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January 10, 2011

"Illusory Prosperity" - Ludwig von Mises on Monetary Policy

John P. Hussman, Ph.D.
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Reprint Policy

A few notes about our investment strategy in the present environment: The stock market continues to be characterized by an overvalued, overbought, overbullish, rising-yields syndrome that has historically proved to be quite negative for stocks. It is urgent to stress here that while overvaluation itself can persist for quarters or even years, the narrower syndrome I have described here has rarely persisted for longer than a few months before resolving into abrupt and typically very steep market losses (a duration of this condition for 6-14 weeks is common). I noted in recent months that we've introduced a broader range of Market Climates, which will allow us to take moderate exposures to market fluctuations more frequently than in recent years. But even on the basis of this richer set of Market Climates, now is not the time. In dozens of subsets of historical data and allowing numerous ways to classify market conditions, we come to the uniform conclusion that market risk is not worth taking, and is in fact quite dangerous to accept, under the present set of conditions.

I doubt that we will clear this condition through a retreat large enough to remove the market's overvaluation, so it is likely that we will clear it instead by removing at least one of the other components of this syndrome: overbought, overbullish or rising yields. At that point, provided that market internals do not break down decisively (which would probably only occur on a decline below about 1120 on the S&P 500), our present set of Market Climates would allow, and even prescribe, a greater exposure to market fluctuations. I would expect this to be on the order of 20-40% of market fluctuations (leaving a significant portion of our assets fully hedged), and maintaining at least a line of put option defense around that 1120 area to limit any persistent loss should market internals break down decisively.

It is certainly not the case that by remaining defensive in the face of this syndrome, we are committed to remaining tightly hedged should the market embark on a bubble similar to the late 1990's. The confluence of all four factors - overvalued, overbought, overbullish, and rising yields, has rarely persisted even in "bubble" advances. I strongly doubt that we'll observe a late-1990's type of valuation bubble anyway, but I also recognize that - given the proclivity of the Fed toward ever larger and more reckless interventions - we can't rule out a repeated attempts to encourage mindless speculation, with similarly devastating consequences at some future point in time.

The past few years have been as unusual as any that investors have experienced since the Great Depression, and though we've outperformed the S&P 500 since the market peak in 2007, I certainly owe you greater absolute returns. It bears repeating that the source of our "miss" in 2009 and early 2010 was my refusal to view the downturn as a typical post-war recession. They do not ring a bell at the bottom, so successfully avoiding major losses in 2008 and early 2009 would have required missing a good chunk of the initial advance from the 2009 lows in any event (after numerous spike rallies that failed spectacularly, the S&P 500 shot up nearly 40% within 8 weeks of the March low, which simply recovered the plunge that it had endured since January). Still, we would have captured a larger portion of the 2009 and early 2010 advance by completely ignoring data related to other post-credit crisis periods. I was (and remain) convinced that what we were observing was "out of sample" with respect to post-war data, requiring us to examine periods with greater historical similarity. But in hindsight, I frankly underestimated the willingness of investors to believe that the underlying structural difficulties of the economy (which still persist in my view) were so easily solved by disabling fair-market accounting disclosure and repeatedly violating the provisions of the Federal Reserve Act (specifically 13c and 14b).

In any event, it is my job to not only defend capital, but to achieve returns despite the recklessness that policy makers choose to pursue. We directed a great deal of effort to developing robust methods to integrate the information from multiple data sets (e.g. post-war, post credit-crisis) coming out of the downturn. Using a weighted average was insufficient, and the proposition that we could ignore other post-crisis data saying "it's different this time" was not testable, except for the littered graveyard the phrase has generally produced. Fortunately, the various "ensemble methods" that we have designed have improved our discipline in a testable way. The broader set of Market Climates we have defined will allow us some additional latitude to accept moderate - if transitory - exposures to market fluctuations more frequently even in richly valued markets. That said, what I will not do is violate our discipline and accept market risk when the evidence is firmly against doing so. Presently, we're fully hedged.

