In this week’s note from Doug Noland, I think he does a good job of explaining how QE leads to speculation in financial assets – in this instance, U.S. equities:
“As an illustration, follow the trail of outflows from a somewhat less popular “Total Return Bond Fund” (TRBF). To fund outflows, TRBF sells Treasuries to the Federal Reserve. TRBF then transfers Fed liquidity to exiting investors that then use this “money” for investment in the now extremely popular “Total Stock Market Index Fund”. This fund then takes this “money” that originated with the Fed and bids up stock prices.
Or, how about an example where a hedge fund moves to exit an underperforming emerging bond market. Here the fund is unwinding a leveraged “carry trade” that involves selling the EM bond and liquidating the EM currency position. With the EM bonds and currency under intense (“hot money” outflow) pressure, the local EM central bank intervenes with currency purchases (sells dollars to buy the local currency). To fund these purchases, the EM central bank sells Treasuries to the Federal Reserve. The central bank then uses Fed liquidity for purchasing currency from the hedge fund, and the hedge fund then has “money” to rotate into 2013’s speculative vehicle of choice - US equities.”
Then in the latest Hussman piece, he covers a lot of interesting ground related to this overvalued stock market. For example, part of the problem is that many look at the market and think that there is nothing remarkable from a multiples perspective – until one considers that corporate profit margins are 70% above historical norms. All of which means, one, expect some mean reversion, and two, it is not practical to extrapolate from the present on what the discounted value for stocks should be prospectively. That’s why the Schiller P/E is a better multiple to focus on since it measures price to 10-year historical, inflation-adjusted earnings. And it currently stands at a robust 25x.
The other noteworthy point is more of a rebuttal to anyone who tries to tie employment and inflation – essentially the logic behind the Phillips Curve. Here’s Mr. Hussman: “This isn’t to say that A.W. Phillips was incorrect. Rather, his “Phillips Curve” was actually a relationship between the unemployment rate and wage inflation, in a century of British data when Britain was on the gold standard and general prices were stable. What Phillips said, in effect, is that unemployment is inversely related to real wage inflation. That proposition holds true in U.S. data as it does internationally. But it is hardly the basis for any strong belief that we can buy a few more jobs by targeting a higher inflation rate in the general price level.”
