“Deja Vu: The Fed’s Real ‘Policy Error’ Was To Encourage Years of Speculation”

Nowadays, when I find myself feeling too good about things I read fund manager John Hussman’s weekly column and it brings me back to Earth. He may be off on the timing but it’s difficult to dispute his main argument that we’re in the late stages of a massive speculative bubble fueled by easy credit and other unwise govt policies.

There’s fraying at the edges in junk bonds and much nervous volatility in stocks, where successive sectors have inflated and then deflated since early 2015. Everyone knows we are due for a market debacle but no one knows when. It could happen in two days or two years. Meanwhile everyone stays invested because what else can you do with your money (answer: keep it in cash, but that’s hard to do until it’s too late) and maybe you can make some profits before the bottom falls out…

From his latest missive:

Over the past several years, yield-seeking investors, starved for any “pickup” in yield over Treasury securities, have piled into the junk debt and leveraged loan markets. Just as equity valuations have been driven to the second most extreme point in history (and the single most extreme point in history for the median stock, where valuations are well-beyond 2000 levels), risk premiums on speculative debt were compressed to razor-thin levels. By 2014, the spread between junk bond yields and Treasury yields had fallen to less than 2.4%. Since then, years of expected “risk-premiums” have been erased by capital losses, and defaults haven’t even spiked yet (they do so with a lag).
From an economic standpoint, the unfortunate fact is that the proceeds from aggressive issuance of junk debt and leveraged loans in the past few years were channeled into speculation. Excess capacity in energy production was expanded at the cyclical peak in oil prices, and heavy stock buybacks were executed at obscene equity valuations. The end result will be unintended wealth transfers and deadweight losses for the economy. Since the late-1990’s, the Federal Reserve has actively encouraged the channeling of trillions of dollars of savings into speculation. Recurring cycles of malinvestment and crisis have progressively weakened the resilience and long-term growth prospects of the U.S. economy.
[. . .]
Our outlook remains decidedly negative at present. I’ll emphasize again that market internals are the hinge that distinguishes a valuation bubble that expands from one that collapses, so an improvement in market internals would reduce the immediacy of our downside concerns, and would also tend to reduce our concerns about oncoming recession. In the absence of clear improvement in market internals – and last week was categorically opposite to that – I view the stock market as being in the late-phase of an extremely overvalued top formation that will likely be followed by profound losses over the completion of this market cycle, and the U.S. economy as being on the cusp of a new recession.

Interesting times ahead.

12 thoughts on ““Deja Vu: The Fed’s Real ‘Policy Error’ Was To Encourage Years of Speculation””

  1. “The fact is that a quarter-point hike comes too late to avert the consequences of years of speculation, and while the hike itself will have little economic effect, the timing is ironic because a recession is already likely.”

    The economy is slow, and manufacturing is probably already in a recession. Without some kind of stealth QE sometime in the first quarter, the outlook seems rather negative. However, the immediate timing of the rate hike is obvious because of the Christmas seasonal effect on the stock market – the ‘Santa Rally’. The Fed tries to play the market like everybody else, but the holiday hangover is inevitable.

  2. If I was a betting man, I would tend to lean to the Fed trying to keep the markets propped up for another year in order to get Hillary elected. If there’s a recession going into the election she will get routed. The stakes are high in the next few years for Obama’s imperial decrees such as Obamacare mandates and the EPA’s take over of industry.

    But who can really say. Rates have been so low for so long that there’s no telling what will happen.

  3. “keep it in cash”: I think so. At some point a bit of precious metals might be a good idea. I have had only two other ideas on this front but one is specific to England. The other involved investing in property in Japan, but a large American company has recently snapped up my preferred vehicle while I was trying to rearrange our money to allow us to invest. I don’t mind being wrong but I positively hate being right and then missing the boat.

  4. The primary cost of decades long periods of easy money is not primarily economic but moral. People expect to get something for no real effort. Saving is penalized. Investors live in fantasy lands. Reality departs. Like lunches, there’s no such thing as free money.

  5. If I was a betting man, I would tend to lean to the Fed trying to keep the markets propped up for another year in order to get Hillary elected.

    Negative interest rates may be the path of least political resistance. That way there’s maximum incentive for people to keep chasing yield in high-risk assets and for corporations to keep borrowing to buy more of their already inflated stock. Never mind that the longer the govt keeps the bubble inflated the worse the inevitable crash will be for everyone.

    Not even the govt can stop the tides. Sooner or later the QE and other tricks will stop working.

    QE and the ZIRP are colossal scandals.

  6. How does one fight an oncoming recession when you are already in a ZIRP environment?…I guess the state buying more securitized assets to pump the prime. Eventually that’ll no longer work as we are already stuffed to the gills with debt.

  7. Mike, Armed with ignorance and some rough numbers: U.S. Gov’t. spent about $4T this year, U.S. consumers spent some 12T. Overall QE totaled about 4T.

    Let’s estimate that 2010 – 2013 average gov’t spending was 3.5T/year. Avg consumer spending of 11T/yr, and QE of 1T/yr. This leads me to believe that QE would lead to aprox. 7% inflation…1/(3.5+11)=7.

    The consumer didn’t see the inflation but the consumer of investment products did. People that spent QE didn’t need another car, a new house, etc., etc. so those monies went to the markets resulting in abnormally high valuations.

    I don’t see that this puts pressure on the market to crash (like the tulip bubble). For example, a product, say a box of cereal, undergoes a price inflation of $4 to $5. Once the phenomena of inflation happens there’s no reason for the cereal to decrease in price. The over-valuation of stocks and bonds should be a relatively permanent condition (all other factors held constant).

  8. it seems to me that the Fed has found themselves in the same position as a pilot who has flown his airplane into the “coffin corner”. In the coffin corner, the airplane is at an altitude where its stall speed (the minimum speed required to maintain level flight) is equal to the critical Mach number. Any reduction in speed will cause the airplane to stall and lose altitude, perhaps in a spin. Because the critical Mach number is the maximum speed at which air can travel over the wings without losing lift due to flow separation and shock waves, any increase in speed will cause the airplane to lose lift, and, perhaps control.

    If the Fed tries to raise rates, they may crash the economy. If they don’t, they may cause long term damage by decreasing savings and investment. Pick your poison.

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