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December 4, 2007

An Irrelevant Fed: Thimbles of Water in a Forest Fire

John P. Hussman, Ph.D.
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Pop Quiz

How much “liquidity” has the Federal Reserve “pumped” into the $12.7 trillion U.S. banking system since March 2007?

a) $1.2 trillion, which banks have used to firm up their balance sheets

b) $600 billion, which banks can now use to make new loans

c) $16 billion, all of which has been drawn out of the banking system as currency in circulation

If you answered c, move to the head of the class. Investors who answered a or b have not only been misled by analysts and media stories, but have no idea how irrelevant the Fed's actions are likely to be, except on short-term market psychology. More charts and data below.

A good opportunity to reduce excess risks

Last week, the stock market enjoyed a typical clearing rally from an oversold low - “fast, furious, and prone to failure.” This presents a good opportunity for investors to reduce positions that they would not be able to tolerate through a complete market cycle, with the S&P 500 only about 5% below a record high.

Let me preface this analysis by stressing again that my intention is not to drive investors out of well considered investment plans. There is nothing wrong with a buy-and-hold approach provided investors are aware of how strong the impulse is to abandon that strategy only after deep declines. I appeared briefly on CNBC last week to discuss recession risk, but beforehand, I was asked to put a positive tone on my comments, to which I responded – “Look, my interest is in making sure that investors have positions that they are able to hold through the complete market cycle, including a potential 30% bear market loss off the highs, without having their financial security endangered. If they're carrying more risk than they could endure through the course of a bear market, they should cut back now. I'm not going to wave my arms around about doom and gloom, but I think it's a crucial time for investors to think about the risk they're taking, and if you don't want me to say that, please don't have me on.” Well, I went on, and though we ran short of time, that's still my message.

In economic developments, durable goods orders came in below expectations last week, while new claims for unemployment shot higher. The ECRI Weekly Leading Index fell to its most negative growth rate since the last recession, as the ECRI commented “US growth prospects have deteriorated further.” Credit spreads widened again, well beyond the highs of a few months ago, and LIBOR (the interest rate to which much floating-rate debt is pegged) rose to just slightly below the level it was at early this year, before the Fed began cutting its own interest rates. While the entire Treasury yield curve is currently below the Fed Funds rate, it's clear that this due to a flight-to-safety in Treasuries. The Fed can certainly penalize savers by pressuring deposit rates lower, but it isn't having a measurable effect on the market-determined interest rates that borrowers actually face. Nor can the Fed significantly affect the solvency of the mortgage market.

As for stocks, I noted a couple of weeks ago (extending Jim Stack's analysis) that in each instance that the market declined materially after successive discount rate cuts, S&P 500 earnings were down sharply a year later. Given that a large portion of S&P 500 profits are from financials, that profit margins in other industries are well above historical norms, and that profit margins have always collapsed during recessions, my impression is that S&P 500 earnings could easily fall by 40% over the next 18 months (investors who view this as impossible haven't examined earnings history). This could become far worse than a 5% decline off the high, which is where the S&P 500 is now.

It's possible that investors could adopt a fresh willingness to speculate on the hopes and eventuality of a Fed rate cut (the economic news this week will determine the likelihood of 25 vs. 50). Regardless, given the economic backdrop, my impression is that any such speculation would be short-lived - as it has after other Fed cuts this year. For now, we don't have evidence to support any amount of bullish speculation. Our own investment position doesn't rely on a recession or a bear market, but those outcomes are increasingly probable rather than simply possible. In the Strategic Growth Fund, we are fully-hedged, but with a “staggered strike” hedge configuration that provides somewhat stronger defense against market losses (largely financed out of the “implied interest” we earn on our hedge). Though I believe that potential market losses could become deep, our investment position isn't driven by that expectation. It is enough that stocks have underperformed Treasury bills, on average, in similar conditions. In any event, historically, investors would have considered themselves lucky to clip off their excess risk so close to all-time highs, even after market action and economic news began to sour.

The Fed – thimbles of water in a forest fire

My greatest concern at present is that investors are being bombarded with empty hope that the Fed will save them by “injecting liquidity” into the banking system. Time spent examining these false perceptions is not time wasted.

