November 22, 2010
Outside the Oval / The Case Against the Fed
When we analyze historical relationships between economic and financial variables, it's important to examine the data for "outliers" that significantly depart from typical behavior. Very often, these outliers are corrected over time in a way that creates profit opportunities. In the office, we usually refer to these observations as being "outside the oval," because they diverge from the cluster that describes the majority of the data.
Failing to recognize data that is outside the oval can lead investors to learn dangerous lessons that aren't valid at all. A good example of this is the relationship between valuations and subsequent market returns. The chart below presents the historical relationship between the S&P 500 dividend yield and the actual annual total return achieved by the S&P 500 over the following decade. The majority of the points cluster nicely - higher yields are associated with higher subsequent returns. But there is a clear segment of the data that breaks away from the oval. I should note that the same departure is evident on the basis of P/E ratios that reflect normalized (full cycle) earnings, so this is not simply a dividend story.
Prior to about 1995, the lowest yield ever observed on the S&P 500 was 2.65%, and then only at the three most extreme valuation peaks in history - August 1929, December 1972, and August 1987. But in the mid-1990's, valuations broke free of their prior norms. As the bubble continued and yields fell further, investors observed that poor dividend yields were actually accompanied by high returns over the following decade anyway. By the time the market reached its peak in 2000, the dividend yield on the S&P 500 had declined to just 1.07%, and dividend yields were almost universally discarded as a measure of stock valuation. The intellectual case was seemingly reinforced by the idea that stock repurchases had made dividend yields an obsolete measure of valuation, even though the calculations made by Standard and Poors for both the level and the growth rate of index dividends for the S&P 500 properly reflect the impact of repurchases.
Unfortunately, discarding the information from dividend yields was the wrong lesson. As you can see in the chart, the data points eventually came back into the oval: the extraordinarily low yields observed at the tail of the bubble were followed by a decade of negative total returns, including two separate declines of more than 50% each.
Despite this outcome, investors have failed to recognize the wrong lesson that they learned. With the exception of the market bubble that took the relationship between yields and subsequent returns outside the oval, the historical evidence is very consistent that low yields (elevated valuations) are accompanied by dismal subsequent returns. At present, the yield on the S&P 500 is just 1.95%. This level can be expected to be followed with S&P 500 total returns of about 2.2% annually over the coming decade, with a confidence interval that easily includes zero. Based on normalized earnings, our projections are somewhat better, at about 4.8%. Meanwhile, our estimate based on forward operating earnings (see Valuing the S&P 500 Using Forward Operating Earnings) gives a 10-year total return projection of about 4.7% annually. Again, this is not simply a dividend story.
In recent months, we've heard a related, but also mistaken lesson from various corners of the investment community. This one suggests that poor market returns over a 10-year period, in and of themselves, can be taken as evidence that market returns over the following decade will be glorious. The problem is that this argument fails to take valuations into account. Historically, poor 10-year periods have invariably terminated with very low valuations and very high yields. It is the low valuations that resulted in high subsequent long-term returns, not the poor preceding market returns per se.
Likewise, high unemployment rates cannot be taken, in and of themselves, as a signal that subsequent market returns will be strong. Look at the relationship between the unemployment rate and the dividend yield, and what you'll find today is that the current dividend yield is way outside of the oval. Historically, high unemployment has been associated with high subsequent returns, but only because high unemployment was associated with high stock yields and depressed valuations. Not today.
Our estimates for S&P 500 total returns remain below 5% at every horizon shorter than a decade. One can argue that 5% is "attractive" relative to less than 3% on a 10-year Treasury bond, but that assumes a static world where stocks are risk-free and securities deliver their returns smoothly. If investors decide that they are no longer ecstatic about these low prospective rates of return a year or two from now, they will promptly re-price the assets to build in higher rates of expected return. Unfortunately, the way you increase the future expected rate of return is to drop the current price, and the amount by which prices would have to drop in order to normalize expected returns is enormous.
