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July 24, 2006

Independent Thought

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

It continues to astonish me how much power investors appear to ascribe to the Federal Reserve. The institution can do nothing but purchase debt (mainly U.S. Treasuries) and pay for it by creating bank reserves, or sell debt and receive payment by reducing bank reserves. When you realize that the total volume of bank lending has virtually no link at all to bank reserves (since the majority of monetary aggregates other than checking accounts have had zero reserve requirements since the early 1990's), and that foreign purchases of U.S. Treasuries have swamped Fed activity in Treasuries three-to-six times over in recent years, this whole focus on every word, syllable, and inflection from the Federal Reserve is just preposterous.

As Bill Hester walks around the office saying, “the markets have lost the ability to think for themselves.”

I don't rely much on forecasting near-term outcomes, and our investment positions are influenced by observable valuations and market action rather than personal opinion. Still, I'm an economist by training, and given the simplistic view of the economy being taken up by investors – that the future will be driven by the actions of the Federal Reserve, that inflation and economic growth necessarily move in the same direction, and that the Fed's dilemma is to either fight inflation or promote growth – it's probably useful to articulate some independent thought.

Mine is fairly strong at present. The Fed is irrelevant.

The U.S. economy is likely to slow and inflation is likely remain persistent, because the U.S. has ascended a mountain of debt upon which there are currently no promising directions to climb. All of the growth in U.S. gross domestic investment since 1998 has been financed by foreign capital inflows, and while the Federal government continues to expand the stock of U.S. debt, the appetite of foreigners for new debt, in addition to their existing holdings, can hardly do anything but slow.

As the growth of foreign capital inflows declines (I'm not suggesting that foreigners will actually sell their existing Treasury debt, just reduce their absorption of new debt), gross domestic investment is likely to stagger, particularly in the area of housing, and credit expansion in the U.S. is likely to slow as well. The excess Treasuries not purchased by foreigners will be forced into domestic hands, either the public, or the Federal Reserve, resulting in a decline in the marginal value of government liabilities that we commonly refer to as “inflation.” If credit defaults increase, then, yes, investors will probably increase their demand for “safe” (at least default free) government securities, which would then support the value of government liabilities and therefore result in lower inflation, but would do nothing to improve economic prospects.

The inability of the markets to think for themselves also leads to a parroting of common errors, rather than a search for unique truths. Analysts currently claim that stock valuations are below historical averages, but this is because the P/E ratios they use are based on forward (i.e. next year or beyond) “operating earnings” (i.e. stripped of virtually any factor that reduces the predictability of earnings), while the historical averages that they reference are based on trailing net earnings. On no soundly reported fundamental (for which a long historical record exists) is the stock market even near its historical averages.

So we are left with the reasonable prospect of tepid economic growth, very possibly rolling into recession late this year or early next (though the evidence doesn't yet suggest recession as a “probable” outcome), persistent structural inflation that will probably not behave “cyclically” by declining as the economy slows, a presently unfavorable Market Climate in stocks (which, as always, will change as the observed evidence changes, but for now holds us to a strongly defensive stance), and a relatively neutral Market Climate in bonds, which is insufficient to accept a great deal of interest rate risk regardless of whether or not the Fed might “pause.”

Eclectic economic indicators

Below is the housing starts oscillator that I presented a few weeks ago, including the latest data point. Note that even with housing starts only modestly off their highs, we've got a downturn in the market's momentum that has typically continued, and has often been associated with recessions. This isn't a warning as yet, but the new data point seems informative.

As noted above, my expectation is that housing investment will be adversely affected by any slowdown in foreign capital inflows. In addition to this, we're also likely to see a slowing in the growth of credit and liquidity in the coming quarters.

The chart below depicts the relationship between real liquidity and employment growth. The blue line tracks the year-over-year growth in liquidity (consumer credit, M2, and the monetary base – the latter being the only aggregate that the Fed has any control over) , adjusted for inflation. The green line tracks the growth of payroll employment over the following 6 months. Historically, when real liquidity growth has declined below 1% on a year-over-year basis, employment has typically contracted over the following months. Notably, consumer credit has been the slowest growing component.

Real liquidity is not simply an indicator of Fed policy, but of general lending and credit growth in the economy, very little of which the Fed actually controls (see Why the Fed is Irrelevant). The economy is much, much bigger than the Fed. The true determinant of liquidity growth is the perception across a wide variety of borrowers that debt is worth taking on – that useful opportunities exist in the economy, combined with the willingness across a wide variety of lenders to actually provide those loans. So what we really see at present is some combination of reduced eagerness of debtors to borrow, and reduced willingness of creditors to lend. My impression is that employment growth in the months ahead is likely to follow suit.

Again, while recession risks appear to be steadily increasing, we don't yet have enough evidence to expect it as an imminent or probable outcome. Meanwhile, the Federal Reserve remains important only because investors believe it is. So we can't ignore the Fed, but neither should we believe that the prospects for the economy and the financial markets are sensitively dependent on its actions.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully-hedged investment stance. We observed the usual fast, furious, prone-to-failure rally last week, to clear the somewhat oversold condition of the stock market. Presently, the market is neither particularly oversold, nor overbought, nor are there any important seasonal factors at work, leaving no opinion to be had at all about short-term market prospects. So while the market is free to advance or decline over the short term, with the Market Climate unfavorable, we have to expect outcomes to be biased negatively on average.

In bonds, the Market Climate remained characterized by relatively neutral valuations and relatively neutral market action, holding the Strategic Total Return Fund to a limited 2-year duration, mostly in inflation protected Treasuries, and about 12% of assets in precious metals shares as its other primary investment stance here.

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