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Notes to the FOMC

February 19, 2014

Janet Yellen, the new Fed chair, has her admirers and her detractors. One unabashed admirer is my good friend David Zervos, Jefferies' chief market strategist, who during the past several months has taken to hollering "Dammit Janet, I love you!" He was at it again yesterday:

Last week was certainly a week for the lovers. Q's broke to new cyclical highs, spoos moved to within just a few points of all time record highs, and Friday was St. Valentine's day! It was all about LOVE, LOVE and LOVE! But for those folks still hiding out in the HATER camp – those who probably spent Friday evening watching Blue Valentine, War of the Roses or Scenes from Marriage – last week must have felt more like a St Valentine's day massacre. These folks, and their econometrically deceitful overlay charts of 1927-1929 vs 2012-2014, were shredded by our new goddess of pleasure, beauty, love and of course easy money – Janet "Aphrodite" Yellen. She gave the haters a taste of the Hippolyos treatment!! And once again it was a triumph of love over hate!!

Janet delivered the perfect message for markets. Her focus on underemployment was unquestionable. Her commitment to eradicate joblessness via the power of monetary policy was also unwavering. And for anyone who thought she would be hawkish, or even middle of the road, this speech was a wake up call. The reality is that we are dealing with a die-hard Keynesian dove! It's really not that complicated.

That said some folks seem to think the rally was mostly a function of the data. Weak ISM, payrolls, retail sales and IP were apparently the drivers of a 5 percent rally off the lows. Pullease!! That is preposterous. The reality is the market was jittery (and downright freaky) into the Fed chairmanship transition. Risk was pared back by folks who began to incorrectly price in a surprise from Janet! And leverage induced illiquidity created an overshoot to the downside. Weak hands sold, and all the usual haters came out of their bunkers to once again warn of impending doom. But as per the norm, their day in the sun was short-lived. The dust has settled and the haters lost again! Love is in the air my friends, and we owe a great deal of thanks to our new goddess of easy money. Dammit Janet, I love you! Good luck trading.

Take note of this phrase: "the new Goddess of Easy Money." It is now in the lexicon. I wonder how many virgins will be sacrificed to this new deity. (Just kidding, Janet!)

Now, David is not above having a bit of fun in his always-entertaining commentaries, but for a somewhat more substantial take on the opening of the Yellen era, I suggest we turn to John Hussman. I wouldn't call John a Yellen detractor, exactly, but he is certainly inclined to take the Fed down a notch or three. Check out these zingers:

While we all would like to see greater job creation and economic growth, there is little demonstrated cause-and-effect relationship between the Fed's actions and the outcomes it seeks, other than provoking speculation in risk-assets by depriving investors of safe yield….

[T]he "dual mandate" of the Federal Reserve is much like charging the National Weather Service to balance the frequency of sunshine versus rainfall….

The FOMC should be slow to conclude that monetary policy is what ended the credit crisis…. The philosophy seems to be "If an unprecedented amount of ineffective intervention is not sufficient, one must always do more."

At present, U.S. equity valuations are about double their norms, based on historically reliable measures.

The primary beneficiary of QE has been equity prices, where valuations are strenuously elevated. QE essentially robs the elderly and risk-averse of income, and encourages a speculative reach for yield.

I think John would agree with me that the current economic theory driving our monetary policy is both inadequate and outdated. Is it any wonder that he concludes that monetary policy as it is practiced today is simply part of the problem? It is as if we are trying to fly a 747 using the knowledge and skills we learned while driving a car, and all the while looking in the rearview mirror. (Do those things have rearview mirrors?)

You can find John's "Weekly Market Comment" and other valuable analysis at the Hussman Funds website.

This weekend I will be writing about some of the recent analysis concerning income inequality. I've actually been thinking a lot about it in conjunction with the rise of the Age of Transformation. I think about it a lot, most personally in terms of my own seven kids. I'm not so concerned about income inequality as I am about income opportunity. It seems to me that we have an education system that was designed to meet the needs of the US and the Second Industrial Revolution that was grown atop the industrial British Empire.

