In March 2007, the Financial Times kindly published a letter from me arguing that the US Federal Reserve seemed “to confuse being market-friendly with being friendly to markets“, and had forgotten
“The famous dictum of William McChesney, the long-serving Fed chairman in the 1960s, that “the job of the Federal Reserve is to take away the punch bowl just when the party starts getting interesting”‘.
I spent an increasing part of 2006 – 2008 trying to warn of the growing potential for a US sub-prime collapse. Thus a further FT letter in September 2007 was headed “Every mania is based on an illusion“, and argued:
“The myth behind the US housing mania is likely to become increasingly transparent, as the fallout from it widens.”
Everybody was very nice about my efforts after the subprime disaster happened in September 2008. Feature articles were printed with headlines such as ‘The Crystal Blog’, and the FT itself recognised I had been on the side of the angels. But my efforts (and those of others) didn’t change anything.
In fact, history shows the Fed took exactly the opposite message from the crash. It decided to boost markets even more, and quickly began Quantitative Easing on a $trillion scale.
WHAT WILL HAPPEN WHEN THE MARKET STOPS LISTENING TO THE FED?
The Fed’s policies today are thus even more dangerous than in 2006-8, due to its belief that a strong stock market is key to economic recovery. As Fed Governor, Richard Fisher, admitted proudly in September, “we have been extremely helpful” in facilitating the markets 250% rise since March 2009.
And now, every time the US market has a minor wobble, the Fed rushes to soothe nerves and encourage investors to continue buying:
- We saw this in October and December, as I discussed last month
- It did it again yesterday after a minor market wobble since New Year, with Fed Governor Charles Evans quickly suggesting interest rates shouldn’t rise this year
- The result is that many investors now believe the Fed will never let markets fall again
- Borrowing to buy stocks is thus at all-time record levels – higher than in 2000 and 2007
The problem is simple, as Doug Short’s chart above from Advisor Perspectives confirms:
- The Fed’s boosting has taken US stock markets well beyond normal nosebleed territory
- The S&P 500 is currently above 94% of all previous valuations, using Prof Shiller’s 10-year Price/Earnings ratios
- It is also 61% above its historical average
- And when markets finally return to reality from these levels, it is generally a very scary process
- This time could be much worse than 2008, due to the borrowing level being so high
My “worst case”, outlined in June, is thus becoming much more likely as the Great Unwinding of stimulus policies continues. Oil prices have now collapsed back towards more normal levels, whilst the US $ has risen very sharply – it has now broken a 30-year valuation trend, since the Plaza Accord in 1985.
And as my own Boom/Gloom Index above shows (blue column), sentiment is weakening across the market.
One day, I fear, the Fed will jump in to boost the market, and nobody will listen.