Very simply, the impact of Fed actions is sorely exaggerated. The amount of liquidity that the Fed provides is minuscule in relation to the U.S. banking system, and also in relation to the volume of capital inflows (about $2 billion daily) that the U.S. relies on from foreigners, thanks to our massive fiscal deficits and low savings rate.

What strikes me as particularly absurd is that the analysts who wax rhapsodic about “Fed liquidity” speak in a way that makes it obvious that they have no understanding of how these Fed operations work. Then again, it's precisely because we do understand how they work that we're convinced that they're irrelevant (aside from boosting short-term market psychology and accommodating short-term spikes in the demand for currency).

Let's start with a basic fact. There is only one monetary aggregate that the Fed directly controls: the monetary base – consisting of currency in circulation plus bank reserves. Here's the data.

Monetary Base : http://research.stlouisfed.org/fred2/data/AMBSL.txt

= Currency in Circulation : http://research.stlouisfed.org/fred2/data/CURRCIR.txt

+ Total Reserves : http://research.stlouisfed.org/fred2/data/TRARR.txt

In the early 1990's, reserve requirements were abolished on everything but demand deposits (checking accounts). Since then, the quantity of bank reserves has gradually declined, and has no relationship with the volume of bank loans or total bank assets – again look at the data. In recent months, as has been the case since the early 1990's, virtually all of the increase in the U.S. monetary base has represented the gradual and predictable increase of currency in circulation, held outside of the banking system.

So how does the Fed increase the monetary base? There are three sources of “liquidity” managed by the FOMC: permanent open market operations, temporary open market operations, and loans through the discount window. Let's take a look at each. Again, here are the Fed's own statistics:

Permanent Open Market Operations:
http://www.ny.frb.org/markets/pomo/display/index.cfm?showmore=1

Temporary Open Market Operations:
http://www.ny.frb.org/markets/omo/dmm/temp.cfm?SHOWMORE=TRUE

Discount Window Borrowings:
http://research.stlouisfed.org/fred2/data/TOTBORR.txt

The Fed uses permanent open market operations primarily to finance the gradually increasing stock of U.S. currency in circulation. The Fed buys Treasury securities (which become an asset on the Fed's balance sheet) and pays for them by printing money (a liability of the Fed, as evidenced by the words “Federal Reserve Note” on top of the pieces of paper in your wallet). The Fed has not engaged in any permanent open market operations since May.

Next, the Fed can use temporary open market operations to vary the amount of day-to-day reserves in the banking system, in order achieve the targeted Federal Funds rate (which is the interest rate that banks charge to lend reserves overnight to other banks that are temporarily short). What's important is that these are temporary operations, in the form of “repurchase agreements”: the Fed provides reserves to the banks, usually for periods of 1-14 days. It purchases Treasuries or government-backed mortgage securities from the banks as collateral, and at the end of the period, the banks are obligated to buy them back from the Fed, at the purchase price plus interest.

What's important here is that every time a repo matures, the Fed generally enters a new one for a similar amount. The average maturity of these repos is only about 7 days, so there is a lot of activity. These transactions are constantly reported by the media as if they are “new injections” of liquidity – but they are just rollovers. If the Fed does a $20 billion 7-day repo one day, you can pretty much bet that the Fed will be doing another $20 billion in repos a week later when the outstanding one comes due. What matters is the total amount of repos outstanding. The chart below presents the 30-day average of Fed repos outstanding since March (see the above link for source data - thanks to Brooke Steinau for tying all of these figures out).

Note that the total amount of liquidity added by the Fed since March is only about $16 billion (it turns out that all of this has been drawn out of the banks as currency in circulation, probably for good, so at some point in the coming months, the Fed will undoubtedly do about $10-$15 billion in “permanent” open market operations to recognize this withdrawal, and will simultaneously reduce the outstanding amount of these “temporary” repos).

The third way the Fed can “inject liquidity” is to make loans to banks through the “discount window,” for which it charges interest at the “discount rate.” While market participants behave as if changes in the discount rate are wildly important, the fact is that even at their peak last summer, total loans to banks through the discount window only rose to about $3 billion. Currently, the total amount of “liquidity” being lent by the Fed through the discount window is $55 million. Yes, million.

