Friday, December 3, 2010
Gold Gone Ballistic
Fed's True Purpose: Permanent Debt and Wall Street Bailouts
Here's how it happens. They call this "quantitative easing".
1) The big banks buy the US debt. The Fed calls them "primary dealers", but they are the same "too big to fail" banks that we were forced to bail out. The banks draw interest from the US treasury -- OUR tax money.
2) The bailed-out banks then "park" the treasuries at the Fed.
3) After a few days or weeks, the banks "sell" the treasuries to the Fed.
4) The Fed gives them cash for those treasuries. But the banks continue to draw the interest.
5) The banks buy stocks, commodities, and more treasuries with the cash. Prices go forever higher.
The Fed swears that this is prosperity. It's really just permanent debt and high inflation!
Is there any difference between this process and the Fed just printing more dollars to buy the debt? Here's the slight difference:
If they just "monetize the debt", the debts are paid off and no one gets the interest. If they use quantitative easing, WE pay taxes to pay INTEREST on the debt! It's the same thing, except that the banks get paid hundreds of billions in interest payments every year from OUR pockets. This is their compensation for creating trillions in bad debt, taking undue risk, and sticking it to the taxpayers? They get bailed out of the mistakes, and PAID to do it?
So why not just monetize the debt? At least that way, we don't have to pay $300 billion in interest every year! This proves that the Fed's real razon d'etre is to keep us permanently in debt and pay the banks, NOT to create jobs or grow the economy.
Where Are the Jobs?
U-6 to 17%
Household survey to 9.8%!
WASHINGTON (MarketWatch) — The U.S. economy added jobs at a much slower pace in November than in October, suggesting that the economy will continue to struggle in coming months.
Nonfarm payrolls rose by 39,000 in November, far lower than the 155,000 gain expected by economists surveyed by MarketWatch and the upwardly revised figure of 172,000 jobs gained in October.
Thursday, December 2, 2010
That About Tells the Story
Don’t they get it?
It’s truly bizarre to me that the powers that be cannot figure out WHY the average American is growing increasingly disenfranchised with how things are going.
Let’s do a quick review of the facts:
1) Food stamp usage at record highs
2) Real unemployment around 17%
3) Food and energy inflation on the rise
4) Incomes and housing prices falling
5) Wall Street bonuses at record highs
6) The Fed continuing to pumping hundreds of billions of dollars into the banks while proclaiming a “recovery”
Seriously, a second grader could connect the dots here and see how this will work out (hint: BADLY).
What’s truly strange is to see allegedly educated, intelligent people like Ben Bernanke talk as though the stock market is somehow an economic indicator. I’m sure it’s a great indicator of prosperity if you work at Goldman Sachs or are a corporate insider at a publicly traded company.
However, for those Americans who DON’T have flawless trading records (or stock option grants) stocks have NOTHING to do with your day-to-day activities.
After all, your typical American DOESN’T buy food or pay their mortgage with the profits from their day-trading; they pay with the money they earn from their JOB.
On that note, get ready for some “interesting” times.
I’ve been warning for months that things are going to get “interesting” in the US.
After all, with over 42 million folks on food stamps and millions of others one paycheck away from being homeless, it was only a matter of time before something broke.
In fact it just did.
As of yesterday, people who have been unemployed for more than six months began losing their unemployment benefits. Whether or not you agree with the concept of unemployment they’ve been the one thing keeping millions from homelessness and desperation.
Desperate people do desperate things. And with two million Americans about to lose their benefits this month, desperation is going to be on the rise BIG TIME going forward.
On that note, NOW is the time to be preparing. I’ve been urging my subscribers to stockpile some food, water, cash, and bullion for well over a year now. I do not believe we’re heading into some Mad Max/ Armageddon times, but I DO think that there will be periods of shortages in the US in the future. And those shortages will not be handled well by most folks.
As a personal anecdote, earlier this year the area I live in suffered a severe snow storm that made it difficult for shipping trucks to get in to town. The grocery stores were virtually picked clean within 24 hours. I shudder to think what would have happened if this has lasted more than a day or two.
Be careful,
Graham Summers of Phoenix Capital Research
Risk On, Risk Off: Sitting on a Ledge of Ice
by John Hussman of Hussman Funds:
"If you have bad banks then you very urgently want to clean up your banks because bad banks go only one way: they get worse. In the end every bank is a fiscal problem. When you have bad banks, it is in a political environment where it is totally understood that the government is going to bail them out in the end. And that's why they are so bad, and that's why they get worse. So cleaning up the banks is an essential counterpart of any attempt to have a well functioning economy. It is a counterpart of any attempt to have a dull, uninteresting macroeconomy. And there is no excuse to do it slowly because it is very expensive to postpone the cleanup. There is no technical issue in doing the cleanup. It's mostly to decide to start to grow up and stop the mess."
MIT Economist Rudiger Dornbusch, November 1998
On the surface, the U.S. economy is gradually recovering. Based on mean reversion to potential GDP (which generally occurs over a 4-year horizon absent an intervening recession), we would expect GDP growth over the coming 4-year period to average 3.8%, with average monthly employment growth of 200,000 jobs. This would be my "benchmark" expectation if the U.S. and international banking systems were "clean." However, my concern is that the surface U.S. recovery is built over a foundation that is vulnerable to further strains. If our policy makers had made proper decisions over the past two years to clean up banks, restructure debt, and allow irresponsible lenders to take losses on bad loans, there is no doubt in my mind that we would be quickly on the course to a sustained recovery, regardless of the extent of the downturn we have experienced. Unfortunately, we have built our house on a ledge of ice.
Debt burdens have not been meaningfully reduced in the mortgage sector - they have only been extended. Home values are still well above their historical norm relative to incomes. Yet more than 20% of homeowners already have "negative equity" - mortgages that exceed the current prices of their homes. A few months ago, Deutsche Bank projected that the negative equity rate may rise to 48% in 2011. Yet even if we ignore the mortgages that have been "modified" by slapping delinquent payments onto the back of the obligation, one in seven U.S. homes is presently delinquent or in foreclosure. As much as we have done to make lenders whole, nothing apart from a major restructuring of mortgage obligations will ease the continuing vulnerability on the debtor side.
