An Open Letter to the FOMC: Recognizing the Valuation Bubble In Equities

In today's Outside the Box, my friend John Hussman of Hussman Strategic Advisors addresses the members of the Federal Open Market Committee, the Federal Reserve committee that makes decisions about interest rates and national monetary policy. The Fed has been notoriously clueless about bubbles, particularly in the run-up to the Great Recession, and so John would like to help them recognize the currently inflating bubble in equities.

He leads off with the key point that when the Financial Accounting Standards Board abandoned the FAS 157 "mark-to-market" accounting standard on March 16, 2009, in response to Congressional pressure from the House Committee on Financial Services, the FASB removed at a stroke the threat of widespread insolvency by making insolvency opaque. In other words, anyone with anything to hide could now hide it. John goes on:

My impression is that much of the market's confidence and oversensitivity to quantitative easing stems from misattribution of the initial recovery to QE. This has created a nearly self-fulfilling superstition that links the level of stock prices directly to the size of the Fed's balance sheet, despite the absence of any reliable or historically demonstrable transmission mechanism that relates the two with any precision at all.

Still, it may ease the burden of power to consider the likelihood that the actions of the Federal Reserve … were not responsible for the recovery.

So he is saying to the FOMC, "Yes, the market hangs on your every word, but don't get to thinking that you're the be all and end all." Ironically, though, when the Fed even hints at tapering its purchases of Treasury bonds, the market falls into paroxysms of despair.

Then he asks, "How does one establish the value of a long-lived asset?" What he's driving at is that if you just look at the current price of a stock, or at the price-earnings ratio based on just a single year of earnings, you aren't likely to be able to figure out anything about long-term value. And that's the fix – well, one of them – that we investors (and the Fed) are in today. It comes right back to that question I've been asking you a lot the past few years: Is this time really different?

If you want beef (your prime rib for Thanksgiving on the brain analyst says), this article has got it. So get out your carving knife (and hopefully a few of our Fed friends will have theirs at the ready, too).

These issues are part and parcel of the concerns that we covered in Code Red, which is again on the Wall Street Journal’s list of best-selling books this week. Let me offer a couple sound bites from some of the many reviews:

If you are concerned with protecting the value of your investments, you should read this book – 2 or 3 times…

Code Red is a solid analytical account of just exactly what that inscrutable fraternity of central bankers has done to the world economy and to our individual stores of wealth. It provides an illuminated tour of the mysterious world of public and private financial institutions, and also unveils many of their dubious and outrageous motives. It is well written and requires intelligence to read. It is not for the fainthearted. I found it to be an education. It is also full of wit, hilarious anecdotes, and humor. Mauldin is folksy and clear in his insights. Tepper is brilliant and makes the complicated and technical realm of high finance, banking, and public policy understandable. It is a five-star read.

You can watch a video of Jonathan Tepper and me discussing the book. It is also on Amazon and at your local bookstore. It might make a great holiday gift for your clients and friends.

I grew up learning to tinker with engines and do plumbing, TV repair, a little simple electrical work, framing, roofing, sheet rock, painting, landscaping, and all manner of things when I ran a print shop. Truly a jack of all trades and never a master of anything. Pretty much everything they are doing upstairs as they build my apartment but nowhere close to the true master’s level I see on display every day. My friend (and no stranger to many readers) Bill Bonner at Agora, who can afford to hire any master of anything he likes, prefers to build stone walls and personally renovate old homes himself, creating gardens and such; but I always did such things as a defense against leaky roofs or to pay the bills or because I couldn’t afford to pay someone to do them.

That being said, watching the true craftsmen work on my new apartment, taking pride in the smooth texture of paint or the finish on the granite or the way joints should be made to fit just so is a real pleasure. My perfectionist designer (and niece) decided that the leftover slabs of granite would make a beautiful backdrop over my bed in the new master bedroom, and the pieces of granite looked truly magnificent when bookended; but there were slight gaps at the joints, which I thought were just part of the piece. But today I look in to find a young man (they are all young to me lately) patiently mixing a half dozen colors of grout which he will work into those small gaps, matching the blues and browns and tans and greens and whites, turning the pieces into one seamless masterpiece. He went on mixing his colors, holding them up in the light to get just the right tones, dabbing a little more brown here, a little blue there.

Wiring is now an art form with the new electronic controllers, and anything electrical or that can be made electric has now been connected to my iPad mini, from which any of 8 TVs, multiple sound systems and speakers, lights (LEDs that can change colors and put on light shows – who knew?), curtains, security cameras that are almost spooky in their latest tech capabilities, locks – everything is connected to one device.

The multiple dozens of workers come from all over the country and world. Carol, my general contractor, has collected a team of subcontractor specialists that work together like a precision dance team, selected over the years for their quality and ability to get it done right and on time. This being Texas, there are of course a number of Latinos on the job. The painting crew comprises something like ten brothers and cousins who clearly come from the same tight gene pool. I turn a corner to find the guy who I thought was in the last room working in the next.

This being Texas, and me being me, I asked yesterday if one particularly gifted craftsman was legal, as his accent betrayed his roots. “I think so,” said Carol, “but the owners are and they all have insurance.” This being Texas, most of us really don’t care. Are you a good and honest person and do you get the job done right? If you make your own way, you are welcome in God’s country to help us build and grow and make it all work better.

Many of my fellow Republicans have this immigration thing all backwards. We should be striving to find more young people to come to this country. Yes, college-educated kids with tech skills are needed. But we need the young people who can build and plough and dig and tinker. The country is going to wake up one day and realize that the most important product it can import is young, hard-working people.

Control the borders, absolutely. Know who is coming in, yes. If you come you must contribute and not have access to welfare. But with those caveats, open the doors very wide. That is oddly a big part of the answer to the Code Red crisis that central banks are bringing our way. Someone has to work and pay the bills for a (large!) generation that will want to retire.

And now it is time to start thinking about cooking and enjoying 50-60 people who will invade my new, almost-finished home. You have a great week and enjoy your family and friends.