This post is prompted by an article by John Hussman. In it he “connects the dots” and gives us an insightful portrayal of the US banking system. Hussman is one of the brightest minds in finance, and always worth careful attention. Highly recommended reading:
Money, Banking, and Markets – Connecting the Dots
In essence, Hussman says – and he is right as rain – that once created any amount of a security must be held by someone until it is retired. This includes dollars, so when the Fed creates a lot of them, they have to go somewhere. There is no such thing as money “on the sidelines”, waiting to be put “into” stocks … every dollar used by one investor to buy stocks is received by another selling them. The only thing that changes is the price at which the transaction takes place.
So if Hussman is so brilliant, why has his investment track record been not so much? I think it is simply because of a single basic missing premise. While Hussman has accurately assessed the unattractiveness of stocks, he has underestimated the unattractiveness of his chosen alternative, cash.
As I have chronically pointed out, currency is not an inert asset to which one may retreat to “get out of the markets”. It’s a security in its own right against which the attractiveness of alternatives must be weighed. No investment asset can be weighed on its own merits, it must be weighed against the alternatives.
I think that if there were such a thing as a neutral, default asset, it would be hard money, primarily gold, and to a lesser degree silver, platinum and copper as well.
His default, get out of the game, sit on the sidelines, asset is USD. If it were hard money, his returns would have been stellar. In fact, had you just put your nest egg in gold on January 1, 2000, and left it alone since, you would have handily beaten stocks.
Hussman was right … most of the time stocks have been unattractive. They’ve lost ground in terms of real money. But dollars have lost even more. Choosing gold as the alternative would have created dramatically different results.
Most of the time long term investors suffer by going to cash when stocks are unattractive, and would be better off going to gold. Sure there are times when cash has beaten both, but they are rare and transient.
Hussman also overrates the role of “psychology”. For instance when the Fed creates a mess of money, he dismisses rising stock prices as due to an irrational yield seeking speculation as investors futilely attempt to escape nonyielding cash. It’s not … they’re just trying to rebalance their portfolios.
What do I mean by this? While traders can vary their asset allocations wildly, most investors do not. Institutional investors such as endowments and pension funds, as well as many individual investors, try to maintain their asset class exposure within certain limits. In the broadest sense, I suppose you could call this “psychology”, but it’s not the irrational, emotionally charged kind.
For simplicity of illustration, suppose there were only two assets available, cash and stocks. And suppose for instance you target an allocation of 20% cash and 80% in stocks. Next suppose the Fed dumps eight trillion dollars into the financial system. In aggregate, investors’ allocation to cash has increased. This cash must after all be held by somebody. If you allocate your portfolio by proportion and happen to be on the receiving end of some of this cash (and on average you are) you may try to rebalance your portfolio. You may even buy stocks. But since the net amount of cash is unchanged by such transactions, investors can’t rebalance in the aggregate this way. The only way overall rebalancing can happen is for the prices of stocks to rise.
This is not mindless yield seeking speculation, just the targeting of asset allocations in the face of aggregate changes in their quantities at work.
Another way of saying this is that stock prices went up because the pricing unit went down. No new goods or services are created by this paper shuffling, so the increase in purchasing power of stocks must have come at the expense of a decrease in purchasing power of dollars. This is why if continued this process must inevitably be followed by other prices adjusting upwards as well. And that if you want to be truly on the sidelines, you have to find other assets whose intrinsic value is unchanged by it.
These issues aside, however, Hussman couldn’t be more right. This article is especially timely because it helps us understand what has gone wrong in the banking system. There’s no question about it … it comes from the top.
Of course this does not absolve individual bankers from responsibility. Not all banks are failing. But Hussman is correct … the banks have some eight trillion dollars in excess uninsured deposits … because the Fed put them there.
3 thoughts on “How Monetary Policy Affects Asset Prices”
>Hussman also overrates the role of “psychology”.
The idea of institutional investors rebalancing when faced with a huge influx of money makes sense and is certainly a major factor but Hussman’s “psychology” is a reference to Keynes’ “animal spirits,” isn’t it? I think the animal spirits have a tremendous amount to do with the ridiculous rise in asset prices because prices are set on the margins and, when animal spirits are running wild, the punters don’t really care about price or value. How else could things such as GameStop, Bed Bath and Beyond, AMC Theaters, cryptocurrencies, and NFTs catch fire unless it was animal spirits run amok?
Hussman now claims (as of late 2017) to use animal spirits as a factor in addition to valuation in deciding whether to stay in the market, hedged, or move to Treasuries or cash. The charts he has published showing the hypothetical performance of such a strategy (looking backwards) looks good and, unless something is very, very different this time, it seems he should sidestep the astonishingly bad returns he has had this past decade.
As another opinion on the viability of going to cash when things are insane,I believe it was before 2022 that Jeremy Grantham said something on the order of, “Going to cash should work.” I suspect Grantham used the word “should” because it is unknown what crooked tricks the Fed or the government itself will try.
Point being, I’m not entirely sure that going to cash is that bad an idea provided that one does not exit far too early and one does not compound problems by going short when there are years to go before the top.
Hussman’s returns are so poor that I have to wonder if it’s due to a combination of bad stock-picking and having substantial short positions at the wrong time.
Much appreciate your comments, Milton. Let me try to address your points.
I think I’ve already conceded that there are times when resort to “cash” USD makes sense … it sometimes outperforms both stocks and gold, for example in the intense dollar rally (deflation) of 2008. My argument isn’t that it doesn’t happen, rather that it’s the exception rather than the rule. Deflations typically prompt a rapid and vigorous response from the Fed and tend to be … uhm … transitory. So it’s more of a tactical trading move than a general investment strategy.
The conclusion that managers like Hussman would have performed better by retreating to “cash” in the form of gold rather than dollars when stocks were unattractive is pretty unavoidable. Gold has outperformed dollars by nearly an order of magnitude since stocks reached an apex of hypervaluation in early 2000. Even random allocations to gold versus dollars over that time frame would have added a lot to returns. My reading of Hussman is that he’s been excessively focused on when to avoid stocks and insufficiently on what he’s avoiding them in favor of. Short of taking a vow of poverty and joining the brotherhood, there’s no such thing as being invested in nothing. It’s not enough to be “out” of something, what you’re in is everything.
Even when you’re short stocks, you’re shorting them against something. It’s inherently a pair trade, typically going long dollars against stocks.
I don’t mean to pick on Hussman … he’s brilliant and one fundamental omission has marred his track record. But Keynes’ “animal spirits” is a bit of a cop out … spirits come from nowhere for no reason and disappear for the same? The 1920s market for instance just happened because people got excited? They didn’t just buy stocks, they bought them on margin. That is, they were shorting dollars against stocks. The Fed had gone on an easy money, bubble blowing, rampage. In 1927 New York Fed president Ben Strong infamously told a French banker he would give the stock market a “coup de whiskey” to help paper over a deflating real estate bubble. Traders weren’t merely fleeing to stocks, they were fleeing from dollars … shorting them (borrowing) against stocks. Keynes’ formulation smacks of an attempt to exculpate the Fed from the ensuing disaster.
In the long run, in the aggregate, stocks don’t “go up”. They maintain their real value as dollars depreciate out from under them. In other words, stock prices have historically risen for the same reason as bread or eggs or oil … a figment of the choice of a depreciating unit of measure, aka inflation. I discuss this in more depth in Making Stock Market History. Notice what happens to stock prices when we choose a different pricing unit, especially the long term chart in terms of gold … they’ve gone virtually nowhere. The real, sustainable returns have come from dividends.