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October 2, 2006

Superstition and the Fed

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

The stock market is currently more committed to “historically implausible themes” than at any time since the bubble peak in 2000. At that peak, stocks traded on a theme that assumed a “new era” of productivity, where recessions were avoidable by a skilled Federal Reserve, where technology earnings would grow at 30% annual rates indefinitely and where extreme valuation multiples were fully justified by that anticipated growth. All of those themes, of course, turned out to be incorrect, but one required a “durable sense of doom” to avoid getting sucked into the final advance. Even during that final advance, market internals began deteriorating notably, as measured by growing divergences across industry groups, poor breadth, waning volume, and other measures of weakening sponsorship.

Likewise, stocks are currently trading on a theme that assumes a “soft landing,” where profit margins will remain indefinitely wide, where price/earnings ratios – seemingly reasonable on the basis of “forward operating earnings” – will expand further, and where both inflation and recession can be avoided by a deft Federal Reserve.

Once again, we already observe both diminishing sponsorship and rich valuations on the basis of “normalized” earnings (i.e. assuming a gradual reversion to normal levels of profit margins and the share of income going to labor compensation). I've covered the valuation arguments regularly in these weekly comments. On the subject of unimpressive market internals, our own conclusions are confirmed by any careful examination of breadth.

For example, Lowry's notes “The rally in big-caps has been deceptively narrow. As of Thursday's close, with the DJ Average within just a few points of a new all-time high, none of the 30 components rose to new all-time highs. Further, 63.3% of the components showed losses of -20% or more from their individual all-time highs, and 43.3% showed losses of -40% or more. As of Thursday's close, 5.7% of domestic common stocks rose to new 52-week highs, while 26.7% already show losses of -20% or more. A concern for the future is that this degree of selectivity has typically been found near major market tops.”

On one hand, substantial market breaks often occur within about 6 months of oncoming recessions, and it's possible that we're within that window. On the other hand, we can't rule out the possibility that investors will run with the existing “theme” for a while longer. Until inflation or earnings news actually derails expectations, investors may continue to load expectations of a so-called “Goldilocks” (ugh) economy into the market. As I've noted in recent weeks, moderate improvement in market internals could prompt us to remove somewhere in the area of 25% of our hedges (or perhaps alter our hedge in a similar way, for example, by adding a very small exposure in “contingent” call option positions).

In any event, it's important to recognize that, despite the apparent excitement of marginal new highs, the market continues to make very limited progress from one intermediate peak to the next. I'm very aware that our hedged position takes us from “champ to chump” on every significant short-term rally, and from “chump to champ” on every significant short-term decline. But our investment approach has always been decidedly full-cycle in nature, and is not based on an attempt to “time” short-term market direction. Meanwhile, we've always been willing to accept some amount of speculative exposure to market fluctuations when the prevailing evidence (not opinion, nor forecasts) indicates that investors have a robust preference to accept risk. We will do so again if those opportunities arise in the weeks and months ahead.

Supersition and the Fed

Of all the hopes that investors have at present, the strongest ones are centered on the Federal Reserve and its probable decisions regarding the Federal Funds rate. This obsession with the Fed comes at the expense of attention that should be focused on profit margins, normalized valuations, market internals, credit spreads, fiscal policy and the U.S. current account. In hopes of refocusing attention on factors that matter, my hope is that the following bit will further explain why the Fed is, in my view, irrelevant.

I should note at the outset that yes, as long as investors believe the Fed matters, it is important to consider the Fed. The real issue, however, is whether the Fed actually has any impact, and my argument is that it does not. It's an argument that goes against what we're conditioned to take for granted (and even what I once used to teach my own economics students). Nonetheless, the evidence against an effective Fed, when you scrutinize the data, is fairly compelling.

A quick primer

The “Federal Open Market Committee” (FOMC) is responsible for making “open market” purchases and sales, generally of U.S. Treasury securities, in order to affect the quantity of reserves (and currency) in the banking system. While Paul Volcker targeted the quantity of money directly, Alan Greenspan targeted the interest rate (the Federal Funds rate) that banks pay on overnight loans of bank reserves. If a bank's reserves fall short of required levels, it has to borrow them overnight from other banks that have excess reserves. If you're controlling the quantity of reserves, you have to let the Fed Funds rate fluctuate. If you're controlling the Fed Funds rate, you have to adjust the reserves.

Ben Bernanke has the stated intention of targeting inflation. Unfortunately, without the help of disciplined fiscal policy, inflation isn't a policy instrument that's controllable by the Fed. In practice, it's looking very much like he's sticking to Greenspan's script, focusing on the Fed Funds rate.

