Hussman Weekly Market Comment: Not In Kansas Anymore

Even in the event that quantitative easing is sufficient to override hostile market conditions in the near-term, it is worth noting that long-term outcomes are likely to be unaffected. We presently estimate a prospective 10-year total return on the S&P 500 Index of just 2.9% annually (nominal). See Investment, Speculation, Valuation and Tinker Bell for the general methodology here, which has a correlation of nearly 90% with subsequent 10-year market returns – about twice the correlation and nearly four times the explanatory power as the “Fed Model” and naïve estimates of the “equity risk premium” based on forward operating earnings.

We presently estimate that the S&P 500 is about 94% above the level that would be required to achieve historically normal market returns. If you work out present discounted values, you’ll find that depressed interest rates can explain only a fraction of this differential, even assuming another decade of QE – and even then only if historically inconsistent assumptions are made to combine normal economic growth with deeply depressed rates.

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On quantitative easing

Over the past three years, the U.S. economy has repeatedly approached levels that have historically marked the border between expansion and recession. There is little question that massive quantitative easing by the Federal Reserve has successfully nudged the economy away from this border for a few months at a time. But as I’ve noted before, the belief that monetary easing solved the 2008-2009 financial crisis is an artifact of timing. The Fed was easing monetary policy throughout 2008, and while it is tempting to view the recovery as a delayed effect, the more proximate factors were a) the change in FASB accounting rules to dispense with mark-to-market accounting, which relieved banks of insolvency concerns even if they were technically insolvent, and b) the move to government conservatorship and Treasury backstop of Fannie Mae and Freddie Mac, which reduced concerns about default risk among mortgage securities.

The Pavlovian response of investors to monetary easing – as if it has anything more than a transitory and indirect effect on the economy – fails to distinguish between liquidity and solvency; between economic activity and market speculation; and between investment value and artificially depressed risk premiums. The economy is not gaining anything durable from these policies, and the conditions for the next bear market are already established. Meanwhile, the chart below updates the extreme that monetary policy has already reached (data points since 1929).

The 3-month Treasury yield now stands at a single basis point. Unwinding this abomination to restore even 2% Treasury bill rates implies a return to less than 10 cents of monetary base per dollar of nominal GDP. To do this without a balance sheet reduction would require 12 years of 6% nominal growth (which is fairly incompatible with sub-2% yields), a more extended limbo of stagnant economic growth like Japan, or significant inflation pressures – most likely in the back half of this decade. The alternative is to conduct the largest monetary tightening in the history of the world.