Inquiring minds are reading John Hussman’s latest post Quantitative Easing and the Iron Law of Equilibrium.
The Iron Law of Equilibrium: Every security that is issued must be held by someone until it is retired.
There are three corollaries to that Law: 1) No security can be under- or over-owned. Prices and expected returns adjust to ensure that the exact quantity outstanding is the exact quantity held. The investor’s challenge is to ask whether those prices and expected returns are reasonable; 2) The outstanding stock of issued currency and money market securities always remains effectively “on the sidelines” and held by someone – until the time those securities cease to exist; 3) Money never goes “into” or comes “out of” a secondary market. It is always “home.”
If you think carefully about equilibrium, it helps to clear up all sorts of fallacies that people hold about the financial markets. For example, the currency and money market securities that are held by investors will – in aggregate – never “find a home” in any other form or any other market. If somebody takes their cash and tries to buy stock, they get the stock and the seller gets the cash. Nothing disappears, and nothing is created – only the owner changes. As I wrote years ago in the Freight Trains and Steep Curves piece that anticipated the recent financial strains, the mountain of money-market securities held by investors is not a reflection of “liquidity looking for a home,” but is rather a measure of how dependent borrowers are on short-term sources of credit. Investors are holding a lot of money market securities because a lot of money market securities have been issued, and those securities will stick around until they are retired.
As I noted last week, an understanding of equilibrium is particularly important when it comes to the Federal Reserve’s program of Quantitative Easing (QE), so some further discussion may be helpful.
Essentially, QE has added to what will soon be $2.4 trillion of non-interest bearing cash and bank reserves, which someone will have to hold. The first effect of QE is therefore to immediately drive the interest rate on near-substitutes of cash (such as 1-month and 3-month T-bills) to nearly zero. This happens because any significant positive interest rate would induce people to try to shift their holdings from non-interest bearing cash to T-bills, and they bid up T-bills to the point where they are indifferent between the two. In the end, all the T-bills that have been issued are held, and all the cash is held (if interest rates could not be pressed lower, the competition between interest-bearing stores of wealth and zero-interest cash would make cash a “hot potato,” causing it to rapidly lose value relative to goods, services, and everything else, which is what we call inflation).
Technically, the Fed is buying Treasury securities and creating currency and bank reserves to pay for them. This would simply be an asset swap were it not for the fact that the U.S. is running a budget deficit of about 10% of GDP, so the Fed’s purchases don’t even absorb the amount of newly issued Treasury debt. The government budget constraint is simple: spending = taxes, plus the change in Treasury securities held by the public, plus the change in Treasury securities held by the Fed (base money creation). So the overall effect of QE is to reduce the amount of debt that the public would otherwise have to buy, and to instead create money and bank reserves to indirectly finance government spending.
The main effect of QE on the financial markets has little to do with stimulating spending, and everything to do with the fact that the currency and bank reserves bear zero interest, and yet have to be held by someone. In equilibrium, QE requires that the interest rates on near-cash securities must also be nearly zero.
Of course, a similar process happens for riskier and longer-term assets, but the resulting returns are less exact. For stocks, we’ve seen investors drive prices up to the point where probable 10-year returns are only about 3.2%. But of course, you can get a 3.2% 10-year return by having zero returns for 1-year, and returns averaging about 3.6% for the next 9 years. So depending on the overall profile of returns expected by investors, it’s quite possible that near term stock returns have already been driven to zero on a risk and maturity-adjusted basis. The key point, in any event, is that the primary function of QE is to distort market equilibrium by raising the price and depressing the future prospective returns on nearly every asset class.
If you look at the commodity markets, the same factors are at play. Regardless of whether one expects modest or significant inflation, it’s clear that the inflation expectations of the market are generally positive. So people expect that a year or two from now, goods and services will be more expensive. But if they are holding cash or money market securities, it is clear that interest earnings will not make up for those higher prices. So what do people predictably do? They hoard commodities now. When does it stop? At the point where commodities are priced high enough that they are expected to have the same negative return, relative to a broad basket of consumer goods, as cash is expected to have.
