crisis. Recall that the global financial crisis ended – and in hindsight ended precisely – on March 16, 2009, when the Financial Accounting Standards Board abandoned FAS 157 “mark-to-market” accounting, in response to Congressional pressure from the House Committee on Financial Services on March 12, 2009. That change immediately removed the threat of widespread insolvency by making insolvency opaque. This might not have meant much if regulators had continued to insist on mark-to-market when evaluating bank solvency. But with regulators willing to go along, the global financial crisis ended with the stroke of a pen.

Those who hail the March 2009 replacement of mark-to-market with mark-to-unicorn as a “necessary” response miss the point (though Iceland has actually done quite well relative to the rest of the world, despite initial disruption, by insisting on massive bank restructuring rather than playing extend-and-pretend). The point is that Fed intervention did not end the crisis, nor would a global financial crisis have occurred in the first place without combination of an activist Fed and a misregulated financial sector. Absent the restoration of Glass-Steagall and greater rules-based constraints on the Federal Reserve, none of the policy responses since 2009 (including Dodd-Frank) effectively reduce the risk of similar speculative bubbles and crises in the future.

Fed easing certainly increased the stock of bank reserves and enabled banks to satisfy withdrawal demands during the crisis – the legitimate function of a central bank. Ben Benanke's violation of Section 13(3) of the Federal Reserve Act (which has since been rewritten by Congress to spell the law out like a children's book) also helped some financial insitututions illegally dump bad securities onto the public balance sheet. Despite these actions, Fed intervention did not produce the economic recovery. The entire recovery we’ve observed in the economy since 2009 has actually represented standard, systematic mean reversion. Indeed, as I demonstrated in March (see Extremes in Every Pendulum), the actual progress of the economy since 2009 has actually been somewhat below what would have been predicted from past values of non-monetary variables alone. Adding monetary variables does not meaningfully improve the power to explain either recent or historical economic fluctuations.

Instead, the main impact of suppressed interest rates is to encourage yield-seeking speculation, to give low quality creditors access to the capital markets, to misallocate scarce saving, to subsidize leveraged carry trades, to reduce the long-term accumulation of productive capital, and to foment serial bubbles and crashes.

Understand this in no uncertain terms: the only economic activities that are encouraged by zero interest rates are activities so marginal and unproductive that they can’t survive even a slightly higher hurdle rate, or where the primary cost of the activity is interest itself, such as leveraged speculative “carry” trades by hedge funds and financial institutions.

What created the housing bubble and global financial crisis? The Fed’s policy of suppressing interest rates. That’s what drove investors to seek higher yields in mortgage debt (which had until then never experienced a widespread default crisis). Wall Street responded to the demand by creating more “product,” but the only way to do that was to lend to increasingly marginal borrowers – hence subprime and no-doc lending to anyone capable of drawing a breath. Institutions, largely under the protection of government insurance, then went about the slicing, dicing and repackaging of “financial engineering” to turn garbage into flowers. Other hedge funds and institutions further enlarged the bubble through speculative carry trades: borrowing heavily at cheap rates to finance massive leveraged purchases of collateralized mortgage securities.

As that yield-seeking bubble was emerging, I observed, “why is anybody willing to hold this low interest rate paper if the borrowers issuing it are so vulnerable to default risk? That's the secret. Much of the worst credit risk in the U.S. financial system is actually swapped into instruments that end up being partially backed by the U.S. government. These are held by investors precisely because they piggyback on the good faith and credit of Uncle Sam.” The repeal of Glass Steagall (which would have prohibited banks to mingle insured banking with reckless speculation), and weak regulatory oversight certainly contributed to creating the global financial crisis. But the Federal Reserve’s suppression of interest rates was at the root of all of it.

We are doing – we have already done – all of this again, only with different instruments. The low-doc loans of the housing bubble have been replaced by the covenant-lite debt of the recent bubble. Housing has been replaced by debt-financed equity repurchases and leveraged buyouts, taking the median stock to more extreme valuations than at the 2000 peak, and putting the capitalization-weighted S&P 500 within 15% of its peak 2000 valuation on measures (e.g. market capitalization to GDP or corporate gross value added) most strongly correlated with actual, subsequent total returns on stocks. From current valuations, investors should expect zero total return on the S&P 500 over the coming decade (see All Their Eggs in Janet’s Basket).

