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March 12, 2007

The "Money Flow" Myth and the "Liquidity" Trap

John P. Hussman, Ph.D.
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I'm pleased to note that, including reinvested distributions, the Strategic Growth Fund achieved record highs in each of the past two weeks – one while the market was declining, and one while the market was advancing. The Fund is intended to outperform the general market over the complete market cycle (bull market and bear market combined), with smaller periodic losses, on average. As detailed in the latest semi-annual report, I estimate that we would require a moderate correction in the area of 10% (though far less than a typical bear market) to put the Fund ahead of the S&P 500 for the largely uncorrected period from 2004 to the present. The market has run the second-longest stretch in history without a 10% correction. The Fund's performance record over longer periods, as well as its risk profile, does encompass a complete market cycle.

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Wall Street seems to making excessively confident use of the past tense in discussions of the recent market pullback. It strikes me as a potentially dangerous mistake to interpret the warning shot of recent weeks as a starting gun. While it's certainly possible that the market will advance further, even a modest further advance will quickly re-establish the overextended conditions which ultimately forced the recent slide in the first place.

On the positive side, market internals did not deteriorate enough during the recent pullback to signal a change in investors' willingness to take risk. That allowed us to soften our hedge somewhat on the decline. For now, the evidence does suggest that investors remain willing to speculate (even if that speculation is of the “damn the torpedoes” variety). On the negative side, the market is a stone's throw from refreshing the overvalued, overbought, overbullish, yields-rising condition we've dubbed “ovoboby” (Investopedia chose that as their word of the day early last week, which was very funny).

The upshot is that we currently observe little upside to further speculation. Having lifted a portion of our hedges (using call options only) in the depths of the recent decline, we've benefited from the latest rebound. Still, I clipped off a small portion of that exposure on last week's advance. Despite rich valuations (on the basis of any measure other than the landmine of “forward operating earnings”), market action remains constructive enough to warrant a modest amount of “one-sided” market exposure using call options. Again however, there is not much remaining distance to the point where the market would again be overextended enough to sound a shrill warning.

The “money flow” myth

I am increasingly losing confidence that Wall Street operates on a well-defined base of knowledge. Instead, I am struck by the number of platitudes and false constructs that seem to dominate the investment management industry.

First, we should be very clear that there is no such thing as money going into or out of a secondary market. When stocks are issued in an IPO, or bonds are floated to investors, companies receive funds from investors and, in return, give investors pieces of paper called stocks and bonds, as evidence of the investors' claim on some future stream of cash. This is a “primary market” transaction.

Once those pieces of paper are issued, they are traded between investors in the “secondary market.” When we talk about the stock market, we're talking almost exclusively about the secondary market, because new issues make up a very small part of total activity.

Dear Wall Street analysts and financial reporters – when investors purchase a stock in the secondary market, the dollars that buyers bring “into” the market are immediately taken “out of” the market in the hands of the sellers. It is an exchange. This is why the place it happens is called a “stock exchange.” The stock market is not an air balloon into which money goes in or out and expands or contracts that balloon. Nor is it a water balloon that is expanded by pouring in “liquidity.” Prices are not driven by the amount of money that buyers “put in” or sellers “take out” (as those dollar amounts are identical). Prices are determined by the relative eagerness of the buyer versus the seller.

If a dentist in Poughkeepsie is willing to pay up 10 cents to buy a single share of General Electric, the total market value of General Electric increases by over $1 billion (GE has 10.28 billion shares outstanding - do the math). In this way, market capitalization can be created and destroyed out of thin air and on the smallest of trading volumes. So you'd better be sure that the there is a sound and fairly reliable stream of expected cash flows backing up the value of the securities you're buying.

Cash does not ever find a “home” in a secondary market. Every time you hear the phrase “investors are putting money into…” or “investors are taking money out of …” or “money is flowing out of … and into …,” it is a signal that the speaker is unable to distinguish a secondary market from a primary one.

As I used to teach my students, if Mickey sells his money market fund to buy stocks from Ricky, the money market fund has to sell some of its T-bills or commercial paper to Nicky, whose cash goes to Mickey, who uses the cash to buy stocks from Ricky. In the end, the cash that was held by Nicky is now held by Ricky, the money market securities that were held by Mickey are now held by Nicky, and the stock that was held by Ricky is now held by Mickey. There may have been some change in the relative prices between cash, money market securities and stocks, depending on which of the three was most eager, but there is precisely the same amount of “cash on the sidelines” after that set of transactions as there was before it.

