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.

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