From our standpoint, it isn't likely that investors will get their expected 5% return over the coming decade in a smooth, diagonal line. Our guess is that they will instead see a large negative return over the first two years or so, followed by subsequent returns that are much closer to the historical norm. The third alternative, of course, is the bubble scenario, where stocks achieve returns above 5% annually in the immediate few years, followed by flat or negative returns for the remainder of the decade. That is certainly the pattern we observed beginning in the late-1990's.
We'll take our evidence as it comes. As I noted at the beginning of this year, as move toward 2011, we are increasingly weighting post-1940 data in setting expectations about prospective returns and risks, in the expectation that there is a wide enough range in that data to manage the residual economic risks we observe.
Presently, we have a combination of overvalued, overbought, overbullish, rising yield conditions that have been very hostile for stocks even in post-1940 data. We also have not cleared our economic concerns sufficiently to lift that depressing factor on the expected return/risk profile for stocks. It follows that changes in some combination of those factors - valuation, overbought conditions, sentiment, and economic conditions, provided that those changes aren't accompanied by a clear deterioration in market internals - would prompt us to remove a portion of our hedges (most probably covering short calls and leaving at least an out-of-the money index put option exposure in place). Unfortunately, with stocks overvalued, a shallow decline that simply clears the overbought condition would not leave much room to advance until stocks were overbought again, so the latitude for a constructive position would be limited. Ideally, we'd prefer a very substantial improvement in valuation, that is, significant price weakness that would also be accompanied by internal deterioration. In that event, as in 2003, we would look for early divergences and internal strength as an indication to remove the short-call portion of our hedges, and possibly more depending on the status of valuations and other factors at the time.
For now, we remain defensive, even purely on the basis of post-1940 relationships.
The Case against the Fed
Ever since the Bear Stearns bailout, I've been insistent that the Federal Reserve is increasingly operating outside of its statutory boundaries. As I noted in the March 31, 2008 weekly comment (What Congress and Investors Should Understand about the Bear Stearns Deal):
"The clear historical role of the Federal Reserve has been to manage the composition of Federal liabilities (by varying the mix of Treasury securities and monetary base - currency and bank reserves - held by the public). The recent transaction is a dangerous break from that role, in which unelected bureaucrats are committing public funds to facilitate private business transactions and selectively defend the holders of corporate securities. Only Congress has the Constitutional right, by the representative will of the people, to commit public funds. The Bear Stearns deal is a dangerous precedent and a dilution of Congressional prerogative."
My concerns here have nothing to do with the direction of the stock market. Ensuring the legality of Fed actions is not a Democratic issue, a Republican issue or a Tea Party issue. Rather, it is about whether we want America to function as a representative democracy. We hear a lot about the risk of "politicizing" the Fed, as if it should somehow operate outside of Constitutional checks and balances. This idea is insane. Reserving the appropriation of public funds to Congress, and by extension to the will of the American people, is central to the meaning of democracy. There is clearly a mindless carnival of circus clowns on financial television that is perfectly willing to look the other way as long as the Fed encourages risk and bails out reckless behavior. We should recognize what we stand to lose.
Over the past week, several observers have interpreted my comments about QE2 as suggesting that this second round of quantitative easing is unconstitutional. This is incorrect. Section 14.1 of the Federal Reserve Act, which relates Open Market Operations, specifically states "Notwithstanding any other provision of this chapter, any bonds, notes, or other obligations which are direct obligations of the United States or which are fully guaranteed by the United States as to the principal and interest may be bought and sold without regard to maturities but only in the open market."
It should be clear that the purchase of Treasury debt by the Federal Reserve is legal, and because Treasury securities are issued as a result of explicit Congressional appropriations, this provision of the Federal Reserve Act also constitutional. QE2 may be reckless and ill-conceived, but it is perfectly legal and constitutional.
Bernanke offered a defense of QE2 last week in Europe that was reported as "coming out swinging," but what he swung before the world was ignorance. Bernanke correctly observed that quantitative easing was capable of "moving asset prices significantly." But he incorrectly said that "we don't know what effect this will have on the real economy." In fact, we do know. The elasticity of GDP growth to stock market changes can be easily estimated to be on the order of 0.05% or less, and transitory at that. In other words, a boost to the stock market isn't interpreted by consumers as "permanent income" or stable wealth that should be consumed. Since QE2 doesn't operate on any constraint in the credit markets that is binding, it is simply a way to blow asset bubbles, and nothing more.
