Friday, May 31, 2013

The silent killer of every bull and bear market

Stocks have reached record levels thanks in large part to a coordinated central bank stimulus.  The current financial market-led recovery is unlike previous recoveries in that the economy, unlike the stock market, has been painfully slow to respond to the stimulus.  Gold also hasn’t benefited this time around, which is partly attributable to the fact that it’s still deflating some of the excess from its speculative bubble of previous years. 

Gold also has failed to capture investor interest this time around owing to the mini-mania for dividend yielding stocks.  “Gold doesn’t pay a divided” is the mantra these investors chant when confronted with the metal’s long-standing safe-haven status.  At some point, however, gold’s declining fortunes will reverse and the investors currently ignoring gold will come to see its value again.

Overlooked in the analysis of what makes –and breaks – an asset bubble is the single most important indicator: price.  Rising prices is what ultimately attracts most investors’ attention, more so than valuation and other fundamental concerns.  Price is a double-edged sword, however; while it serves to entice investors on the upside, it eventually evokes its own reversal if it continues rising long enough.  When an asset becomes too pricey, investors begin to lose interest simply because the asset becomes unaffordable or otherwise undesirable at such lofty levels.  This truism applies in all cases to all markets, whether stocks, bonds, commodities or even gold itself. 

In the typical lifecycle of a bull market the small investor will join the party at some point, unable to resist the allure of rising prices.  The average investor has fun while watching his investment grow.  He tends to move in and out of the market during the bull run, which explains why at some point he can no longer justify buying back in at extremely high levels.  It’s the big-money institutional investors who stick out a bull market to the end, mainly because they’re the only ones who can afford it.  But a bull market’s days are numbered when only the big-money players are involved.  The big money, after all, has to have someone else to sell to – they can’t keep a bull market alive for very long by selling among themselves.  This is one reason why gold peaked in 2011, although the end was definitely aided by the tightening of margin requirements. 

A bear market is much like a bull market in its psychological allure – only in reverse.  Just as the institutional crowd is the last to leave the party in a bull market, they’re among the first to get things moving at the end of a bear market.  Attracted by low prices and valuations, they’re early (and at time premature) buying paves the way for the commencement of a new cycle.  The rising prices generated by their collective buying eventually captures the attention of the public and before long a new bull market is underway. 

At what point does gold become attractive, then, to institutional investors?  One way of discerning this is by staying abreast of the research reports and commentaries of top flight analysts and fund managers.  They’ll often throw out hints as to what downside price targets they’re watching for buying opportunities.  In recent weeks I’ve read more than one analyst mention $1,250-$1,300 as an area where gold purchases would become attractive to them. 

Meanwhile there is talk in the financial press that both stocks and bonds have entered a “bubble” phase.  These concerns are increased with the fear that the Fed will taper off its QE stimulus program sooner than anticipated.  PIMCO, the world’s largest bond investment company, recently warned of a sharp drop in risk assets if economic growth turns out to be much worse.  The bull market in stocks will be especially vulnerable to bad news and economic shocks later this summer when a series of weekly Kress cycles is scheduled to peak.  This could portend a turning point both for stocks and for gold. 

As Barclays pointed out, the strength in gold’s physical demand has somewhat mitigated recent outflows in gold-backed ETFs.  The outflows have amounted to some 39 tons during the first week of May and nearly 380 tons for the year to date.  Barclays believes, however, that there is a bigger risk of the physical demand slowing down instead of the ETF flows bouncing back in the near term.  “Nevertheless,” as Sharps Pixley points out, “central banks will again be the supporter of gold prices at lower prices.”  I would add that if gold does indeed reach the $1,250-$1,300 area by summer, we should also see institutional support come to the rescue. 

According to CFTC data, speculative short positions for gold – the so-called “dumb money” – remain at its highest level since 1999, the previous long-term low for the yellow metal.  By contrast, the commercial interests – the “smart money” in the gold market – have built up a large net long position in gold since 2008.  This is another future potential support for gold as major short covering will ensue at some point.

