John P. Hussman, Ph.D.
First, a quick review of market conditions. Short-term measures of market action became extremely oversold mid-week, and investors took the Fed’s latest statement as an occasion to launch a fairly typical « fast, furious, prone-to-failure » rally to clear those conditions. Beyond that, however, the full ensemble of evidence remains negative at present, and we remain defensive as market internals have collapsed, our Recession Warning Composite is fully active, credit spreads have blown out as in 2008, advisory bullishness is excessive and has paradoxically increased, and valuations remain too rich.
There are certainly developments that could move us quickly to a more constructive investment stance, but the most promising one would involve a deeper decline, coupled with significant turn toward bearish sentiment and then a reversal from negative to positive breadth. While we focus more on aligning ourselves with prevailing conditions than on distinctions like « bull » or « bear » (which can only be confirmed in hindsight), strong reversals from negative to positive breadth can be useful in identifying the potential for multi-week advances during what are, in hindsight, continuing bear markets. Unfortunately, those reversals don’t tend to hold if overvalued and overbullish conditions are in place. This is particularly true given that typical pre-recession conditions are active, because further advances are likely to be used as selling opportunities. It is important to recognize that the S&P 500 is presently only about 13% below its April peak, and the word « only » deserves emphasis. Our valuation impressions align fairly well with those of Jeremy Grantham at GMO, who puts fair value for the S&P 500 « no higher than 950 » – a level that we would still associate with prospective 10-year total returns of only about 8% annually. I would consider investors to be very fortunate if the market does not substantially breach that level in the coming 12-18 months. Wall Street continues its servile attachment to forward operating earnings, seemingly unconscious that the perceived « norms » for the resulting P/E are artifacts of a bubble period. The fact is that historical periods of overvaluation and poor subsequent long-term returns correspond to forward operating P/E multiples anywhere above 12, while secular buying opportunities such as 1950, 1974 and 1982 map to forward operating multiples of only 5 or 6 (based on the strong correlation but downward-biased level of forward operating P/E ratios, when compared with multiples based on normalized earnings).
The composite of recession warning evidence we observe here (year-over-year GDP growth of just 1.6%, S&P 500 below its level of 6 months earlier, widening credit spreads versus 6 months earlier, yield curve spread at 2.2%, Purchasing Managers Index at 50.9, year-over-year nonfarm payroll growth below 1%) falls into a Recession Warning Composite that has been observed in every recession since 1950, and has never been observed except during or immediately preceding a recession. European growth has also stalled abruptly, and the latest read on consumer confidence (University of Michigan) collapsed to levels not seen since 1981. It is worth noting that while the weakness in the summer of 2010 generated enough indications of oncoming recession to prompt the Federal Reserve to kick the can down the road by initiating QE2, the Purchasing Managers Index never deteriorated below 54.4, and the print on real GDP was still 3.5% year-over-year growth. Needless to say, our concern about oncoming recession is even stronger today.
Without question, one of the notions buoying Wall Street optimism here is the hope that the Fed will pull another rabbit out of its hat by initiating QE3. That’s a nice sentiment, but it does overlook one minor detail. QE2 didn’t work.
Actually, that’s not quite fair. The Federal Reserve was indeed successful at provoking a speculative frenzy in the financial markets, which has now been completely wiped out. The Fed was also successful in leveraging its balance sheet by more than 55-to-1 (more than Bear Stearns, Lehman, Fannie Mae, Freddie Mac, or even Long-Term Capital Management ever achieved), and driving the monetary base to more than 18 cents for every dollar of GDP – a level that requires short-term interest rates to remain below about 3 basis points in order to maintain price stability ( see Charles Plosser and the 50% Contraction in the Fed’s Balance Sheet ). The Fed was indeed successful in provoking a wave of commodity hoarding that affected global supplies and injured the poorest of the poor – particularly in developing countries. The Fed was successful in setting off a very predictable decline in the value of the U.S. dollar. The Fed was successful in punishing savers and the risk averse, and driving investors to reach for yield in risky investments that they would normally avoid were it not for the absence of yield. The Fed was successful in provoking those with strong balance sheets to pay down existing higher interest-rate debt, and in creating an incentive for those with weak balance sheets to issue more of it at low rates, resulting in a simultaneous deterioration of credit quality and compensation for risk in the financial system. The Fed was successful at boosting the trading profits of the banks that serve as primary dealers, by announcing precisely which securities it would be buying prior to Treasury auctions, and buying them on the open market a few days later from the dealers that acquired them. The Fed was successful in creating a portfolio of low yielding securities that will be almost impossible to disgorge without capital losses unless the Fed holds them to maturity. On proper reflection, the list of the Fed’s successes from QE2 is nothing short of stunning.
