March 7, 2011
Quantitative Easing and the Iron Law of Equilibrium
Last week, I had the pleasure of speaking to investors at the Ibbotson-Morningstar 2011 investment conference. Since I rarely travel outside of charitable work, it was a nice opportunity to talk with shareholders and other investors. The topic was "Useful Laws and Dangerous Myths of Investing," which featured a number of topics regularly covered in these weekly comments that I view as durable truths of investing.
Nearly a century ago, Charles Dow said "to understand values is to understand the meaning of the market." So I began with what I call The Iron Law of Value: An investment is nothing more than a claim on an expected stream of cash flows that will be delivered to investors over time. Much of that topic is very familiar to readers of these weekly comments - I focused the discussion on the difference between the "fundamentals" that are reported over the short-term (trailing net earnings, forward operating earnings, etc) and the long-term stream of cash flows that is actually delivered to investors, which depends on much broader considerations such as profit margins, sustainability of revenue growth, return on invested capital, the extent to which repurchases simply offset dilution from options grants to insiders, and so forth.
We also talked about simplistic valuation methods such as the Fed Model, which takes the simultaneous decline in 10-year Treasury yields and S&P 500 forward earnings yields from the early 1980's to about 2000, and presumes that there must be a one-to-one correspondence between 10-year yields and S&P 500 earnings yields - which is clearly not supported by longer-term evidence. Likewise, we discussed the uses and drawbacks of "multiples-based" valuation methods (price = fundamental x "fair" price/fundamental ratio) - particularly the large amount of "work" that is quietly required of that "fair" multiple, and the danger of choosing it arbitrarily. As an alternative to those uses of forward operating earnings, I presented our standard methodology, and the historical record of the 10-year total return projections from that model, compared with the actual realized total returns that the S&P 500 subsequently achieved.
Next, I discussed what I call The Iron Law of Equilibrium: Every security that is issued must be held by someone until it is retired.
There are three corollaries to that Law: 1) No security can be under- or over-owned. Prices and expected returns adjust to ensure that the exact quantity outstanding is the exact quantity held. The investor's challenge is to ask whether those prices and expected returns are reasonable; 2) The outstanding stock of issued currency and money market securities always remains effectively “on the sidelines” and held by someone - until the time those securities cease to exist; 3) Money never goes “into” or comes “out of” a secondary market. It is always “home.”
If you think carefully about equilibrium, it helps to clear up all sorts of fallacies that people hold about the financial markets. For example, the currency and money market securities that are held by investors will - in aggregate - never "find a home" in any other form or any other market. If somebody takes their cash and tries to buy stock, they get the stock and the seller gets the cash. Nothing disappears, and nothing is created - only the owner changes. As I wrote years ago in the Freight Trains and Steep Curves piece that anticipated the recent financial strains, the mountain of money-market securities held by investors is not a reflection of "liquidity looking for a home," but is rather a measure of how dependent borrowers are on short-term sources of credit. Investors are holding a lot of money market securities because a lot of money market securities have been issued, and those securities will stick around until they are retired.
As I noted last week, an understanding of equilibrium is particularly important when it comes to the Federal Reserve's program of Quantitative Easing (QE), so some further discussion may be helpful.
Essentially, QE has added to what will soon be $2.4 trillion of non-interest bearing cash and bank reserves, which someone will have to hold. The first effect of QE is therefore to immediately drive the interest rate on near-substitutes of cash (such as 1-month and 3-month T-bills) to nearly zero. This happens because any significant positive interest rate would induce people to try to shift their holdings from non-interest bearing cash to T-bills, and they bid up T-bills to the point where they are indifferent between the two. In the end, all the T-bills that have been issued are held, and all the cash is held (if interest rates could not be pressed lower, the competition between interest-bearing stores of wealth and zero-interest cash would make cash a "hot potato," causing it to rapidly lose value relative to goods, services, and everything else, which is what we call inflation).
Technically, the Fed is buying Treasury securities and creating currency and bank reserves to pay for them. This would simply be an asset swap were it not for the fact that the U.S. is running a budget deficit of about 10% of GDP, so the Fed's purchases don't even absorb the amount of newly issued Treasury debt. The government budget constraint is simple: spending = taxes, plus the change in Treasury securities held by the public, plus the change in Treasury securities held by the Fed (base money creation). So the overall effect of QE is to reduce the amount of debt that the public would otherwise have to buy, and to instead create money and bank reserves to indirectly finance government spending.
The main effect of QE on the financial markets has little to do with stimulating spending, and everything to do with the fact that the currency and bank reserves bear zero interest, and yet have to be held by someone. In equilibrium, QE requires that the interest rates on near-cash securities must also be nearly zero.
