April 9, 2012
Is the Fed Promoting Recovery or Desperation?
On Friday, the Department of Labor reported that March non-farm payrolls increased by 120,000, falling well short of consensus expectations in excess of 200,000. For our part, we continue to expect a deterioration in observable economic variables, with weakness that emerges gradually and then accelerates toward mid-year. On the payroll front, our present expectation is that April job creation will deteriorate toward zero or negative levels.
Immediately after the payroll number was released, CNBC shot out a news story titled "Disappointing Jobs Report Revives Talk of Fed Easing." Of course it does, because this remains a market dependent on sugar. And with little doubt the Fed will eventually deliver it - perhaps following a market plunge of 25% or more - but with little doubt nonetheless, because like the indulgent parent of a spoiled toddler, the FOMC can't stand to see Wall Street throw a tantrum without reaching for a lollipop.
If the Fed indeed steps in with an additional round of QE, a few distinctions may be helpful. First, regardless of Fed actions, and even in the past few years, the market has invariably suffered significant losses following the emergence of the "overvalued, overbought, overbullish, rising-yields" syndrome that we presently observe. In contrast, the main window where it has not paid to "fight the Fed," so to speak, has been the period coming off of oversold lows. That's primarily the window where financials, cyclicals, materials, and garbage stocks with highly leveraged balance sheets have outperformed. Regardless of the fact that QE has had no durable economic benefits (more on that below), and does little but to repeatedly lay fresh wallpaper over the rotting edifice that is the global banking system, the main effect of QE has been to provide temporary support for the most speculative corners of the financial market after they have been pummeled.
Strategically, then, we concede that there is some latitude to ease back on defensiveness between the point where QE induces an early improvement in market internals and an upturn in various trend-following indicators (coming off of a previously oversold condition), and the point where an "overvalued, overbought, overbullish, rising-yields" syndrome is established. But once that syndrome is established, it is unwise to ignore it, and a defensive stance becomes essential (as we saw separately in 2010 and 2011, not to mention at most major market tops over history). Meanwhile, it is unwise to believe that additional rounds of QE will do much to help the economy in any event, as its primary effect is merely to drive investors into speculative investments by starving them of safer yields.
There is a very well-defined theoretical and empirical relationship between the monetary base and targets like short-term interest rates and monetary velocity (see Sixteen Cents: Pushing the Unstable Limits of Monetary Policy), but investors should note that the response of the stock market and other financial assets to quantitative easing is far more based on superstition than on structure. We can observe, for example, that drowning the financial markets in zero-interest assets has tended to lower the yields (and therefore raise the prices) of higher-risk, longer-duration assets, but that response is dependent on a certain form of myopia. Specifically, investors either have to assume that they can safely speculate until some particular date arrives on the calendar and they can all take their profits simultaneously, or they have to ignore the tendency for low prospective long-term returns to go hand in hand with quite negative prospective intermediate-term returns. For that reason, any "QE indicator" we might develop (as several people have requested) would likely be spurious and not very robust going forward, even though one might be back-fitted to the data. A better approach, as noted above, is to take a signal from market action and trend-following measures, but emphatically to also impose several alternate exit criteria - including for example a deterioration of those measures, or the establishment of an overvalued, overbought, overbullish, rising-yields syndrome. I remain convinced that investors who simply have blind faith that QE is reliably bullish in and of itself, or can be trusted to limit losses, will have their heads handed to them.
How QE "works"
Keep in mind that the U.S. banking system has trillions of dollars sitting in idle deposits with the Fed already. Quantitative easing simply does not relieve any constraint that is binding on the economy. Rather, QE is a method by which the Fed hoards longer-duration, higher-yielding securities like U.S. Treasury bonds and replaces them with cash that bears zero interest. At every moment in time, somebody has to hold that paper. The only way for the holder to seek a higher return is to trade it for a more speculative asset, in which case whoever sells the speculative asset then has to hold the cash. The process stops when all speculative assets are finally priced so richly and precariously that the people holding the cash have no further incentive to chase the speculative assets, and are simply willing to hold idle, zero-interest cash balances.
Why does the Fed want this? Simple. Chairman Bernanke believes that by creating a bubble in speculative assets, people will "feel" wealthier and keep consuming - regardless of the fact that real incomes are stagnant and debt burdens are already intolerable, and despite the fact that there is extremely weak evidence for any such "wealth effect" in the historical record. Undoubtedly, it would be difficult for Bernanke to refrain from these reckless policies when everyone is crying "do something!" But the willingness to tolerate short-term criticism in the interest of long-term benefit is part of what separates leadership from cowardice.
In my view, individuals like Sheila Bair - the former head of the FDIC, Paul Volcker - the former Fed Chairman, and Elizabeth Warren - the former head of the Congressional oversight panel for TARP, demonstrated leadership in elevating the interests of the public over the interests of bank bondholders, reckless lenders, and entrenched interests. Unfortunately, all of their voices were stifled during the credit crisis - though hopefully some provisions of the Volcker Rule will survive, particularly those related to bank restructuring. We would be far along the road to economic recovery had we dealt with our crisis the way Sweden durably dealt with its own in the early 1990's (essentially taking a large portion of the banking industry into receivership, wiping out existing shareholders, writing down bad assets, and then taking the banks public to recapitalize them under new owners). Bernanke, in contrast, has been at the forefront of the kick-the-can strategy of bailouts, accounting changes, customizable stress tests, and helicopter money.