Part of the reason the Fed found it so difficult last week to justify a move away from zero interest rates is that the Fed seems incapable of recognizing, much less admitting, the speculative risks it has created. The strongest reason to normalize monetary policy was to reduce those risks, but the proper time to have done that was years ago. At this point, obscene equity valuations are already baked in the cake on valuation measures that are reliably correlated with actual subsequent stock market returns. At this point, hundreds of billions of dollars of low-grade covenant-lite debt have already been issued at risk premiums that are next to nothing. The bursting of this bubble is no longer avoidable. If history is any guide, policy makers will manage the resulting disruption by the seat of their pants, since they seem incapable of learning from history itself.

With the Fed showing no willingness to recognize the speculative risks of what it has done, it was left trying to justify a policy normalization based on an economy that remains uninspiring. Justifying a rate increase on a purely economic basis was impossible, but the logic of leaving rates unchanged was equally tortured – that zero interest rates have had so little impact on the real economy that a continuation of zero interest rates is actually justified. In the end, the Fed was forced to play the same “we expect the economy to strengthen soon” game it has been playing for years. Unfortunately, with new orders and order backlogs uniformly weak across numerous regional Fed and purchasing manager’s surveys, and with unsold inventories accumulating, the prospects for fresh economic weakness remain much stronger than the prospects for surprising near-term strength.

In the end, we expect the following outcome to unfold over the coming quarters: a) the headline economic numbers will likely weaken rather than strengthen; b) the Fed will likely discover that the opportunity to normalize interest rates has passed; c) unless investors shift back to risk-seeking preferences, as evidenced by uniformity of market action across a wide range of internals, even fresh Federal Reserve easing can be expected to be accompanied by a steep market retreat.

by Rand Paul and Mark Spitznagel
September 15, 2015

 (Editor’s Note: Mr. Paul is a U.S. senator from Kentucky and a Republican presidential candidate. Mr. Spitznagel is the chief investment officer of Universa Investments and an economic adviser to the Paul campaign.)

The recent tumult in U.S. equity markets has prompted many analysts to urge the Fed to postpone any increase in interest rates. This advice assumes that rock-bottom interest rates are balm for a weak economy, with the only possible side effect being price inflation. Yet it is the Fed’s artificially low interest rates that set up the economy for the 2008 crisis, not to mention previous crises.

The “doves” are right to point out that higher interest rates will lead to a repricing of many securities, aka a crash. But years of near-zero interest rates have made this inevitable. Continuing on the current course will only allow structural distortions caused by these interest rates to fester and an inevitable reckoning that will be much worse than seven years ago.

The master fallacy underlying so much economic commentary is to imagine that a handful of experts in Washington should be setting the price of borrowing money. Instead, the Fed should set markets free.

In their theory of business cycles, the Austrian economists Ludwig von Mises and Friedrich Hayek explained several decades ago that artificially cheap credit misleads entrepreneurs and investors into doing the wrong things — which in the current financial context includes making unsustainable, levered investments in risky assets, including companies loading up on debt to buy back and boost the price of their stock. Low interest rates may create an illusion of robust markets, but eventually rates spike, assets are suddenly revealed to be too highly priced, and debt unpayable. Many firms have to cut back production or shut down, unemployment rises and the boom goes bust.

The Austrian diagnosis leads to an unorthodox prescription: Rather than provide “stimulus” to boost demand during a slump, the Federal Reserve and Congress should stand aside. Recessions are a painful but necessary corrective process as resources — including labor — are guided toward more sustainable niches, in light of the errors made during the giddy boom period.

In 2000 the stock market, bloated by earlier Fed rate cuts, started falling when the tech bubble burst. Markets bottomed out in 2002, as the Fed slashed rates. Although people hailed then-chairman Alan Greenspan as “the Maestro” for providing a so-called soft landing, in hindsight he simply replaced the dot-com bubble with a housing bubble.