Meanwhile, the dependence of the banking system on short-term deposits is worse than it was prior to the crisis. The FDIC reports that time-deposits have declined for the 7th consecutive quarter, while the cost of funding assets has dropped below 1%, as banks rely on the shortest liabilities possible in order to earn higher interest spreads. So while the month-to-month progress of the economy has been somewhat encouraging, our policy makers have put us in the position of continually revisiting a can that they simply kicked down the road.
As we look ahead to the coming years, I believe that the best way to avoid major losses will be to remain mindful of the distinction between surface economic progress and latent (underlying) risks. As a starting point, we'll look at the "benchmark" scenario - the potential growth in GDP and employment that we can expect in the absence of further economic shocks. Second I think it's useful to review the observations that the late MIT economist Rudiger Dornbusch made in 1998, many of which are directly applicable to the present environment. Finally, we'll review the current state of the economy and the financial markets.
The Mean-Reversion Benchmark
Although estimates by the Congressional Budget Office indicate potential GDP (driven by population growth and other factors) is likely to expand by only 2.3% annually over the coming four years, the "output gap" - the difference between actual GDP and current potential GDP - is large enough that simply closing that gap would require an additional 1.5% of GDP growth annually over the coming 4 years. In other words, simply closing the gap between actual and potential GDP over the coming 4-year period implies a "benchmark" expectation of roughly 3.8% annual real growth. This requires that we avoid fresh credit strains or other shocks.
Similarly, the pool of unemployed workers is sufficiently large, and potential gains from downsizing are sufficiently exhausted, that we would expect to observe a gradual expansion in employment simply on the basis of long-term mean reversion, provided that we avoid fresh credit strains or other shocks. The U.S. economy has lost over 7.5 million jobs in less than three years, putting non-farm payrolls at roughly 130 million jobs. Historically, the growth rate of payrolls has run at about half the growth rate of real GDP (with the remainder accounted for by productivity growth - this is a corollary to Okun's Law). So 3.8% real GDP growth implies job growth of about 1.9% annually. In an economy gradually reverting back to potential over the coming four year period, that would imply net job growth of about 2.5 million jobs annually, or about 200,000 jobs a month, on average.
As a side note, even if you tack on 2.2% inflation to get 6% growth in nominal GDP and corporate revenues, stock market investors are still stuck with the fact that any normalization profit margins and profits to GDP (which are highly cyclical and presently near their historic peak) would result in roughly zero earnings growth for the S&P 500 over the 4-year period.
These "benchmark" estimates assume that we avoid another economic downturn in the next few years. In the chart below, you can see the impact of such downturn on the actual 4-year growth of the economy, versus what one would have projected. Notice that in the chart below, periodic recessions have caused GDP growth to fall short of the benchmark expectations. For instance, the 1981-1982 recession caused a shortfall versus the 4-year growth that one would have anticipated in 1977-1978. The 1991 recession caused a shortfall versus what one would have expected in 1987. And the 2009 collapse caused a shortfall versus what one would have expected in 2005.
So the current "benchmark" expectation for 4-year real GDP growth is about 3.8% based on a gradual reversion to potential GDP, and the corresponding "benchmark" for job growth is about 200,000 jobs per month on a sustained basis. Still, these levels are highly dependent on avoiding a fresh recession in the interim, and unfortunately, the U.S. is perpetuating policy mistakes that threaten that result.
Hard Money and Clean Banks
In 1998, MIT economist Rudi Dornbusch gave a set of lectures in Munich on "International Financial Crises." I've excerpted some of his remarks below. Much of what Dornbusch discussed is particularly relevant to the present credit strains in Europe and various small countries across the globe, but is also important with respect to how we continue to approach difficulties in the United States. Dornbusch highlighted three essential concerns: 1) the vulnerability of banking systems that are dependent primarily on short-term deposits and funding that can be withdrawn on demand, 2) the risk of having national liabilities denominated in a foreign currency (which is essentially the case with Ireland, Portugal, Greece and Spain, all of which are constrained by the European Monetary Union and cannot simply print their own money), and 3) the importance of restructuring bad debt and avoiding bank bailouts.
"So let me focus on these new financial crises and ask where do they come from? It's very easy to predict a crisis, but then you have to wait for two years until it happens. There is the issue of contamination. Why innocent bystanders get hit. And there is the last issue of the depth of crisis. Why are they so traumatic, leaving a crater that is unbelievably deep?
"The argument is that the national balance sheet is extremely vulnerable. You could live for years and years and years with a balance sheet like that, and nothing ever happens, and nobody ever talks about you, and you are a great story of success, with high growth and a miracle. In a very rich country you can afford to do bad things very, very long.
"And then something happens and then it turns out that that very vulnerability is such that it's a dramatic end of all success. Suddenly in the afternoon of an otherwise sunny day, the world financial system wants 50 billion dollars from a country, and the country doesn't have the 50 billion dollars, and the IMF cannot get there fast enough, and the next thing, the place blows up, and there is a massive depreciation of the currency, pervasive bankruptcy, and the fire spreads to the next country.
"A banking system is a very important part of how a country hangs together... Very, very large, very, very short term liabilities can in no time become a bankruptcy issue for an entire banking system, more so if it's unregulated. And that means people can want to get their money back tomorrow afternoon, and when someone wants their money back, they all want their money back. And if they all want their money back, there is no way for an economy to pay at short notice. And if I can't repay, then they'll be much more eager to get their money, and as the bank run occurs, of course the rest of the economy will collapse with it. Maturity is the first issue.
"The second issue is denomination. There is a very big risk for a country to denominate its liabilities in foreign exchange. Something that they cannot print, something that they cannot get their hands on, and therefore something that is very vulnerable if in fact the exchange moves, the burden of those liabilities increases and bankruptcy of the country and the underlying companies becomes a big issue. Because if that is seen to be happening, then of course, everybody wants their money before it happens, and as they try to get it, they provoke the very collapse that I'm describing.
"If a country has an extraordinary withdrawal of short-term credit and they made the mistake of having short-term credit positions, then they should have a debt restructuring. Then they should say, 'We are now going to default on our debt and we are very, very sorry and what you thought was an overnight loan actually isn't an overnight loan - it is a long-term stabilisation loan.' That makes an extraordinary important distinction between direct investment, which should be favoured at all times, and you should create a history of always treating direct investment extremely well, and short-term debt, which if things go bad may turn out to be long-term debt.