Here's how it works. In principle, the FOMC lowers the Fed Funds rate by buying securities (primarily U.S. Treasuries) on the “open market.” Notice that if you or I bought a Treasury bond, we would pay the seller from our bank account, and the seller would deposit the proceeds in their bank account. The total amount of currency and bank reserves (the "monetary base") wouldn't change. In contrast, when the Fed buys Treasuries, it creates new currency and bank reserves that didn't exist before (that's why your dollar bill says “Federal Reserve Note” at the top – it's basically a security that was created by the Fed when it bought securities issued by the Treasury). With reserves more plentiful, the Fed Funds rate tends to fall. In contrast, the FOMC raises the Fed Funds rate by selling Treasuries on the open market and essentially retiring bank reserves, making them more scarce and driving up the interest rate on overnight loans of those reserves. At least that's the idea.

To what effect?

There's no question that the Fed's open market operations determine the total supply of currency and bank reserves (the “monetary base”), but that's a power of little practical effect. There are three problems with putting a lot of faith in the Fed's activities to significantly influence the economy, to “determine interest rates,” or even to control inflation:

First, foreign holdings of U.S. Treasuries swamp the holdings of the Fed by almost 3-to-1. Moreover, the Fed's holdings of Treasuries hardly fluctuate from year-to-year, particularly compared with the volatility of foreign holdings. Buying and selling of U.S. Treasuries by foreigners (particularly foreign central banks) swamps the impact of the Fed by more than 10-to-1.

Second, although the Fed can vary the monetary base, those fluctuations have virtually no effect on bank reserves. In the past 15 years, every single dollar of growth in the monetary base has been withdrawn from the banking system in the form of currency. Why? The banks don't need these reserves because the reserve requirement rules were changed in the early 1990's to apply only to checking accounts. And even the balances in these checking accounts are increasingly swept into accounts free of reserve requirements. Yes, everything I taught to my undergraduate economics students about “money multipliers” has become hogwash. To get a feel for this, since 1995, the monetary base has grown by nearly $400 billion. Meanwhile, the total amount of bank reserves has actually declined by $15 billion – from $58 billion to the current $43 billion.

That's right. The total amount of bank reserves in the U.S. banking system is just $43 billion, and that's all the FOMC is responsible for controlling. In an economy with a GDP of $13 trillion and a public debt of over $8 trillion, the Fed Funds rate is based on $43 billion of dough.

Which brings us to the third problem with the belief that the Fed matters: since bank reserves are only required on checking deposits, which are a small fraction of the sources from which banks can lend, influencing the amount of reserves in the U.S. banking system has no effect on the volume of lending in the U.S. banking system. (This should be immediately evident given that reserves are a pittance, economically speaking, and have even declined over the past decade, while bank lending clearly has not). Still believe that “injecting reserves into the banking system” matters? It's just not in the data.

Sure, if the economy starts to slow and inflation cools, the market will tend to reduce short term interest rates. The Fed will respond to the same data by cutting the Fed Funds target, but this will be a response, not a cause. If instead inflation pressures persist, the market will drive short term interest rates higher on its own. The Fed will choose not to cut the Fed Funds target. Investors will be disappointed in the Fed, but its actions again will be a response, not a cause.

The dog might bark when the mailman walks by, but nobody thinks that the barking is what brought the mail. Likewise, it's important to recognize that Fed actions can be correlated with economic events without causing them. If you want to argue causation, you've got to articulate the actual mechanism between cause and effect; otherwise you're just being superstitious. As I noted in our latest Annual Report, the Fed is a lot like a little boy who waves his arms whenever he hears music playing, so people come to believe he's actually conducting the band.

Now, it's certainly true that changes in Fed-controlled rates are convenient and relatively predictable events that banks use to coordinate their own rate changes. So you'll generally see the prime rate being changed by a majority of banks at the same time that Fed-controlled rates are changed (to coordinate rate changes at other times would smack of price collusion). Still, the Fed essentially responds to market-driven interest rate pressures – it doesn't cause them.

Except in times of financial crises, when people are trying to convert their deposits into cash and the Fed has a truly legitimate role as a “lender of last resort,” the Fed's moves are essentially irrelevant.

But doesn't the Fed play a major role in the Treasury market?

The basic fact is that the Federal Reserve holds only about 9% of the total stock of Treasury securities, and those holdings are very stable (the main asset on the Fed's balance sheet is Treasuries, while the main liability is currency in circulation). By contrast, foreigners now hold about 24% of Treasuries. Looking at the “float” held outside of the federal government, foreigners now hold about 51% of all privately held Treasuries.

[The “float” includes, for example, holdings of mutual funds, insurance companies, state and local governments, pension funds, and private individuals, but excludes Treasury holdings within the federal government, such as the Social Security Trust Fund and the Federal Reserve].

