And Hussman Said It Best

As a follow up to my post about the lunacy in the Fed's equity risk premium/the market is undervalued analysis, John Hussman of Hussman Funds says it best in his weekly column...

The total capitalization of the U.S. stock market is presently about $17 trillion (about $16.2 trillion as non-financials). The Federal Reserve is purchasing $85 billion of Treasury and mortgage-backed bonds each month. This creates a pool of bank reserves that have to be held by someone at each point in time, until those reserves are retired. This zero-interest cash is a hot potato that certainly creates speculative demand. But it is thesuperstitious aspect of the belief in QE – as if it has some inexplicable power to remove downside risk – that deserves just as much credit for the recent advance. It is the superstition that QE mysteriously removes economic risk, and the psychological discomfort of low interest rates far beyond its true effect on investment value, that has encouraged investors to abandon their demand for a risk premium to adequately compensate them for the risk they are taking.

How can we know that? Simple. We can demonstrate that QE is not exerting the bulk of its effects through cash flows or the effect of lower interest rates on earnings or present discounted value. This leaves the suppression ofrisk premiums as the remaining and primary effect of QE. In other words, QE has not increased the value of equities. It has only increased the price, but that increase in price has no significant fundamental underpinning.

To see this, first consider cash flows. Imagine that instead of attempting to boost stock prices indirectly through quantitative easing, the Fed took the candy-land approach of literally handing the $85 billion directly to stockholders to reward them for owning stocks. How much would that direct cash distribution benefit a stock market with a $17 trillion market capitalization? Do the arithmetic. Only 0.5% a month. Yet investors have chased prices at a far more rapid pace as a result of quantitative easing. Remember, of course, that the Fed is not in fact distributing cash to shareholders.

What about the benefit of lower interest rates? Domestic nonfinancial corporate debt is presently $8.6 trillion. Even a 4% reduction in interest rates (400 basis points) comes to $344 billion a year. Assume that benefit accrues strictly to publicly traded companies, and extend that benefit over 5 years. It’s still only worth 10% of market capitalization. As a side note, lower interest rates also suppress income from corporate investments, particularly with large amounts of cash on corporate balance sheets. And though it has become a fad to subtract out cash from market capitalization, it is a profoundly incorrect fad. If it was correct, a company with a billion dollars of market cap could issue a billion dollars of debt, hold the proceeds in cash, and the stock could be considered "free."

What about higher GDP leading to greater profits and supporting stocks that way? Take the current ratio of corporate profits/GDP of 11% at face value (even though that share is 70% above the historical norm), and let’s even assume that all of these profits go to corporations with publicly traded stocks. How much would GDP have to rise, sustained over 5 years, to justify even a 10% increase in market capitalization? The required amount of additional GDP is 1.7 trillion / 0.11, or $15.5 trillion, or about $3.1 trillion a year sustained over 5 years. The present size of the U.S. economy is about $16 trillion. So yes, if QE could boost the size of the U.S. economy by about 20% and sustain it over 5 years, and the additional earnings could be delivered entirely to stock market investors in cash, it would justify a 10% increase in market capitalization.

Here’s one for geeks: What about the effect of a lower capitalization rate on discounted future cash flows? Simple. Take a given initial cash distribution and assume 6% annual growth, which is about the long-term peak-to-peak growth rate of earnings and nominal GDP over the economic cycle. Discount those cash flows annually into the indefinite future. Now drop the discount rate by about 4% (400 basis points) for 5 years. Even 10 years. Try 15. How much does the present discounted value increase? Not much – about 5-15% depending on your initial discount rate and how long you sustain the change.

We’ve certainly seen people correlate the monetary base with the S&P 500 since 2009, ignoring that two rising lines will always have a correlation of over 90%, and inferring targets for the S&P based on assumptions about base money. But this is little more than extrapolation based on statistical misuse. It may very well be that the promise of more QE will produce a reflexive pursuit of stocks in the same direction, but investors should at least be aware that this pursuit has no fundamental basis, and rests purely on the willingness of investors to abandon any need to be compensated for risk.

What concerns me most here is the lack of effort that investors are taking to analyze and quantify the mechanism by which quantitative easing should work, beyond a vague superstition that “it just does.” The notes I receive suggesting that somehow QE makes all historical economic relationships, profit margin dynamics, and financial relationships irrelevant remind me of some remarks that appeared in Business Week:

“During every preceding period of stock speculation and subsequent collapse there has been the same widespread idea that in some miraculous way, endlessly elaborated but never actually defined, the fundamental conditions and requirements of progress and prosperity have been changed, that old economic principles have been abrogated, that all economic problems have been solved, that industry has suddenly become more efficient than it ever was before … that business profits are destined to grow faster and without limit, and that the expansion of credit can have no end.”

Those remarks unfortunately waited to appear until November 1929.   

In short, there is no transmission mechanism by which QE has any large and beneficial effect on the value of equities. There has certainly been an effect on price – but this effect is driven by the willingness of investors to abandon their demand for a risk premium that will actually compensate them for the risk they are taking.

Sounds more like the equity risk premium is a lot lower than 5% to 6%.