"If you have bad banks then you very urgently want to clean up your banks because bad banks go only one way: they get worse. In the end every bank is a fiscal problem. When you have bad banks, it is in a political environment where it is totally understood that the government is going to bail them out in the end. And that's why they are so bad, and that's why they get worse. So cleaning up the banks is an essential counterpart of any attempt to have a well functioning economy. It is a counterpart of any attempt to have a dull, uninteresting macroeconomy. And there is no excuse to do it slowly because it is very expensive to postpone the cleanup. There is no technical issue in doing the cleanup. It's mostly to decide to start to grow up and stop the mess.
"If you have a hard money and if you have clean banks then you don't have macroeconomics as a problem anymore. Yes, you have slowdowns in the economy and yes you have booms and the key macro problem, the government, has been taken out of it. That's very important to understand that in the economies we are talking about, the problem is the government. The government is not the solution. Hyperinflations are made by governments, debt defaults are made by governments, exchange rates crises are made by governments. And if they don't know how to do it well, and the assumption is: no they do not know how to do it well, then take them out of the business."
Dornbusch likens an unsound financial system to drunk driving. "Think of someone who has made a great expertise of drunk driving, regularly drives drunk, tells you that he never has a problem, and one day there is a terrible, terrible accident. And he'll say, “Well, it was the red light. It wasn't my being drunk. Normally that light is green.” Drunk driving, which for years has worked, with a financial structure that is recklessly, recklessly unsound. But the light was green and then one day it wasn't green, and then the house of cards came crumbling down."
In applying Dornbusch's observations to the recent financial crisis, it is important to distinguish liquidity from solvency. During a bank run, it is essential to provide sufficient liquidity to ensure that depositors can get their money back. That is the only way to stop the run. But if the government does that, the only thing it should buy outright when providing liquidity is its own Treasury debt - everything else should be on a repurchase basis. The Treasury can even provide capital provided that its claims are senior to those of the bank's bondholders. U.S. policy makers did some of this correctly during the recent crisis, but they also bought bad mortgage debt outright, suspended disclosure, and avoided every attempt to restructure, which stemmed the bleeding without addressing the underlying problem.
As I've frequently noted, even if a bank "fails," it doesn't mean that depositors lose money. It means that the stockholders and bondholders do. So if it turns out, after all is said and done, that the bank is insolvent, the government should get its money back and the remaining entity should be taken into receivership, cut away from the stockholder liabilities, restructured as to bondholder liabilities, recapitalized, and reissued. We did this with GM, and we can do it with banks. I suspect that these issues will again become relevant within the next few years.
The present situation
Europe will clearly be in the spotlight early this week, as a run on Irish banks coupled with large fiscal deficits has created a solvency crisis for the Irish government itself and has been (temporarily) concluded with a bailout agreement. Ireland's difficulties are the result of a post-Lehman guarantee that the Irish government gave to its banking system in 2008. The resulting strains will now result in a bailout, in return for Ireland's agreement to slash welfare payments and other forms of spending to recipients that are evidently less valuable to society than bankers.
Essentially, the problem in Ireland is exactly what Dornbusch described: First, Ireland has a banking system that like other countries around the world, including the United States, carries a mountain of bad long-term debt on the asset side, and has become increasingly dependent on funding them with short-term deposits over the past decade, thanks to the allure of "cheap" money at the short-end of the maturity curve.
Next, Ireland and other countries in the European Monetary Union have their liabilities denominated in a currency (the euro) that they cannot actually print on their own. As Ireland, Greece, Portugal and other European countries run budget deficits, they have to induce the private market to buy their government bonds, which are denominated in the common currency. This is effectively like being on a fixed exchange rate or a gold standard, so rather than being able to print money or depreciate the currency, the only adjustment variable is the interest rate. So rates have been soaring in these countries. To some extent, states and municipalities in the U.S. are in a similar situation.
Over the short run, Ireland will promise "austerity" measures like Greece did - large cuts in government spending aimed at reducing the deficit. Unfortunately, imposing austerity on a weak economy typically results in further economic weakness and a shortfall on the revenue side, meaning that Ireland will most probably face additional problems shortly anyway.
Germany's Chancellor Angela Merkel is effectively the only major leader who recognizes the correct prescription, which is - as Dornbusch advises - to grow up, restructure the debt, and clean up the banks, because bailing them out will simply make the problem worse down the road. Merkel calls this "burden sharing" - which is another phrase for "restructuring" - but she is also vilified for it, because lenders would much prefer to have the government make them whole at public expense (and mostly the German public at that). And so, predictably, Europe is now choosing to kick the can down the road.
Here at home, the situation is only a little different from the standpoint of underlying fundamentals, but as noted at the outset, month-to-month economic progress has been reasonably positive in the U.S. lately, so there is a larger distinction between surface conditions and latent ones.
The main problem, of course, remains mortgage debt. Unfortunately, because of the suspension of FASB mark-to-market rules, investors don't actually have the ability to fairly assess the balance sheet of the banking system. Still, various mortgage statistics provide a partial, if incomplete picture. The latest report from Lender Processing Services notes that the inventory of homes in foreclosure is now 7.4 times the historical average, and rising. When a home actually enters foreclosure, it is removed from "delinquent" status, so distressed housing can shift from "delinquent," to "foreclosure," to "real-estate-owned" classifications depending on where they are in the chain, which is important when interpreting these statistics.
Though about 20% of homes that have been delinquent for more than two years are still not in foreclosure, distressed mortgages eventually either go into foreclosure, or they are "cured." What is interesting about this is that a growing portion of homes classified as newly delinquent are actually re-defaults of homes that were previously delinquent and were temporarily "cured" through modification. Typically, these modifications involve taking all of the missed payments (which in more than one-third of the cases have been delinquent for well over a year), and tacking them on to the back-end of the loan, essentially extending the maturity, and often reducing the interest rate for the first year of the modified loan. Because of this repeated cycle of cure and re-default, the number of distressed properties is most likely significantly higher than the still-elevated delinquency and foreclosure rates might suggest.