I believe that fiduciaries have the responsibility to discuss the reasoning behind the decisions they make, and should have the maturity to admit where their judgments have been in error. Still, given my view that our investment approach is more sound than ever, allow me to also note what we've done right. The Strategic Growth Fund has outperformed the S&P 500 from the 2007 market peak to the current peak, with a fraction of the interim loss. The Fund outperformed the S&P 500 from the 2002 bear market low to the 2009 bear market low. The Fund outperformed the S&P 500 from the 2000 peak to the 2007 peak. The Fund has powerfully outperformed the S&P 500 from the 2000 peak to the present. That is our intended objective - to outperform our benchmarks over complete market cycles with smaller periodic losses than a passive investment strategy.

As I've emphasized for more than a decade, a "full market cycle" is taken from the peak of one bull market to the peak of another, or the trough of one bear market to the trough of another. It is inappropriate and misleading to evaluate the performance of a hedged investment strategy from a bear trough to a bull peak, or from a bull peak to a bear trough. For example, the period from the March 2003 market trough to the present is not one full market cycle, but one full cycle plus an uncompleted half - it includes the 2003-2007 bull market, the 2007-2009 bear, and the bull market from 2009 to the present, but leaves out the potential for the recent advance to be corrected by a future bear market. Again, our objective is to outperform the major indices over the complete market cycle, with smaller periodic losses.

As always, the Funds do take risk, past performance does not ensure future returns and there is no assurance that the Funds will achieve their objectives. To the extent that we are successful in our objectives, my hope is the Hussman Funds will be useful either as stand-alone, long-term investments (all of my own liquid assets, outside of a small amount in money market funds, are invested in this way), or for investors who prefer less "tracking risk," that the Funds will provide useful diversification for traditional (market-tracking) funds, in a way that enhances long-term returns while reducing portfolio risk over the full market cycle.

With respect to shorter-term returns, the bulk of the pullback in Strategic Growth that we've seen in the past few months is simply a reversal of the gains that the Fund achieved during the April - July market decline. On the stock selection front, we've had some "basis risk" recently in that stocks having poor rankings for quality and yield and high rankings for risk have outperformed stocks with the opposite characteristics, but given that our stock selections have outperformed the S&P 500 on a total return basis by more than 700 basis points annually, we're maintaining our discipline there. So, we're comfortable with the stocks we hold, despite the recent exuberance for speculative issues, and we're also comfortable with our hedged position here, given the overvalued, overbought, overbullish, rising-yields syndrome that we presently observe.

Full performance information for the Hussman Funds over all standard horizons, quarterly and annual Fund returns (stock-selection only and including hedge impact), Fund performance charts, annual and semi-annual Fund reports, and Fund Prospectuses, are available on The Funds page.

Where does "liquidity" go?

Among the most zealous articles of economic faith here is the idea that additional "liquidity" provided by the Federal Reserve has to ultimately either "find its way" into the asset markets or produce an increase in economic activity, as if the economy and financial markets are simply a set of vessels to be filled. There is no denying the psychological impact that these beliefs about Fed actions have on the actions of investors. Still, it is equally important for investors to understand the extent to which these beliefs represent reality or delusion. And here, the only way to achieve this understanding is to "follow the money," so to speak.

I've often observed that once any security is issued, it has to be held by someone until it is retired. This is true for stocks, bonds, Treasury bills, currency, bank reserves, and every other financial claim in the economy. In aggregate, there is simply no way for money to go "out of stocks" and "into bonds" or vice versa. Every share of stock that is outstanding at any point in time must, by necessity, be held by someone. The same is true for bonds, and the same is true for bank reserves.

Suppose that investor A has $100 in a bank account, and decides to move that money "into the stock market." Investor A goes to the stock market, and buys some number of stock certificates from investor B. Investor B now gets a claim on the $100 of bank reserves, and the stock certificates formerly owned by investor B are now owned by investor A. Investor B might now choose to buy Treasury bonds with the proceeds. When all is said and done, investor A will own stock shares previously owned by investor B, investor B will own Treasury bonds previously owned by investor C, and investor C will have a claim to bank reserves previously owned by investor A. Money has not gone "off the sidelines" and "into" stocks. Previously issued securities have simply changed ownership, and those securities will remain outstanding until they are retired.