Last week, investors made a great deal about an $8 billion 43-day repo that the Fed initiated. While this was reported as an extraordinary measure to stabilize the financial markets, the fact is that the Fed regularly enters a long-dated repo every year, just before the holidays, in order to accommodate a moderate increase in the demand for currency (in 1999, the amount was massive because of year-2000 fears, and was quickly reabsorbed after the new year). The $8 billion repo the Fed entered last week amounts to roughly $25 per American in extra cash to carry around the malls. To frame this as some sort of extraordinary effort to stabilize the banking system is absurd.

Again, the problem with the U.S. financial system here is not liquidity, but the solvency of mortgage loans and securitized debt. The Fed's actions are not likely to have material impact on this. To believe otherwise is mindless sheep-like superstition. Do investors really want to bet their financial security on the hope for “Fed liquidity” promised by uninformed analysts who don't understand monetary policy because they can't be bothered to look at the data?

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. The Fund currently has a “staggered strike” hedge, which has about 1% of assets invested in time-premium (compared to a flat hedge where our short call and long put strikes are matched). This amount is essentially financed from interest that we would otherwise earn on the hedge, so while we do have substantially better protection against losses, we would not expect to experience a sustained loss of value on account of hedging if the market was to advance significantly. As usual, the main driver of fluctuations in the Fund, both day-to-day and over time, is the difference in performance between the stocks owned by the Fund and the indices we use to hedge (primarily the S&P 500, Russell 2000, and a modest hedge in the Nasdaq 100).

The objective of the Fund is to outperform the S&P 500 over the complete market cycle, with smaller periodic drawdowns than a passive buy-and-hold strategy. Fund performance over the complete cycle is an appropriate measure of the strategy, but a focus on day-to-day fluctuations is not particularly useful. The Fund is not appropriate for short-term investments. As I've noted before, a portion of the day-to-day gains that our "staggered strike" position achieves on down days may be given up if the market rebounds before we have a good opportunity to reset our strikes. Given our current mix of industries, the Fund will tend to pull back on days when financials are particularly strong relative to technology, health, energy and consumer stocks, and the Fund will tend to gain on days when the opposite is true. Our relative industry weights are intentional, and we don't try to game very short-term moves by, say, loading up on poorly situated financials in order to catch a quick "bounce."

The market has now cleared the oversold condition that it established a week ago. Stocks aren't overbought here, but overbought conditions in unfavorable Market Climates tend to be rare. The steepest bear market losses tend to follow immediately on the heels of such overbought conditions. As I've noted before, the only times I ever have a clear short-term expectation about market direction is either when the market is overbought in a negative Market Climate, or oversold in a favorable Market Climate. Presently, we've cleared the oversold condition, but could just as well move sideways for a bit rather than down again, so I have no pointed expectation about market direction.

With regard to the international markets, Bill Hester has some interesting comments about global market breadth and correlations in International Markets Show Important Divergences (additional link below).

In bonds, the Market Climate continues to be characterized by unfavorable yield levels and favorable yield trends. Real interest rates are clearly under pressure here, which is supportive for gold and commodities, and very hostile to the U.S. dollar. While nominal Treasury yields may also be pressed lower as a likely recession unfolds, long-term Treasury yields tend to be “stickier” than short-term rates once an economic slowdown is obvious, so that the yield curve tends to steepen during recessions. I would expect to increase our durations modestly on any short-term spikes in yield that we might observe, but chasing an overbought Treasury market at a 10-year yield of less than 4% would be overly speculative at present.

Some analysts have noted that 10-year Treasury yields are now well below the “forward operating earnings yield” of the S&P 500, interpreting the flight to safety in the face of mounting loan losses as a “Fed Model buy signal.” Unfortunately, “buy signals” on the Fed Model when bond and stock yields are low (as they are now) tend to have little usefulness for stocks, but are often very good points to sell bonds. While this instance may be different given rapidly increasing recession risks, we can't rule out the impact of dollar weakness, import price inflation, and commodity price pressures as possible threats to Treasury prices. Given already low long-term yields, I believe our risk budget is better allocated to precious metals shares, where conditions are less ambiguous. Presently, the Strategic Total Return Fund holds a moderate exposure of about 15% of assets in these shares.

New from Bill Hester: International Markets Show Important Divergences

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