John P. Hussman, Ph.D.
All rights reserved and actively enforced.
Reprint Policy
"There is the possibility... that after the rate of interest has fallen to a certain level, liquidity preference is virtually absolute in the sense that almost everyone prefers cash to holding a debt at so low a rate of interest. In this event, the monetary authority would have lost effective control."
John Maynard Keynes, The General Theory
One of the many controversies regarding Keynesian economic theory centers around the idea of a "liquidity trap." Apart from suggesting the potential risk, Keynes himself did not focus much of his analysis on the idea, so much of what passes for debate is based on the ideas of economists other than Keynes, particularly Keynes' contemporary John Hicks. In the Hicksian interpretation of the liquidity trap, monetary policy transmits its effect on the real economy by way of interest rates. In that view, the loss of monetary control occurs because at some point, a further reduction of interest rates fails to stimulate additional demand for capital investment.
Simply put, monetary policy is far less effective in affecting real (or even nominal) economic activity than investors seem to believe. The main effect of a change in the monetary base is to change monetary velocity and short term interest rates. Once short term interest rates drop to zero, further expansions in base money simply induce a proportional collapse in velocity.
Undoubtedly, we would have preferred the Fed to have provided that liquidity in recent years through open market operations using Treasury securities, rather than outright purchases of the debt securities of insolvent financial institutions, which the public is now on the hook to make whole. The Fed should not be in the insolvency bailout game. Outside of open market operations using Treasuries, Fed loans during a crisis should be exactly that, loans - and preferably following Bagehot's Rule ("lend freely but at a high rate of interest"). Moreover, those loans must be senior to any obligation to bank bondholders - the public's claim should precede private claims.
At present, however, the governors of the Fed are creating massive distortions in the financial markets with little hope of improving real economic growth or employment. There is no question that the Fed has the ability to affect the supply of base money, and can affect the level of long-term interest rates given a sufficient volume of intervention. The real issue is that neither of these factors are currently imposing a binding constraint on economic growth, so there is no benefit in relaxing them further. The Fed is pushing on a string.
I've generally been critical of Keynes' willingness to advocate government spending regardless of its quality, which focused too little on the long-term effects of diverting private resources to potentially unproductive uses. His remark that "In the long-run we are all dead" was a reflection of this indifference.
Market Climate
As of last week, the Market Climate for stocks remained characterized by an overvalued, overbought, overbullish condition. This has been historically associated with a poor return-risk profile and "negative skew" - a tendency for the market to establish a string of marginal new highs, and for occasional 2-3 day pullbacks to be followed by sharp recoveries. The pattern is for little overall progress, but repeated slight highs, terminating with a steep, abrupt decline that can wipe out weeks or months of gains in a matter of days. In statistical terms, the mode of the distribution is positive, the mean is negative, and the skew is downright wicked.
The Strategic Growth Fund remains fully hedged, with our put strikes raised close to the current market to tighten our downside protection, at a cost of just over 1% of assets in additional time premium. The Strategic International Equity Fund remains largely but not fully hedged against international equity fluctuations. Currency fluctuations typically account for only a small fraction the variability in international returns, so our primary risk is covered by equity hedges, but the Fund also has nearly one-third of its currency risk hedged as well. The Strategic Total Return Fund moved to a fairly defensive stance last week, with an average duration of less than 1.5 years, and only about 3% of assets in precious metals shares, 1% in foreign currencies, and 2% in utility shares. Though we sharply cut our precious metals exposure over the past few weeks on overbought price conditions and other factors, I expect that we'll continue to vary our exposure opportunistically. The Fed's insistence on bad policy will probably continue to support commodity hoarding behavior, but commodity market conditions threaten to become very tenuous if economic conditions strengthen. Presently, I remain concerned about additional weakness in employment, housing, and the broad economy, but we'll take our evidence as it comes.
http://www.hussman.net/wmc/wmc101025.htm
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