December 14, 2015
Deja Vu: The Fed's Real "Policy Error" Was To Encourage Years of Speculation
Over the past several years, yield-seeking investors, starved for any “pickup” in yield over Treasury securities, have piled into the junk debt and leveraged loan markets. Just as equity valuations have been driven to the second most extreme point in history (and the single most extreme point in history for the median stock, where valuations are well-beyond 2000 levels), risk premiums on speculative debt were compressed to razor-thin levels. By 2014, the spread between junk bond yields and Treasury yields had fallen to less than 2.4%. Since then, years of expected “risk-premiums” have been erased by capital losses, and defaults haven’t even spiked yet (they do so with a lag).
From an economic standpoint, the unfortunate fact is that the proceeds from aggressive issuance of junk debt and leveraged loans in the past few years were channeled into speculation. Excess capacity in energy production was expanded at the cyclical peak in oil prices, and heavy stock buybacks were executed at obscene equity valuations. The end result will be unintended wealth transfers and deadweight losses for the economy. Since the late-1990’s, the Federal Reserve has actively encouraged the channeling of trillions of dollars of savings into speculation. Recurring cycles of malinvestment and crisis have progressively weakened the resilience and long-term growth prospects of the U.S. economy.
Investors repeatedly forget that reaching for yield in speculative securities only works if capital losses don’t wipe out the “pickup” in yield. Since mid-2014, we’ve emphasized the increasing deterioration in market internals and credit spreads, noting that this deterioration has historically been a reliable signal of a shift from risk-seeking to risk-aversion by investors. This risk-aversion is now accelerating. Last week, a number of high-yield bond funds placed delays on redemptions in order to give them time to liquidate holdings into a collapsing market. When a problem is specific to a particular fund, orderly liquidation can protect investors. But in this case, the need for liquidation isn’t specific to those particular funds - it’s driven by selling pressure and illiquidity in the junk debt market as a whole. As a result, these “redemption holds” risk contributing to general panic across the entire high-yield market.
Given the valuation extremes we presently observe in the equity market (see Rarefied Air: Valuations and Subsequent Market Returns), our view is that spiking yields in the junk debt market are a precursor of significant losses in stocks, as we’ve observed in other market cycles across history. At present, the valuation measures we find most tightly correlated (~92%) with actual subsequent 10-12 year S&P 500 total returns are consistent with negative nominal total returns over a 10-year horizon, and roughly 1% annual returns over a 12-year horizon. Razor-thin risk premiums are already baked into equity valuations, even assuming historically normal economic growth over these horizons.
At current valuations, the notion that “There Is No Alternative” (TINA) to zero-interest cash is profoundly incorrect. The only thing that equities offer here is to promise wider extremes of panic, despair, excitement, and hope over the coming 10-12 years, on the way to overall returns no better than safe, liquid cash equivalents are likely to achieve. That's the unfortunate consequence of the obscene valuations Fed policy has encouraged. Valuations, market internals, and the overall market outlook will change over the completion of this market cycle, but here and now, market conditions pair the second most extreme valuations on record with deteriorating internals and accelerating risk aversion among investors. This is a wicked combination.
The Fed's Real Policy Error
The Federal Reserve is also in a rather difficult situation. Based on a broad range of economic factors, our economic outlook has shifted to a guarded expectation of recession. Now, if there was historical evidence to demonstrate that activist Fed policy had a significant and reliable impact on the real economy, and didn’t result in ultimately violent side-effects, we would argue that a Fed hike here and now might be a “policy error.” In reality, however, decades of economic evidence demonstrate that activist monetary interventions (e.g. deviations from straightforward rules of thumb like the Taylor Rule) have unreliable, weak, and lagging effects on the real economy.
Moreover, as we should have learned from the global financial crisis, when the Fed holds interest rates down for so long that investors begin reaching for yield by speculating in the financial markets and making low-quality loans, the entire financial system becomes dangerously prone to future crises. If the Fed's mandate is really to support long-run employment and price stability, the first priority of Congress should be to rein in this cycle of activist Fed intervention; to end the Fed's ability to promote yield-seeking speculation and malinvestment that only produces inevitable crises and weakens long-run U.S. economic prospects.
The fact is that a quarter-point hike comes too late to avert the consequences of years of speculation, and while the hike itself will have little economic effect, the timing is ironic because a recession is already likely. The main effect of a rate hike will be to add volatility to an already speculative and now increasingly risk-averse market. The Fed’s real policy error, as it was during the housing bubble, was to hold interest rates so low for so long in the first place, encouraging years of yield-seeking speculation and malinvestment by doing so.