Now suppose the Federal Reserve comes in and buys the Treasury bonds held by investor B. Investor B now gets some newly created bank reserves. Somebody has to hold them. Regardless of whether investor B holds them directly, or investor B makes a trade so that someone else holds them, those bank reserves have to be held by someone until they are retired. The extent to which these reserves will affect the prices of goods, commodities, stocks or anything else is determined by whether investor B is satisfied to hold the bank deposit. If not, investor B may bid up the price of some other good or asset by just enough that some other marginal holder is satisfied to trade their asset for the cash, but there is certainly no reason for the resulting change in prices to be proportional to the change in the quantity of bank reserves.

From this perspective, what is presently occurring in the stock market is that investors who were previously satisfied to hold stocks at lower valuations have been induced to transfer those shares to speculators who are now satisfied to hold those stocks at rich valuations. One has to ask who the smart money is in this trade.

So money never goes "into" or "out of" a secondary market. Investors can never "sell bonds" and "buy stocks" in aggregate. Nor can they use their "sideline" cash to buy stocks, in aggregate. Whatever funds are on the sidelines in money market assets such as short term debt instruments must, in equilibrium, stay "on the sidelines" until those instruments are retired. What moves prices is not the amount of money moving "into" or "out of" some market, but the relative eagerness of demand versus supply.

New issuance, savings and investment

It is important to distinguish ordinary trades in stocks and bonds from the new issuance of securities. When a share of stock is newly issued, money that has been saved by some investor goes directly to the company issuing the stock. Those real savings can then be used to finance real investment. The new share of stock is essentially evidence of those transferred savings. When people invest in stocks through their 401Ks, they may believe that their money is going "into" the stock market, but in fact, the moment they take their money "into" the market, it goes out in the hands of a seller. How the funds are actually used is then out of the 401K investor's hands. The money might simply end up being spent on Twinkies.

More generally, provided that the investment is made with new savings (new income that has not been spent for consumption), it must be true that somewhere in the economy, one of two things will happen: 1) each new dollar of savings will end up financing a new dollar of real, physical investment, intentionally through the deliberate investment of those savings, or unintentionally through unwanted "inventory investment" or; 2) somebody will spend the proceeds of their security sale on consumption goods, offsetting the savings of the first investor with "dissavings," and leaving the capital stock unchanged. In short, new savings produce new investment. Everything else is just a transfer of ownership.

One might think, well, if the Fed creates $100 of bank reserves, and banks only have to hold a fraction of them against deposits, then the banking system can create say, $900 of additional new loans and automatically create a huge amount of real investment. This is what is typically taught somewhat carelessly in undergraduate economics. The problem here is that it quietly demands a great deal from the savings-investment identity. If you follow the money carefully, it becomes clear that the only way for the economy to produce $900 of new investment is if it automatically produces $900 of new savings. Otherwise, the "increased" investment represented by the $900 purchase must be offset by a decrease in inventory investment. In the end, what really matters for the economy is whether the best use of scarce savings is to produce a new machine. Once there is a reasonably unencumbered way for savers to transfer their funds to prospective borrowers if they choose to do so, the best way to encourage productive investment is to ensure that the signals from prices and investment returns are not distorted.

By now, it should be clear that large amounts have "flowed into" bond funds over the past few years, not because money has been "shifted" from somewhere else, but rather because so many new bonds have been issued, largely by the U.S. Treasury to finance mammoth budget deficits. This is where the world's "savings" have gone. People earned some amount of income, they consumed part of it, they saved the rest, and those savings went to the government, which issued Treasury debt and spent the money as deficit spending or "dissavings," which made up part of the income that people earned, but without adding to the existing capital stock because no net savings occurred. It's all one happy circle, except that the people who consumed were Americans and the people who bought the Treasuries were Chinese. So what we have done, in effect, is that we have consumed off of what would otherwise have been capital, had our savings instead been allocated to real investment rather than deficit spending. The largely foreign savers now have claims that can be exercised either against our future production, or to accumulate real assets such as U.S. property or business enterprises.