The “liquidity” trap

I'm similarly convinced that Wall Street has no idea what it's talking about when it uses the word “liquidity.” While using the phrase “global liquidity” lends a further element of worldly sophistication, Wall Street still hasn't the slightest idea what it's talking about. The phenomenon that's being called “liquidity” is nothing more than a combination of fiscal irresponsibility and risk blindness, and will ultimately prove itself to be the time-bomb that it is when investors begin to “re-price” that risk.

Let's go back to basics. If the economy produces output valued at $100, we can classify that $100 as either consumption or investment. Let's say that $80 represents “consumption.” We define “savings” as the portion of output that wasn't consumed ($100-$80), which is $20. Not surprisingly, that's exactly the value of the stuff we classified as “investment.” It's an accounting identity that saving always equals investment (always – if the investment goods weren't sold, the income wasn't generated, and the saving didn't happen).

If we look at individual actors in the economy, it will generally be true that some of them want to save part of what they have, and some of them want to invest more than they have. So we need a way for savers to transfer their income to the people who want to use those savings. This is done by issuing securities. Money is transferred from the saver to the spender, and the spender issues a receipt which offers some hope of repayment in the future.

Here is the crucial point. Once a security is issued, that piece of paper thereafter represents savings that have already been deployed in order to purchase investment goods and services (factories, equipment, housing, computers, and so forth).

The security is simply a receipt. It means that at some point in the past, someone produced goods and services without consuming them, and someone consumed or invested in goods and services without producing them. That change of ownership was accomplished by issuing that stock, or bond, or IOU. Again, it represents money that has already been spent – goods and services that have already been deployed.

Now consider government and foreign trade. The U.S. is currently running massive federal deficits, and massive current account deficits. What's really happening here is that we are, in aggregate, consuming more than we produce, and foreigners are producing more than they consume. This difference requires the issuance of a huge volume of new securities to enact that transfer of purchasing power. The resulting mountain of issued securities does not represent newly created money looking for a home, or looking to be spent. It has already been spent! And we've spent it.

Specifically, the U.S. has issued huge volumes of Treasury securities that have been purchased, largely, by China and Japan . There's your global liquidity. It's a monstrous stock of Treasury debt that represents the claims of foreigners on our future production. That's in addition, of course, to the enormous inter-generational claims that we've promised via Social Security and Medicaid, which place further burdens on our future production.

So yes, enormous volumes of securities, primarily U.S. Treasuries and mortgage securities, have been issued in recent years. Foreigners hold a staggering quantity of the Treasury securities. Our own financial system holds direct and indirect claims on a lot of the toxic stuff like mortgage debt. Wall Street talks about all of this using the upbeat term “liquidity.” But what it really represents is a crushing pile of claims on our future production, as well as high risk junk, some of which (like sub-prime mortgage debt) is already starting to go belly-up. This is not money “looking for a home.” It is a pile of IOU's for money that has already been spent.

To understand the importance of this to the “money on the sidelines” mirage and the “liquidity sloshing around looking for a home” fallacy, notice that as the U.S. issues more Treasury debt, that debt simply must be held by someone. It is clear, then, that we must by necessity observe a rising stock of apparent “money on the sidelines” in the form of Treasuries on the balance sheets of foreign central banks, U.S. corporations, and individual investors. There is no other way. Again, these securities represent spending that our government has already done. It is not wealth (at least, not to the U.S. ) but a claim on future production. Nor it is money that “has to find a home.” It has already arrived, moved in, and in many cases, trashed the place. If somebody sells these bonds to buy stocks, somebody else has to buy the bonds and sell the stocks. In aggregate, no money goes into or out of either stocks or bonds by virtue of such transactions.

With regard to the “yen carry trade,” want to know who is the largest investor in that trade? Simple: the nation of Japan. It is the Japanese themselves who are most active in selling yen, buying dollars, and investing in U.S. Treasuries at higher yields. Japan has done this, as China has with its currency, in order to support the value of the U.S. dollar. But as their ownership of Treasury securities has grown, the potential cost of any realignment of exchange rates is becoming dangerously high, so both countries are beginning to diversify their central bank assets into other currencies such as the euro. Accumulating U.S. securities may have been fun while it lasted, but China and Japan are beginning to realize that the U.S. government has no plans to restrain its fiscal irresponsibility (largely because it lacks the capacity for constructive diplomacy).

This will end badly. “Global liquidity” is not a positive for U.S. markets. It is simply evidence of the existing claims of other nations against our future prosperity. There will be an increasing amount of apparent “money on the sidelines” in the years ahead, for the simple reason that the U.S. government will keep issuing securities and somebody will have to hold them.

