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Essays & Articles |
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September 15, 2007 by Gary North, Ph.D.
But the media are interested only in the short run. So are fund managers who are up to their eyeballs in debt and who rely on their Christmas bonuses. In the short run, things are likely to remain chaotic. The wild fluctuations will continue. When a market fluctuates around a trend, investors can see a pattern, either up or down. Fluctuations are normal. A straight line reveals a fake price. The most notable fake price is the Federal Reserve System's interest rate for the federal funds market. It is merely a stated target, not a real rate, although most investors are unaware of this. When the stock market reveals an underlying direction around which the index fluctuates, investors can assess the consensus opinion of specialists who control literally trillions of dollars. But when the index fluctuates wildly, revealing no clear direction, this reveals confusion on the part of experts who are acting as the economic agents of the investing public. Ever since July 19, when the Dow Jones Industrial Average closed for the first and -- so far -- last time above 14,000, the Dow has revealed a growing confusion among investment professionals regarding the future value of the capital stock that undergirds the prosperity of the United States. Other stock market indexes reveal this same confusion, but the Dow's number is so familiar that it is reported as "the market." We are in a classic struggle between bulls and bears. This struggle goes on moment by moment with respect to the price of any asset, but when it becomes visible through sharp fluctuations, day after day, in a widely followed index, we identify this as a prelude to a market turning point. These periods are relatively rare. WHAT'S BOTHERING THE FUND MANAGERS? They see that there is a growing problem with subprime debt. Assets that are packaged pools of now-unreliable promises to repay were sold to what investors regarded as very sophisticated: fund managers, banks, and the trillion-dollar pools of promises to pay known as Fannie Mae and Freddie Mac. These people are supposed to know what they are doing with investors' money. All of a sudden, it appears that some of them were blithering idiots. These packages of promises have fallen by 50% or more in a matter of weeks. Investment funds that bought them are being shut down. Their investors cannot pull out what little remains of their money. This has come in the wake of bankruptcies and forced mergers in the mortgage market. Again, pools of assets worth billions of dollars are being revealed by free market forces as being worth maybe hundreds of millions of dollars, and may be headed to tens of millions. The delightfully named Implode-o-Meter site has tracked the number of these failures since December, 2006. At last report, it was 155. The site also provides headlines that serve as links to media stories. Here were the top stories on September 12.
And so on, down the page. None of this was expected last December by the experts who act as economic agents for millions of Americans. None of this was foreseen by Federal Reserve Chairman Ben Bernanke, who calmly told a group of bankers in South Africa on June 5:
When the experts who are in charge of national monetary policy get blind-sided by the effects of the policy they have pursued, a sense of dismay spreads to those who are in charge of allocating the nation's capital. This question arises: "Who's in charge here?" Then came Jim Cramer's fit on CNBC on August 6, which was replayed in part that evening on the NBC Evening News. You have to see it to believe it. He literally screamed that the decision-makers at the Federal Reserve had no idea how bad the market was, no idea of what the FED's tight-money policy was doing to market values. This looked like the ravings of a madman -- Mad Money Cramer gone around the bend. There was method in his madness -- or maybe method acting. Within two weeks, on August 20, the FED lowered the discount window rate from 6.25% to 5.75%. Two days later, the nation's four largest banks borrowed $500 million each. What message did this action send to fund managers? This:
The FED's action did push the stock market back up, although nowhere near the 14,000 level of July 19. But it did not push it up in an orderly fashion. The Dow began to reveal widespread confusion, including opening minutes in which it fell straight down by over 100 points. The chart reveals a nightmare for investors who want safe, stable returns. What the chart reveals is a mutual fund industry in turmoil and confusion about what to expect next. This does not send a message of confidence to stock market investors. FAITH IN A RATE CUT There is widespread faith in the FED's willingness to cut the target rate for the federal funds market, meaning the rate at which banks lend to each other overnight. We will see if this faith is well placed on September 18. There is also widespread faith that this intervention will re-establish stability in the nation's capital markets. It will supposedly keep the economy from falling into a recession, which everyone -- I mean EVERYONE -- in the mainstream financial community denied was possible as recently as August 5. Here is what this faith in the FED really means. There is widespread lack of faith in economic freedom, which allocates capital in terms of people's individual assessments of the economic future: bull vs. bear. The mainstream financial community now suspects that individual investors, left to themselves, are likely to start selling at today's prices, driving down stocks, driving up T-bonds, and driving out of business more mortgage companies, hedge funds, and designers of creative finance. The fund managers are terrified of a free market in capital. Cramer's tantrum spoke on behalf of most of them. They do not trust the free market. They do not trust relatively stable money. We had comparatively stable money, as the data of the adjusted monetary base reveal, mid-June, 2006 to early July, 2007: a 1.8% per annum increase. The people managing the investment funds of American investors believe that without Federal Reserve intervention with great wads of digital money, the capital markets will produce huge losses for them, meaning for their investors. They will get no Christmas bonuses, and they may even get demoted or fired. Their clients will call in with that four-letter word: "Sell!" So, we are told that the Dow has risen recently because fund managers believe that the FED will cut rates, meaning the FedFunds rate, meaning the FedFunds officially announced target rate. But in order to force economic reality to conform to the target rate, the FED will have to buy bank collateral on a repurchase arrangement basis, which it will do with newly created digital money. Then it will roll over the purchases. The increase in the money supply will become permanent. The