Paul Krugman recently said that by engaging in QE2, "it's not as if the Fed is doing anything radical." I couldn't disagree more. Look. My furnace may be intended to regulate the temperature in my house, but at the point it starts blazing at temperatures beyond anything ever intended in the wildest imagination of the engineers, there's a problem.
Maybe this aversion is a Stanford thing. My views on economics were heavily influenced by John Taylor, Joe Stiglitz (both who reject QE2 even though they are at opposite sides of the political spectrum), Tom Sargent (rational expectations), Ron McKinnon (international economics), and Robert Hall (who chairs the NBER business cycle dating committee). If I had proposed a half-brained idea like QE2 at my dissertation defense, these guys would all have looked at me and wept.
I do agree with Krugman that the U.S. could use additional stimulus spending, particularly targeted at non-residential investment, infrastructure, and R&D. With respect to the deficit, it's important to target what I'd call a "full employment surplus" - policies that could reasonably be expected to produce a surplus at a normal unemployment rate - rather than imposing austerity on an already weak economy. But as for QE2, the Fed's policy is just reckless.
b) Maiden Lane and QE1
While QE2 is clearly both legal and constitutional, this contrasts with the activities of the Federal Reserve in creating Maiden Lane and other off-balance sheet vehicles to purchase private debt, as well as the first round of quantitative easing. In these instances, I am convinced that these transactions were outside of the restrictions of the Federal Reserve Act.
QE1 was clearly the most egregious, because the Fed bought obligations of Fannie Mae and Freddie Mac outright - securities that were not "fully guaranteed by the United States as to the principal and interest," and whose issuers were insolvent and in conservatorship when the Fed bought the securities. Even though Fannie and Freddie securities maturing before 2012 have since been effectively guaranteed by the Treasury, the Fed's ownership of later maturities is still legally problematic.
Moreover, even if these purchases were consistent with the Federal Reserve Act, they still have, in Bernanke's own words, "a fiscal component." This makes them unconstitutional. The Fed cannot simply make transactions that have a "fiscal component" - such as buying bad debt to make what Bernanke calls a "money-financed gift to the private sector" - unless that expenditure is the consequence of appropriations made by law (per Article 1, Section 9 of the Constitution). Congress never intended such "money financed gifts." When you read the Federal Reserve Act itself, there are numerous provisions to explicitly prevent transactions that would risk the loss of principal, or that would perpetually roll over debt with no expectation of final payment.
c) Open Market Operations
With respect to Open Market Operations (Section 14), the restrictions in the Federal Reserve Act are important, and should probably be memorized by Congress, because I suspect that the next place the Fed may look to do "quantitative easing" will be in the area of municipal bonds, and Bernanke has demonstrated a clear willingness to ignore the obvious intent of the Act:
Notice the conservative way that the Federal Reserve Act is written. Section 14.1 (Purchase and Sale of Obligations of United States, Counties etc., and of Foreign Governments) allows the Federal Reserve (boldface mine):
1. To buy and sell, at home or abroad, bonds and notes of the United States, bonds issued under the provisions of subsection (c) of section 4 of the Home Owners' Loan Act of 1933, as amended, and having maturities from date of purchase of not exceeding six months, and bills, notes, revenue bonds, and warrants with a maturity from date of purchase of not exceeding six months, issued in anticipation of the collection of taxes or in anticipation of the receipt of assured revenues by any State, county, district, political subdivision, or municipality in the continental United States, including irrigation, drainage and reclamation districts, and obligations of, or fully guaranteed as to principal and interest by, a foreign government or agency thereof, such purchases to be made in accordance with rules and regulations prescribed by the Board of Governors of the Federal Reserve System. Notwithstanding any other provision of this chapter, any bonds, notes, or other obligations which are direct obligations of the United States or which are fully guaranteed by the United States as to the principal and interest may be bought and sold without regard to maturities but only in the open market.