From my perspective, this is another perpetual game of kick-the-can-down-the-road to prevent mortgages from being classified as delinquent, which prevents banks from having to reserve against loan losses or write down the value of the assets. The real question is whether this is sustainable. Since perpetuating this Ponzi scheme seems to be official U.S. policy at every level, further strains may follow Dornbusch's law: "The theorem is that financial crises take much, much longer to come than you think and then they happen much faster than you would have thought. So you have a chance to be wrong twice."
That said, we've observed a gradual improvement in a variety of economic indicators in recent months, particularly in new unemployment claims. While some of the regional Fed indices (Philly, Empire State) have enjoyed positive surprises, the Chicago Fed survey, which is national, was disappointing, and at a level consistent with GDP growth of about 1.25%. That is still positive, but the confidence interval easily includes zero, so we're not quite to the point where we would conclude that a fresh economic downturn is "off the table." Financial strains tend to come on abruptly. Until we observe debt restructuring and transparent accounting rules (especially some modified version of mark-to-market), it will be dangerous to think of economic risks as being "off the table," when they are probably just hidden under a napkin.
Research Update
In the meantime, we have to work with the economy and the markets that we have. As I've noted in recent weeks, our present defensiveness is not driven by concerns about fresh credit or economic difficulties, but rather by a combination of overvalued, overbought, overbullish, rising-yield conditions that has generally turned out badly in post-war data. While we will remain mindful of underlying economic risks, I do believe that there is a wide enough range of outcomes in post-war data to allow us to manage the residual economic risks we face. As we clear various unfavorable elements of the current market environment, we will be able to periodically accept small or moderate exposures to market fluctuations, even in the absence of undervalued conditions. For now, however, we remain defensive on the basis of conditions that have rarely worked out well for stocks.
Our investment approach is fairly straightforward - accept proportionately greater exposure to risk when the expected return per unit of risk is high, and proportionately reduce exposure to risk when the expected return per unit of risk is low. The details are in the implementation, and that is where we focus most of our research. Over the past two years, most of these efforts have focused on the proper use of multiple data sets, on broadening the range of classifications that we define as distinct "Market Climates," and on enhancing the "robustness" of these classifications across subsets of the data.
Without going into technical details that would be useful only to competitors, the basic outcome of this research is that we continue to refine the Market Climates we identify, and have developed additional methods to make robust estimates of their associated return/risk profiles. I expect that you'll observe the first fruit of this research in the form of modest, transitory exposures to market fluctuations on a more frequent basis. This isn't a major change - large, persistent exposures will still await some combination of significantly improved valuations, downward yield pressures, and economic clarity - but we should be able to better exploit our latitude for modest variations in our market exposure as conditions vary over time. As always, we retain a strong emphasis on risk management, with the objective of outperforming our benchmarks with smaller periodic drawdowns than a passive investment strategy.
I continue to view the stock market as richly valued, and priced to achieve returns of less than 5% at every horizon out to a decade. The expected returns at the shorter horizons are more volatile, of course, than those at longer horizons, and it is there that a broader range of "Market Climate" classifications can be helpful. We'll modestly alter our exposure to market fluctuations in response to modest changes in conditions, but of course, we would prefer a large shift in valuations which would allow us to accept an unhedged exposure.
Here and now, we remain tightly defensive. We can certainly identify conditions under which one could have expected a speculative benefit, on average, from taking market risk despite overvaluation. But when overvaluation has been coupled with overbought, overbullish, rising yield conditions, the average outcomes have been quite poor.
Market Climate
As noted above, the Market Climate in stocks remains characterized by overvalued, overbought, overbullish, rising-yield conditions that have historically been associated with poor market returns. Strategic Growth and Strategic International Equity remain tightly hedged at present.
In recent weeks, we've observed a decided tendency toward "risk on" and "risk off" days, where entire classes of securities are treated as if they were a single object. During "risk on" days, the market advances, paced by financials, cyclicals, commodities, and smaller speculative issues, while the dollar weakens. During "risk off" days, the market declines, with relative strength in consumer, health, and high-quality stocks, while the dollar rallies. Since our stock selection generally focuses on higher quality issues, which has served us very well over the long-term, this type of pointed "risk on/risk off" behavior creates a situation where our stocks appear to have a smaller "beta" on a day-to-day basis than we actually believe is applicable over large moves or longer horizons.
As a result, the equity funds may respond slightly counter to general market movements on a day-to-day basis. While I expect that this is short-term behavior, we are still gradually modifying our hedge ratios in response. We are doing this carefully, since it is likely that our stock holdings will pop back to having their normal, full betas in the event of a serious market decline. Suffice it to say that our emphasis on what we view as higher quality stocks (e.g. stable revenue growth, profit margins and balance sheets) makes us a bit more sensitive to the recent risk on/risk off pattern of market action, and while we see this primarily as local, day-to-day behavior, we are gradually modifying our hedge ratios accordingly.
Fed Clearly Violating Federal Reserve Act
Ever since the Bear Stearns bailout, I've been insistent that the Federal Reserve is increasingly operating outside of its statutory boundaries. As I noted in the March 31, 2008 weekly comment (What Congress and Investors Should Understand about the Bear Stearns Deal):
"The clear historical role of the Federal Reserve has been to manage the composition of Federal liabilities (by varying the mix of Treasury securities and monetary base - currency and bank reserves - held by the public). The recent transaction is a dangerous break from that role, in which unelected bureaucrats are committing public funds to facilitate private business transactions and selectively defend the holders of corporate securities. Only Congress has the Constitutional right, by the representative will of the people, to commit public funds. The Bear Stearns deal is a dangerous precedent and a dilution of Congressional prerogative."
