John Hussman: Why QE2 is Illegal, and Realistic Stock Return Expectations

John Hussman: Why QE2 is Illegal, and Realistic Stock Return Expectations

Excellent commentary from John Hussman (as usual) in his most recent weekly piece.

On expected returns based on dividend yields (yes, THAT barbaric measure of value):

Our estimates for S&P 500 total returns remain below 5% at every horizon shorter than a decade. One can argue that 5% is “attractive” relative to less than 3% on a 10-year Treasury bond, but that assumes a static world where stocks are risk-free and securities deliver their returns smoothly. If investors decide that they are no longer ecstatic about these low prospective rates of return a year or two from now, they will promptly re-price the assets to build in higher rates of expected return. Unfortunately, the way you increase the future expected rate of return is to drop the current price, and the amount by which prices would have to drop in order to normalize expected returns is enormous.

On QE2 – why it’s dangerous, and illegal:

Bernanke offered a defense of QE2 last week in Europe that was reported as “coming out swinging,” but what he swung before the world was ignorance. Bernanke correctly observed that quantitative easing was capable of “moving asset prices significantly.” But he incorrectly said that “we don’t know what effect this will have on the real economy.” In fact, we do know. The elasticity of GDP growth to stock market changes can be easily estimated to be on the order of 0.05% or less, and transitory at that. In other words, a boost to the stock market isn’t interpreted by consumers as “permanent income” or stable wealth that should be consumed. Since QE2 doesn’t operate on any constraint in the credit markets that is binding, it is simply a way to blow asset bubbles, and nothing more.

Paul Krugman recently said that by engaging in QE2, “it’s not as if the Fed is doing anything radical.” I couldn’t disagree more. Look. My furnace may be intended to regulate the temperature in my house, but at the point it starts blazing at temperatures beyond anything ever intended in the wildest imagination of the engineers, there’s a problem.

It should be obvious that the Maiden Lane arrangements didn’t represent “discount” transactions under any reasonable interpretation of the Federal Reserve Act. Instead, the Fed created shell companies to stash long-term securities of questionable credit quality, bought them outright, and still holds them more than two years later. This is simply illegal.

You can read Hussman’s full piece here.

Big hat tip to our correspondent Dr. Evil for sending this along!