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October 8, 2007

The Bag Will Not Inflate, And Liquidity Will Not Be Flowing

John P. Hussman, Ph.D.
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As expected, the Fed entered $28 billion of repurchases on Thursday to roll over existing repos that were due on that day. The Fed did not “add” or “inject” reserves to the banking system, nor has any amount of overall reserves been added in recent weeks. There have been no “permanent” open market operations in recent months, and the “temporary” ones have been pure rollovers of existing repos. Aside from $3 billion that banks briefly borrowed from the Fed a few weeks ago, the Fed has not “added liquidity” through the discount window either. The total outstanding amount borrowed by the banking system through the discount window fell to just $202 million last week. Meanwhile, the total reserves of the banking system remain about $45 billion, nearly all of which represents temporary repurchase agreements that are continuously rolled over as they become due.

Do investors honestly believe that $45 billion of reserves and $202 million of discount window borrowings control a $6.3 trillion banking system and a $13.8 trillion economy? Bank reserves hardly vary from that $40-$45 billion level, and have been gradually falling since the early 1990's. Nor are reserves a dynamic pool of money that banks draw off and the Fed replenishes - if that were the case, we would continuously observe new "permanent" open market operations. But we don't. Bank reserves are essentially stagnant water. Indeed, permanent open market operations closely coincide with the $30-$50 billion of currency the Fed predictably issues each year, which is outside of the banking system and partly in your wallet (with the words "Federal Reserve Note" at the top).

Look at the data.

Fed Open Market Operations: http://www.ny.frb.org/markets/openmarket.html
Total Discount Window Borrowings: http://research.stlouisfed.org/fred2/data/TOTBORR.txt
Total Bank Reserves: http://research.stlouisfed.org/fred2/data/TRARR.txt

As a side note, roughly $30 billion of repos will roll over this Thursday; $24 billion of 7 day repos from last week, and another $6 billion in 14 day repos from the week before.

The reason all of this is worth noting is because investors are putting so much false hope on the notion that the Fed is “injecting” all sorts of “liquidity” into the markets. Analysts discuss this as fact, when they evidently have not even looked at the facts. They literally make things up and present their claims as truth. At one particular moment last week, a guest on one of the CNBC morning programs spoke authoritatively about the enormous amount of liquidity the Fed is pumping into the economy, and how “all that liquidity has to go someplace, and a lot of it is finding its way into the stock market.” At that point I stopped watching out of the instinctive will to live.

My immediate objection to that statement, of course, is that there is no liquidity being “injected” at all. Again, the Fed certainly has a psychological effect on investors, provides coordinating signals to banks, manages an interest rate on a very stable $40-$45 billion pool of reserves through its “temporary” open market operations, facilitates the predictable issuance of $30-$50 billion annually of currency in circulation through its “permanent” open market operations, and even has a useful role to play in providing temporary liquidity in the face of seasonal factors (most notably, the year-2000 turn). But the Fed does not provide meaningful amounts of ongoing liquidity to the $6.3 trillion banking system (the quantity of loans has literally zero relationship with the small, stable pool of bank reserves, which has been falling since the early 1990's). Nor does the Fed control the $13.8 trillion U.S. economy. Foreign purchases of U.S. Treasuries outweigh the Fed's actions many, many times over.

My second objection is that the stock market is not some balloon into which money “flows into” or “out of.” Every purchase is matched by a sale. Every sale is matched by a purchase. Stock prices move because the buyer is more eager than the seller or vice versa. A purchase doesn't put money “into” the market, nor does a sale take money “out.” Even in the case of new issues, the proceeds go to the issuing company. Money “on the sidelines” stays on the sidelines. Stocks, bonds, commercial paper and currency simply change hands between Ricky, Mickey and Nicky. There is no stock market balloon holding all the money that people invest. There are only certificates traded between people at prices on which they mutually agree from day to day.

