Despite the fact that the Federal Reserve has likely done far more harm than good over the course of the past few decades, investors remain convinced that our nation's central bank has magical powers. That is one reason why equity investors, for instance, have remained steadfastly bullish despite the economic and financial earthquake that has been shaking the ground around them. Unfortunately, as Dr. John Hussman, president and principal shareholder of Hussman Econometrics Advisors, notes in "An Irrelevant Fed: Thimbles of Water in a Forest Fire," that confidence seems terribly misplaced.
Pop Quiz
How much “liquidity” has the Federal Reserve “pumped” into the $12.7 trillion U.S. banking system since March 2007?
a) $1.2 trillion, which banks have used to firm up their balance sheets
b) $600 billion, which banks can now use to make new loans
c) $16 billion, all of which has been drawn out of the banking system as currency in circulation
If you answered c, move to the head of the class. Investors who answered a or b have not only been misled by analysts and media stories, but have no idea how irrelevant the Fed's actions are likely to be, except on short-term market psychology. More charts and data below.
A good opportunity to reduce excess risks
Last week, the stock market enjoyed a typical clearing rally from an oversold low - “fast, furious, and prone to failure.” This presents a good opportunity for investors to reduce positions that they would not be able to tolerate through a complete market cycle, with the S&P 500 only about 5% below a record high.
Let me preface this analysis by stressing again that my intention is not to drive investors out of well considered investment plans. There is nothing wrong with a buy-and-hold approach provided investors are aware of how strong the impulse is to abandon that strategy only after deep declines. I appeared briefly on CNBC last week to discuss recession risk, but beforehand, I was asked to put a positive tone on my comments, to which I responded – “Look, my interest is in making sure that investors have positions that they are able to hold through the complete market cycle, including a potential 30% bear market loss off the highs, without having their financial security endangered. If they're carrying more risk than they could endure through the course of a bear market, they should cut back now. I'm not going to wave my arms around about doom and gloom, but I think it's a crucial time for investors to think about the risk they're taking, and if you don't want me to say that, please don't have me on.” Well, I went on, and though we ran short of time, that's still my message.
In economic developments, durable goods orders came in below expectations last week, while new claims for unemployment shot higher. The ECRI Weekly Leading Index fell to its most negative growth rate since the last recession, as the ECRI commented “US growth prospects have deteriorated further.” Credit spreads widened again, well beyond the highs of a few months ago, and LIBOR (the interest rate to which much floating-rate debt is pegged) rose to just slightly below the level it was at early this year, before the Fed began cutting its own interest rates. While the entire Treasury yield curve is currently below the Fed Funds rate, it's clear that this due to a flight-to-safety in Treasuries. The Fed can certainly penalize savers by pressuring deposit rates lower, but it isn't having a measurable effect on the market-determined interest rates that borrowers actually face. Nor can the Fed significantly affect the solvency of the mortgage market.
As for stocks, I noted a couple of weeks ago (extending Jim Stack's analysis) that in each instance that the market declined materially after successive discount rate cuts, S&P 500 earnings were down sharply a year later. Given that a large portion of S&P 500 profits are from financials, that profit margins in other industries are well above historical norms, and that profit margins have always collapsed during recessions, my impression is that S&P 500 earnings could easily fall by 40% over the next 18 months (investors who view this as impossible haven't examined earnings history). This could become far worse than a 5% decline off the high, which is where the S&P 500 is now.