Monday, May 27, 2013

“Smart money” places its bets on the market’s future

The “smart money” crowd has been placing a lot of bullish bets on the future of the large cap stocks as measured by the S&P 100 (OEX).  The OEX put-call ratio, which is historically a “smart money” indicator has registered one of its most bullish reading of the last four years. 
To see where the smart money is putting its money we examine the 3-week (15-day) moving average of the OEX put-call open interest indicator.  Whenever this indicator declines below the green zone (see chart below) it implies the smart money is heavily purchasing call options, i.e. bullish bets on the stock market. 

The OEX open interest ratio is by no means a precision timing indicator, for it can be several weeks – or even months – early in its signals.  But historically whenever the ratio has gotten this low there has always been a major rally ahead for equities in the not-too-distant future. [Excerpted from the May 24 issue of Momentum Strategies Report] 

Thursday, May 23, 2013

Bond yields give stocks a run for their money

A couple of reasons can be attributed to the market’s increasing sensitivity to news.  One is the fact that interest rate on the 10-year Treasury note has been rising lately.  As we talked about in the previous report, this puts pressure on stocks and the longer the rising trend in Treasury yields continue, the more vulnerable the stock market becomes to short-term selling pressure. 

The CBOE 10-Year Treasury Note Yield Index (TNX), shown below in relation to its 15-day moving average, was up 4.22% on Wednesday as Treasury prices fell.  Also worth mentioning is that prices for corporate bonds and high-yield debt have been falling while yields have been rising.  This is a potentially negative combination for stocks heading into the summer if the trend persists. 

[Excerpted from the May 22 issue of Momentum Strategies Report]

Monday, May 20, 2013

The magazine cover indicator

There are growing signs that the bull market is gaining greater acceptance among mainstream investors.  There has, for instance, been a notable increase in the number of times the bull has appeared on the front cover of mainstream financial publications.  The latest instance of the bull showing up on a magazine cover was in last week’s issue of The Economist, which proclaimed “The Bull is Back!”

Last week also saw the appearance of the bull yet again on the front cover of Barron’s, along with the headline, “Dow 15,000: This Bull Has Room To Run.” 

What are we to make of this increase in bullish headline sentiment?  The contrarian in us is tempted to conclude the market is getting frothy and that a top could be approaching.  But not so fast!  The so-called “magazine cover indicator” is a sentiment tool which works best at market bottoms.  At tops the magazine cover indicator isn’t nearly as reliable due to the fact that fear as an emotion tends to reverse much faster than greed.  That’s why market declines often end with sharp, sudden V-type reversals whereas market tops are much more jagged and irregular and can take several months before finally reversing. 

The fact that The Economist has placed a bull on its front cover is no cause for alarm.  While it could be a sign that the point of maximum recognition of the bull market is approaching – and therefore a top – the latest bullish covers are more a case of media belatedly acknowledging a trend that has been in place for four years now.  [Excerpted from the May 20 issue of Momentum Strategies Report]

Friday, May 17, 2013

Still no signs of a bubble

Friday’s rally out of the gate followed the publicly stated opinion from Minneapolis Fed President Kocherlakota that the Fed hasn’t lowered real interest rates sufficiently.  Surprisingly, there are some policy analysts who agree with Kocherlakota that the Fed still has room to loosen monetary policy even more. 

For instance, Ramesh Ponnuru and David Beckworth, writing in the May 20 issue of National Review, assert their opinion that Fed monetary policy as measured by nominal income (i.e. the size of the economy measured in dollar terms) is actually “too tight.”  While that assertion may be debatable, few will argue with the authors’ statement that households are “nonetheless continuing to deleverage, rather than to add to their net borrowings.”  This, as the authors rightly point out, “suggests that this is not a bubble economy.” 

Not only is the U.S. economy not a bubble economy, neither is the equities bull market if we use various gauges of investor psychology to measure it.  The latest release of the AAII sentiment poll shows that bullish sentiment remains rather muted in the face of a series of all-time highs in the major indices lately. 