Total return experiments

Near-term considerations for the stock market aside, I am sometimes asked what the prospects are for stock returns perhaps five years ahead. In general, a 10-year horizon is more reliable because speculative influences wash out to a greater extent, but some observations on this may be useful.

I've noted for some time that S&P 500 earnings are at the very top of their long-term 6% peak-to-peak growth trendline – a level of earnings that has typically been associated with an average price/earnings multiple of 10 (not the current 17). See last week's market comment for a review of these conditions. Meanwhile, the dividend yield on the S&P 500 is about 1.9%.

We can imagine a few reasonably optimistic outcomes. First, suppose that record profit margins are persistently maintained, so that earnings continue to grow along the very peak of their 6% growth trend. Rather than assuming the price/earnings multiple on these peak, record-margin earnings will fall to anywhere near 10, let's assume that 5 years from now, the multiple merely touches 15 (just two points lower than presently). Given that assumption, the 5-year S&P 500 total return would work out to be:

1.06(15/17)^(1/5) + .019(17/15+1)/2 – 1 = 5.41% annually.

Alternatively, we could assume that given extremely wide profit margins and rising unit labor costs, profit margins will normalize somewhat in the coming years. Assuming continued revenue growth at 6% annually, profit margins would still have to be above their historical norms 5 years from now just for earnings to remain at present levels. As it happens, we can identify many historical periods where earnings did not, in fact, grow over a 5-year period, and not surprisingly, those periods generally started when earnings were at the peak of their long-term 6% growth trend. But let's not be too dour. Let's also assume that the price/earnings ratio on the S&P 500 will increase to 19, which would still be a rich valuation on earnings at that point. Given those assumptions, the 5-year S&P 500 total return would be approximately:

(19/17)^(1/5) + .019(17/19+1)/2 – 1 = 4.05% annually.

Neither of these cases require particularly negative or bearish assumptions, but they imply quite unsatisfactory long term returns, which underscores the point that rich valuations rarely deliver pleasant long-term results.

In order for the S&P 500 to achieve a “normal” annual return of about 11% over the coming 5 years, we have to assume a maintenance of record margins, sustained top-of-channel earnings growth (which has never before been sustained for such a period), and an expansion of valuations to a multiple of 20 times peak earnings (the same multiple as at the 1929 and 1987 peaks, which is double the average historical multiple on top-of-channel earnings). Investors should think now about whether these assumptions are plausible, because they may find themselves wondering later why they ever did.

My impression is that the probable expectation for total returns on the S&P 500 over the coming 5-years is below 5% annually, in a likely interval that includes zero. It takes implausibly optimistic assumptions to move substantially above that range.

As for 10-year returns, for which the historical evidence has typically allowed tighter confidence intervals, the following chart updates the study that appeared in the February 22, 2005 market comment (“The Likely Range of Market Returns in the Coming Decade”) using the same methodology. Note that actual market returns moved outside of the typical range only during the late 1990's bubble, and that the most recent 10-year return of about 7.6% since 1997 has been at the top of the expected range precisely because current valuations are at the top of historical norms.

Currently, the likely range for S&P 500 returns over the coming decade is between a -3% annual loss and a 5% annual return, centering in the low single digits. That range will seem preposterous to some investors, but remember that it took the late 1990's market bubble to move actual returns even 5% outside of this set of bands. Unless investors anticipate a repeated excursion into similar valuation extremes, it would be a good idea for them to recognize now, rather than later, that stocks are unlikely to produce satisfactory long-term returns from current valuations.

On the bright side, there is nothing that prevents us from hedging risk during portions the coming years when valuations and market action are unfavorable, and accepting risk during the many likely periods when one or both of those factors are favorable. Nor does it prevent us from constructing portfolios of stocks which appear more favorably valued than the major indices. A buy-and-hold approach on the S&P 500 has produced a total return of about zero since 2000, but that has not prevented our more flexible investment strategy from achieving very satisfactory returns at contained risk.

Market Climate

As of last week, the Market Climate for stocks was characterized by unfavorable valuations and modestly favorable market action. There is not much room between current levels and a level that would represent overextended market conditions (from which stocks have typically produced average returns below Treasury bill yields). A 2-4% further advance would remove the basis for even modest speculation – our current exposure uses a limited position in call options only. A 4-6% further advance would most likely re-establish extreme overvalued, overbought, overbullish, yields-rising condition that has typically resulted in hostile declines. We need not actually revisit those conditions to be concerned, even here, about the potential for a much deeper correction. Suffice it to say that while we're willing to accept a limited exposure to market fluctuations using call options, even a moderate further advance will probably remove that willingness. Meanwhile, our essential downside protection remains largely in place.

