Superstition and the Fed

[bob5]

I would be interested to hear what people think about this article. Market commentary by John Hussman, manager of the Hussman Strategic Growth fund. I included his bio below to give him some credibility.

http://www.hussmanfunds.com/wmc/wmc061002.htm


What is Dr. Hussman�s investment background?
Dr. Hussman holds a Ph.D. in economics from Stanford University (1992), and two
degrees from Northwestern University: a Masters degree in education and social
policy (1985) and a bachelors degree in economics (1983, Phi Beta Kappa). Dr.
Hussman is the president and principal shareholder of Hussman Econometrics
Advisors, the investment advisory firm that manages the Hussman Funds. He is also
the President of the Hussman Investment Trust.
Prior to managing the Hussman Funds, Dr. Hussman was a professor of economics
and international finance at the University of Michigan. His academic research
centers on market efficiency and information economics. Of particular interest is the
potential for the market to be inefficient even when traders hold �rational
expectations�, and the ability of price movements to convey the private information
held by disparately informed traders even in the presence of �noise.�
Dr. Hussman has been active in the financial markets since 1981. In the mid-1980�s,
he worked as an options mathematician for Peters & Company at the Chicago Board
of Trade. In 1988, he began publishing the Hussman Econometrics newsletter. He
has been active in portfolio management since 1993.

 

[oag]

I've been an avid reader of Dr. Hussman's weekly columns and market research for almost two years now. His research, analysis and straight forward way of presenting his conclusions are among the best that I have come across.

This week's article on the relevancy of the Federal Reserve is a topic that he's touched on many times. This week he presented even further evidence on the limited influence the Fed has on U.S. bank reserves and the ability of the Fed (by itself) to control the amount of funds available for lending and thus the ability to control market based interest rates (thus the yield curve conundrum). The most significant aspect of his Fed conclusions fly in the face of conventional views of Wall Street and what we're taught in our business/finance courses (and the CFA program). But he's very clear in pointing out that as long as Wall Street feels the Fed controls everything, one has to account for the Fed in their overall investment analysis(at least until the conventional wisdom comes to understand the Fed doesn't have the influence it had in the past).

He may be a bit too conservative(or pessimistic on his market valuation view) in his investment philosophy for more active/aggressive investment types(or individual stock pickers), but his research on market risk management (market hedging strategies) and digging deeper into the internals of the market to see what's really going on below the broad indices have taught me a great deal.

I do agree that the biggest long term issue facing the U.S. stock market and the North American economy as a whole is the over consumption (much of it leveraged) beyond our means by consumers and our governments (a.k.a debt). Though I don't think the dooms day scenarios will play out for a very long time (as in most things, you don't have to be good, just better than a bad lot). But it's good to understand the downside risks and be prepared to look after those downside risks when the perpetually rosy outlook for the stock market drilled into the public by Wall Street (made possible by CNBC and the rest of the financial media) doesn't turn out and everyone starts to head for the exits. This way you're not the one left holding the bag believing what Wall Street is telling you (great valuations, buying opportunity, etc.) while at the same time the smart ones are selling. I wish I knew in 2000 what I know now about managing downside risk.

His column is required reading for me on Sunday evenings.

 

[gamblingeconomist]

It is an interesting article but I'm not convinced. Note that his empirical evidence (i.e. graphs) are presented to support his arguments on why the fed SHOULD BE ineffective but he did not provide any empirical evidence that the Fed IS ineffective. In other words he did not present any empirical evidence that the Fed Funds rate does not impact short or long term interest rates. In fact, he conceded that the prime rate IS affected by changes in the Fed Funds rate even if he says that it is only through coordination. I would be interested in any evidence that shows that short term treasury notes are not impacted by changes in the Fed Funds rate or (more reasonably) that long term treasury rates are not impacted by the Fed Funds rate.

The recent housing boom (1) likely was the driver of ending the recent recession (for better or worse) and (2) was fueled by Adjustable Rate Mortgages that were attractive due to the low short-term interest rates. If these low rates were caused by the Fed, which pretty much every economist believes other than Hussman (whose academic research did not focus on monetary policy) then the Fed does in fact matter.

Furthermore, the fact that inflation has been pretty much contained in this country since the early 80's is further evidience that monetary policy has been effective. My understanding is that one of the main differences between countries that do not have inflation problems and countries that do is the presense of a strong central bank that fights inflation.

 

[oag]

Some comments on the current "herd" view on inflation.

Hussman didn't touch on it as much in this current commentary, but Hussman (and many others) debates in previous articles whether or not the actual level of inflation is as the government says it is (http://www.hussmanfunds.com/wmc/wmc060925.htm). Even the government statistics show the infamous "core inflation rate" running between 2% and 3% for over a year(which the Fed and Wall Street just discovered was a problem this past May). People long gold back in 2002 and 2003 being the astute ones that saw inflation as an issue and profited handsomely from their analysis. Overall inflation when you actually include the things that are going up in price that the government takes out may be running as high as 5% to 7% according to many inflation studies.

In the past Hussman has talked at length about the differences between the Volcker (the Great Paul Volcker as many refer to him) Fed of the early eighties and the Greenspan (Easy Al) Fed of the nineties and their difference methods/approaches and the banking system rule changes with respect to the ability (willingness?) to control the money supply/reserve levels and market based U.S. and global interest rates. Not enough time/cycles have passed to determine statistically if Hussman's relatively new Fed relevancy analysis is right or at the very least partly right and the Fed doesn't have the influence it had in the past in the global market place.

The following link (http://www.hussmanfunds.com/wmc/wmc051031.htm) has an article from last fall that discusses some of the differences between Volcker, Greenspan and what he feels Bernanke is trying to do in targeting inflation which Hussman feels is greatly affected by the level of government debt. His research argument being that when government debt levels were decreasing, inflation was decreasing. When debt levels started to increase again in the early 2000's, inflation started to pick up. The current level of inflation may not be a concern to Wall Street Instituitions (and/or the wealthiest consumers) right now, but history has shown that eventually constant high rates of inflation become a problem for most consumers (we see this already in the working poor. It just hasn't hit the U.S. housing ATM crowd yet) and foreign investors financing the domestic debt. Eventually leading to problems for the economy and corporate earnings which drive the stock market.

I want to stress again that I personally don't feel dooms day will arrive tomorrow like many have been predicting for two years now for the stock market and the economy. I took my hedges off in mid-August (put my hedges on in May when the market started to falter) and I'm 100% long right now. My short term analysis led me to believe the near term upside reward was worth the market risk that Hussman is currently not willing to take for his clients. Short term, in hindsight it was the right call for me personally. But it's always prudent to understand when your risk is too great for the potential reward and take your chips off the table. I'm ready to put my hedges back on at the first sign of trouble in the market and take the reduced risk rate of return.


One of Hussman's first articles discussing the relevancy of the Fed (from 2001) is below:

http://www.hussmanfunds.com/html/fedirrel.htm