If we are looking for policies to encourage economic activity such as real investment, the best approach is to create an environment that rewards the accumulation and productive allocation of savings. Instead, the Federal reserve is punishing savings by depressing the rates of return available on nearly every class of assets, while simultaneously ensuring that whatever scarce savings do emerge are misallocated to the most speculative pursuits.

Look historically, and you'll find that growth typically does not follow depressed or negative real interest rates, but instead usually follows high ones. High real interest rates are an inducement to save, and therefore encourage the accumulation of savings that can be allocated to productive investment. Undoubtedly, the situation is helped when many productive investment opportunities exist. In that event, real interest rates are also bid up by demand for funds to needed finance these projects.

In the chart below, real interest rates are in blue on the left scale, and real GDP growth over the following year is depicted in red on the right scale. While there were periods of strong GDP growth in the 1960's and 1970's beyond what would have been expected given the level of real interest rates, it is important to recognize that population growth and other factors at that time combined to produce a growth rate in "potential GDP" (which is regularly calculated by the Congressional Budget Office) that was nearly double the rate that can be expected over the coming decade.

As I've noted in recent weeks, simply to gradually close the present output gap over a 4-year period (which has historically been reasonable), the "mean reversion benchmark" would be for GDP to grow by about 3.8% annually over the coming 4 years, with average employment growth in the range of 200,000 jobs per month. The problem is that while this might be the outcome if underlying structural problems were absent, in reality the U.S. economy continues to be burdened by continuing underlying fiscal challenges and credit difficulties - even if these difficulties are made opaque as a result of 2009 changes to FASB accounting rules.

For now, the surface veneer of economic recovery continues to be relatively intact. That may change at some point, for example, around mid-year when Federal stimulus runs out and state budgets hit what is referred to as "the cliff." But in any event, the distortive policies of recent years will most likely provoke another downturn long before we take up the existing output gap. The process of stable recovery would be dramatically helped by debt restructuring and abandonment of the more egregious efforts to distort the credit markets through Fed intervention, but there appear to be few prospects for more enlightened policy here. We have to invest in the real world, and during the next several years, we will almost certainly live in interesting times.

Illusory Prosperity - Ludwig von Mises on Monetary Policy

"Credit expansion cannot increase the supply of real goods. It merely brings about a rearrangement. It diverts capital investment away from the course prescribed by the state of economic wealth and market conditions. It causes production to pursue paths which it would not follow unless the economy were to acquire an increase in material goods. As a result, the upswing lacks a solid base. It is not a real prosperity. It is illusory prosperity. It did not develop from an increase in economic wealth [i.e. the accumulation of savings made available for productive investment]. Rather, it arose because the credit expansion created the illusion of such an increase. Sooner or later, it must become apparent that this economic situation is built on sand."

Ludwig von Mises, The Causes of Economic Crisis (1931)
Historical note - The U.S. stock market lost more than two-thirds of its value over the following year

If one looks back to the recent housing crisis, it is clear that the policy emphasis on easy money was one of the primary elements that created the illusory prosperity of the housing bubble and eventually led to crisis. The same is true of the various other crises that we have observed over the past decade. At present, I am convinced that the misguided policies that have been pursued in response to the recent downturn will again be reflected as significant new strains within a few years, if not sooner. While we will exercise as much latitude as possible to accept moderate investment exposures when the evidence is supportive, we have to be aware of the longer-term outcomes that are being set in motion by the present course of monetary and fiscal recklessness.

Perhaps more than any other economist, Ludwig von Mises got the theory of money and credit right, because he made distinctions between various forms of money and credit that are often conflated by other theorists. The amount of real physical investment in the economy is, and must be, precisely equal to the amount of output not allocated to consumption but instead to savings. Unlike many other economists, Von Mises not only recognized this identity, but carried it through to what it implied for monetary policy. Specifically, he observed that all real investment in the economy must be financed by real savings, while the creation of financial claims (which he called "circulation credit" or "fiduciary credit") in the absence of those savings tends to distort prices rather than output.

