“The events of the past decade demonstrate the enormous human costs of asset price bubbles and crashes.” – San Francisco Fed President John Williams, September 2013
And yet, here we are again. The Federal Reserve has now enabled the creation of a third equity bubble in hardly more than a decade. It has enabled this, in part, by intentionally targeting equity prices in a vain attempt to create a “wealth effect” that economists have known for decades does not exist – as consumers spend based on their view of lifetime “permanent income” and not based on fluctuations in volatile assets. The Fed has also enabled this, in part, by ignoring the inverse relationship between government/household deficits and corporate profit margins (which make equity valuations seem only modestly elevated on the basis of temporarily bloated earnings, even while stocks remain steeply overvalued on cyclically normalized measures). This week, the Federal Reserve is likely to make a small step toward addressing this mistake.
The breaking news is that Larry Summers has removed himself from the running for Fed Chairman, and while the choice between Summers and Yellen was largely a choice between Scylla and Charybdis, I did prefer Summers, as Yellen is a more conventional Phillips Curve thinker. We now face the prospect of Janet Yellen, who in October 2005, at the height of the housing bubble, delivered aspeecheffectively proposing that monetary policy could mitigate any negative economic consequences of a housing collapse, and arguing that the Fed had no role in preventing further housing distortions:
“First, if the bubble were to deflate on its own, would the effect on the economy be exceedingly large? Second, is it unlikely that the Fed could mitigate the consequences? Third, is monetary policy the best tool to use to deflate a house-price bubble? My answers to these questions in the shortest possible form are, ‘no,’ ‘no,’ and ‘no.’”
Fortunately, the fact is that quantitative easing is largely Bernanke’s beast, making it at least somewhat less likely that other Fed leaders will pursue this policy with the same zeal once he is gone. Indeed, even those who agree with its premises seem increasingly constrained by its already gargantuan scope. A Yellen Fed will almost surely remain interventionist in hopes of affecting outcomes where the Fed’s impact is weak (employment), while taking a benign view toward financial bubbles, resulting in repeated insults to the economy when those bubbles crash. My own preference would have been Martin Feldstein or Thomas Hoenig, but both seem unlikely choices from the President, leaving – among thoughtful choices for Fed Chairman – Roger Ferguson as the most appropriate and politically acceptable alternative to Yellen.
In a Yellen Fed, I expect our approach would not participate in speculative advances that occur within strenuously overvalued, overbought, overbullish segments of any bubble period, but that’s always where we tend not to participate, because that’s where downside risk has always been greatest. Beyond that, regardless of the Fed Chair, I have little concern that the coming cycles will be restricted to diagonal advances, forever locking the market in an overvalued, overbought, overbullish condition like the period since late-2011. This most recent speculative episode has rested largely on the novelty of “unlimited” QE and a near-superstitious belief in its effectiveness. It's only the recency of this speculation and what Galbraith called "extreme brevity of the financial memory" that makes investors believe that diagonal speculative advances are a new, permanent reality. I have no doubt that that the completion of the present cycle, and the full course of future cycles will encompass periodic retreats to more typical valuation ranges, sufficient to provide ample opportunities for risk-conscious investors.
As for the likely initial tapering of quantitative easing this week, the initial move will likely be a baby step, because while the members of the FOMC are increasingly concerned about the diminishing economic impact and increasing financial distortion created by quantitative easing, they still overlook the extent of the damage that is already baked in the cake, and the lateness of this reduction from full speed. As Martin Feldstein, the President emeritus of the National Bureau of Economic Research observed a few months ago, “The danger of mispricing risk is that there is no way out without investors taking losses. And the longer the process continues, the bigger those losses could be. That's why the Fed should start tapering this summer before financial market distortions become even more damaging.”
The step will be small, because many members of the FOMC still cling to the belief that there is some relationship between the creation of trillions of dollars in idle excess bank reserves and the creation of jobs. This is something that cannot be demonstrated on even the most basic scatterplot.
The step will be small, because the FOMC still operates on the presumption that there is a “Phillips Curve” that might allow them to buy a little more employment by creating a little more inflation. Such a tradeoff cannot be demonstrated to exist to any economically meaningful extent, and again cannot even be illustrated on a basic scatterplot. As I’ve argued before, even A.W. Phillips’ original 1958 Economica paper was actually about the relationship between unemployment and inflation in nominal wages – in a century of data where Britain was on the gold standard with a stable general price level; making the Phillips curve actually nothing but a simple labor scarcity relationship between unemployment and real wage inflation (something that actually can be demonstrated on a scatterplot, and even in U.S. data). This finding was later bent into an assertion about unemployment and general inflation – something that economists have been trying to “augment” and “instrument” for half a century because that version fails to hold true in real-world data, and certainly not to an extent that can be manipulated for the benefit of workers.
