The Hussman Report

...A Trifecta of Reckless Central Bankers

I continue to view Bernanke's apparent objective for QE2 - to create a "wealth effect" by encouraging speculation in risk assets - to be dangerously misguided. Historically, the elasticity of GDP to changes in the stock market is on the order of 0.03 to 0.05, and is transitory at that. In plain English, this means that even large changes in the value of the stock market do not translate well into changes in GDP. This is because consumers correctly consume on the basis of what they see as their "permanent income," and are well aware that changes in volatile assets tend to be transitory when they are not accompanied by growth in real output and incomes. Bernanke is not thinking as an economist in this regard. He is thinking as a witch doctor (ooh, eee, ooh-aah-aah, ting, tang, walla-walla bing-bang).

Meanwhile, Alan Greenspan appeared on CNBC on Friday, and said with a straight face (I believe he has no other kind) that the "equity risk premium" on stocks was higher than it has been in 50 years. Evidently, this remark reflects the standard "Fed model" idea that the forward operating earnings yield on stocks can be usefully compared with the yield on 10-year Treasuries in order to estimate the attractiveness of stocks.

With all due respect, Mr. Greenspan - no less reckless than he was during the dot-com and housing bubbles - is out of his gourd. 

...Finally, last week, Jean Claude Trichet, the head of the European Central Bank, provided early indications that the ECB would be stepping up its buying peripheral government debt issued by Ireland, Greece, Portugal and Spain. Of course, the ECB prefers to "sterilize" these interventions, so it can be expected to sell the debt of stronger members such as Germany. Accordingly, yields dropped on the debt of credit-strained European countries, while German yields pushed to fresh yearly highs.

It doesn't take much thought to recognize that, like Bernanke's actions, the actions of the ECB are ultimately likely to represent not monetary policy but fiscal policy. When you buy the debt of countries that have a high likelihood of defaulting on this debt, or will avoid default only by the creation of currency that could have been issued to finance fiscal expenditures, it follows that you are engaging in fiscal policy without the authorization of elected governments.

This is a dangerous and cowardly road. We are allowing 99% of the world to accept budget cuts and austerity in order to defend bondholders from taking losses or having to accept debt restructuring. When bondholders lend money to a financial company or to a country, at a spread over the yield available safe debt, they are explicitly accepting the risk that the bet will not work out, and that they may lose money in the event of a restructuring. When government policy at every level focuses on making bondholders whole, then government policy at every level focuses equivalently on protecting the inefficient and dangerous misallocation of capital. The situation is even worse when unelected officials such as Ben Bernanke and Tim Geithner bend the clear meaning and intent of the law (such as section 13-3 of the Federal Reserve Act) in order to arbitrarily reward private interests. This will end badly. That doesn't mean that we need to persistently avoid market risk until it does, but investors who put these risks too far from their minds are likely to be blindsided as repeatedly as they have over the past decade.

Government Deficits and Potential GDP

As a final note on the U.S. budget deficit, the working group on deficit reduction failed to reach a consensus on Friday. My own impression is that we should be careful to recognize the effect of the present "output gap" (the difference between actual and potential GDP) on the deficit. In general, every 1% shortfall in GDP from the potential GDP (as estimated by the CBO) is associated with a reduction of about 0.33% in government revenues as a share of potential GDP, and an increase of about 0.33% in government expenditures as a share of potential GDP. In other words, there is a natural and useful "counter-cyclical" element to the deficit that serves as what economists call an "automatic stabilizer. "

Rather than targeting a balanced budget in the midst of a deep economic downturn (still more than 6% below potential GDP), we should be focused on policies that could reasonably be expected to achieve a deficit of between 0-1.5% of GDP at the point where GDP is again operating at potential. While I certainly think there is room to integrate unemployment compensation, earned income tax credits and Social Security in a way that strengthens the incentive for part-time work (I have friends with special needs who would lose all benefits if they worked even a few hours a week), I also believe that extending unemployment compensation is the smallest of our problems.

The larger problem is that we have still failed to restructure debt, so we will see perennial credit strains, and perennial short-term fixes that use public funds to bail out private lenders. Our current deficit is in the yellow oval, and is over $600 billion than it should be even in the presence of normal automatic stabilizers. Much of this is bailout funding to Fannie Mae and Freddie Mac, with another major contribution from defense spending. The immediate objective in deficit reduction is to take further bailout funding off the table, and to push aggressively toward debt restructuring. The public is being abused for the sake of protecting bondholders that lent at a spread. This protection should end, or the resulting "austerity" will either weaken our defense or remove our automatic stabilizers. If the world doesn't wake up to the fact that central bankers exist to serve the banks, we will suffer for it.

Market Climate

As of last week, the Market Climate for stocks remained characterized by overvalued, overbought, overbullish, rising-yield conditions that have historically been hostile for stocks. Both Strategic Growth and Strategic International Equity remain tightly defensive. A variety of outcomes could, in combination, clear this condition sufficiently to warrant some exposure to risk - most likely moderate and transitory in the near term - but at present, the expected return/risk tradeoff in the equity markets is poor.

In bonds, the Market Climate last week was characterized by slightly unfavorable yield levels and unfavorable yield pressures. In general, yield levels are a more important driver of total returns in bonds than yield pressures because unlike equities, there is no uncertainty about future cash flows (which is the main element that contributes to bubbles in stocks). Accordingly, expect that we'll modestly increase duration on further increases in yields, but the key word will remain "modestly" unless we observe fresh indications of economic pressures. The November jobs figure last week may have been a disappointment to the markets, but on the basis of the new unemployment claims we've seen over the past weeks, we're actually still at a level that has historically been associated with job losses averaging nearly 100,000 per month. Suffice it to say that the economic data is much more spotty than one would infer from many analysts, but at least over the short-term, the ebullience of the markets over QE2 has translated into more favorable economic sentiment. Strategic Total Return continues to carry a duration of only about 1 year, with about 1% of assets in precious metals shares, about 2% in utilities, and about 1% in foreign currencies. 

http://www.hussman.net/wmc/wmc101206.htm