September 7, 2003
John P. Hussman, Ph.D.
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The more I reflect on the current economic environment, the more I come back to the concept of interdependence, or more precisely, the interbeing of things. The notion of interbeing rejects the idea that anything has a truly separate self. Rather, "self" is really made of non-self elements; every thing has origins, every action has consequence. This is because that is; this is not because that is not. The idea is inherent in the koans "How many elephants are in this blade of grass?" and "What is the sound of one hand clapping?"
In economics, we have a similar notion called "general equilibrium." It is a much more demanding view of economics than the "partial equilibrium" analysis practiced in most research. In partial equilibrium, the essential qualifier is ceteris paribus - other things being equal. Partial equilibrium allows us to examine the effect of a change in the supply or demand in a given market, on the assumption that other conditions in the economy are held constant.
In general equilibrium, that qualifier is dropped. Everything is analyzed as part of an interdependent system in which changes in one market affect all the other markets. Rather than the simple partial equilibrium condition "supply equals demand," general equilibrium approaches look for a solution to a whole system of interrelated equations derived from preferences, technology, profit maximization, utility maximization, budget constraints, and market clearing in the markets for labor, capital, output and financial assets.
Only partial equilibrium thinking allows statements like "Money is going out of Treasuries and into stocks." General equilibrium looks closer and recognizes that if bonds are being sold by Mickey, they have to be bought by Nicky; if stocks are being bought by Mickey, they have to be sold by Ricky. So in order to understand what is happening, we have to know more than Mickey's actions. We also have to know how eager Nicky and Ricky are to make these trades. It is the general equilibrium between stock, bond, and money markets that determines whether Mickey's trades will result in higher or lower stock prices, higher or lower bond prices, higher or lower short-term interest rates.
In fact, Mickey's selling Treasuries and buying stocks may not be associated with lower bond prices and higher stock prices at all. Suppose that these trades are in response to new bankruptcy risks, making Ricky frantic to sell stock, and Nicky frantic to buy Treasuries, while Mickey thinks that the entire response is overblown. In that case, Mickey's selling bonds and buying stocks would be accompanied by higher bond prices and lower stock prices. In every case, you have to know who are the other agents in the general equilibrium and which one is most eager in order to understand the outcome properly.
General equilibrium leads directly to the law of unintended consequences. It is what creates a health care crisis from a small wrinkle in the tax code. Specifically, by allowing full deductibility for employer-provided insurance from all income and payroll taxes, yet little deductibility of costs borne at the personal level, there is enormous bias toward full, employer-provided insurance, creating an all-you-can-eat health care system where prices fail to provide any effective constraint on demand.
General equilibrium is why there is no such thing as government stimulus, assuring that fiscal and monetary interventions must always take the form of redistributions and reallocations, which are only stimulative if those policies ease some constraint that is binding. General equilibrium is why the currency and government securities produced by these reallocations represent not aggregate wealth, but claims of some members of society on the future production of others. (This is also why Robert Barro, not Eugene Fama nor Kenneth French, ought to receive the Nobel Prize in economics.)
Then again, there's no harm in ignoring insignificant things like the price of tea in China, is there?
Why the single most important risk to the U.S. economy is the price of tea in China
With general equilibrium in mind, I want to go back to a little-recognized risk that could quickly throw the U.S. economy into a deep recession: abrupt revaluation of the Chinese yuan (renminbi). I first discussed this risk in a July article called Freight Trains and Steep Curves, and again in the Annual Report of the Strategic Total Return Fund. Last week, Bill Gross of Pimco echoed these concerns in his September commentary, which is worth reading.
Though I discussed the risk that an abrupt revaluation of Asian currencies would have, I also viewed that risk as somewhat remote - an important element to watch but not any sort of imminent threat. After all, China and Japan seemed to be willing to continue with the status quo, and nobody in the Administration would possibly provoke an event that could so profoundly destabilize the U.S. economy.
Well, in a move that is simply beyond comprehension, Treasury Secretary John Snow last week tried to jawbone China and Japan into revaluing their currencies relative to the U.S. dollar (i.e. to allow their currencies to become more expensive). In the unilateralist, partial equilibrium, no-unintended-consequences world that is the Bush Administration, more expensive Asian currencies are a way of protecting U.S. manufacturers from the competition of cheap imports. In the general equilibrium world that is reality, the potential effect of this policy could be disastrous.