My concerns here have nothing to do with the direction of the stock market. Ensuring the legality of Fed actions is not a Democratic issue, a Republican issue or a Tea Party issue. Rather, it is about whether we want America to function as a representative democracy. We hear a lot about the risk of "politicizing" the Fed, as if it should somehow operate outside of Constitutional checks and balances. This idea is insane. Reserving the appropriation of public funds to Congress, and by extension to the will of the American people, is central to the meaning of democracy. There is clearly a mindless carnival of circus clowns on financial television that is perfectly willing to look the other way as long as the Fed encourages risk and bails out reckless behavior. We should recognize what we stand to lose.
a) QE2
Over the past week, several observers have interpreted my comments about QE2 as suggesting that this second round of quantitative easing is unconstitutional. This is incorrect. Section 14.1 of the Federal Reserve Act, which relates Open Market Operations, specifically states "Notwithstanding any other provision of this chapter, any bonds, notes, or other obligations which are direct obligations of the United States or which are fully guaranteed by the United States as to the principal and interest may be bought and sold without regard to maturities but only in the open market."
It should be clear that the purchase of Treasury debt by the Federal Reserve is legal, and because Treasury securities are issued as a result of explicit Congressional appropriations, this provision of the Federal Reserve Act also constitutional. QE2 may be reckless and ill-conceived, but it is perfectly legal and constitutional.
Bernanke offered a defense of QE2 last week in Europe that was reported as "coming out swinging," but what he swung before the world was ignorance. Bernanke correctly observed that quantitative easing was capable of "moving asset prices significantly." But he incorrectly said that "we don't know what effect this will have on the real economy." In fact, we do know. The elasticity of GDP growth to stock market changes can be easily estimated to be on the order of 0.05% or less, and transitory at that. In other words, a boost to the stock market isn't interpreted by consumers as "permanent income" or stable wealth that should be consumed. Since QE2 doesn't operate on any constraint in the credit markets that is binding, it is simply a way to blow asset bubbles, and nothing more.
Paul Krugman recently said that by engaging in QE2, "it's not as if the Fed is doing anything radical." I couldn't disagree more. Look. My furnace may be intended to regulate the temperature in my house, but at the point it starts blazing at temperatures beyond anything ever intended in the wildest imagination of the engineers, there's a problem.
Maybe this aversion is a Stanford thing. My views on economics were heavily influenced by John Taylor, Joe Stiglitz (both who reject QE2 even though they are at opposite sides of the political spectrum), Tom Sargent (rational expectations), Ron McKinnon (international economics), and Robert Hall (who chairs the NBER business cycle dating committee). If I had proposed a half-brained idea like QE2 at my dissertation defense, these guys would all have looked at me and wept.
I do agree with Krugman that the U.S. could use additional stimulus spending, particularly targeted at non-residential investment, infrastructure, and R&D. With respect to the deficit, it's important to target what I'd call a "full employment surplus" - policies that could reasonably be expected to produce a surplus at a normal unemployment rate - rather than imposing austerity on an already weak economy. But as for QE2, the Fed's policy is just reckless.
b) Maiden Lane and QE1
While QE2 is clearly both legal and constitutional, this contrasts with the activities of the Federal Reserve in creating Maiden Lane and other off-balance sheet vehicles to purchase private debt, as well as the first round of quantitative easing. In these instances, I am convinced that these transactions were outside of the restrictions of the Federal Reserve Act.
QE1 was clearly the most egregious, because the Fed bought obligations of Fannie Mae and Freddie Mac outright - securities that were not "fully guaranteed by the United States as to the principal and interest," and whose issuers were insolvent and in conservatorship when the Fed bought the securities. Even though Fannie and Freddie securities maturing before 2012 have since been effectively guaranteed by the Treasury, the Fed's ownership of later maturities is still legally problematic.
Moreover, even if these purchases were consistent with the Federal Reserve Act, they still have, in Bernanke's own words, "a fiscal component." This makes them unconstitutional. The Fed cannot simply make transactions that have a "fiscal component" - such as buying bad debt to make what Bernanke calls a "money-financed gift to the private sector" - unless that expenditure is the consequence of appropriations made by law (per Article 1, Section 9 of the Constitution). Congress never intended such "money financed gifts." When you read the Federal Reserve Act itself, there are numerous provisions to explicitly prevent transactions that would risk the loss of principal, or that would perpetually roll over debt with no expectation of final payment.
c) Open Market Operations
With respect to Open Market Operations (Section 14), the restrictions in the Federal Reserve Act are important, and should probably be memorized by Congress, because I suspect that the next place the Fed may look to do "quantitative easing" will be in the area of municipal bonds, and Bernanke has demonstrated a clear willingness to ignore the obvious intent of the Act:
Notice the conservative way that the Federal Reserve Act is written. Section 14.1 (Purchase and Sale of Obligations of United States, Counties etc., and of Foreign Governments) allows the Federal Reserve (boldface mine):
1. To buy and sell, at home or abroad, bonds and notes of the United States, bonds issued under the provisions of subsection (c) of section 4 of the Home Owners' Loan Act of 1933, as amended, and having maturities from date of purchase of not exceeding six months, and bills, notes, revenue bonds, and warrants with a maturity from date of purchase of not exceeding six months, issued in anticipation of the collection of taxes or in anticipation of the receipt of assured revenues by any State, county, district, political subdivision, or municipality in the continental United States, including irrigation, drainage and reclamation districts, and obligations of, or fully guaranteed as to principal and interest by, a foreign government or agency thereof, such purchases to be made in accordance with rules and regulations prescribed by the Board of Governors of the Federal Reserve System. Notwithstanding any other provision of this chapter, any bonds, notes, or other obligations which are direct obligations of the United States or which are fully guaranteed by the United States as to the principal and interest may be bought and sold without regard to maturities but only in the open market.
2. To buy and sell in the open market, under the direction and regulations of the Federal Open Market Committee, any obligation which is a direct obligation of, or fully guaranteed as to principal and interest by, any agency of the United States .
Note: The FHA, and its financing arm, Ginnie Mae, are agencies of the U.S. Government. Fannie Mae and Freddie Mac are "government sponsored enterprises," but are private corporations that lack agency status, and whose securities are not guaranteed as to principal and interest by the U.S. government (at least those maturing beyond 2012).
Let me be clear - if Congress decides by a vote of its members to defend Fannie Mae and Freddie Mac, and to give their securities the full faith and credit of the United States, with an appropriation as to the cost of doing so, then there is no legal or constitutional problem. It may not be good policy - I'd prefer to let Fannie and Freddie pay on the existing mortgage pools without recourse for losses, and start fresh with a far more risk-based and capital-regulated entity to keep the mortgage market going - but in any event, any bailout should result from the representative will of the American people. No government bureaucrat should have the ability to take what amount to fiscal actions without an appropriation by Congress.
