Hussman - The Grand Superstition

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.