To get an idea of whether Fed buying and selling of Treasuries has much impact, the chart below depicts the year-over-year change in ownership of U.S. Treasuries, in billions of U.S. dollars, of the Fed (blue line), versus foreign investors in Treasuries (green line).

Looking at the chart above, you might be wondering how the foreign holdings of Treasuries could have fluctuated that much without having a major impact on the U.S. economy. The answer is simple. The supply of Treasuries fluctuated by virtually the same amount, thanks to fiscal policy. What's happening here is that in recent years, China and Japan have basically altered their holdings year after year to finance the U.S. budget deficit or retire its surplus. Here's a longer term chart, which adds the annual federal budget deficit to the picture (inverted, so deficits appear as positive values and budget surpluses show as negative values).

Notice that the U.S. budget deficit exploded in the early 80's and persisted until after the 1990-91 recession. Once George Bush senior dropped his “read my lips” pledge, the federal deficit began to decline. By the mid-1990's, the U.S. was in a full-scale economic boom, and foreign investment in the U.S. surged, both in stocks and bonds.

By 1997, the U.S. was running budget surpluses. This dramatically reduced the need for foreign capital inflows. The accompanying decline in the rate of foreign purchases in the late 1990's was largely “passive” – the U.S. was essentially repurchasing its debt, and a good portion of this evidently came from the holdings of foreigners. By 2002, the U.S. was again running deficits, and financing them thanks to the eagerness of foreign central banks, primarily China and Japan, to accumulate U.S. securities in order to support the value of the dollar.

And there, wiggling slightly near the zero line, is the Fed.

Pay no attention to the man behind the curtain

Yes, that's the great and all-powerful Fed, whose pronouncements hold Wall Street breathless about whether it will be increasing or decreasing the pace at which it accumulates Treasuries; whose reserve requirements have, since the early 1990's, applied only to checkable deposits that make up a small fraction of the funding for bank lending; whose “injections” and “withdrawals” of “liquidity” into the banking system – except in times of financial crisis – don't amount to a hill of beans.

Put into perspective, the Fed's operations are relatively minuscule and are overwhelmed by the impact of foreign transactions in U.S. Treasuries. Meanwhile, there is no longer any material link between the quantity of bank lending and the bank reserves that the Fed controls. It's perfectly reasonable for investors to carefully monitor inflation, broad interest rate trends, and economic growth. However, except for the shortest duration interest rates, there's no mechanism by which Fed actions have a dominant effect on these. The Fed may have a psychological effect by dictating where it thinks short-term interest rates should be, but the whole effect requires that people believe the Fed is in control. In truth, the Emperor has no clothes.

Sure, we can write down models of economies where monetary policy would have an effect. But in practice, those economies are based on assumptions that don't match the one we live in. That's why academic economists and even the Fed's own analysts can't demonstrate how the presumed “monetary transmission mechanism” actually works (or doesn't work) in reality. That's also why even a decade ago, a study produced by the Federal Reserve Bank of Kansas City (“Bank Lending and Monetary Policy”) concluded from the data that “lending is not constrained by restrictive monetary policy.”

Yet Wall Street assumes a direct and powerful link between monetary policy and the economy. The only lip service about possible ineffectiveness is the parroted phrase “monetary policy works with a lag.” It doesn't seem to matter that there is, in fact, no credible mechanism by which U.S. monetary policy “works.”

On the subject of inflation, as I've noted before, the main factor that governs inflation is not monetary policy, but fiscal policy; specifically, growth in government liabilities in excess of the amount that investors (including foreigners) are willing to absorb. The Fed only controls how much of these liabilities take the form “monetary base” (currency and bank reserves) instead of Treasury bonds. Except during bank runs, when the Fed has to expand the monetary base to meet a sudden demand for currency, it's a distinction without much of a difference.

To believe that the Fed's actions control the economy is just plain superstition. The only reason to pay attention to the Fed is that other investors are not rid of this superstition.

Market Climate

As of last week, the Market Climate for stocks was characterized by unfavorable valuations and slightly unfavorable market action. On a short-term basis, stocks remain strenuously overbought. The Strategic Growth Fund remains in a fully-hedged investment stance. If we observe a moderate short-term decline without further deterioration in market internals, it's possible that we could allocate a very small percentage of assets to contingent call option positions, or remove a limited percentage of our hedges, but beyond that, I don't anticipate any major shifts in this regard.

In bonds, the Market Climate remained characterized by unfavorable valuations and relatively neutral market action. The Strategic Total Return Fund continued to carry a duration of about 2 years, mostly in Treasury Inflation Protected Securities, with an allocation of just under 20% of assets to precious metals shares.

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