This week’s AAII results showed that 38% of respondents were bullish versus 29% bearish.  Unbelievably, there hasn’t been anything close to a 50% or higher bullish reading – the bellwether for a “bubbly” market sentiment – since January.   Presently the cumulative bull/bear sentiment gauge is only slightly above the mean for the last couple of years.  [Excerpted from the May 17 issue of Momentum Strategies Report]

Thursday, May 16, 2013

When central banks buy stocks

The investment story of the year to date is the central bank-led financial market recovery.  While everyone is aware of the impact the Fed’s $85 billion-a-month asset purchases is having on stocks, few investors realize that central banks are making direct purchases of stocks.  The implication of this new development is shocking. 

Bank of America stated that global central banks have cut rates an incredible 511 times since June 2007 in an effort at re-inflating the global economy.  “Most central banks in our coverage universe still have a bias to ease,” Morgan Stanley economists led by London-based Joachim Fels said in a recent report.  “Given this disposition, it doesn’t take much in terms of downside surprises in growth or inflation to tip the balance for more central banks to pull the trigger for more easing.”

Mohamed El-Erian, CEO of Pacific Investment Management, stated: “Central banks are our best friends not because they like markets, but because they can only get to their macro objectives by going through the markets.  The hope is that improving fundamentals will validate what central banks have done.”

As if to underscore the unified commitment of the world’s central bankers to fighting deflation, the Reserve Bank of Australia cut to a record 2.75 percent this week, while the European Central Bank and Reserve Bank of India acted to ease last week.  And while the Bank of Japan (BOJ) and the U.S. Federal Reserve refrained from changing policy at their last meetings, the BOJ doubled its monthly bond purchases in April and Fed policy makers last week raised the prospect of increasing their pace of bond buying above $85 billion a month.

The simple yet undeniable reality here can be summarized in two Wall Street bromides: “The trend is your friend” and “Don’t fight the Fed.”  Not only are central banks like the Fed paving the way for continued financial market recovery by purchasing bonds and mortgage debt, some are now directly buying equities according to a recent report.

In an April 25 Bloomberg article, Sarah Jones reported that some central banks are buying stocks in “record amounts” as falling bond yields entice investors to look toward equities.  In a survey of 60 central bankers last month by Central Banking Publication and Royal Bank of Scotland Group Plc, 23 percent of respondents said they own shares or plan to buy them.  The Bank of Japan, holder of the second-biggest foreign-exchange reserves, said April 4 it would more than double investments in equity exchange-traded funds to 3.5 trillion yen ($35.2 billion) by 2014. 

The Bank of Israel bought stocks for the first time last year while the Swiss National Bank and the Czech National Bank have boosted their holdings to at least 10 percent of reserves, according to Bloomberg.  Germany’s Bundesbank appears to be open to the possibility of buying equities.  While neither the U.S. Federal Reserve nor the Bank of England are buying stocks directly, some analysts are already speculating that the Fed may soon step in to do so, using its mandate of “price stability and maximum employment” as an excuse.

“Managers of banks’ assets are looking for alternatives to holding government bonds after efforts to stimulate growth from the Federal Reserve, the Bank of Japan and the Bank of England helped send yields near to record lows,” Jones reported in the Bloomberg article.  The survey of 60 central bankers, overseeing a combined $6.7 trillion, found that low bond returns had prompted almost half to take on more risk. Fourteen said they had already invested in equities or would do so within five years. “Those conducting the annual poll had never before asked that question,” according to Bloomberg. 

As one institutional trader aptly put it, “Equities are the last asset class standing.”  Now that dividend yields on stocks exceed bond yields, it only makes sense that banks are chasing yields via the stock market.  It also puts into perspective the relentless stock market rally of the past six months.  Not only is it being fueled by the Fed’s $85 billion in asset purchases per month, but we now know that foreign central bank purchases of dividend-yielding stocks contributes additional strength to the rally.  This provides even greater context behind the relentless rally of the last six months as shown in the following graph of the S&P 500 Index (SPX).