2. To buy and sell in the open market, under the direction and regulations of the Federal Open Market Committee, any obligation which is a direct obligation of, or fully guaranteed as to principal and interest by, any agency of the United States .
Note: The FHA, and its financing arm, Ginnie Mae, are agencies of the U.S. Government. Fannie Mae and Freddie Mac are "government sponsored enterprises," but are private corporations that lack agency status, and whose securities are not guaranteed as to principal and interest by the U.S. government (at least those maturing beyond 2012).
Let me be clear - if Congress decides by a vote of its members to defend Fannie Mae and Freddie Mac, and to give their securities the full faith and credit of the United States, with an appropriation as to the cost of doing so, then there is no legal or constitutional problem. It may not be good policy - I'd prefer to let Fannie and Freddie pay on the existing mortgage pools without recourse for losses, and start fresh with a far more risk-based and capital-regulated entity to keep the mortgage market going - but in any event, any bailout should result from the representative will of the American people. No government bureaucrat should have the ability to take what amount to fiscal actions without an appropriation by Congress.
To revisit Bernanke's own words from his 1999 speech "Japanese Monetary Policy - A Case of Self-Induced Paralysis?":
“In thinking about nonstandard open-market operations, it is useful to separate those that have some fiscal component from those that do not. By a fiscal component I mean some implicit subsidy, which would arise, for example, if the BOJ purchased nonperforming bank loans at face value (this is of course equivalent to a fiscal bailout of the banks, financed by the central bank). This sort of money-financed “gift” to the private sector would expand aggregate demand for the same reasons that any money-financed transfer does. Although such operations are perfectly sensible from the standpoint of economic theory, I doubt very much that we will see anything like this in Japan, if only because it is more straightforward for the Diet to vote subsidies or tax cuts directly. Nonstandard open-market operations with a fiscal component, even if legal, would be correctly viewed as an end run around the authority of the legislature, and so are better left in the realm of theoretical curiosities.”
As for the Maiden Lane transactions, the Fed uses Section 13.3 of the Federal Reserve Act to justify the creation of off-balance sheet shell companies to purchase private debt of uncertain quality and undisclosed valuation. This is illegal, because it is neither authorized by, nor consistent with, the provisions of the Act.
To see this, it's essential to understand the word "discount" as it is used in the Federal Reserve Act. Discounting relates to providing short-term liquidity, and is much like providing a check-cashing service. To "discount" a note, draft, bill or other security is to purchase it at slightly less than the face value that will be delivered at a slightly later date. Think about Treasury securities. The only ones that trade on a "discount" basis are Treasury bills with maturities of less than a year. For example, if you buy a one-year Treasury at $98 and it pays $100 at maturity, you'll earn 2.04% in "interest."
Similarly, suppose a manufacturer buys $100 worth of widgets, and gives the widget maker an IOU to pay for them 30 days from today. If the widget maker sells that IOU to a bank for, say, $99 today, the note is said to be "discounted." In 30 days, the manufacturer pays the $100 to the bank to clear the obligation. Within the meaning of the Federal Reserve Act, the word "discount" is exclusively used in the context of this sort of short-term payment clearing function.
The Federal Reserve Act gives the Fed the ability to discount a wide variety of "paper." These provisions, mostly in Section 13, were put in place to guarantee short-term liquidity - again, essentially a sort of "check cashing" function. It was not intended to make long-term loans, purchase risky securities, or to provide solvency. To the contrary, there are numerous provisions to ensure that the obligations that the Fed pays off (by purchasing them at "discount") are short-term, promptly collectible, and well-collateralized.
Consider Section 13.2 (Discount of Commercial, Agricultural, and Industrial Paper). This allows any Federal Reserve bank to discount "notes, drafts, and bills of exchange arising out of actual commercial transactions; that is, notes, drafts, and bills of exchange issued or drawn for agricultural, industrial, or commercial purposes." It also provides that "Notes, drafts, and bills admitted to discount under the terms of this paragraph must have a maturity at the time of discount of not more than 90 days, exclusive of grace." That section does give the Board of Governors the "right to determine or define the character of the paper thus eligible for discount," but only "within the meaning of this Act."