We are simply not preparing most of our children for the challenges that lie ahead. Many of course are going to do quite well, but that will be in spite of the educational process, not because of it. The complete higher-academic and bureaucratic capture of the educational process is as much at the root of income inequality as the other usual suspects are. There is more than one cause, and another root is the manipulation of capitalism and free markets by vested interests.

But that's all too serious, because now it's time to hit the send button and think hard about an Italian dinner and the Miami Heat being in town. Even if Lebron James is on the other team, he is simply a pleasure to watch. Lebron, you should've come to Dallas to play with Dirk!

Your getting ready to sit courtside analyst,

John Mauldin, Editor
Outside the Box

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Notes to the FOMC

John P. Hussman, Ph.D.

The following are a few observations regarding Dr. Yellen’s testimony to Congress. The objective is to broaden the discourse with alternative views and evidence, not to disparage FOMC members. We should all hope that Dr. Yellen does well in what can be expected to be a challenging position in the coming years.

  1. While we all would like to see greater job creation and economic growth, there is little demonstrated cause-and-effect relationship between the Fed’s actions and the outcomes it seeks, other than provoking speculation in risk-assets by depriving investors of safe yield. That’s essentially the same M.O. that got us into the housing crisis: yield-starved investors plowing money into mortgage-backed securities, and Wall Street scrambling to create “product” by lending to anyone with a pulse. To suggest that fresh economic weakness might justify further efforts at quantitative easing is to assume a cause-and-effect link that is unreliable, if evident at all, and to overlook the already elevated risks.
  1. In this context, the “dual mandate” of the Federal Reserve is much like charging the National Weather Service to balance the frequency of sunshine versus rainfall. If Congress was to require the Federal Reserve to change itself into a butterfly, it would not be the fault of the Federal Reserve to miss that objective. Moreover, what is absent from nearly every reference to the dual mandate is the phrase “long run” that is repeatedly included in that mandate. It seems probable that the cyclical response to economic weakness following the 2000-2001 recession – suppressing safe yields in a way that encouraged yield-seeking and housing speculation – was largely responsible for present, much longer-term difficulties.
  1. The FOMC should be slow to conclude that monetary policy is what ended the credit crisis. The main concern during that period was the risk of widespread bank insolvency, resulting from asset losses that were wiping out the razor-thin capital levels at banks. In the first weeks of March 2009, in response to Congressional pressure, the Financial Accounting Standards Board changed accounting standards (FAS 157) to allow “significant judgment” in the valuation of assets, instead of valuing them at market prices. That change coincided precisely with the low in the financial markets and the turn in leading economic measures. By overestimating the impact of its actions, the FOMC may underestimate the risks. The philosophy seems to be “If an unprecedented amount of ineffective intervention is not sufficient, one must always do more.”
  1. At present, excess reserves in the U.S. banking system amount to $2.4 trillion – more than double the total amount of demand deposits in the U.S. banking system, far more than all commercial and industrial loans combined, and 25% of total deposits in U.S. banks. Short term interest rates have averaged less than 10 basis points since late-2009, when the Fed’s balance sheet $2 trillion smaller. Based on the tight relationship between monetary base / nominal GDP and short-term interest rates, it is evident that even an immediate and persistent reduction in the Federal Reserve’s balance sheet of $20-25 billion per month would be unlikely to result in even 1% Treasury bill rates until 2020, absent much higher interest on reserves. The FOMC has done what it can – probably too much. A focus on the potential risks of equity leverage (where NYSE margin debt has surged to a record and the highest ratio of GDP in history aside from the March 2000 market peak), covenant lite lending, and other speculative outcomes should be high on the priorities of the FOMC.
  1. Dr. Yellen suggests that equity valuations are not “in bubble territory, or outside of normal historical ranges.” The historical record begs to differ on this. The first chart below reviews a variety of reliable valuation measures relative to their historical norms. The second shows the relationship of these measures with actual subsequent 10-year equity returns. With regard to alternate measures of valuation such as price/unadjusted forward operating earnings, or various “equity risk premium” models, it would be appropriate for the FOMC to estimate the relationship between those measures and actual subsequent market returns. Having done this, the spoiler alert is that these methods do not perform very well. In contrast, the correlation between the measures below and actual subsequent 7-10 year equity returns approaches 90%. At present, U.S. equity valuations are about double their norms, based on historically reliable measures.

