Sunday, September 8, 2013

Twin Distortions

By Cullen Roche

If you’re looking for the bearish view on the economy and the markets then look no further than John Hussman’s annual letter in which he describes why he thinks the US equity market is in a bubble due to “twin distortions”:

“First, as job losses accelerated and household savings collapsed in order to maintain consumption, U .S . fiscal policy responded with enormous government deficits approaching 10% of GDP . Since the deficits of one sector always emerge as the surplus of another, the record combined deficit of governments and households was reflected – as it has been historically – by a mirror image surplus in corporate profit
margins, which have surged to record levels in recent years . Essentially, government and household deficits have allowed consumer spending and corporate revenues to remain stable – without any material need for price competition – even though wages and salaries have plunged to a record low share of GDP and labor force participation has dropped to the lowest level in three decades . This mirror-image behavior of profit margins can be demonstrated in decades of historical data, but investors presently seem to believe that these profit margins are a permanent fixture, and have been willing to price stocks at elevated multiples of earnings that are themselves elevated over 70%, relative to historical norms .

Second, the monetary policy of quantitative easing has gradually become the nearly exclusive focus of investors . The goal of quantitative easing is to create a “wealth effect” – to encourage greater consumption and economic activity by intentionally distorting the prices of financial assets . Unfortunately, economists have known for decades (and Milton Friedman won a Nobel Prize partly by demonstrating) that people don’t consume based on fluctuations in the value of volatile assets like stocks, but instead on the basis of their perceived lifetime “permanent income .” As a result, each 1% change in the value of the equity market has historically been associated with a short-lived change in Gross Domestic Product of only 0 .03% to
0 .05% . Meanwhile, while lowering long-term interest rates might have a positive effect on the demand for credit (though a negative effect on its supply), the fact is that long-term interest rates are virtually unchanged since August 2010, when Federal Reserve Chairman Ben Bernanke first hinted at shifting to quantitative easing as the Fed’s main policy tool.

Despite individual features that convinced investors in each instance that “this time is different,”my perspective is that the truly breathtaking market losses in history share a single origin: the willingness of investors to forgo the need for a risk premium on securities that have always required one over time . Market crashes are largely synonymous with a spike in risk premiums from previously inadequate levels . Once the risk premium is beaten out of stocks, there is no way out, and nothing that can be done about it . Poor subsequent returns, market losses, and the associated destruction of financial security are already baked in the cake . This should have been the lesson gleaned from the period since 2000, but because it remains unlearned, I am convinced that it will also become the lesson of the coming decade.”

I think it’s hard to deny that there have been distorting effects from the government’s deficit as well as QE.  Both have played huge psychological and even fundamental roles in the economic and market performance of the last few years.  I don’t necessarily think Dr. Hussman is wrong that this could all come back to haunt us, but I am not nearly as bearish as he is in the near-term and when it comes down to it, these kinds of bets on big outlier events are largely about timing and thus far the fear trade has been a big loser….

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