Many of my long-term bearish friends believe that the Fed’s motives are nefarious. To them QE (Quantitative Easing) and ZIRP were about cronyism — designed specifically and cravenly only to bail out failing banks during the financial crisis, and nothing more. The Fed was just greasing the skids for the bankers to skim ever more profit from the economy.
Sure, there probably is an element of that. There’s a lot of cronyism between the Fed and its member banks. The door between the Fed and Wall Street is a revolving door. Even those Fed members who were primarily academics, have had their reward stints as high level officers of Wall Street banks. Yes, it’s a cesspool.
But I’m less certain that the Fed’s aim was that perverse. Certainly the Fed was panicked, and that was one of its motives. But the Fed continued QE and ZIRP long after the panic had subsided. So why did they create such massive dislocations?
I believe the answer is simple. The Fed did what it did because Fed policy makers are nuts.
The Fed behaves the way it does because it is a ship of fools. Central bankers believe their own mythology. Look at Ben Bernanke. The man wrote a paper once that basically mimicked what Milton Friedman had written earlier about what caused the Great Depression. They said it was because the Fed was too tight in 1929.
That’s baloney. We won’t get into the details of that here. But there are some serious economists who have thoroughly debunked the idea. In short, the 1929 crash and the Great Depression were caused by one of the greatest bubbles in history. 90% margin on stocks and real estate driving an enormous bubble were the cause, not tight money.
It seems that everyone in the economic establishment buys the Freidman-Bernanke nonsense. Not because it was proven, but because Ben Bernanke was the chair of the Economics Department at Princeton. That automatically gives him cred among the big shots in the media and policy making establishment.
The Peter Principle states that in management people rise to their level of incompetence. In central banking, that’s a particularly harmful place.
The history of the Fed’s “dot plots,” which are simply graphical representations of the forecasts of FOMC members, makes that point pretty clearly. Not only can’t central bankers tell where the economy is heading, they usually can’t even get the current status of the economy correct. They’re operating in a self-congratulatory echo chamber, in which the Washington-Wall Street media echo chamber fully participates. There simply are no critics in these academic-central banking media bubbles. So they believe and reinforce their own nonsense all the time.
Those of us who are critics of the Fed are all on the outside, usually ignored by the mainstream media. On those rare occasions when Fed critics do appear on your TV screen, they are usually attacked and ridiculed by the TV talking heads.
Meanwhile the TV anchors and media reporters fawn over the Fed and Fed supporters. The softball questions they toss Janet Yellen at her dog and pony show press conferences are embarrassing.
It’s mass brainwashing.
Then once a generation or so when bubbles blow up, everyone acts surprised. “No one could have seen this coming,” they say. Of course, that happens when people are constantly fed a steady stream of misinformation and useless drivel.
I ran a bearish message board between 2000 and 2009. It was one of several very active bear boards that had tens of thousands of regular visitors. Those people saw the bubble as it was happening, and they foresaw the crash. You may have been one of them.
All of these folks, ordinary people like you and me, saw things as they were. It was obvious! All of them foresaw the crash.
Only the Fed and mainstream economists and media pretended not to see it. Ben Bernanke’s excuses that “no one” in the economic establishment foresaw that there was a housing bubble, that “no one” saw the crash coming is pretty clear evidence that the economic establishment is delusional. They believe their own mythology, even in the face of overwhelming, obvious evidence to the contrary. Evidence that millions of ordinary people were aware of.
So I don’t think that the Fed’s manipulation of money is mostly nefarious. I believe that it’s mostly about hubris and the propagation of self-serving economic mythology. As Oscar Levant famously told us, there’s a fine line between genius and insanity. The evidence suggests that central bankers have crossed that line. Put 12 academic geniuses in a closed room to make policy, and what comes out is insanity.
However, there is a silver lining to this hapless fumbling: when you have been studying it for as long as I have, you can see what’s coming and what the consequences will be for the stock market.
The Unbridled Madness of QE and ZIRP
Why does the Fed do this? Is it on purpose? Are they deliberately asking us to look at what the right hand is doing? Or is it a function of the government not knowing how “real” money works?
The Fed’s mandate from Congress is to maintain maximum employment, stable prices, and moderate long-term interest rates. The Fed believes, or pretends to believe, that it has the power to do that. It can create conditions that will enable the economy to grow, and add jobs, while keeping inflation low.
The economic priesthood and the Wall Street media templars of the holy grail all act as if the Fed has the power to guide the economy toward these objectives.
These ideas are religious beliefs, not observable fact. After all, how do we know if Fed policy is working if there’s nothing to compare it to, specifically, the absence of Fed manipulation? Even when it appears that the economy is doing what the Fed wants it to, how do we know that this isn’t just coincidence, and not cause and effect?
The fact is, we can’t prove that Fed policy works, despite virtually everyone assuming that it does. The economy always recovered in the past without QE and zero interest rates. Are we to believe that it would not have done so in the recent past? It’s an article of faith in the economic establishment that we would have had an extended Great Depression had the Fed not engaged in extraordinary measures.