Given the bubbling concerns among various FOMC members about inflation risk, the next round of QE is likely to be "sterilized." Essentially, the Fed would buy Treasury bonds from banks, and would pay for them with newly created cash, but the Fed would then borrow those funds back from banks, holding them as idle deposits with the Federal Reserve. By definition, the additional "liquidity" created by a sterilized round of QE would not be available for new lending (as if there aren't enough idle reserves in the banking system already). So again, the main goal is to increase the outstanding stock of zero- and low-interest assets in the economy, in order to lower the yields and increase the prices of more speculative investments.
Now, if you think carefully about this, you'll recognize that the U.S. government is still running a deficit of more than 8% of GDP, so the Treasury will have to issue more than a trillion dollars of new debt in the coming year anyway. Given that banks already hold trillions of dollars in idle balances, the Treasury could have the identical effect of an additional round of QE simply by issuing a larger portion of the new debt as very short-term T-bills, which also yield next to nothing. So why bother doing this as "quantitative easing" when the Treasury could just change the maturity profile of the new debt all by itself?
Well, for one, the Treasury securities are issued on the open market. The Fed typically pre-announces which issues it will buy, allowing the banks that act as primary dealers to essentially front-run: buying the newly issued debt from the Treasury in expectation of getting a higher price from the Fed. So doing all of this as QE has the benefit of handing the banks a nice trading profit. Second, the Fed has an awful lot of Treasury debt on its balance sheet, which is leveraged about 50-to-1 against its own capital. By purchasing Treasury securities and creating zero-interest cash (or low-interest reserves), the Fed essentially earns a spread that can cover any shortfall it might experience if it is ever forced to unwind its position and sell any of those securities at a loss. It's true that if the Fed earns any surplus interest, it has to go back to the Treasury, but the surplus rendered back to the Treasury is only what remains after a night on the town in the Fed's balance sheet.
Finally, the reason for doing QE through the Fed (rather than simply changing the maturity profile of the new Treasury debt) is that Wall Street - at least - believes that the Emperor is actually wearing clothes. Despite the fact that the main effect of QE is to boost speculation and release brief bursts of pent-up demand, both which immediately soften when the policies are suspended, this recurring pattern is still unclear to many investors and analysts. As long as that delusion persists, we can expect the Fed to periodically exploit it.
Ignore that the side-effect of this delusion is the misallocation of capital toward speculative assets in the belief that the Fed has set a "put option" under the markets. Forget that savings are discouraged, bad lending decisions are rescued, incentives and economic signals are distorted, and the accumulation of productive capital is disabled. We have the most creative, entrepreneurial nation on the planet, but our policy makers are intent on preventing debt restructuring and misallocating scarce capital. As a result, they continue to compromise long-term growth in favor of temporary bouts of short-term speculation.
What about recent employment gains?
But wait. How can we say that quantitative easing has such weak effects on the economy when we've clearly enjoyed a significant amount of job creation since mid-2009? Isn't that clear evidence that Fed policy is working?
Well, that depends on what one means by "working."
Last week, we observed "Real income declined month-over-month in the latest report, which is very much at odds with the job creation figures unless that job creation reflects extraordinarily low-paying jobs. Real disposable income growth has now dropped to just 0.3% year-over-year, which is lower than the rate that is typically observed even in recessions." It wasn't quite clear what was going on until I read a comment by David Rosenberg, who noted that much of the recent growth in payrolls has been in "55 years and over" cohort. Suddenly, 2 and 2 became 4.
If you dig into the payroll data, the picture that emerges is breathtaking. Since the recession "ended" in June 2009, total non-farm payrolls in the U.S. have grown by 2.32 million jobs (establishment survey, or 2.03 million using Household survey figures). However, if we look at workers 55 years of age and over, we find that employment in that group has increased by 3.04 million jobs. In contrast, employment among workers under age 55 has actually contracted by nearly one million jobs, regardless of which survey you use. Even over the past year, the vast majority of job creation has been in the 55-and-over group, while employment has been sluggish for all other workers, and has already turned down.
For most of history prior to the late-1990's, employment growth in the 55-and-over cohort was a fairly small and stable segment of total employment growth. Undoubtedly, part of the recent increase has simply been a change in the classification of existing workers as they've aged (1945 + 55 = 2000, so the we would have expected to see some gradual bulge in this bracket since 2000 due to aging baby boomers). But the shift is too large to be explained simply by reclassification. Indeed, while the civilian labor force participation rate has declined significantly for virtually every class of worker since mid-2009, the participation rate for workers over the age of 65 has hit new highs. The over-55 and over-65 cohorts have a reservoir of skills and experience, but real income is growing much slower than employment, which means that they are not being fully compensated for it. And despite the much-vaunted uptick in hourly wages, real after-inflation wages have been falling. Something more troubling has been underway.