In bonds, the Market Climate was characterized last week by moderately unfavorable valuations and relatively neutral market action. Unit labor costs increased at a 6.6% rate (quarterly, annualized) in the latest report (note that these already adjust for productivity growth), and the highest year-over-year rate in 6 years. Labor costs have been pushing higher both in financial and non-financial sectors, so the argument that the increase was due to Wall Street bonuses is a canard.

While the bond market seems trapped between upward inflation surprises and downward economic surprises, the larger picture is one of relatively low long-term yields, inflation slightly but persistently above comfortable levels, and an inverted yield curve. Keep in mind that it would take 7 or 8 quarter point reductions in short-term interest rates to minimally normalize the yield curve, even holding long-term interest rates constant. Accordingly, the prevailing structure of yields provides little basis for a long-duration investment position in Treasury bonds. With the emerging weakness in sub-prime mortgage debt, credit spreads are waking up slightly, but we still don't observe the sort of spike that would convey pressing recession risks or deflationary pressures. That doesn't rule out such risks from emerging over the months ahead – only that we're not observing them in the indicators that typically provide red flags.

For now, both stocks and bonds appear priced to deliver relatively unsatisfactory long-term returns for the risks involved. Stock market investors are still expressing a preference to speculate, at least on the basis of price/volume behavior, but we are not far from the point where stocks could again be characterized as overextended.

In the Strategic Growth Fund, current investment conditions allow us to accept modest speculative exposure (our investment position looks essentially like a fully hedged stance plus a reasonable number of in-the-money call options). If the market encounters further downward pressure, our investment position will look increasingly like a full hedge, without requiring us to manage risk by selling into a decline.

In the Strategic Total Return Fund, we continue to hold a short-duration investment stance, mostly in Treasury Inflation Protected Securities. The Fund also holds about 20% of assets in precious metals shares. It's worth noting that the fairly simple but generally useful Gold/XAU ratio is now pushing close to 5.0, though it has not breached that level.

To reiterate my remarks on the Gold/XAU ratio from the May 2, 2005 comment:

“To put some historical context on this measure, since 1974, the Gold/XAU ratio has been greater than 5.0 about 15% of the time. When the ratio has been this high, the XAU has followed with annualized gains of 89.6%, on average – a figure that remains high even if the data is split into multiple samples. When the ratio has been greater than 4.0, the XAU has followed with average annualized gains of 27.4% (though the finer profile of returns has been sensitive to other conditions such as interest rates, economic trends, and inflation). In contrast, when the ratio has been less than 3.0 (meaning that the gold stocks are very elevated relative to the actual metal), the XAU has declined at an annualized rate of -36.6%, on average.

“Importantly, the return/risk profile for precious metals shares is strengthened further if the economy is experiencing weakness. For example, when the Gold/XAU ratio has been greater than 5.0 and the ISM Purchasing Managers Index has been less than 50 (indicating a contracting U.S. manufacturing sector), gold shares have appreciated at an average annualized rate of 125.6%. In contrast, when the Gold/XAU ratio has been less than 3.0 and the Purchasing Managers Index has been greater than 50, precious metals shares have plunged at an average annualized rate of -49.9%.”

Such strong periods for gold are also generally associated with weakness in the U.S. dollar. Something to think about as the economic picture evolves in the months ahead.

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Other remarks -- A way forward

While unsatisfactory financial outcomes are already built into the rich valuations of stocks, bonds, and low-quality debt, we do have the ability, as a nation, to determine whether American hopes for peace and prosperity will improve or deteriorate in the years ahead. The most pressing issue at the moment is the course of U.S. foreign policy, which has had a stabilizing effect neither on the financial system nor on international relations.

The outlook for fiscal stability and international peace will continue to be undermined so long as our leaders imagine that violence can remove violence – especially when there is no central authority from which to extract surrender, and when each act of escalation creates far more enemies than can ever be destroyed. The effort to open a dialogue as a step toward peace (rather than requiring peace as a step toward dialogue); to understand those we call enemies; would not be an act of weakness but an act of strength and self-defense. Particularly with numerous, scattered factions, the attempt to find common ground and negotiate disputes is also most probably the only way to achieve peace.

It is the beginning of wisdom to listen and understand the motivations of each side - their fears, hatreds, misconceptions, ignorance, suffering, feelings of injustice, and aspirations, without each side branding the other as inhuman, and somehow unworthy of human rights, or lacking any human commonalities. Diplomacy doesn't require us to appease an enemy by granting dishonorable concessions, but only to ask “To what is each side entitled?” For a nation with a history of respect for diplomacy, international cooperation, human rights, and beyond all else, the sacrifice of our troops, the present course is no path to peace, and is no way to lead.

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