When the housing bubble eventually burst, the crisis was much worse than in 2000. When Lehman Brothers failed in September 2008, it seemed as if the whole financial infrastructure was in jeopardy. And Fed Chairman Ben Bernanke followed the same playbook: cut interest rates.

When near-zero-percent interest rates did not jump-start the economy, the Fed launched a series of “quantitative easing” (QE) programs, buying unprecedented amounts of Treasurys and mortgage-backed securities. The Fed has roughly quintupled its balance sheet, going from $905 billion in early September 2008 to almost $4.5 trillion today.

The U.S. stock market rose with each new wave of QE. Does this wealth represent genuine economic progress? Economic growth is still far below previous recoveries. Unfortunately, the performance of equities, as well as the unprecedented increase in public and private debt, may be another asset bubble in the making, leading to another inevitable crisis likely worse than in 2008.

At its core, the market economy is a homeostatic mechanism that self-corrects by cleansing mistakes from the system. When policy makers — in the Fed or Congress — try to spare us from all pain, they cripple that mechanism and ironically make the system vulnerable to a major crash.

Consider an analogy. When the U.S. Forest Service took a zero-tolerance approach to forest fires 100 years ago, what ultimately happened was a massive wildfire at Yellowstone National Park in 1988 that wiped out more than 30 times the acreage of any previously recorded fire. Paradoxically, by refusing to allow small fires to run their natural course, the forest managers made the entire park vulnerable to a giant inferno.

What is true of forests holds for the economy: When governments create a lie, whether it’s a fabricated ecology of no fires or a fabricated economy of no failures, the truth reveals itself even more violently than otherwise. Attempts to stop any dips in the stock market with monetary stimulus postpone the necessary adjustments to how and where resources and workers are deployed. Interest rates are a vital signal in the market; they must be allowed to do their job — that is, they must be allowed to be free.

The sooner Fed officials withdraw their artificial monetary injections and let interest rates rise to their natural level set by free markets rather than government decree, the sooner the economy can return to genuine, sustainable growth.

Weekly Market Comments
September 14, 2015
by John P. Hussman, Ph.D.

The beauty of truth, and the beast of dogma

Other “relationships” that are used to justify activist monetary policy have similarly weak support when one actually takes the effort to examine the data. You’ll find a similar shotgun scatter of uncorrelated points if you plot unemployment versus general price inflation, for example. It’s unfortunate that the Federal Reserve is actually allowed and even encouraged to impose massive distortions on the U.S. economy based on relationships that are indistinguishable from someone sneezing on a sheet of graph paper.

We do know one thing very clearly, and we should have learned it during the housing bubble – suppressed interest rates encourage yield-seeking speculation, enable low-quality creditors access to the capital markets, direct scarce savings toward unproductive malinvestment, subsidize leveraged carry-trades, and unleash a whole host of “structured” products “engineered” by financial institutions to directly or indirectly piggyback on the good faith and credit of Uncle Sam.

When you examine historical data and estimate actual correlations and effect sizes, the dogmatic belief that the Fed can “fine tune” anything in the economy is utter hogwash. At the same time, the demonstrated ability of the Fed to provoke yield-seeking speculation and malinvestment is as clear as day. An activist Federal Reserve is an engine of disaster and little more. Even with the best intentions, a dogmatic Fed, unrestrained by reasonable rules and constraints, is a reckless and deceptive beast, constantly offering to heal the nation with precisely the same actions that inflicted the wounds in the first place.

Truth, on the other hand, is beautiful. Economic relationships that are supported in real-world data are a sight to behold. You want to see some relationships you can count on? The chart below shows the relationship between the 3-month Treasury bill and the ratio of the monetary base (currency and bank reserves) to nominal GDP, in data since 1929. Notice something. Without paying banks interest to hold excess reserves idle in the banking system, the Fed could reduce its balance sheet by more than one-third (over $1.4 trillion) without pushing short-term interest rates above zero. That excess base money does nothing to support the real economy.