The Fed’s tapering step will be small, because Wall Street has demonstrated that it must be nursed from a bottle. Though short-term interest rates were already at zero when the Fed balance sheet was more than a trillion dollars smaller, the FOMC still discovered that it had to stage a full-scale dog-and-pony show to convince the markets that reducing the pace of its purchases was not the same thing as raising short-term interest rates. Indeed, based on the tight relationship between the monetary base (per dollar of nominal GDP) and short-term interest rates, we estimate that the Fed would have to actively contract its balance sheet by more than $1 trillion simply to engineer the first quarter-point hike in the Fed funds rate.
Assuming that the Fed adds another $300 billion or so to its balance sheet between now and the end of quantitative easing, it will have to reduce a then $3.8 trillion balance sheet to roughly $2.5 trillion (15 cents per dollar of nominal GDP) in order to achieve a 0.25% Fed Funds rate on the open market. That puts the first likely interest rate hike no sooner than late-2016, and then only if the Fed begins to contract its balance sheet by $50 billion a month beginning in June 2014.
Of course, the Fed might also be able to raise interest rates a quarter of one percent by paying roughly $9 billion a year to major banks, as incentive to hold reserves idle – paying banks an additional $9 billion annually as interest on reserves for each quarter-point hike in rates thereafter – but this will fly with the public for something like ten minutes once it goes beyond a fraction of a percent. The prospect of paying banks to hold idle reserves is particularly challenging given that the Fed is already likely insolvent, having blown through the bottom of its balance sheet with a portfolio leveraged 60-to-1 against even its stated capital, quietly wiping out that capital as long-term interest rates have surged well above the weighted-average yield at which those positions were established. The larger the Fed’s balance sheet becomes, the greater the risk that public scrutiny will demand a reduction in the Fed’s independence.
It’s quite possible that even a small taper will be too much for investors, but the alternative to tapering is to make an already precarious situation more precarious, while damaging the Fed’s credibility in the process.
For our part, what matters is not the short-term news but the long-term discipline. We are less focused on the size of the taper, the potential short-term response, and even the choice of Bernanke’s replacement than we are on constantly aligning our outlook with the prospective market return/risk tradeoff that we estimate at each point in time. Those estimates are based on a century of evidence that includes monetary factors, market action, and trend-following considerations, as well as valuations. As I’ve noted frequently, history takes a dark view of strenuously overvalued, overbought, overbullish setups, particularly once they are followed by increasing internal dispersion and technical breakdowns. Despite the recent relief rally, that set of conditions continues to be our main concern here.
Our view is that the Federal Reserve will taper its program of quantitative easing this week, in the range of a $10-15 billion reduction in the pace of monthly debt purchases. The Fed really has no “communication problem” about this – the economic impact of further quantitative easing has had diminishing returns; the economic drag from fiscal reductions has thus far been smaller than the Fed feared when it justified QEternity on the basis of those concerns last year; and the “costs and risks” of distortions related to quantitative easing have become more obvious and material (though they are still vastly underestimated as a result of temporarily bloated profit margins).
Perception and Reality
Finally, as the Fed takes the first step toward diminishing the impact of quantitative easing in economic and financial life, it’s worth considering the enormous gap between the effectiveness of QE in perception and its effectiveness in terms of real economic mechanisms. In our view, the initial advance from the 2009 low was driven not by monetary policy, but instead by a change in accounting rules by the Financial Accounting Standards Board (FASB) inApril 2009that abandoned “mark-to-market” accounting, and with it, the risk that insolvent banks would actually be treated as insolvent. So risk perceptions collapsed, and stock prices advanced. The problem is that the advance occurred at a time when the Fed was also easing. Even though both the 2000-2002 and 2007-2009 plunges occurred in an environment of aggressive and persistent monetary easing, investors allowed themselves to believe that it was the Fed’s program of quantitative easing – not the suppression of bank solvency concerns – that provoked the advance.