The chart below shows how these measures are related with actual subsequent 10-year total returns in the S&P 500. The specific calculations are detailed in a variety of prior weekly comments (the price / revenue and Tobin’s Q models are straightforward variants of the others).

  1. Finally, when confronted with the difficulties that quantitative easing has posed for individuals on fixed incomes, Dr. Yellen asserted that interest rates are low not only because of Fed policy, but because of generally lackluster economic conditions. This argument is difficult to support, because there is an extraordinarily close relationship between the level of short-term interest rates and quantity of monetary base per dollar of nominal GDP (see the chart below). With regard to long-term interest rates, it’s notable that the 10-year Treasury yield is actually higher than when QE2 was initiated in 2010, and is also higher than the weighted average yield at which the Federal Reserve has accumulated its holdings. In order to restore even 1% Treasury bill yields without paying enormous interest on reserves, the Fed would not only have to taper its purchases, but actively contract its balance sheet by more than $1.5 trillion.


The primary beneficiary of QE has been equity prices, where valuations are strenuously elevated. QE essentially robs the elderly and risk-averse of income, and encourages a speculative reach for yield. Importantly, one should not equate elevated stock prices with aggregate “wealth” (as higher current prices are associated with lower future returns, but little change in long-term cash flows or final purchasing power). Rather, the effect of QE is to give investors the illusion that they are wealthier than they really are. It is certainly possible for any individual investor to realize wealth from an overvalued security by selling it, but this requires another investor to buy that overvalued security. The wealth of the seller is obtained by redistributing that wealth from the buyer. The constant hope is to encourage a trickle-down effect on spending that, in any event, is unsupported by a century of economic evidence.

The risks of continuing the recent policy course have accelerated far beyond the potential for benefit. The Fed is right to wind it down, and as it does so, the FOMC should focus on addressing the potential fallout from speculative losses that to a large degree are now unavoidable. Ultimately, the U.S. economy will be best served by a return to capital markets that allocate scarce savings toward productive investment rather than speculative activity. The transition to that environment will pose cyclical challenges, but is well worth achieving if the U.S. economy is to escape the grip of what is now more than 15 years of Fed-enabled capital misallocation.

Discuss This


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Bill Geer

Feb. 23, 2014, 6:18 p.m.

I don’t understand why economist in this case John Hussman, refrains from calling a spade a spade.  Mr Hussman clearly reports on the effect of fed action in which he describes as “...provoking speculation in risk-assets….”  The correct and most commonly used economic term, that no one wants to utter- for some reason - is “equity price inflation.”  We hear that inflation is being held in check for consumable goods and apparently everyone seems to be content that with claim; however, significant inflationary effects of the fed policy is seen in equity prices .  Isn’t one of the fed’s mandate to attempt to maintain stable prices; if so why does it only apply to consumables and services - not to equity prices?  Inflation is inflation regardless of the market sector it occurs in.

David Tebeau 77341609

Feb. 20, 2014, 5:11 p.m.

Article in USA today mentions a reason for growing equity market that I’ve not heard discussed before.  Is this true?

Wall Street’s growing legions of analysts might have overlooked one reason the stock market has risen in recent years: The U.S. stock market itself is shrinking.

At the end of last year, 5,008 stocks traded on U.S. exchanges, down 44% from a peak of 8,884 in 1997, according to the World Federation of Exchanges. Similarly, there were only 3,776 stocks in the Wilshire 5000 stock index, the broadest gauge of the U.S. equity market, which also peaked in 1997, with 7,459 stocks.