You can count on the fact that if you save $100, somebody, somewhere in the world ends up acquiring $100 worth of tangible investment goods or services. This is a well-known economic identity, and you can prove it. Even if you save $100 by stuffing it under your mattress, it must be the case that total spending has fallen short of total output by that $100, in which case we know that somebody has involuntarily accumulated $100 in “inventory investment.” Even if your $100 went “into” the stock market, the fact is that your $100 immediately went “out” of the stock market in the hands of the seller, and then to someone else, and someone else, until your $100 eventually made it into the hands of someone who used it to buy (or in the case of inventory investment, accumulate) real goods and services.

You know how flight safety demonstrations always include the phrase “even though the bag will not inflate, oxygen will be flowing”? Well the same is not true of “Fed liquidity” and the stock market. There is no bag that inflates, and if you look at the data, no liquidity is flowing either.

The stock market has advanced in recent weeks on very dull volume and relatively tepid breadth. This type of action is typically associated with short-squeezes and a backing-off of sellers, without robust underlying demand. If you look at the dull price-volume behavior, the trailing breadth in the recent rally, and the growing divergences between the major indices and other market internals, it is not clear that buyers are particularly eager.

Market Climate

As of last week, the Market Climate for stocks was characterized by unfavorable valuations, and still unfavorable market action on the basis of market internals. The advance in recent weeks has evidently been driven by the hope of people who are already holding stocks, not by any measurable increase in the speculative demand of new investors. Historically, that distinction has been vital to the sustainability of market strength. Any renewed eagerness to sell in those situations isn't met with matching buying interest, which can force greater price adjustments to match sellers to buyers (which have to be identical - there are never "more sellers than buyers" or "more buyers than sellers")

Meanwhile, the market has already reestablished an overvalued, overbought, overbullish combination that has historically been associated with average returns below Treasury bills even when market action has otherwise been favorable. As I've noted before, these poor average returns are not the result of relentless market losses. Rather, historical overvalued, overbought, overbullish environments have generally been associated with a mild upward drift followed by steep, abrupt losses that typically wipe out weeks or months of upside progress within a handful of trading sessions. Treasury bond yields are also pushing higher. Though 10-year yields are not quite above their levels of say, 6 months ago, any further upward pressure on long-term yields would put the stock market into a particularly hazardous set of conditions.

We do not have sufficient evidence of investment merit (favorable valuations) or reliable speculative merit (favorable market action) to justify an exposure to market fluctuations at present. Meanwhile, however, we do identify a variety of individual stocks that have favorable valuations and market action on our measures. We continue to be fully invested in a broadly diversified portfolio of those stocks, with an offsetting short position in the S&P 500 and Russell 2000 indices to hedge the impact of general market fluctuations. As usual, our returns when fully hedged are largely driven by the difference in performance between the stocks we hold and the indices that we use to hedge. This difference may be positive or negative, but since the inception of the Fund in 2000, it has accounted for the majority of returns in the Strategic Growth Fund.

In bonds, the Market Climate was characterized last week by unfavorable yield levels and relatively neutral market action. Overall economic pressures are likely to favor slower growth, and a large wave of mortgage resets due this month will probably raise credit concerns, to the benefit of default-free securities. On the negative side, inflation pressures have been quietly growing in China, while the recent weakness in the U.S. dollar is also likely to feed into import price pressures. Wage inflation and unit labor costs remain relatively firm as well. It's also notable that market yields have drifted higher since the Fed reduced its target for the Fed Funds rate.

Given this combination of factors, we're clearly most comfortable with inflation protected securities, which will tend to benefit from downward pressure on real inflation-adjusted yields, without an exposure to any short-term inflation surprises that might emerge. Overall, my impression is that we're not likely to see much sustained inflation pressure as long as credit problems are elevated (since high credit risk tends to lower monetary velocity), but with yield levels generally low in the first place, there's little reason to accept a great deal of interest rate risk through duration exposure in straight Treasuries.

The Strategic Total Return Fund continues to carry a duration of about 3 years, mostly in TIPS, with about 15% of assets in precious metals shares, where the overall Market Climate remains favorable. As usual, we tend to trade around these positions in response to unusual price strength or weakness, but we have been well served by holding conservative, core positions in TIPS and precious metals given moderating economic growth and continued U.S. dollar risk.

New from Bill Hester: Global Yield Curves, Earnings Growth, and Sector Returns

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