Monday, October 8, 2012

Hussman Weekly Market Comment: Number Five

Examine the points in history that the Shiller P/E has been above 18, the S&P 500 has been within 2% of a 4-year high, 60% above a 4-year low, and more than 8% above its 52-week average, advisory bulls have exceeded 45%, with bears less than 27%, and the 10-year Treasury yield has been above its level of 20-weeks prior. While there are numerous similar ways to define an “overvalued, overbought, overbullish, rising-yields” syndrome, there are five small clusters of this one in the post-war record: November-December 1972, July-August 1987, a cluster between late-1999 and early 2000, early 2007, and today. The first four instances preceded the four most violent market declines in the post-war record, though each permitted a few percent of additional upside progress before those declines began in earnest. We do not know what will happen in the present instance, particularly over the short-run. But on the basis of this and a broad ensemble of additional evidence, we estimate that the likelihood of deep losses overwhelms the likelihood of durable gains. To ignore those four prior outcomes as “too small a sample” is like standing directly underneath a falling anvil, on the logic that falling anvils are an extremely rare occurrence.


Meanwhile, the balance sheet of the Federal Reserve presently comes to about $2.8 trillion, with an average duration of 7.3 years, meaning that a 100 basis point change in interest rates would be expected to impact the Fed’s position by about 7.3% on the basis of bond price changes. Now, keep in mind that the Fed presently has just $54.7 billion in capital, which means that the balance sheet is leveraged by over 50-to-1, or put differently, the balance sheet has just 1.95% capital coverage. The unpleasant arithmetic here is that a 27 basis point change in bond yields (1.95%/7.30%) would effectively wipe out the Fed’s capital. While the Fed doesn’t mark its balance sheet to market, and can therefore run an insolvent balance sheet without immediate consequence, it should at least be a subject of public understanding that monetary policy becomes fiscal policy 27 basis points from here. Over time, of course, the Fed earns interest on its bond holdings, and that interest is normally handed over to the Treasury for public benefit. Presently, a 30 basis point increase in yields over a one-year period would wipe out even this interest, at which point the government would be paying interest on its debt simply to cover the Fed’s losses, with no net benefit to the public. That is, unless one believes that the Federal Reserve’s manipulation of financial markets is of equivalent benefit in and of itself. We don’t, and it is likely that investors will discover that in an uncomfortable way over the coming quarters.