Of course, a similar process happens for riskier and longer-term assets, but the resulting returns are less exact. For stocks, we've seen investors drive prices up to the point where probable 10-year returns are only about 3.2%. But of course, you can get a 3.2% 10-year return by having zero returns for 1-year, and returns averaging about 3.6% for the next 9 years. So depending on the overall profile of returns expected by investors, it's quite possible that near term stock returns have already been driven to zero on a risk and maturity-adjusted basis. The key point, in any event, is that the primary function of QE is to distort market equilibrium by raising the price and depressing the future prospective returns on nearly every asset class.
If you look at the commodity markets, the same factors are at play. Regardless of whether one expects modest or significant inflation, it's clear that the inflation expectations of the market are generally positive. So people expect that a year or two from now, goods and services will be more expensive. But if they are holding cash or money market securities, it is clear that interest earnings will not make up for those higher prices. So what do people predictably do? They hoard commodities now. When does it stop? At the point where commodities are priced high enough that they are expected to have the same negative return, relative to a broad basket of consumer goods, as cash is expected to have.
Keep in mind that commodities aren't really a good inflation hedge once inflation is well anticipated. Rather, commodities tend to "overshoot" in the early stages of inflation, and then typically lose ground relative to the broad CPI as inflation proceeds. For example, in 1975, the CRB shot to about 5 times the level of the CPI. By the early 1980's, the ratio had dropped to half that level, and continued to decline during the subsequent disinflation.
It is widely believed that the rise in commodity prices reflects the effects of China, India and other developing countries, but this long-term growth story certainly didn't prevent commodities from collapsing in 2008. It's a well-known result in resource economics that even when a resource is exhaustible and in significant demand, the price does not rise at a spectacular rate. Rather, except when there are new shocks that were previously unanticipated, the price of an exhaustible resource will tend to increase at roughly the rate of interest (Hotelling's rule).
Certainly, concerns in Libya and elsewhere are creating some additional short-term pressures, but it should be clear that the primary force behind the rise in commodity prices is that QE has suppressed real interest rates to negative levels. If anything, QE is one of the primary forces driving up food and energy prices globally, contributing to extreme difficulty among the impoverished of the world, and adding to social tensions and resulting violence.
With the notable exception of the spike in the CRB triggered by the OPEC oil embargo in 1973, which preceded the movement of real interest rates, a significant portion of commodity price fluctuations reflects pre-emptive hoarding and release of commodities as surrogates for future consumption of goods and services, in response to the difference between expected inflation and the interest rate available on money-market securities.
The Ibbotson-Morningstar presentation concluded with some remarks about "efficient" versus "inefficient" risk - noting in particular that accepting greater risk is only a useful strategy toward achieving greater returns for portfolios where the expected return per unit of risk has already been optimized. We also talked about the relationship between volatility and compound returns, as well as the relationship between valuations and "tail-risk" - the risk of deep market losses over the subsequent 5-year period. I'll plan to touch on some of these topics in future market comments.
On the prospects for a long-term secular bull market
As of last week, the estimate from our standard methodology is that the S&P 500 is priced to achieve total returns over the coming decade averaging about 3.2% annually. That said, this long-term estimate does not reduce into a forecast for near-term returns, or even returns over the next year or two.
With respect to the near and intermediate-term, market conditions remain characterized by an overvalued, overbought, overbullish, rising-yields syndrome which has historically been associated with a negative return/risk profile and often abrupt market weakness. However, if we can clear some component of this syndrome without a sharp deterioration in market internals, we'll be able to accept moderate, periodic exposure to market fluctuations. We were able to raise our put strikes during the advance to last month's market highs, so the subsequent pullbacks have given us a chance to cover nearly 40% of the short-call side of our hedge as our put options went "into-the-money," while still leaving the Strategic Growth Fund fully hedged. At present, the Fund's put options are largely at-the-money, and about 60% of those are matched with short calls, so we're still well covered against downside risk. Yet even the modest opportunities we've had in the past couple of weeks should make us much more comfortable in the event that stocks continue higher without immediately clearing the hostile syndrome that remains in place.
While I do believe that the market is overvalued, I should emphasize that the basis for our current defensiveness is very specific - driven by the narrow syndrome of unfavorable conditions we presently observe - and is also likely to be cleared within several weeks. At that point, provided that we don't see a more troublesome breakdown in market internals, we'll have some latitude to accept more constructive exposure to market fluctuations.
On the economic front, I continue to view the baseline "mean-reversion scenario" for real GDP growth to be about 3.9% annually over the next several years, with job growth averaging about 200,000. That would be the economic performance that we would expect simply on the basis of gradual reversion to "potential GDP" about 4 years from now. Over the short-term, provided that we don't have any significant economic shocks, that is roughly the economic performance we should witness. Unfortunately, that short-term behavior reflects surface considerations and is dependent on the continuation of very large fiscal deficits and extraordinary monetary intervention. The underlying credit problems and imbalances in the economy certainly have not been adequately addressed, in my view. So while the short-term economic picture seems to be fairly smooth sailing, I suspect that Nessie is still under the boat, and that there will be numerous disruptions of that baseline scenario in the next few years.