Look at other provisions, and you'll also consistently see what Congress intended by the word "discount" within the meaning of the Federal Reserve Act.
Section 13.4 (Sight Drafts): "...Provided , That all such bills of exchange shall be forwarded promptly for collection, and demand for payment shall be made with reasonable promptness after the arrival of such staples at their destination: Provided further, that no such bill shall in any event be held by or for the account of a Federal reserve bank for a period in excess of ninety days."
Section 13.6 (Acceptances): "...which have a maturity at the time of discount of not more than 90 days' sight, exclusive of days of grace, and which are indorsed by at least one member bank: Provided , That such acceptances if drawn for an agricultural purpose and secured at the time of acceptance by warehouse receipts or other such documents conveying or securing title covering readily marketable staples"
Section 13.13 (Advances): "... secured by direct obligations of the United States or by any obligation which is a direct obligation of, or fully guaranteed as to principal and interest by, any agency of the United States. Such advances shall be made for periods not exceeding 90 days"
Section 13A (Agricultural Paper): "... Provided , That notes, drafts, and bills of exchange with maturities in excess of six months shall not be eligible as a basis for the issuance of Federal reserve notes unless secured by warehouse receipts or other such negotiable documents conveying or securing title to readily marketable staple agricultural products or by chattel mortgage upon live stock"
Section 24(b) (Real Estate Loans): "...Notes representing loans made under this section to finance the construction of residential or farm buildings and having maturities not to exceed nine months shall be eligible for discount as commercial paper within the terms of the second paragraph of section 13 of the Federal Reserve Act if accompanied by a valid and binding agreement to advance the full amount of the loan upon the completion of the building entered into by an individual, partnership, association, or corporation acceptable to the discounting bank."
The restriction that the Fed can only operate "within the meaning of this Act" is a real problem for the Fed.
Now, consider Section 13.3, which is the section that the Fed used as the justification for making outright purchases of questionable long-term mortgage securities from Bear Stearns:
"Section 13.3 Discounts for Individuals, Partnerships or Corporations: In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided , That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe."
It should be obvious that the Maiden Lane arrangements didn't represent "discount" transactions under any reasonable interpretation of the Federal Reserve Act. Instead, the Fed created shell companies to stash long-term securities of questionable credit quality, bought them outright, and still holds them more than two years later. This is simply illegal.
These arguments are not about whether various financial institutions should or should not be bailed out. They are about whether we have any interest in preserving a representative democracy that operates under the rule of law; or whether we instead want a fourth branch of government that operates independently of Constitutional checks and balances, where unelected bureaucrats can arbitrarily commit a greater amount of public funds in a day than the National Institute of Health spends on public research for cancer, Alzheimers, Parkinsons, autism and other disorders in a year. Count me out.
As of last week, the Market Climate for stocks remained characterized by an overvalued, overbought, overbullish, rising yields conformation that has historically been hostile for stocks. As noted above, we would be likely to take a more constructive position after clearing some combination of these factors, if it was coupled with a further improvement of various leading economic measures (Philly Fed was a start, but the overall set of measures is still negative and mixed). A constructive position, given current valuations, would most likely be limited to covering a portion of our short call positions, leaving most or all of our put option defenses in place. A significant improvement in valuations, followed by a firming of market internals, would give us more latitude for larger exposures to market fluctuations. For now, both Strategic Growth and Strategic International Equity remain tightly hedged. In bonds, the Market Climate remains characterized by unfavorable yield levels and rising yield trends. Strategic Total Return remains strongly defensive, with a duration of less than one year, and only about 4% in bond market alternatives such as precious metals, foreign currencies and utility shares.
Prospectuses for the Hussman Strategic Growth Fund, the Hussman Strategic International Equity Fund, and the Hussman Strategic Total Return Fund, as well as Fund reports and other information, are available by clicking "The Funds" menu button from any page of this website.
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