The Grand Superstition (click here for website)
John P. Hussman, Ph.D.
October 28, 2013

Under existing accounting rules, banks and other financial institutions were required to report the value of the securities they held, using prevailing market prices, a requirement known as “mark-to-market.” As asset values collapsed in 2008 and early-2009 because of mortgage losses, financial institutions across the globe found themselves rapidly approaching insolvency.

As the willingness of investors to buy mortgage securities seized up, and economic activity plunged, the Federal Reserve stepped into the financial markets and became the major purchaser of existing and new mortgage securities issued by Fannie Mae and Freddie Mac. This arguably helped to support continuing activity in the housing market, but it is not what ended the crisis.

Rather, the crisis ended – and in hindsight, ended precisely – on March 16, 2009, when the Financial Accounting Standards Board abandoned mark-to-market rules, in response to Congressional pressure by the House Committee on Financial Services on March 12, 2009. The decision by the FASB gave banks “substantial discretion” in the values that they assigned to assets. With that discretion, banks could use cash-flow models (“mark-to-model”) or other methods (“mark-to-unicorn”).
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The misattribution of cause and effect in 2009 created the Grand Superstition of our time – the belief that Federal Reserve policy was responsible for ending the financial crisis and sending the stock market higher. By 2010, this narrative was so fully accepted that the Fed’s announcement of further “quantitative easing” was met by equally great enthusiasm by investors.
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Still, the rate of monetary growth has been breathtaking in recent years, relative to history, so it’s important to understand the mechanism by which QE has exerted its effects more recently. Simply put, quantitative easing impacts stock prices by creating a mountain of zero-interest cash that must be held by someone at each point in time. The hope and mechanism behind QE is to force those cash holders to feel so distressed that they reach for yield in speculative assets they would otherwise choose not to hold. The process ends at the point where investors are indifferent between holding zero-interest cash and more speculative securities such as long-term bonds or stocks. At this point, every speculative security is priced to achieve the lowest possible risk premium that investors are willing to accept. And here we are.

What’s important here is that in any environment where savers and investors actually desire relatively safe assets as part of their portfolios, quantitative easing is likely to be wholly ineffective in supporting stock prices. Recall that stock prices collapsed by half in 2000-2002 and again in 2007-2009 despite aggressive monetary easing. A friendly Fed doesn’t help stocks to advance except in environments where investors are already inclined to accept risk. To believe that QE makes stocks go up because “it just does” is superstition.
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In sum, the financial markets presently rest on a spectacular and exaggerated superstition about the power of Fed policy to impact the financial markets and the real economy. This superstition was born of crisis, and is likely to end in crisis, as investors re-learn what they should have learned about Fed policy in the 2000-2002 and 2007-2009 plunges.

By Mark Spitznagel
Investors.com
October 7, 2013

Time is nearly up for Ben Bernanke, the chairman of the Federal Reserve who supposedly applied his scholarly knowledge of the Great Depression to steer the U.S. to safety after the financial crisis.

In truth, Bernanke navigated a monetarist course that favored intensive intervention, following in the footsteps of many mainstream economists who grossly misunderstood the lessons of the Crash of 1929 and the ensuing malaise.

That lesson is that when corrective crashes occur, intervention is far from the cure — it is the cause.

Until we learn from the past, we will continue to expose ourselves to devastating booms and busts. The Bernanke-led Fed has only exacerbated the problem, leading us to the brink of an even worse correction.

To capture the lessons learned, we turn to a scholar of the Great Depression: Murray Rothbard of the Austrian School of Economics, who refutes the common misconception that "laissez-faire capitalism was to blame."

His contrarian and far less popular — yet more accurate — view is that the booms and busts of the business cycle result from shocks to the system caused by monetary intervention.

Specifically, Rothbard blames the 1929 Crash on loose monetary policy during the 1920s. For Rothbard, the boom was the problem; once the Fed pushed asset prices up to unsustainable levels, a crash was inevitable.

Without the meddling of central-bank intervention, the market — like any natural homeostatic system — can reestablish equilibrium on its own by allowing its natural entrepreneurial "governors" to work. Greater savings prompts longer-term production for future greater consumption (and the inverse). The natural order trumps intervention every time.

Laissez-faire, however, gets a bad rap because it has been erroneously attributed to President Hoover, who supposedly did little or nothing to "save" the U.S. after the Crash of 1929.

In this popular and convenient narrative, Hoover sat back and did nothing as the U.S. sunk into the depths of the Depression, while the activist Franklin Delano Roosevelt finally "got us out of the Depression" with the New Deal.

Hoover, however, was nothing if not an interventionist — and his actions prevented what could have been the "downturn of 1929-30" from resolving itself, just as the recession of 1920-21 had.

Instead, it was the government to the rescue, and the downturn became a depression.

The events leading up to the Crash and Depression form an incriminating trail. The Federal Reserve expanded bank reserves and its holdings of government securities, creating excess liquidity that flowed into a land boom in Florida followed by a stock bubble — the signature traits of mal-investment.

By Maureen Farrell  @maureenmfarrell
October 11, 2013

Mark Spitznagel expects the stock market to crash in the next year, but the chief investment officer of the hedge fund Universa thinks a debt default by the United States is unlikely to be the catalyst.