On a longer-term basis, I believe that our 10-year total return projection of 3.2% is a bit harsh. This is not because I doubt that the overall total return will be relatively accurate, but rather, because I believe that the next long-term secular bull market is likely to begin much sooner than 10 years from now, so I certainly don't expect that we'll observe a full decade of poor market returns.
To better explain this, let's define some terms - a "secular" bull market involves a series of several complete "cyclical" bull and bear markets, with the characteristic that each successive bull market peak achieves a higher level of valuation (based on P/E multiples, not price alone). In contrast, a "secular" bear market involves a sequence of smaller "cyclical" bull and bear markets, with the characteristic that each successive bear market trough achieves a lower level of valuation. Historically, these long secular bull and bear periods have usually lasted roughly 16-18 years. Most recently, the secular bear market that ended in 1982 gave way to a secular bull market ending in 2000. That year marked the beginning of a secular bear market, which has thus far included several "cyclical" bear-bull-bear-bull fluctuations. Given the elevated valuations we presently observe, I doubt that this secular bear is behind us.
As a side note, the cyclical bull markets during secular bear markets are shorter, on average, than the cyclical bull markets in secular bull markets. At about 2-years in duration, the present bull is about the average length of a cyclical bull in a secular bear, but this is hardly predictive of the market outlook here.
If you mark the beginning of a secular bear at 2000, you would expect the next secular bull to begin somewhere around 2016-2018. There are both optimistic and pessimistic considerations for investors who expect a secular bull market to begin less than 10 years from now. See, if you look at the projected 10-year returns for the S&P 500 that characterized the beginning of other secular bull markets, you've historically seen projected total returns close to or exceeding 20% annualized. Unfortunately, in order for stocks to be priced at levels that have historically given rise to sustained, long-term secular bull markets, you would have to have the S&P 500 begin at valuations - and prices - far deeper than we observed at the 2009 low (where stocks were priced to achieve 10-year returns modestly above 10% annually - most of which has been compressed into the advance since then).
While we're expecting a 3.2% annual total return for the S&P 500 over the coming decade, it doesn't follow that we expect 10 years of poor market returns. More likely, in my view, the weaker returns will be concentrated in the next 6 years or so, followed by normal or above-normal returns. So for example, to get 3.2% average annual returns for a decade, you can have 6 years averaging -1.1%, followed by 4 years averaging 10%. Alternatively, you can have 6 years averaging -4%, followed by 4 years averaging 15%. To get very strong returns in the back years of the decade, you would need to set up deep initial valuations, say 6 years averaging -6.7% annually, followed by 4 years averaging about 20%.
All of this is a way of saying that investors should not allow the experience of the bubble period from the mid-1990's to the present to become their benchmark of long-term valuations. When the market is at high levels of historical valuation, it is easy to view the valuations of previous market troughs as impossible and implausibly low. I'm not making a short-term argument here, nor even an argument about the next year or two - over that period, we can't rule out the potential for economic progress to continue and for valuations to become even richer. On that, we'll take the evidence as it emerges.
Still, I hope to emphasize that valuations are the essential driver of long-term returns, and if one hopes - as I do - that the next secular bull market will begin at some point sooner than a decade from now, the downside of that hope is that we would need to reach market valuations at some point between now and then that could be distressingly low. While short-term economic factors look reasonably stable, investors should not rule out eventual strains from various fundamental imbalances (including the large overhang of delinquent and unforeclosed homes, eventual adjustments and losses in bank capital, sovereign debt issues, fiscal strains, or other factors).
As of last week, the Market Climate for stocks remained characterized by a syndrome of overvaluation, overbought conditions, overbullish sentiment and rising interest rates. This combination has historically been associated with a negative overall return/risk profile, but if we can clear one of these components without a broader breakdown in market internals, we'll be able to accept moderately greater exposure to market fluctuations. For now, Strategic Growth Fund and Strategic International Equity remain well hedged. As noted above, in the Strategic Growth Fund, we were able to use some of the volatility of recent weeks to first raise our put strikes on market strength, and then cover some of our short calls on subsequent weakness, in a way that keeps us well-hedged, but gives us greater ability to participate in a sustained market advance if it emerges without clearing the present, hostile syndrome.
In bonds, the Market Climate last week was characterized by relatively neutral yield levels and unfavorable yield pressures. Strategic Total Return continues to carry a duration of less than 2 years, and continues to have about 8% of assets in precious metals shares, maintaining a relatively conservative investment stance overall.
Prospectuses for the Hussman Strategic Growth Fund, the Hussman Strategic Total Return Fund, and the Hussman Strategic International Equity Fund, as well as Fund reports and other information, are available by clicking "The Funds" menu button from any page of this website.
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