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:
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.