Writing in the May 2013 issue of the Market Cycle Dynamics Letter (, David Knox Barker asked some interesting questions of the central banks foray into equities: “There is a radical difference in a financial world where central banks served as commercial bank overnight lenders, to now being actively engaged in equity investment.  Will they eventually also go short?  Do they have a fiduciary responsibility to hedge their long positions?  Do they trade through major commercial banks?” 

These questions and others will eventually be answered.  For now suffice it to say that an equity market receiving the additional support of central bank buying will likely be further insulated against a major crash occurring anytime soon.  While the existence of the so-called “Plunge Protection Team,” or PPT, may have been debatable in the past it certainly isn’t debatable anymore.  

Monday, May 13, 2013

Another perspective on NYSE margin debt

A client writes: “Regarding margin debt, I laugh whenever the media first bring it up – always as soon as the nominal figure hits old nominal high.  The problem is that they never adjust for inflation.  As you are well aware we need the S&P 500 Index to perhaps hit 1700+ in order to reach 2007 high in real terms, and consequently we need a lot more margin debt to match 2007.

He adds, “Personally I’d establish real inflation as approximately:

2007 – 5%
2008 – 1%
2009 – -2%
2010 – 1%
2011 – 3.5%
2012 – 4.5%

“I could be wrong in Ben's eyes, just my observation/understanding within a margin of error of course.”

Comment: I think it’s worth adding that on a year-over-year basis, NYSE margin debt is not only still well below its 2007 peak, but is also currently below its 2010 peak prior to the “flash crash.”  See chart below from

Saturday, May 11, 2013

Markets want deflation, central banks want inflation

“The Bank of Japan is in shock at the latest deflation numbers. Despite their extreme efforts the past few months, prices dropped another 0.5% in March and were 0.9% lower than a year ago. Deflation appears to be accelerating….

“It is the central banks that are playing a major role driving the deflation by keeping producers in business that otherwise would have failed during the last business cycle decline and the one that should be underway. Thousands of factories and assembly lines are still humming that would have been shut down without aggressively lower interest rates and easy money. Artificial demand being created by all the aggressive QE, especially mortgage buying, and deficit spending is keeping demand higher than it otherwise would be in almost all industries. The strong producers should be capturing far more market share with pricing power. They are now in far more competitive environments without pricing power.

“In short, the central bank are producing the opposite of what they are intending. They are driving goods and service deflation - financial inflation.  The only way the central banks will get the inflation they are yearning for is to first give markets the deflation they are yearning for, restoring legitimacy to markets.”  [David Knox Barker, International Market Cycle Dynamics Letter, May 20,

Thursday, May 9, 2013

Will margin debt cause the next stock market crash?

The latest fear on Wall Street is that record levels of margin debt may end up toppling the stock market rally. 

NYSE margin debt recently reached its highest level since 2007 before the last major stock market peak and credit crash.  Stephen Suttmeier, technical research analyst at Bank of America, noted that margin debt, rose 28% in March from a year ago to $380 billion. That figure is slightly below the July 2007 peak of $381 billion, although analysts speculate that April’s margin debt totals (which haven’t yet been released) have already surpassed this mark.

Suttmeier told The Wall Street Journal that the currently high margin debt levels are “contrarian bearish.”  While high margin levels have coincided with major market tops of the past, there’s an important twist to this particular indicator.  In order to confirm that a top has been made, margin debt levels normally turn down before major indices like the S&P 500 peak.  See the following graph, courtesy BoA Merrill Lynch.

“It’s no surprise people have been taking on more risk as the market has moved to record highs,” writes Steven Russolillo in The Wall Street Journal.  “But the question is what happens when the easy ride higher turns south and some of that margin debt turns into margin calls?”  The article goes on to warn of a potential selling wave if stock prices reverse and margin calls lead to mass liquidation.  “A wave of margin calls can worsen selling pressure on stocks and was seen as partly to blame for the market’s woes during the financial crisis,” writes Russolillo.