To revisit Bernanke's own words from his 1999 speech "Japanese Monetary Policy - A Case of Self-Induced Paralysis?":
“In thinking about nonstandard open-market operations, it is useful to separate those that have some fiscal component from those that do not. By a fiscal component I mean some implicit subsidy, which would arise, for example, if the BOJ purchased nonperforming bank loans at face value (this is of course equivalent to a fiscal bailout of the banks, financed by the central bank). This sort of money-financed “gift” to the private sector would expand aggregate demand for the same reasons that any money-financed transfer does. Although such operations are perfectly sensible from the standpoint of economic theory, I doubt very much that we will see anything like this in Japan, if only because it is more straightforward for the Diet to vote subsidies or tax cuts directly. Nonstandard open-market operations with a fiscal component, even if legal, would be correctly viewed as an end run around the authority of the legislature, and so are better left in the realm of theoretical curiosities.”
d) Discounting
As for the Maiden Lane transactions, the Fed uses Section 13.3 of the Federal Reserve Act to justify the creation of off-balance sheet shell companies to purchase private debt of uncertain quality and undisclosed valuation. This is illegal, because it is neither authorized by, nor consistent with, the provisions of the Act.
To see this, it's essential to understand the word "discount" as it is used in the Federal Reserve Act. Discounting relates to providing short-term liquidity, and is much like providing a check-cashing service. To "discount" a note, draft, bill or other security is to purchase it at slightly less than the face value that will be delivered at a slightly later date. Think about Treasury securities. The only ones that trade on a "discount" basis are Treasury bills with maturities of less than a year. For example, if you buy a one-year Treasury at $98 and it pays $100 at maturity, you'll earn 2.04% in "interest."
Similarly, suppose a manufacturer buys $100 worth of widgets, and gives the widget maker an IOU to pay for them 30 days from today. If the widget maker sells that IOU to a bank for, say, $99 today, the note is said to be "discounted." In 30 days, the manufacturer pays the $100 to the bank to clear the obligation. Within the meaning of the Federal Reserve Act, the word "discount" is exclusively used in the context of this sort of short-term payment clearing function.
The Federal Reserve Act gives the Fed the ability to discount a wide variety of "paper." These provisions, mostly in Section 13, were put in place to guarantee short-term liquidity - again, essentially a sort of "check cashing" function. It was not intended to make long-term loans, purchase risky securities, or to provide solvency. To the contrary, there are numerous provisions to ensure that the obligations that the Fed pays off (by purchasing them at "discount") are short-term, promptly collectible, and well-collateralized.
Consider Section 13.2 (Discount of Commercial, Agricultural, and Industrial Paper). This allows any Federal Reserve bank to discount "notes, drafts, and bills of exchange arising out of actual commercial transactions; that is, notes, drafts, and bills of exchange issued or drawn for agricultural, industrial, or commercial purposes." It also provides that "Notes, drafts, and bills admitted to discount under the terms of this paragraph must have a maturity at the time of discount of not more than 90 days, exclusive of grace." That section does give the Board of Governors the "right to determine or define the character of the paper thus eligible for discount," but only "within the meaning of this Act."
Look at other provisions, and you'll also consistently see what Congress intended by the word "discount" within the meaning of the Federal Reserve Act.
Section 13.4 (Sight Drafts): "...Provided , That all such bills of exchange shall be forwarded promptly for collection, and demand for payment shall be made with reasonable promptness after the arrival of such staples at their destination: Provided further, that no such bill shall in any event be held by or for the account of a Federal reserve bank for a period in excess of ninety days."
Section 13.6 (Acceptances): "...which have a maturity at the time of discount of not more than 90 days' sight, exclusive of days of grace, and which are indorsed by at least one member bank: Provided , That such acceptances if drawn for an agricultural purpose and secured at the time of acceptance by warehouse receipts or other such documents conveying or securing title covering readily marketable staples"
Section 13.13 (Advances): "... secured by direct obligations of the United States or by any obligation which is a direct obligation of, or fully guaranteed as to principal and interest by, any agency of the United States. Such advances shall be made for periods not exceeding 90 days"
Section 13A (Agricultural Paper): "... Provided , That notes, drafts, and bills of exchange with maturities in excess of six months shall not be eligible as a basis for the issuance of Federal reserve notes unless secured by warehouse receipts or other such negotiable documents conveying or securing title to readily marketable staple agricultural products or by chattel mortgage upon live stock"
Section 24(b) (Real Estate Loans): "...Notes representing loans made under this section to finance the construction of residential or farm buildings and having maturities not to exceed nine months shall be eligible for discount as commercial paper within the terms of the second paragraph of section 13 of the Federal Reserve Act if accompanied by a valid and binding agreement to advance the full amount of the loan upon the completion of the building entered into by an individual, partnership, association, or corporation acceptable to the discounting bank."
The restriction that the Fed can only operate "within the meaning of this Act" is a real problem for the Fed.
Now, consider Section 13.3, which is the section that the Fed used as the justification for making outright purchases of questionable long-term mortgage securities from Bear Stearns:
"Section 13.3 Discounts for Individuals, Partnerships or Corporations: In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided , That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe."
It should be obvious that the Maiden Lane arrangements didn't represent "discount" transactions under any reasonable interpretation of the Federal Reserve Act. Instead, the Fed created shell companies to stash long-term securities of questionable credit quality, bought them outright, and still holds them more than two years later. This is simply illegal.
These arguments are not about whether various financial institutions should or should not be bailed out. They are about whether we have any interest in preserving a representative democracy that operates under the rule of law; or whether we instead want a fourth branch of government that operates independently of Constitutional checks and balances, where unelected bureaucrats can arbitrarily commit a greater amount of public funds in a day than the National Institute of Health spends on public research for cancer, Alzheimers, Parkinsons, autism and other disorders in a year. Count me out.