Beginning first with Alan Greenspan, and then with Ben Bernanke, the Fed has increasingly pursued policies of suppressing interest rates, even driving real interest rates to negative levels after inflation. Combine this with the bursting of two Fed-enabled (if not Fed-induced) bubbles - one in stocks and one in housing, and the over-55 cohort has suffered an assault on its financial security: a difficult trifecta that includes the loss of interest income, the loss of portfolio value, and the loss of home equity. All of these have combined to provoke a delay in retirement plans and a need for these individuals to re-enter the labor force.
In short, what we've observed in the employment figures is not recovery, but desperation. Having starved savers of interest income, and having repeatedly subjected investors to Fed-induced financial bubbles that create volatility without durable returns, the Fed has successfully provoked job growth of the obligatory, low-wage variety. Over the past year, the majority of this growth has been in the 55-and-over cohort, while growth has turned down among other workers. Meanwhile, broad labor force participation continues to fall as discouraged workers leave the labor force entirely, which is the primary reason the unemployment rate has declined. All of this reflects not health, but despair, and helps to explain why real disposable income has grown by only 0.3% over the past year.
It's important to recognize that our concerns about the stock market here are independent of our economic concerns, in that the "Angry Army of Aunt Minnies" we've recently observed are associated with very negative average market outcomes regardless of economic conditions. Even in the past few years, the emergence of these conditions has invariably been followed by declines that have wiped out all of the intervening gains since the earliest signal was observed.
As noted above, even in the event of another round of quantitative easing, the particular window to ease back on a defensive position would be between the point where QE induces an improvement in market internals and an upturn in various trend-following indicators (coming off of a previously oversold condition), and the point where an "overvalued, overbought, overbullish, rising-yields" syndrome is established. To ignore the syndromes we observe at present, in the hope that the hope of QE will be sufficient to limit market risk, is a strategy that would not have been successful even in recent years.
Still, though our present market concerns are independent of economic concerns, they are also reinforced by those economic concerns. We've reviewed various lines of evidence, from leading indicators to "unobserved components models," and I continue to view the coming weeks as a likely minefield of economic disappointments. The issue here remains the distinction between leading, coincident and lagging measures of the economy. As I've noted before, a tendency toward positive economic surprises over this period would improve the underlying economic state that we infer from observable data, but here and now, the most leading components remain clearly negative. The concerns are also clearly compounded by the uniform deterioration in economic measures in Europe, China and India, among other regions. The charts below convey the general situation.
Over the weekend, the New York Times published a good article (Some Dreary Forecasts from Recovery Skeptics) that summarized the concerns of a number of economic observers, placing Lakshman Achuthan of the ECRI and me into the classification of "perma-bears." Actually, with respect to the economy, I'm pleased to be in good company, and don't greatly object to the "perma-bear" label in that I continue to believe major underlying economic problems have merely been kicked down the road and remain unresolved (primarily an overhang of unserviceable debt, which continues to need restructuring, and which will leave the global economy prone to recurring crises until that happens).
I also periodically get the "perma-bear" label with respect to my views on the financial markets. While I do believe that stocks have been generally overvalued since the late-1990's (a view that is supported by the predictably dismal overall total returns on stocks since that time), I do think that some observers misclassify the 2009-early 2010 period as being a reflection of our standard investment strategy instead of what it was - a period when we suspended risk taking until we were confident that we had adequately stress-tested our methods against Depression-era data. That may seem like a distinction without a difference, but the difference is that for most periods since 2000, our present investment methods would do very little differently than we actually did in practice (though there are of course a few moderate differences due to various refinements and ongoing research). The 2009-early 2010 period is distinct in that it is not at all indicative of the hedge position that can be expected of our strategy in future market cycles, even under identical conditions and evidence. The fact that we removed about 70% of our hedges in 2002 (when our projection for 10-year S&P 500 total returns was not much more compelling than what it is today), should be some evidence of that.
Financial markets fluctuate, and prospective returns change. We will undoubtedly have ample opportunities to accept financial risk in expectation of reasonable returns, and if history is any guide, those opportunities will emerge well before our economic problems are behind us. What concerns me here is the refusal of investors to even recognize those problems; the army of hostile syndromes we observe in both financial and economic data; the blind faith that simply changing the mix of Treasury debt and bank reserves can produce growth and put a floor under speculative assets; the near-complete denial of ongoing debt strains; and heavily bullish sentiment that Investors Intelligence correctly notes is now in "territory associated with market tops."
As of last week, the Market Climate for stocks remained characterized by a hostile "overvalued, overbought, overbullish, rising-yields" syndrome, and a variety of other hostile syndromes that I've reviewed in recent comments. Strategic Growth and Strategic International Fund remain tightly hedged here. Strategic Dividend Value has a hedge equal to about 50% of the value of its holdings - its most hedged stance. Strategic Total Return continues to have a duration of just under 3 years, and a small percent of assets in utility shares and foreign currencies. We raised our exposure in precious metals shares to just over 4% on last week's price weakness, but there too, our stance remains decidedly conservative at present.
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