While it’s true that rising margin debt levels should be viewed as a potential yellow flag for the stock market, other indicators don’t yet suggest the rally has reached bubble proportions.  As economist Ed Yardeni pointed out in a recent blog (, “Valuation multiples aren’t flashing irrational exuberance yet, but that could change quickly in a debt-financed melt-up of stock prices.” 

Yardeni suggests that while NYSE margin requirements have been unchanged since January 1974, Fed Chairman Bernanke could boost the requirement later this year in response to charges that the Fed’s stimulus program is leading to a stock market bubble. 

Lest investors forget, margin requirement hikes can take a huge toll on investor psychology and can completely take the wind out of a market’s sails.  Remember the gold and silver margin increases of 2011, anyone?

Wednesday, May 8, 2013

How to spot (and avoid) market manipulation

We often hear investors complain of financial markets (and the gold market in particular) being “rigged” or manipulated.  The sad yet somewhat humorous tale of Henry Gribbohm recently brought this accusation to life.  The 30-year-old Gribbohm infamously lost his life savings of $2,600 on a carnival game in an attempt at winning an Xbox Kinect valued at $100.  For his efforts, he walked away with a giant stuffed banana sans his $2,600 life savings.

Gribbohm’s tale is instructive if only because it reveals a common psychological pitfall that has plagued all of us at one time or another, viz. the desire the “win back what I lost” from the market.  According to news reports, Gribbohm attempted to win a ball-toss game at a traveling carnival but quickly lost $300.  He then returned home to get $2,300 more in hopes of winning back the lost $300 and –hopefully- the prize Xbox.  After losing everything he accused the carnival of rigging the game (sound familiar)?  (The game owner actually did end up refunding $600 of his $2,600).

Had Gribbohm been thinking clearly he would have cut his losses after his initial loss.  Investors who have “played the game” long enough know from experience to do this; it’s a simple money management tool that keeps you in the game and prevents you from losing all your capital.  More importantly, it prevents you from allowing your emotions to get the best of you.  Paraphrasing Jesse Livermore’s famous maxim, “A trading position that goes against you from the start is likely to be a losing proposition, so you should get out immediately.”

Along these lines, W.D. Gann taught that a stock or commodity that repeatedly stops you out with a loss should be avoided altogether since there could be a psychological reason for the constant losses.  Gann believed it’s better to stick to trading vehicles in which you’ve shown you can profit from. 

Gribbohm’s explanation for his stubborn refusal to cut his losses was revealing: “You just get caught up in the whole, ‘I’ve got to win my money back [thing].” 

The above statement perfectly summarizes a truism of investor psychology which has led to countless losses for the average market participant.  The way to overcome this all-too-human failure is to steel yourself beforehand with the mindset of cutting your  losses the minute the trading position goes against you by a certain percentage.  The use of a judiciously placed conservative stop-loss is paramount, and stops should always be employed in every trading or investment position. 

Traders/investors should also consider such factors as relative volatility before initiating a new position, especially with the advent of High Frequency Trading (HFT), which if prevalent in a particular asset can increase your chances of being stopped out with a loss.  This is one of the biggest tip-offs of a manipulated market.  If the asset you’re watching is trading erratically or tracing out a pattern which can’t be easily classified by conventional chart pattern theory, it’s best to avoid it.  Instead, trade only in assets which display “clean” and tight looking consolidation and/or continuation patterns.  Better safe than sorry.

Always compare the recent and historical trading pattern of the asset you’re interested in to a broad market benchmark such as the S&P 500 or the CRB Index (depending on whether it’s a stock or commodity).   It’s also imperative that the stock or commodity you choose to trade should have ample liquidity on a daily basis which makes it easier to enter or exit the trade.  Lightly traded stocks and commodities are the ones most liable to manipulation by vested interests. 