Stocks Grossly Overvalued on a Historical Basis
by John Hussman:
When we analyze historical relationships between economic and financial variables, it's important to examine the data for "outliers" that significantly depart from typical behavior. Very often, these outliers are corrected over time in a way that creates profit opportunities. In the office, we usually refer to these observations as being "outside the oval," because they diverge from the cluster that describes the majority of the data.
Failing to recognize data that is outside the oval can lead investors to learn dangerous lessons that aren't valid at all. A good example of this is the relationship between valuations and subsequent market returns. The chart below presents the historical relationship between the S&P 500 dividend yield and the actual annual total return achieved by the S&P 500 over the following decade. The majority of the points cluster nicely - higher yields are associated with higher subsequent returns. But there is a clear segment of the data that breaks away from the oval. I should note that the same departure is evident on the basis of P/E ratios that reflect normalized (full cycle) earnings, so this is not simply a dividend story.
Prior to about 1995, the lowest yield ever observed on the S&P 500 was 2.65%, and then only at the three most extreme valuation peaks in history - August 1929, December 1972, and August 1987. But in the mid-1990's, valuations broke free of their prior norms. As the bubble continued and yields fell further, investors observed that poor dividend yields were actually accompanied by high returns over the following decade anyway. By the time the market reached its peak in 2000, the dividend yield on the S&P 500 had declined to just 1.07%, and dividend yields were almost universally discarded as a measure of stock valuation. The intellectual case was seemingly reinforced by the idea that stock repurchases had made dividend yields an obsolete measure of valuation, even though the calculations made by Standard and Poors for both the level and the growth rate of index dividends for the S&P 500 properly reflect the impact of repurchases.
Unfortunately, discarding the information from dividend yields was the wrong lesson. As you can see in the chart, the data points eventually came back into the oval: the extraordinarily low yields observed at the tail of the bubble were followed by a decade of negative total returns, including two separate declines of more than 50% each.
Despite this outcome, investors have failed to recognize the wrong lesson that they learned. With the exception of the market bubble that took the relationship between yields and subsequent returns outside the oval, the historical evidence is very consistent that low yields (elevated valuations) are accompanied by dismal subsequent returns. At present, the yield on the S&P 500 is just 1.95%. This level can be expected to be followed with S&P 500 total returns of about 2.2% annually over the coming decade, with a confidence interval that easily includes zero. Based on normalized earnings, our projections are somewhat better, at about 4.8%. Meanwhile, our estimate based on forward operating earnings (see Valuing the S&P 500 Using Forward Operating Earnings) gives a 10-year total return projection of about 4.7% annually. Again, this is not simply a dividend story.
In recent months, we've heard a related, but also mistaken lesson from various corners of the investment community. This one suggests that poor market returns over a 10-year period, in and of themselves, can be taken as evidence that market returns over the following decade will be glorious. The problem is that this argument fails to take valuations into account. Historically, poor 10-year periods have invariably terminated with very low valuations and very high yields. It is the low valuations that resulted in high subsequent long-term returns, not the poor preceding market returns per se.
Likewise, high unemployment rates cannot be taken, in and of themselves, as a signal that subsequent market returns will be strong. Look at the relationship between the unemployment rate and the dividend yield, and what you'll find today is that the current dividend yield is way outside of the oval. Historically, high unemployment has been associated with high subsequent returns, but only because high unemployment was associated with high stock yields and depressed valuations. Not today.
Our estimates for S&P 500 total returns remain below 5% at every horizon shorter than a decade. One can argue that 5% is "attractive" relative to less than 3% on a 10-year Treasury bond, but that assumes a static world where stocks are risk-free and securities deliver their returns smoothly. If investors decide that they are no longer ecstatic about these low prospective rates of return a year or two from now, they will promptly re-price the assets to build in higher rates of expected return. Unfortunately, the way you increase the future expected rate of return is to drop the current price, and the amount by which prices would have to drop in order to normalize expected returns is enormous.
From our standpoint, it isn't likely that investors will get their expected 5% return over the coming decade in a smooth, diagonal line. Our guess is that they will instead see a large negative return over the first two years or so, followed by subsequent returns that are much closer to the historical norm. The third alternative, of course, is the bubble scenario, where stocks achieve returns above 5% annually in the immediate few years, followed by flat or negative returns for the remainder of the decade. That is certainly the pattern we observed beginning in the late-1990's.
We'll take our evidence as it comes. As I noted at the beginning of this year, as move toward 2011, we are increasingly weighting post-1940 data in setting expectations about prospective returns and risks, in the expectation that there is a wide enough range in that data to manage the residual economic risks we observe.
Presently, we have a combination of overvalued, overbought, overbullish, rising yield conditions that have been very hostile for stocks even in post-1940 data. We also have not cleared our economic concerns sufficiently to lift that depressing factor on the expected return/risk profile for stocks. It follows that changes in some combination of those factors - valuation, overbought conditions, sentiment, and economic conditions, provided that those changes aren't accompanied by a clear deterioration in market internals - would prompt us to remove a portion of our hedges (most probably covering short calls and leaving at least an out-of-the money index put option exposure in place). Unfortunately, with stocks overvalued, a shallow decline that simply clears the overbought condition would not leave much room to advance until stocks were overbought again, so the latitude for a constructive position would be limited. Ideally, we'd prefer a very substantial improvement in valuation, that is, significant price weakness that would also be accompanied by internal deterioration. In that event, as in 2003, we would look for early divergences and internal strength as an indication to remove the short-call portion of our hedges, and possibly more depending on the status of valuations and other factors at the time.
For now, we remain defensive, even purely on the basis of post-1940 relationships.
Wednesday, December 1, 2010
Dow Rallies 200 Points Off 50-Day Moving Average
Tuesday, November 30, 2010
Case Shiller Says Home Prices Declined at Twice the Expected Rate
but stocks are rising following the open anyway. The Fed is money printing again today.
from Fox Business:
Prices of single-family homes in September fell more than twice as fast as expected from the prior month, while prices compared to a year earlier rose more slowly than forecast, according a widely watched index of U.S. home prices released on Tuesday.
The Standard & Poor's/Case-Shiller composite index of 20 metropolitan areas declined 0.8% in September from August on a seasonally adjusted basis.
Economists polled by Reuters had expected a decline of 0.3%.
S&P, which publishes the indexes, also said home prices in the 20 cities index rose 0.6% from September 2009, slower than the 1.1% expected.
