Restoring the "Virtuous Cycle" of Economic Growth 

John P. Hussman, Ph.D.  

Quantitative Easing and “Cash on the Sidelines”

The Federal Reserve’s policy of quantitative easing has certainly had a massive effect on the form of the IOUs held by individuals and businesses. Following the massive government deficits of recent years, one would expect that the IOUs would be held as Treasury securities. But the Fed has bought trillions of dollars of that debt, and replaced it with currency and bank reserves. Regardless, holding the IOUs in the form of cash does little to provoke individuals or businesses to spend them. What the Fed’s policy has done, however, is to encourage investors to reach for yield in speculative assets in the hope of greater returns than are available on zero-interest cash.

The effect of QE has been to make this potato very hot, encouraging investors to chase one risky security after another, so that now nearly every risky asset has been driven to such rich valuations that their probable future returns match the zero return available on cash. 

Over the short-term, driving risky assets to valuations associated with zero future returns may be an equilibrium in a world where cash presents the same dismal opportunity. But this is also a highly unstable equilibrium. A broad range of historically reliable valuation metrics now imply zero or negative expected nominal total returns on the S&P 500 – with the additional likelihood of deep intervening losses – over every horizon shorter than about 7 years. Over a full decade, we estimate 10-year nominal total returns for the S&P 500 averaging just 2.4% annually. 

DYI Comments:  There is no doubt this is an overblown, overvalued, stock market.  For those who are so inclined a modest short position of 5% to 10% is warranted.  You may want to look into the Prudent Bear Fund or Comstock Capital Value Fund.

DYI