only way that the FED can keep this from becoming inflationary is to sell an off-setting asset whenever it enters into repurchase agreements with the banks. That means either gold, which it never sells (officially), or T-bills. In a credit panic, it can sell T-bills without driving up the T-bill rate. How? Because investors, seeking safety, start buying T-bills. This forces the interest rate down, offsetting upward pressure from FED sales. I think this is what happened, beginning immediately after the FED issued $2 billion in loans to the nation's four largest banks. Again, look at the chart of the adjusted monetary base. Look at the fall-back in late August. This did not drive up the T-bill rate. The T-bill rate has fallen in early September from 4.5% to 4%. Investors are still looking for safety. WHAT WILL A RATE CUT ACCOMPLISH? It will send a signal to investors: "We are willing to supply sufficient funds to keep the credit markets orderly." Can the FED actually do this? Yes, but not with a piddling increase in the money supply. It will have to go whole hog, beyond even Greenspan's legacy. (It is worth noting that Greenspan's new book will be released on September 17. Now, that is marketing!) This infusion of new funds is mostly for show. But show works. Investors respond to symbolic moves. If the FED drops the rate by half a point instead of a quarter point, it will send a loud signal: "Let the good times roll!" The reality is different. The mortgage market is for long- term money, not overnight, FedFunds money. It is a huge market. The FED cannot bail out this market without injecting huge quantities of money at double-digit rates. There is of course far more to the economy than the mortgage market. There is far more to it than just American investors. There are international investors to consider, the people who buy dollars to buy dollar-denominated assets. The dollar has been falling, in expectation of more inflation. This cuts the hoped-for rate of return for foreign investors. But the government does not care, so long as someone buys T-bills. The export sector wants a falling dollar: more buyers abroad for American goods. Cramer and his peers want a falling dollar if this is what it takes to provide the illusion of rising equity value. The number of people with money who favor inflation is gigantic compared to the number of people who favor stable money with whatever short-term market results occur, which means a recession. The inflationists always win their case, year after year, decade after decade. That a rate cut larger than expected can and probably will be bullish for stocks is a conventional prediction. The question is: Can the bull move be sustained by (1) a fall in the FedFunds target rate, when accompanied by (2) sufficient new money necessary to sustain the target rate in the actual overnight market? I don't think it can. The years of monetary expansion under Greenspan's later administration, 2001-2006, accomplished what he and the bankers wanted: (1) the reversal of the 2000-2003 fall of the stock market, and (2) the continuation of the housing market bubble. The housing market bubble has ended. I do not think the FED can resurrect it without massive monetary inflation, which Bernanke will oppose. Because people believe in symbols, and because the FED's primary symbol is the target FedFunds rate, I think the response of the investing public will be favorable to a rate cut. What amazes me in retrospect is how the public imagined that an increase from 1% in 2003 to 5.25% in 2006 would not produce a credit crunch and the end of both the stock market mini-boom and the housing bubble. Why did investors keep pouring money into assets that had been driven up after 2001 only by FED inflation and a falling FedFunds rate. Why did this year's inverted yield curve, the traditional precursor of recession, not create a stock market sell-off months earlier? People assume that the good times will always roll. They do not acknowledge that early signs of economic slowdown are meaningful. They respond mainly to positive symbols rather than negative signals. This is why the investment world waits with baited breath for September 18's announcement from the FED. This is why people believe in the positive benefits of an interest rate that is manipulated by tenured economists who do not have their own money on the line. This is why they do not believe that the free market, on its own, can provide the conditions necessary for stability. They believe in Goldilocks economy: not too slow, not too fast, but just right. This is why stock market volatility makes them nervous. Symbols count for a great deal in the short run. They count for much less in the long run. They also change. When investors adopt new symbols, such as the price of gold rather than the Dow, investment markets change. What counts in the long run is productivity. When the crucial economic symbol is a manipulated fake interest rate, the economy is skating on thin ice. When the crucial symbol is manipulated by tenured economists who have the legal authority to print money, you had better not trust this symbol for your long-run plans. You had better get prepared for reality: reduced productivity. Eventually, volatility undermines confidence, and reduced confidence leads to reduced productivity. Fiat money leads to volatility. Statistics from the FED indicate that they are putting their fiat money where their mouths are. They pooh-poohed all talk of a looming credit crisis until two things happened: (1) the FedFunds market rate daily began to exceed the target rate; (2) Jim Cramer started screaming. The FED began pumping in new money in early July to deal with the first problem. It announced the discount rate cut to deal with the second. The investment community favors a rate cut on September 18. That is, it favors intervention by the FED to overcome free market forces that have been driving up the actual FedFunds rate in recent months. The investment community fears what investors are doing with their own money: bailing out of low-interest lending and bailing out of the stock market. CONCLUSION You must look to the long run. You had better hedge your capital, which surely includes your career, against the short-run policies of the money managers and also the fund managers who trust the judgment of the money managers. When Jim Cramer can force the hand of the money managers, it is unwise to trust the good judgment of the money managers.
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Resource Center Main Page & Index |
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What
about the stock market? Is it likely to head back
up, and keep heading up, over the next few years?
Yes and no, in that order. You can read my reasons
here: "Stock Markets and Economic Liberty." Print
it out and go back to it when you have the time to
spend. You money is on the line -- and far more
than your money.
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