How to quickly eliminate our gaping current account deficit
Recall that every major expansion in the U.S. economy has begun with a current account surplus. This means that the U.S. had not only enough savings to finance its own investment, but was even sending savings overseas by purchasing foreign securities. This allowed the U.S. to finance huge investment booms, first by drawing on those excess savings, and then by quickly moving to a current account deficit and importing savings from foreigners. Needless to say, with the U.S. presently running the deepest current account deficit in history, our ability to finance much sustained growth in domestic investment (factories, housing, equipment, capital spending) is sharply limited. Even our present level of economic activity is dependent on the largest inflows of foreign capital in history, largely from China and Japan.
In effect, the factor that allows the U.S. to continue its consumption binge, finance its investment, extend its housing boom, run irresponsibly large government deficits, swap corporate debt payments into ridiculously low short-term interest rates, and maintain unusually high valuations in the equity markets - the quiet support that keeps this whole house of cards standing - is the willingness of Asian economies to accumulate an endless supply of U.S. dollar assets (largely Treasury and U.S. agency securities). That willingness is driven by one goal - to hold their currencies down in relation to the U.S. dollar.
Incomprehensibly, the Administration is now trying to pressure China and Japan to give up that goal. If this effort succeeds, and particularly if that success is abrupt, surging short-term interest rates, higher corporate defaults, and a collapse in U.S. domestic investment would likely follow. As I used to teach my students, there is a really quick way to "balance" a current account deficit (which is also the main way that it happens in practice): plunge the economy into a deep recession. This isn't our expectation yet. It is, however, an increasing risk born of misguided economic analysis.
The Market Climate for stocks remains characterized by unusually unfavorable valuations and modestly favorable market action. We have, however, taken the opportunity from the recent market advance to increase our hedge to cover about 2/3 of our stock portfolio, meaning that we are now accepting only 1/3 of the impact of market fluctuations inherent in the stock portfolio that we hold.
At present, stock valuations are as high as they were at any prior market extreme except the year 2000 peak, roughly matching valuation highs seen in 1929, 1965, 1972 and 1987. The real question is whether investors actually learned anything from the decline of the past three years. Aside from the recognition that stocks don't go straight up, my inclination is to believe that investors have learned precious little. An unrepentant chorus of investment strategists and Wall Street analysts continues to deliver the proposition that stocks move on the basis of near-term economic direction and earnings momentum. The concept of stocks as a claim to a long-term stream of free cash flows does not seem to enter their analysis, nor does the acceptable rate at which those cash flows should be discounted to the present.
So we have, really, a bunch of analysts touting stocks based on notions of economic and earnings momentum, rather than a careful analysis of values. It's one thing to say that stocks appear overvalued, but that investors still appear willing to take on more risk (which is essentially our argument). It is another thing to ignore those valuations, or to overlook the very substantial risk to market values if investors begin to adopt a more selective approach to risk-taking.
We remain positioned primarily to benefit from market advances, but our exposure to market risk is only moderate here. This is because of very unfavorable valuations, subtle deterioration in market action, and the actions of the Treasury Secretary, which have inexplicably created near-term risks out of what ought to be only long-term ones.
In bonds, the Market Climate continues to be characterized by modestly favorable valuations and modestly favorable market action. We continue to hold an overall duration of about 6 years in the Strategic Total Return Fund. This position is fairly comfortable even in the face of possible currency risks. An abrupt revaluation of the yuan would most probably have the effect of sharply raising short-term interest rates and flattening the yield curve. There could certainly be some near-term pressure on inflation, but the prospect of economic weakness would most probably offset this impact on long-term yields. We certainly don't base our current investment position on the currency situation, but we remain comfortable with our stance even taking that situation into account.
In gold, however, we took last week's strength as an opportunity to liquidate most of our holdings in precious metals stocks. This is not a forecast regarding the direction of precious metals - indeed, the currency situation may be supportive of them. However, at present, we simply don't have enough evidence to override the less favorable Market Climate for precious metals that has now emerged. The article Going for the Gold includes a relevant, though somewhat simplified, set of considerations behind our current stance.
In short, the potential for turmoil in the currency markets is a bullish argument for gold, but this potential isn't sufficient for us to take gold market risk against other conditions we currently observe, or to sidestep the opportunity to take profits on very strong prices. As usual, we try to replace lower ranked holdings on short-term strength, and to buy higher ranked candidates on on short-term weakness.
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