Put simply, beyond its effect in reducing short-term interest rates (which was exhausted more than a trillion dollars ago) and the resulting pressure on investors to reach for yield in more speculative assets, quantitative easing has been “effective” in supporting stock prices primarily because investors misattributed the 2009-2010 market advance to monetary policy rather than to the FASB’s abandonment of mark-to-market accounting. The past few years have been little more than that misattribution and self-fulfilling superstition writ large. At some point in the present cycle, this superstition is likely to prove as unfounded as the faith in the tech bubble and the housing bubble were, though I’m a bit concerned that market losses following a reduction in QE might actually strengthen the superstition that QE has real effects. In any event, we don’t know what catalyst will be associated with the completion of the present cycle. As I’ve observed before, major historical market losses have typically been in full-swing before the specific catalyst is evident (and in some cases like 1987 a specific catalyst is not evident at all).
What we do know is that over every market cycle, the range of estimated market return/risk varies enormously. The strongest opportunities accompany a moderate or steep retreat in valuations followed by an early firming in market internals. The steepest risks accompany strenuously overvalued, overbought, overbullish conditions followed by an early deterioration in market internals. I continue to believe that “broken speculative peak” is an apt phrase to describe conditions here.
Our practice is disciplined and patient – to align our outlook with the return/risk profile we estimate at each point in time; to augment our approach with new research to the extent that it can be validated in market cycles across history; to view moderate risk as necessary, but deep downside risk as something requiring active avoidance; and to release any attachment to shorter-term outcomes or forecasts. The recent episode of overvalued, overbought, overbullish conditions persisted longer than has historically been the case, but it should be needless to say that we view this as a delay rather than an avoidance of negative full-cycle consequences. This extraordinary but unfinished half-cycle has done no favors for the appeal of our risk-conscious approach recently, but then, the typical bear wipes out more than half of the preceding bull market gain (with far deeper declines emerging from valuations similar to the present), and the historical evidence remains compelling when the complete market cycle is considered (seeAligning Market Exposure With the Expected Return/Risk Profile).
Despite extraordinary events and policies that have driven the markets to another bubble peak, I’m convinced that patient, historically-informed, risk-conscious investment disciplines will prevail. The central element to any discipline is a careful analysis of market cycles across history, and the estimation of prospective return and risk on the basis of that analysis. Without that, no lesson of history is available even when nearly identical conditions arise. Even a buy-and-hold strategy imposes an effective, though very difficult, full-cycle discipline. But good buy-and-hold investors recognize that the market can experience deep losses over the course of the full cycle, realize that the depth of these periodic losses and the prospects for long-term gains are still affected by valuations, set the size of their exposures commensurate for their tolerance for risk, and diversify across weakly-correlated asset classes in order to mute the portfolio effects of deep periodic losses that they fully expect to encounter. Jack Bogle is a model of careful thinking in this regard.
The problem is that investors constantly abandon effective full-cycle strategies when those strategies encounter their own bear markets, and then pile into other effective (and ineffective) full-cycle strategies at the peaks of their own bull markets. This amounts to investing with no discipline at all.
What I fear at present is how many investors seem to be acting without the benefit of any analysis of market history (believing that we have entered some “new era” of endlessly – or at least predictably – supportive monetary policy), without attention to the relationship between cyclically-adjusted valuations and long-term return and risk, ascribing great importance to factors that have a weak historical relationship with the financial markets, attentive only to the most patently obvious trends while ignoring historically meaningful deterioration in market internals (particularly among interest-sensitive securities), and under the delusion that one can simply exit by selling to a greater fool upon the arrival of the same signal that all others await. The completion of the present cycle, immediately or over time, is likely to be an unpleasant reminder of how unkind the financial markets are to undisciplined approaches.
Though our estimates of prospective market returns remain weak on a 10-year horizon, and are unusually negative on a blended horizon ranging from 2-weeks to 18-months, we have no particular attachment to a forecast of when market losses will emerge. My guess (which we don't invest on and neither should you) is that what we view as a topping process for the market may have several more months to run, with increasing market volatility and little net progress before more severe losses unfold. At present valuations, it's enough to be confident that stronger investment opportunities will arise over the course of this market cycle as market conditions change.
In any worthwhile pursuit, I believe that the best approach to success over time is to develop an informed set of actions that you are convinced will be effective if you follow them consistently; and then follow them consistently. While the market offers a million enticing distractions, that discipline is where we choose to focus our attention.
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