I have my doubts. I think that the economy might have recovered on a more healthy footing had there not been these massive, perverse incentives that rewarded useless speculation, and punished hard work and lifelong thrift. This policy was the epitome of moral hazard. In moral hazard lies long term economic rot.
Aside from the fact that it can’t be proven that monetary policy works, conversely, we have seen that most of the time, the economy doesn’t do what the Fed wants it to. There’s plenty of evidence that monetary policy has no effect on the economy, and there is even clear logic that suggests that monetary policy is counterproductive.
To my way of thinking, cheating savers out of earning any return on their savings while rewarding speculators for self-serving speculation has been counterproductive. If you are a retiree who expected to live off a safe income from your hard-earned savings, you know exactly what I mean. Monetary policy has either forced you to consume your principal, or cut your spending, or speculate inappropriately in a rising stock market that is almost certainly in a bubble.
Yet neither the Fed nor the economic establishment has considered the cost to the economy of destroying the disposable income, and the spending, of millions of savers. If they have less interest income, they spend less. That’s detrimental to economic growth.
ZIRP (Zero Interest Rate Policy) also hurt insurance companies and pension funds who depend on their fixed income investments to reliably fund their current and future needs. That income was crushed. Pension fund shortfalls are growing. That’s a ZIRP time bomb that has a delayed fuse.
The Fed never considered or addressed those costs. It considered only the illusion of benefits that rising stock prices supposedly cause trickle down. It didn’t and the Fed has finally awakened from its dream.
The only two measurable effects of the Fed’s absurdly easy money policies were to send bond prices and mortgage rates to the sub-basement of history. Never in modern times have long term interest rates been this low, outside of World War 2. This has driven drove massive house price inflation. And zero short term rates drove massive asset speculation and monetary arbitrage, absolutely non-productive uses of funds that merely transferred wealth from workers to speculators.
The second effect of ultra easy policy was to power the even more massive inflation of stock prices. Stock prices far outran the growth of corporate earnings.
Worse, QE even goosed earnings per share (EPS). Corporate CEOs and CFOs used virtually free money commercial loans to buy back their stocks, reducing the amount of shares outstanding. In many cases their total earnings grew only slowly, or not at all. But EPS rose because there were fewer shares outstanding.
Even with that magic trick, Price/Earnings ratios today are near all-time highs. They are at levels only seen in past stock market bubbles that led to crashes.
I’m not a valuation guy. I see PE ratios as a kind of long term sentiment measure. They represent what buyers are willing to pay for $1 of earnings. When buyers are willing to pay more for a dollar of earnings than just about at any time in history, that tells me that market sentiment has gone off the rails. This is peak irrationality. Previous episodes have not ended well.
But when you know where the irrationality lies, you can at least do something about it.
How The Fed’s Irrational Policy Affects Your Investments
My job as an analyst is not to be a Fed critic. That would be a useless pursuit. No Fed critic will ever penetrate the Fed’s protective, self-congratulatory cocoon. My job is to follow the Fed and understand its impact on the financial markets, so that I can help you to protect and grow your capital.
Eventually the Fed does get around to recognizing its mistakes. It takes years. Now is one of those times. The Fed won’t say it, but it realizes that its policies have failed, and now it has begun to reverse them. As it reverses those policies, it stands to reason that the effects will also reverse.
So my job is not to criticize. The criticism comes as a result of careful observation over the years. My job is to analyze and understand how Fed policy affects your investments.
The stock market is my particular focus. And there, as I have shown you, and will continue to show you, the Fed’s impact is direct. For the past decade, the Fed focused on raising stock and bond prices. Its policies, aided by the policies of other major world central banks, have been effective in doing that.
I recognized when the Fed began QE in 2009 that that direct infusion of cash into the accounts of Primary Dealers would result in a bull market. I had no idea that the Fed would continue this policy for as long as it did. But as long as it did, with a few exceptions when the Fed paused QE, we had to stay bullish on the market.
I knew that the Fed’s rigging was working to lift stock prices, while it was clear that there was no trickle down. The Fed’s printed money goes into and through the market first. The economy is at best tangential. The economy is only relevant to the extent that it influences the Fed to change course. You can (and perhaps should) ignore the economy completely, and still be a very successful investor, simply by following the dictum, “Don’t fight the Fed.” I call it Rule Number One.
That applies now in particular. The Fed has finally realized that QE failed. It is pulling the punchbowl. Turn out the lights. The party’s over.
Continue to sell stocks until you reach your goal of a cash cushion that you would be comfortable with in the event that the market does crash. It may not, but if you have cash, you’ll be able to buy stocks when they’re low.
I’ll be here to keep you up to date on what the LAMPP is telling us about the flow of money to and from the markets. We’re on a new short term red signal. A long term red signal is coming. I’ll be sure to let you know when that light changes.