Some would argue that the Federal Reserve “saved” us from the global financial crisis. I couldn’t disagree more. My view is that the financial crisis was caused because the Fed overly depressed interest rates in the early 2000’s, encouraging investors to reach for yield in mortgage securities. In response, poorly regulated financial institutions, with banks free from the constraints of Glass Steagall, and other institutions having inadequate capital requirements, created a huge mountain of new, low-grade mortgages in the frenzy to create more “product.” The easy lending created a housing bubble, but someone had to hold the mortgages when they went belly-up, and those holders were banks, insurance companies, hedge funds, and individuals. As the mortgages went into foreclosure, banks had to mark the value of those mortgages to market value on their books, to the point where the value of their assets was less than the value of their liabilities: insolvency.
In hindsight, the financial crisis actually ended - precisely - in March 2009. How? The Financial Accounting Standards Board changed rule FAS 157 and overturned the mark-to-market requirement, instead allowing financial institutions “significant judgment” in the way they valued their assets: often called mark-to-model (or as some of us call it, mark-to-unicorn). That has given financial institutions time to build up their capital and clean up their balance sheets, for the time being. The Fed’s policy of buying up government backed mortgage securities (Fannie Mae, Freddie Mac) can certainly be credited for stabilizing the housing market in the depths of the crisis, but don’t think for a second that years of zero-interest rate policy is what produced the recent recovery.
So what happens now? In our view, the Fed is in a rather unpleasant situation of its own making. A U.S. economic recession is already likely, regardless of what the Fed does. A quarter-point rate hike isn’t likely to have any material effect on the real economy, but given the already elevated level of risk-aversion, most clearly observed in the junk debt market, a rate hike could be viewed as aggravating that risk. Undoubtedly, any further market deterioration (which we see as baked in the cake) would easily be blamed on the Fed’s “policy error.” Alternatively, a failure to raise rates next week would be seen as a sudden vote of no-confidence in the U.S. economy. As I noted a few months ago (see When An Easy Fed Doesn’t Help Stocks, and When It Does), a shift to easier Fed policy is actually the most negative possible outcome for the stock market when it occurs in an environment of rising risk-aversion. Such shifts (as we saw in 2007 and early 2001, followed by two of the worst market collapses in history) are generally a response to sudden economic and financial deterioration. Once investors become risk-averse, safe and low-interest liquidity is a desirable asset rather than an inferior one. So creating more low-interest liquidity fails to drive investors to chase yield and speculate, as it does when market internals are uniformly favorable and investors are inclined toward risk-seeking.
Despite extreme valuations at present, market conditions will change significantly over the completion of the present market cycle. Based on our present methods of classifying expected market return/risk profiles, market conditions are likely to encourage a significant exposure to equities more often than not - even over the coming decade. That expectation is supported by a century of historical evidence (see A Better Lesson Than "This Time Is Different" for a discussion). But throughout history, a constructive market outlook has always been best supported by some combination of favorable valuations and/or favorable market action (ideally the presence of uniformly favorable market internals, and the absence of overvalued, overbought, overbullish features). Now is emphatically not one of those times. The following quotes from 2000 and 2008 may create a sense of deja vu about current market conditions. They should be a reminder of points when we observed conditions similar to what we observe today, and what I wrote before the rather undesirable outcomes that followed.
“Historically, when trend uniformity has been positive, stocks have generally ignored overvaluation, no matter how extreme. When the market loses that uniformity, valuations often matter suddenly and with a vengeance. This is a lesson best learned before a crash rather than after one. Valuations, trend uniformity, and yield pressures are now uniformly unfavorable, and the market faces extreme risk in this environment. There are also other risks. Historically, consensus economic forecasts have never correctly warned of an oncoming recession. Market action is profoundly more informative, particularly interest rate and credit spreads. Based on the most reliable set of leading indicators, a recession warning is now in hand. Our investment position does not rely on a recession to be effective, so we hope that this signal is incorrect. With earnings warnings and loan defaults already on the rise, investors should hope for anything but a slower economy.”
“I am emphatic that investors should evaluate their risk exposures and tolerances now, in order to allow for substantial further market weakness. Market conditions presently feature a Pandora's Box of rich valuations, vulnerable profit margins, rising default risk, rapidly deteriorating market internals, failing support levels, and accumulating evidence of oncoming recession.”Our outlook remains decidedly negative at present. I’ll emphasize again that market internals are the hinge that distinguishes a valuation bubble that expands from one that collapses, so an improvement in market internals would reduce the immediacy of our downside concerns, and would also tend to reduce our concerns about oncoming recession. In the absence of clear improvement in market internals - and last week was categorically opposite to that - I view the stock market as being in the late-phase of an extremely overvalued top formation that will likely be followed by profound losses over the completion of this market cycle, and the U.S. economy as being on the cusp of a new recession.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Please see periodic remarks on the Fund Notes and Commentary page for discussion relating specifically to the Hussman Funds and the investment positions of the Funds.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
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