Keep in mind that commodities aren’t really a good inflation hedge once inflation is well anticipated. Rather, commodities tend to “overshoot” in the early stages of inflation, and then typically lose ground relative to the broad CPI as inflation proceeds. For example, in 1975, the CRB shot to about 5 times the level of the CPI. By the early 1980’s, the ratio had dropped to half that level, and continued to decline during the subsequent disinflation.
It is widely believed that the rise in commodity prices reflects the effects of China, India and other developing countries, but this long-term growth story certainly didn’t prevent commodities from collapsing in 2008. It’s a well-known result in resource economics that even when a resource is exhaustible and in significant demand, the price does not rise at a spectacular rate. Rather, except when there are new shocks that were previously unanticipated, the price of an exhaustible resource will tend to increase at roughly the rate of interest (Hotelling’s rule).
Certainly, concerns in Libya and elsewhere are creating some additional short-term pressures, but it should be clear that the primary force behind the rise in commodity prices is that QE has suppressed real interest rates to negative levels. If anything, QE is one of the primary forces driving up food and energy prices globally, contributing to extreme difficulty among the impoverished of the world, and adding to social tensions and resulting violence.
With the notable exception of the spike in the CRB triggered by the OPEC oil embargo in 1973, which preceded the movement of real interest rates, a significant portion of commodity price fluctuations reflects pre-emptive hoarding and release of commodities as surrogates for future consumption of goods and services, in response to the difference between expected inflation and the interest rate available on money-market securities.
Sideline Cash Myth Revisited
Corollaries two and three above are simply another iteration of the sideline cash myth that Hussman and I have written about many times before.
The myth is “cash is waiting to come into the market driving up the price of stocks”. The reality is that except for IPOs and debt offerings, for every buyer of a security there is a seller. Thus, no matter how many shares of stock anyone buys, the amount of sideline cash does not change.
However, the Fed did succeed in changing short-term sentiment towards equities and commodities alike, and that sentiment change has been to the upside.
Will Stocks Be Firm Until QE II Ends?
Based on continually bullish surveys, it appears that most market participants expect a positive market bias to commodities and equities until Quantitative Easing stops.
While that could be the case, it is not necessarily so.
Recall the stock market and commodities started rising on the Fed’s QE announcement,months before the program actually started. Might not equities and commodities sell off months ahead of the end of QE II?
Of course everyone expects QE III and QE IV. However, those expectations may not translate into reality and it’s also possible those expectations have already been priced in, if not more than priced in.
CRB Overshoot, Are We There Yet?
Hussman points out the tendency of the CRB to “overshot” to the point where commodities have have a large negative value in further hoarding. The same applies to equities. We may (or may not be) at such a point already.
Yet, Bernanke denies any responsibility for commodity price pressures while conveniently taking credit for the rise in the stock market. Such a position is clearly not defensible.
Stock Market Valuations
Hussman wrote “As of last week, the estimate from our standard methodology is that the S&P; 500 is priced to achieve total returns over the coming decade averaging about 3.2% annually. That said, this long-term estimate does not reduce into a forecast for near-term returns, or even returns over the next year or two.”
I think 3.2% is in the high side. For details, please see Negative Annualized Stock Market Returns for the Next 10 Years or Longer? It’s Far More Likely Than You Think
Whatever the rates of return are, I side with Hussman in regards to skew. Returns are highly unlikely to be uniform.
Moreover, given the current structural headwinds and fiscal constraints, I believe there is a much greater than even chance the next five years will not be as good as the subsequent five years.
Finally, even if Hussman’s model is correct, 3.2% annualized returns will cause massive additional stress on poorly-funded pension plans and their unsustainable assumptions of 7.5 to 8% annual returns.
Mike “Mish” Shedlock
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