Manipulation is an unfortunate fact of the financial market.  Stocks and commodities have always been subject to manipulation, whether by individuals, pools, central banks or even governments.  If you are unable to come to terms with this reality then it’s best to avoid participating in the market altogether.  But if you’re able to come to grips with this then there is money to be made once you’re able to spot the tell-tale signs of manipulation, a skill which becomes better with experience.  

Tuesday, May 7, 2013

Japan's rebound for real

“The Japanese stock market has been in decline for nearly 25 years, and all of its surges since the beginning of its deterioration have ended in new lows.  So is the recent 43% jump in four months really a sign that the worst is over?  Many investors think so, thanks to a new prime minister, Shinzo Abe.  He has pledged to do whatever it takes to end deflation and bring about inflation.  Japan’s plan is to weaken the yen, which will make the country’s many export companies more competitive around the world, lift their profits, create more jobs and boost the economy.”  [Kiplinger’s Personal Finance Adviser, May 2013]

Comment: As I noted in the Feb. 18 post, Japan was the first to enter deflation well before any other nation and will likely be the first to emerge from it.  It may turn out that while the U.S., China and other nations are experiencing their own fight against the deflationary headwinds created by the 120-year Kress cycle in 2014, Japan bucks the trend and leads the way into a new period of long-term inflation.  As I wrote then, “In the post-2014 world, Japan is worth keeping an eye on as a potential leader.”

Monday, May 6, 2013

The Great Wall of Liquidity

“If you buy stocks now, you have the Federal Reserve, the European Central Bank (ECB), the Bank of Japan, and China’s central bank on your side. They are basically providing an insurance that the markets will not have a big decline. That’s a very good guarantee…until eventually it doesn’t work anymore. But for now, it’s the best guarantee investors could ever hope for….

“Japan announced that it will buy around $78 billion of its own bonds per month. That means the globe is now seeing perhaps $160 billion of fresh money created each month to swamp the financial markets. That’s almost $2 TRILLION per year. It’s a ‘Wall of Liquidity.’

“The ECB just cut interest rates to 0.5%, the lowest ever for them. China is already actively trying to patch over the bad financial problems of its banks. As Europe and China struggle with recessions, or at least weakening economies, their central banks will only become more aggressive.”  [Bert Dohmen, 5/4/13,]

Saturday, May 4, 2013

Can Bernanke beat the Kress cycles?

A client writes: “Is it possible for the Fed to step on the gas so much that the upcoming Kress cycle bottoms over the next 18 months could be invalidated or drastically minimized?  Right now, we almost have to ignore the cycles and trade based on your momentum tools.  I do understand that all this could change quite rapidly, and that might be the environment we'll find ourselves in soon.

Answer: Yes, it's possible the Fed could sublimate the weekly cycles through its monetary policy for the remainder of this year.  As for next year, I have a hard time believing the Fed could achieve this same result.  For one thing, Bernanke's term expires in January and he is widely expected to step down then.  The next Fed president may not be as loose with monetary policy as Bernanke.

Another consideration is that if things keep progressing the way they have been, the Fed in 2014 will have no reason to stimulate the economy as much as they have in recent years.  It may even begin to tighten depending on the performance of the economy between now and then.

If market history teaches any lesson it's that the yearly cycles always exert their strongest impact during the final year of the bottom.  So with the 120-year cycle bottoming late next year, I'd be very surprised if it's effects weren't manifest in 2014.

Friday, May 3, 2013

Sell in May and go away?

The month of May begins the so-called “worst six months of the year” according to Stock Trader’s Almanac.  May does tend to be a volatile month from a seasonal standpoint. 

An investor who bought the S&P 500 every October 31 and then sold the following April 30 would be up 898%, notes Bespoke Investment Group.  By contrast, someone who bought every April 30 and sold in late October would have gained just 56%. 

There is a chance the market will shrug off the May seasonal weakness tendency this year if recent investor behavior is any guide.  Investors have been using market pullbacks as buying opportunities this year and have so far shrugged off underwhelming earnings reports.  As Barron’s recently noted, “Calendar trades are more guideline than gospel.”  Barron’s goes on to ask rhetorically, “With global central banks finally printing money in concert, will 2013 avoid the [spring] swoons of years past?” 