It is beyond comprehension why anyone would wish for more of this recklessness.
Two one-way lanes on the road to ruin
The reason we are facing a renewed economic downturn is that our policy makers never addressed the essential economic problem, which was, and remains, the need for debt restructuring. There are two one-way lanes on the road to ruin, and these – in endless variation – are unfortunately the only ones on the present policy map:
1) Policies aimed at distorting the financial markets by suffocating the yield on lower-risk investments, in an attempt to drive investors to accept risks that they would otherwise shun;
2) Policies aimed at defending bondholders and lenders who made bad loans, which they now seek to have bailed out at public expense.
Government policy can act in two ways. It can alter the distribution of resources, and it can act as a coordinating mechanism to bring about ends that would be difficult to achieve through voluntary cooperation. Both functions are necessary to some extent, but the hallmark of good policy is that it preserves pro-growth and pro-social incentives (saving, investment, innovation, work, and a discerning approach to risk), protects individual liberty (as Hayek wrote, « socialism can only be put into practice by methods of which most socialists would disapprove »), and operates to relieve constraints that would otherwise be binding.
Think about Fed actions in this context. Ten-year Treasury yields were already below 3% before Bernanke breathed a word about QE2. Treasury bill yields were already at just 15 basis points. Mortgage rates were already low. A long record of historical evidence was available to demonstrate that every 1% move in stock prices has only a 0.03-0.05% impact on real GDP, and a transitory one at that. Banks already held a trillion dollars of idle reserves on their balance sheets. How could a policy targeted at further suppressing yields and distorting financial markets possibly be viewed as a way to relieve binding constraints? How could an economy already plagued by « moral hazard » possibly benefit from the belief that the Fed had provided a « backstop » for speculative risk-taking? With interest rates already at zero, what possible intent could increasing the stock of zero-interest assets by $600 billion have, except to provoke investors to « reach for yield » by accepting greater risk without the material likelihood of durable reward?
Ben Bernanke’s objective of distorting the investment opportunity set and suppressing all risk aversion is dangerous, and is ultimately hopeless as a strategy to improve economic performance. In our view, the prospect of QE3 is questionable, and would be unlikely to draw the same market response as QE2 anyway, given that investors now have more information about its ineffectiveness. The latest iteration of Fed distortion was last week’s explicit promise to suppress interest rates for two more years, until mid-2013. Even that action was met by more opposition from FOMC members than any other decision under Bernanke’s tenure. Nevertheless, the promise to extend zero interest rates for two more years is simply a further attempt – now becoming desperate – to distort the financial markets by dressing up the same pig with lipstick and a flirty dress.
Meanwhile, investors continue to hold similar hope that policy makers will take us down the other lane, which is to defend bad debt with public funds. In Europe, there might have been a kernel of sensibility a year ago to pursue short-term stabilization as a way to buy time to prepare for debt restructuring among peripheral, highly indebted countries such as Greece. But this time has been wasted, and as a result, there is increasing pressure to shift from restructuring (often called « burden sharing » there), to central bank purchases of bad debt and attempts to construct a full bailout package. Periodic news of tentative agreements on this front will undoubtedly provoke short-term relief rallies in the financial markets. Ultimately however, credit spreads continue to imply a virtually certain default of Greek debt, and I expect the eventual exit of peripheral members of the European Monetary Union from the euro. This would actually contribute to the durability of the euro under its fiscally stronger members, but it would also be chaotic, so we can expect at least a year of convulsive efforts to push off that outcome.