Monday, November 29, 2010
No Risk! What a Reversal!
Stocks just went positive (not shown in this chart). The world, especially Europe, is in meltdown, but stocks are a good buy anyway. With SPY trading at a 45.6 P/E and yield at a paltry 2%, Wall Street is happy!
The Bulls Win!
Even More Selling After the Open
Stocks Turn Bearish Before the Open
Futures have turned decidedly bearish before the open. This from Marketwatch:
LONDON (MarketWatch) — An initial rally in European shares quickly petered out Monday as a multi-lateral 85 billion euro ($113 billion) bailout package for Ireland only briefly lifted sentiment.
Several developments helped sour the mood, including a lackluster Italian bond auction and concerns that the debt crisis will not end with Ireland but spread to Spain, Portugal and other peripheral euro-zone countries. Madrid and Lisbon led European stocks lower, while the Irish and Greek markets were the only ones managing to eke out gains.
The Stoxx Europe 600 index /quotes/comstock/22c!sxxp (ST:STOXX600 264.58, -2.02, -0.76%) opened higher but slipped into the red two hours into the session. In recent trading, it was down 0.6% to 265.03. The index lost 1.1% last week.
Of the main indexes in the region, France’s CAC-40 index /quotes/comstock/30t!i:px1 (FR:PX1 3,683, -45.93, -1.23%) fell 0.8% to 3,759.04, the U.K.’s FTSE 100 index /quotes/comstock/23i!i:ukx (UK:UKX 5,613, -55.21, -0.97%) slipped 0.4% to 5,649.26, and Germany’s DAX 30 index /quotes/comstock/30p!dax (DX:DAX 6,767, -82.42, -1.20%) declined 0.7% at 6,803.90.
Initially, all these indexes rallied after European Union finance ministers Sunday endorsed a bailout package for Ireland. The package includes €10 billion for immediate recapitalization measures, €25 billion on a contingency basis for the banking system and €50 billion to cover budget-financing needs.
But as Monday’s session progressed, attention shifted to the fact that some issues were still not sorted out by the measures announced.
“The news yesterday, on the whole, was more positive than negative. The obvious measure aimed at stabilizing the market was the fast-forwarding of the debt-restructuring mechanism,” said Elisabeth Afseth, fixed-income analyst at Evolution Securities.
The details of the mechanism were previously set to be discussed in mid December.
Afseth noted, however, that whether a country is deemed solvent or not will need to be a unanimous decision, and thus open to political pressures. She also said that existing bond holders “could face losses if a country is deemed insolvent in the post mid-2013 world.”
In the current context, “you’d be struggling to find anyone to put a lot of money into a fund that invests in peripheral markets. At the moment a low return from safe assets seems pretty desirable,” she said.
Auto stocks were at the forefront of the decline Monday, with shares of Daimler AG /quotes/comstock/11e!fdai (DE:DAI 50.40, -0.93, -1.81%) down 2.1% in Germany and Peugeot SA /quotes/comstock/24s!e:ug (FR:UG 29.66, -0.80, -2.61%) down 1.7% in Paris.
The telecoms sector also came under pressure, with Vodafone Group /quotes/comstock/23s!a:vod (UK:VOD 162.00, -3.30, -1.10%) /quotes/comstock/15*!vod/quotes/nls/vod (VOD 25.31, -0.62, -2.39%) and Telefonica SA /quotes/comstock/06x!e:tef (ES:TEF 16.75, -0.22, -1.27%) /quotes/comstock/13*!tef/quotes/nls/tef (TEF 65.85, -1.31, -1.95%) both down around 1%.
Financial weaken again
While many financial stocks initially got a lift from the Irish rescue package, particularly in the U.K. and in peripheral markets, only a handful remained higher in late morning.In France, BNP Paribas SA /quotes/comstock/24s!e:bnp (FR:BNP 47.53, -1.22, -2.50%) fell 2.5% and Credit Agricole SA /quotes/comstock/24s!e:aca (FR:ACA 9.83, -0.24, -2.35%) lost 1.1%. In Germany, Commerzbank AG /quotes/comstock/11e!fcbk (DE:CBK 5.74, -0.07, -1.17%) declined 1%.
It was a more cheerful day in Ireland, where the ISEQ index /quotes/comstock/30q!ieop (XX:IEOP 2,685, +18.27, +0.69%) rose 0.7% to 2,685.32, boosted by a 21% gain for Bank of Ireland /quotes/comstock/13*!ire/quotes/nls/ire (IRE 1.72, +0.28, +19.44%) /quotes/comstock/30b!bir (IE:BIR 0.32, +0.06, +21.21%) and a 8% jump for Allied Irish Banks PLC /quotes/comstock/13*!aib/quotes/nls/aib (AIB 1.03, +0.08, +8.78%) /quotes/comstock/30b!aib (IE:AIB 0.37, +0.03, +9.36%) .
In a regulatory statement, Bank of Ireland said it would seek to raise €2.2 billion in capital by Feb. 28, via “internal capital management initiatives, support from existing shareholders and other capital market sources.”
Shares of Irish Life & Permanent Group Holdings surged 53% in Dublin trading.
In the U.K. shares of financial institutions with a large exposure to Irish sovereign debt also got a lift. Royal Bank of Scotland Group /quotes/comstock/23s!a:rbs (UK:RBS 38.70, +0.01, +0.03%) /quotes/comstock/13*!rbs/quotes/nls/rbs (RBS 12.03, -0.04, -0.33%) , in particular, was buoyed by the rescue deal, gaining around 1%.
In Spain, the IBEX 35 index /quotes/comstock/20r!i:ib (XX:IBEX 9,397, -150.20, -1.57%) lost 1% to 9,448.60, as Banco Bilbao Vizcaya Argentaria SA /quotes/comstock/13*!bbva/quotes/nls/bbva (BBVA 9.62, -0.70, -6.78%) /quotes/comstock/06x!e:bbva (ES:BBVA 7.39, -0.16, -2.16%) fell 1.6%.
Portugal’s PSI 20 index /quotes/comstock/30t!i:psi20 (XX:PSI20 7,489, -92.65, -1.22%) slumped 1%.
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