What’s more, the number of outstanding shares of stock available to be bought or sold has shrunk by nearly 10% since the end of 2010, according to S&P Dow Jones Indices.



Feb. 20, 2014, 3:30 p.m.

The share of investments in the stock market regarding the retired is limited by risk.  Interest on savings is negligible.

What are the elderly going to do.  Significantly pare expenses AND share expenses with one or more of your children.  It can be done. 

Save $2,500.00 a year on your cable bill if you can use a TV antenna.  Moving in with a relative and sharing expenses will save you $2,000.00 a year for real estate taxes plus $3,000.00 a year for utilities and and $1000.00 a year for insurance.  If you share expenses, you could put $4,000.00 or more into savings per year.  A lot more if you stop eating out and cut way down on clothing, etc.  A lot of these things can add up to big bucks you can add to savings each year. You will have money to gradually invest one-half or less in the stock market when it has big corrections. 

Vincent Roach

Feb. 19, 2014, 3:53 p.m.

A reasoned response is beyond anyone’s attention threshold in the 21st century. A “chirp” (my new service for people with not enough attention for a Tweet) would be “duh”.  Somewhere in the middle is “of course the last few sentences make perfect sense; they are 100% prophetic and all we do not know is the timing.” Like the Biblical Armageddon, it will be swift and decisive, and utterly unpredictable as to the day and the hour.


Feb. 19, 2014, 3 p.m.

John, you deal with financial advisors in your work. You should poll a few of them to determine how many have clients/family who fall into the category of “elderly” that John Hussman refers to as living on a “fixed income”. No one in my family or on my client roster. We and they need inflation-adjusted income. I realize that many seniors are trapped in their CD’s since that has been their preferred method of saving and it worked quite well when rates were at 5-7% in bygone days. However, nobody is forcing them to sit in zero-interest accounts. Where are their advisors and family members who have some financial knowledge?

Everyone is railing about the Fed, the debt and the deficit. Well, get over it because there is nothing you can do about it but adapt and prosper. No one whom we might elect is going to go to Washington and eliminate the Fed or the deficit or the debt, though they will tell you what you want to hear to get your vote. The debt and unfunded obligations of the government has increased every year that I can count, and it will continue to do so. Your best bet is to try and figure out what you are going to do about it in your personal financial life.

If you haven’t heard about it, I recommend Ed Seykota’s new book, “Govopoly in the 39th Day”. He has done a quite masterful job of reviewing the history of all the issues your readers are concerned about and draws a realistic conclusion. Go with the flow.

Dallas Kennedy

Feb. 19, 2014, 2:53 p.m.

Hussman’s write-up is respectful, but clearly no love note.

It’s not love, not money, not love of money that makes the world go round, but the money of love ... a special love that only central bankers can give, only central bankers can give ... but Alan, Ben, and Janet’s is the most special of all ... oh you people at Eccles, we’re crazy, oh crazy, for loving’ you.

jack goldman

Feb. 19, 2014, 1:27 p.m.

Janet Yellen has financial venerial disease that is spread with counterfeit currency. The economic collapse is the solution, the cure. The one per cent don’t want the cure to wipe out their ill gotten gains from counterfeiting currency. The problem is simple. Dow was 750 silver dollars in 1964 and is STILL 750 silver dollars in 2014, fifty years later. It’s a fake internet phony quota economy run be the Fed. In counterfeit Fed debt notes the Dow is $750 in 1964 and $16,000 in 2014. This is fraud. This is evil. America has been raped and pillaged by a central bank. This disease of fraud ends badly but the fraudsters at the Fed will walk away wealthy, cashing out at the top. Wall Street wins. Main street suffers and children lose. Creating $15 Trillion in counterfeit debt to enrich the 1% is fraud. The Silver Dollars, real US Treasury money, exposes this fraud.