The next few days will go a long way toward answering this question, but the answer is leaning toward the affirmative.  [Excerpted from the May 1 issue of Momentum Strategies Report]

Thursday, May 2, 2013

How the Fed creates bull and bear markets (part 2)

There are some economists who overestimate the effect of loose money and credit in creating market crashes.  While they correctly identify loose monetary policy as a prime contributor to a financial market bubble, they ignore the devastating impact of a subsequent tight money policy.  Loose money doesn’t cause a market crash by itself; it’s the combination of loose money followed by tight money and credit conditions which serves as the catalyst for a crash. 

There is an “X-factor” to all of this, however.  While there is no sign of monetary policy tightness on the Fed’s part, there is what might be called “policy tightness” by the world’s leading governments, including the U.S. Congress.  Fiscal austerity current reigns supreme among U.S. and European governments and it could eventually prove detrimental to the Fed’s efforts at continuously flooding the system with liquidity.  As Dr. Scott Brown of Raymond James has said, fiscal tightness amounts to a “self-inflicted restraint on growth” and that amounts to “very bad economic policy.”  It also explains why, despite record levels of liquidity, the economy has been able only to tread water in recent years while financial markets have soared to new heights. 

Could it be that austerity will ultimately prove to be the catalyst that kills the recovery?  The question remains unanswered but with the downward pressure exerted by next year’s 120-year Kress cycle bottom, a failure of Congress and other governments to admit that austerity has been a failure could prove fatal.

Wednesday, May 1, 2013

How the Fed creates bull and bear markets

Bull and bear markets don’t just happen – they’re created by the Federal Reserve.  While few investors dispute the power that Fed interest rate policy has on the market, the extent to which it influences the direction of stock prices in both directions is often downplayed.  Moreover, the health of the economy is often decided by the Fed’s interest rate policy.

While it’s no secret that loose monetary policy on the Fed’s part benefits stocks and can lead to credit bubbles, researchers tend to underestimate the effect tight money policy has in creating market crashes and economic recessions.  Restrictive money policy on the Fed’s part has frequently led to falling stock prices.  The extent and duration of the monetary tightness is what determines the severity of the bear market.  The longer the Fed restricts money, the more severe the downturn will be. 

Consider the bear market of 1973-74.  The Dow Jones Industrial Average experienced a decline of 40 percent, which at the time was the worst bear market since the Great Depression.  The Dow peaked in early 1973 at an all-time high of 1150 before commencing a Chinese water torture type decline for the next two years.  The decline was precipitated by tight money on the part of the Fed, which began raising interest rates in early 1972. 

It wasn’t until mid 1974 that the Fed began lowering rates and loosening money.  Although it took about six months to have the desired effect, by 1975 the Dow launched a recovery rally which by early 1976 had completely retraced the decline of 1973-74.

The next major crash was of course the October 1987 stock market crash which witnessed a 1-day drop of 22% in the Dow.  Not surprisingly, the October ’87 crash was preceded by a rising fed funds interest rate in the year prior to the crash.  The effective rate rose from approximately 5.8 percent a year before the crash to around 7.3 percent at the time of the crash.

By far the most egregious example of the Fed abusing its power to engineer a financial debacle occurred in the period between 2004 and 2007.  This was the 3-year period that transitioned into the credit crisis of 2007-2009.  The Federal Reserve under the chairmanship of Alan Greenspan raised the interest rate from 1 percent in 2004 to just over 5 percent in 2006.  Rates were then left at this level for another year before being reduced.  By that time, however, the damage had been done and it was too little, too late.   

The interest rate hike of 2004-2006 could not have occurred at a worse time, for the financial market and the economy of those years were predicated on a real estate boom that was dependent on low interest rates.  By raising the fed funds rate as many times as he did, Greenspan essentially sealed the doom of the U.S. economy and stock market.