What follows are writings that I have selected from Von Mises work. The warnings that he gave prior to the Great Depression were particularly acute. Though Von Mises concerns unfortunately went mostly unheeded, they speak volumes about the origins of the recent crisis, and the risks that we are likely to face in the years ahead. As you read these, keep the recent housing crisis and the recent actions of the Federal Reserve in mind.

"Every serious discussion of the problem of credit expansion must start from the distinction between two classes of credit: commodity credit and circulation credit. Commodity credit is the transfer of savings from the hands of the original saver into those of the entrepreneurs who plan to use these funds in production. The original saver has saved money by not consuming what he could have consumed by spending it for consumption. He transfers purchasing power to the debtor and thus enables the latter to buy these nonconsumed commodities for use in further production. Thus, the amount of commodity credit is strictly limited by the amount of saving, i.e. abstention from consumption. Additional credit can only be granted to the extent that additional savings have been accumulated. The whole process does not affect the purchasing power of the monetary unit.

"Circulation credit is granted out of funds especially created for this purpose by the banks. It increases the amount of money substitutes, of things which are taken and spent by the public in the same way in which they deal with money proper. It increases the buying power of the debtors. The debtors enter the market of factors of production with an additional demand, which would not have existed except for the creation of such banknotes and deposits. It is the main tool of policies aiming at cheap or easy money."

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"Every deviation from the prices, wage rates and interest rates which would prevail on the unhampered market must lead to disturbances of the economic equilibrium. This disturbance, brought about by attempts to depress the interest rate artificially, is precisely the cause of the crisis. The ultimate cause, therefore, of the phenomenon of wave after wave of economic ups and downs is ideological in character. The cycles will not disappear so long as people believe that the rate of interest may be reduced, not through the accumulation of capital [i.e. savings made available for productive investment], but by banking policy."

"The calculation of entrepreneurs is misguided by the issue of additional fiduciary media. The greater this quantity of fiduciary money, the more factors of production have been firmly committed in the form of investments which appeared profitable only because of the artificially reduced interest rate and which prove to be unprofitable [as soon as] the interest rate has again been raised. Great losses are sustained as a result of misdirected capital investments. Many new structures remain unfinished. Others, already completed, close down operations. Still others are carried on because, after writing off losses which represent a waste of capital, operation of the existing structure pays at least something.

"It may well be asked whether the damage inflicted by misguiding entrepreneurial activity by artificially lowering the loan rate would be greater if the crisis were permitted to run its course. Certainly many saved by the intervention would be sacrificed in the panic, but if such enterprises were permitted to fail, others would prosper. Still, the total loss brought about by the "boom" (which the crisis did not produce, but only made evident) is largely due to the fact that factors of production were expended for fixed investments which, in the light of economic conditions, were not the most urgent. If banks emerge from the crisis unscathed, or only slightly weakened, what remains to restrain them from embarking once more on an attempt to reduce artificially the interest rate on loans and expand circulation credit?

"The discrepancy between what the entrepreneurs do and what the unhampered market would have prescribed becomes evident in the crisis. The fact that each crisis, with its unpleasant consequences, is followed once more by a new "boom," which must eventually expend itself as another crisis, is due only to the circumstances that the ideology which dominates all influential groups - political economists, politicians, statesmen, the press and the business world - not only sanctions, but also demands, the expansion of circulation credit."

Ludwig von Mises, Monetary Stabilization and Cyclical Policy (1928)
Historical note - The Great Depression began the following year.

"If the market rate of interest is reduced by credit expansion, many projects which were previously deemed unprofitable get the appearance of profitability. The entrepreneur who embarks upon their execution must, however, very soon discover that his calculations were based on erroneous assumptions. However, as the banks do not stop expanding credit and providing business with 'easy money,' the entrepreneurs see no cause to worry. Everybody feels happy and is convinced that now finally mankind has overcome the gloomy state of scarcity and reached everlasting prosperity.