"The debt ceiling is much ado about nothing" said Spitznagel. "This is a sideshow."

Spitznagel knows a thing or two about investing in a crisis. His fund manages several billion dollars and promises portfolio protection in the event of a market correction or crash. In 2008, it returned more than 100%, while the S&P dropped by more than 40%.

Universa also has Nassim Taleb, who's famous for coining the term "black swan" to explain unforeseen events that wreak havoc on global markets, as an advisor. Spitznagel does not think a potential debt default would be such a black swan. There's been too much discussion about it.

But Spitznagel is still worried about Washington. He says the real problem facing the market is the nation's overall debt burden -- not the arbitrary debt ceiling set by Congress.

Spitznagel expects Congress and President Obama to do what it takes to avoid a near-term default. But he's concerned that neither can control the Federal Reserve's bloated balance sheet.
he Fed's ongoing bond buying program has added roughly $4 trillion to the central bank's balance sheet since the financial crisis.

"The Fed has created massive market distortions," said Spitznagel. "This kind of monetary distortion will end in a credit collapse."

Spitznagel's views are not widely accepted on Wall Street. While many investors and analysts are concerned about the disconnect between the stock market's rally and anemic economic growth, they often cite the Fed's easy money policies as a reason for optimism.

But Spitznagel says the Fed can only pump up the market for so long. Those gains will be fleeting if they can't kick start the economy and hiring. "The Fed is pushing on a string. At some point what they're doing will no longer matter," he said.

He is convinced that both the Fed and U.S. government need to rein in spending to avoid a major collapse.

If Congress and the President were to allow the U.S. to default on its obligations, Spitznagel says investors may finally be forced to grapple with the nation's "unsustainable level of debt." It won't be a good thing for the market. But the U.S. has to deal with its debt at some point.

To Spitznagel, a short-term deal to raise the debt ceiling is even more worrisome, because it would just prolong the inevitable day of reckoning.

"The system needs to repair itself, and it will be ugly," he said.

So while the black swan may not be spreading its wings over the nation's capital this month, it could sometime in the future.

Monday, 07/10/2013

Institutional investors across the world are most concerned about tail risk and rising interest rates as they begin to position their portfolios for the end of ultra-loose monetary policy in developed markets.

 
That is one of the key findings from Allianz Global Investors’ survey of nearly 400 senior decision makers at institutional investors from 41 countries around the world.
 
While only a minority of respondents expect interest rates to rise towards their long-term historical averages before 2015, rising interest rates and tail risk are seen as most prevalent economic risk factors affecting investment performance over the next three years. A quarter of investors see rising interest rates as a “great risk” and further 31 per cent see this as a “considerable risk”.  Likewise, 20 per cent of respondents describe tail risk as great and an additional 39 per cent view it as considerable.
 
Investors also recognise the double-edged nature of loose monetary policy with 59 per cent of the respondents believing that the actions of central banks have stimulated short-term GDP growth while nearly as many see an increase in inflation (57 per cent), an increase in systemic risk (55 per cent) and a deterioration in the health of the retirement savings system (54 per cent) as side effects. Over two thirds of investors (68 per cent) believe that the monetary policies of developed nations in the past five years have increased the risk of abnormal price distortions in the fixed income market.
 
In contrast to concerns about fixed income, investors’ attitudes towards equity risk are somewhat more benign.  For 60 per cent of the respondents, equity risk is seen as likely to pay off over the next three years (credit risk was mentioned by only 32 per cent).  More than 90 per cent of investors survey expect global equities to generate positive returns over the next three years, with the average expected annual return coming out at six per cent.
 
Elizabeth Corley, chief executive of Allianz Global Investors, says: “Like the investors surveyed, we expect monetary policy to be accommodative for quite some time. Nevertheless, respondents are understandably already preparing for a world where interest rates increase from their historic lows.  Bond holders are rightly concerned about capital losses when rates start to rise again as well as the inability to generate positive returns in the meantime. It is encouraging that investment in risk assets – equities – are seen as the most likely asset to pay off in the coming year.”
 
Although investors largely acknowledge the need for and benefits of greater regulation, 73 per cent of the survey respondents say that regulation comes with a price and just over half of respondents expected the policy climate to become less favourable in the next three years.  Pessimism about the regulatory environment is particularly evident in the responses from Europe.  On average, the net effect of regulation is seen to hold back annual investment performance by 2.3 per cent.
 
Of the regulatory and governance factors most likely to threaten investment performance, stricter government regulation and new capital controls and investment requirements were identified as risks over the next three years by four per cent and 31 per cent of respondents, respectively.  Nearly 27 per cent are concerned about the impact of political and regulatory environment on their ability to meet investment targets.
 
Arun Ratra, head of global solutions at AllianzGI, says: “With low yields on sovereign bonds and squeezed risk budgets, clients are challenged and are rethinking their asset allocation strategies. They look for more than managing one specific asset class against a benchmark. We clearly see demand for holistic advise and solutions that range from managing the liability side to regulatory risk reporting. For asset managers, future business success will largely depend on their ability to help clients in making capital market risk work for them in a smart way and mindful of their respective regulatory constraints.”