Nobody’s desired level of saving, consumption, or real investment changes just because the Fed has chosen to force the economy to hold more base money and fewer Treasury bonds. But somebody has to hold that cash at every point in time – and nobody wants to hold it. So it simply acts as a hot potato, encouraging yield-seeking speculation in the financial markets. In my view, the most urgent action the Federal Reserve should take is to cease reinvestment of principal as the holdings on its balance sheet mature, in order to reduce this massive pool of idle base money, which does nothing but to promote speculation. No increase in interest rates would need to result from that action.

September 7, 2015
by John P. Hussman, Ph.D.
Weekly Market Comments - excerpt

The market decline of recent weeks was not a crash. It was merely an air-pocket. It was probably just a start. Such air pockets are typical when overvalued, overbought, overbullish conditions are joined by deterioration in market internals, as we’ve observed in recent months. They are the downside of the “unpleasant skew” that typically results from that combination – a series of small but persistent marginal new highs, followed by an abrupt vertical decline that erases weeks or months of gains within a handful of sessions (see Air Pockets, Free-Falls, and Crashes).

Actual market crashes involve a much larger and concerted shift toward investor risk-aversion, which doesn’t really happen right off of a market peak. Historically, market crashes don’t even start until the market has first retreated by 10-14%, and then recovers about half of that loss, offering investors hope that things have stabilized (look for example at the 1929 and 1987 instances). The extensive vertical losses that characterize a crash follow only after the market breaks that apparent “support,” leading to a relentless free-fall that inflicts several times the loss that we’ve seen in recent weeks.
--
The reason why the word “crash” has been bandied about to describe the recent selloff, I think, is partly because investors have lost all perspective of the losses that have historically been associated with that word, but mostly because it gives market cheerleaders the needed "cover" to encourage investors to continue speculating near record market valuations. After all, everyone “knows” that investors shouldn’t sell after a crash, thus the endless flurry of articles advising “selling in a crash is a textbook mistake,” “selling off stocks during a crash is a terrible idea”, “whatever you do, don’t sell”, “market crash: don’t rush to press the panic button,” “the worst investing move during a market crash,” … you get the idea.

Hand-in-hand with the exaggeration of the recent decline as a “crash” and “panic” is the exaggeration of investor sentiment as being wildly bearish. The actual shift has been from outright bulls to the “correction” camp, but that’s a rather meaningless shift since anyone but the most ardent bull would characterize current conditions as being at least a market correction. Historically, durable intermediate and cyclical lows are characterized by a significant increase in the number of outright bears. That’s not yet apparent here. Indeed, Investors Intelligence still reports the percentage of bearish investment advisors at just 26.8%.

It’s generally true that one doesn’t want to sell stocks into a crash (as I've often observed, once an extremely overvalued market begins to deteriorate internally, the best time to panic is before everyone else does). Still, the recent decline doesn’t nearly qualify as a crash. For the record, those familiar with market history also know that even “don’t sell stocks into a crash ” isn’t universally true. Recall, as an extreme example, that from September 3 to November 13, 1929, the Dow Industrials plunged by -47.9%. The market briefly recovered about half of that loss by early 1930. Even so, it turned out that investors would ultimately wish they had sold at the low of the 1929 crash. By July 8, 1932, the Dow had dropped an additional -79.3% from the November 1929 trough. In any event, the recent market retreat, at its lowest closing point, took the S&P 500 only -12.2% from its high, and at present, the index is down just -9.7% from its highest closing level in history. To call the recent market retreat a “crash” is an offense to informed discussion of the financial markets.

To understand the market cycle is to understand this: Valuations are the primary driver of long-term investment returns, but returns over shorter portions of the market cycle are driven by the attitude of investors toward risk, and the most reliable measure of this is the uniformity and divergence of market internals across a broad range of individual securities, industries, sectors, and security types, including debt of varying creditworthiness. When investors are risk-seeking, even extreme valuation may have no immediate consequence. When investors shift to risk-aversion, previously irrelevant overvaluation can suddenly matter with a vengeance.