"In fact, all this amazing wealth is fragile, a castle built on the sands of illusion. The artificial prosperity cannot last because the lowering of the rate of interest, purely technical as it was and not corresponding to the real state of the market data, has misled entrepreneurial calculations. Deluded by false reckoning, businessmen have expanded their activities beyond the limits drawn by the state of society's wealth. In short, they have squandered scarce capital by malinvestment.

"The sooner one stops, the less grievous are the damages inflicted and the losses suffered. Public opinion is utterly wrong in its appraisal of the [business] cycle. The artificial boom is not prosperity, but the deceptive appearance of good business. Its illusions lead people astray and cause malinvestment and the consumption of unreal apparent gains which amount to virtual consumption of capital. The depression is the necessary process of readjusting the structure of business activities to the real state of the market data, i.e., the supply of capital goods and the valuations of the public. The depression is the first step on the return to normal conditions, the beginning of recovery and the foundation of real prosperity based on the solid production of goods and not on the sands of credit expansion.

"It is vain to object that the public favors the policy of cheap money. The masses are misled by the assertions of pseudo-experts that cheap money can make them prosperous at no expense whatever. They do not realize that investment can be expanded only to the extent that more capital is accumulated by savings. What counts in reality is not fairy tales, but people's conduct. If men are not prepared to save more by cutting down their current consumption, the means for a substantial expansion of investment are lacking. These means cannot be provided by printing banknotes or by loans on the bank books.

"If one does not terminate the expansionist policy in time by a return to balanced budgets, by abstaining from government borrowing, and by letting the market determine the height of interest rates, one chooses the German way of 1923."

Ludwig von Mises, The Trade Cycle and Credit Expansion: The Economic Consequences of Cheap Money (1946).

Historical note - Von Mises recognized that inflation is not simply a monetary issue but a fiscal one. While conditions in 1946 did not reflect the credit strains that presently keep monetary velocity in check, fiscal conditions were similar, with war-related deficits peaking at just over 10% of GDP. It is often forgotten that in the U.S., the CPI, which had averaged only about 2% inflation prior to 1946, shot to an inflation rate of over 20% by 1948. The S&P 500 plunged, and despite a dividend yield exceeding 4%, it would not durably exceed its 1946 peak until 1950.

Market Climate

As noted above, the Market Climate for stocks continued to be characterized last week by an overvalued, overbought, overbullish, rising-yields syndrome that has historically been very hostile to stocks. If we clear some component of this (most likely the overbought or overbullish aspects), we would have some latitude to accept a moderate if transitory exposure to market fluctuations. The latitude to do so, however, would most likely be removed by a break below the 1120 level or so on the downside - at which point, market internals would most probably have suffered ominous deterioration. At the same time, the ability to maintain a constructive market position would most likely be reduced if we were again to approach present levels from below, unless we also observe an easing of interest rate pressures in the interim. In short, there is a good chance that we will have moderate opportunities to accept market fluctuations, possibly within as little as a few weeks, but the luxury of operating without a safety net would require a much larger adjustment in valuations and resolution of structural credit risks than is likely in the near term. For now, both Strategic Growth and Strategic International Equity remain fully hedged.

While the Market Climates for bonds and precious metals are certainly not as negative as for stocks, neither were favorable as of last week. The uniformly negative Climates for stocks, bonds and commodities reflects a combination of narrow risk premiums as well as unfavorable yield pressures. The most straightforward factor that would improve the Climate for both bonds and precious metals would be a decline in 10-year Treasury yields below their levels of 6 months earlier, but the prospect of that on a sustained basis is presently thin, and appears likely to remain so for several months. That said, further price declines would also improve valuation conditions for each of these markets, so we will remain focused on the Climates at hand without placing too much expectation on what the environment for stocks, bonds or precious metals will be even a few weeks from now. We continuously re-evaluate market conditions. For now, those conditions are uniformly hostile.

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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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