Financial Markets on Crack

by Kevin Duffy
by Kevin Duffy

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Critics of paternalist government were hardly surprised last Friday when the Federal Reserve responded to the hopes, tantrums and demands of the investor class (led by the likes of Larry Kudlow, Jim Cramer, and Barton Biggs) by lowering the discount rate from 6.25% to 5.75%. Cramer immediately predicted the largest single day Dow Jones Industrials Average point gain ever (wrong) and Dow 14,500 by the end of the year, up nearly 11% from Friday's close. He also recounted the tread marks on his back from fighting the Fed's response in October, 1998 to the Long-Term Capital Management fiasco, professing his allegiance to "don't fight the Fed" this time.

This is now the third time in 9 years the Fed has acted as "fireman" as many believe is part of its job description:

You can't just say 'we told you so' and turn your back.  The Fed is the fireman of our economy, and there's a fire and they're gonna put it out.  That's their job.  Their job is not to sit around and scold people for making bad loans [and] for other people for buying those bad loans.  The Fed's job is to put out the fire.

~ Peter Yastrow, market strategist, MF Global, August 9, 2007

Let's review all three rescue missions:

October 15, 1998 – In response to Russian default, rising credit spreads, and a banking system on the hook for $1 trillion in notional bets by LTCM, the Fed surprised the markets late on a Thursday afternoon (well-timed right before an option expiration Friday) to catch short-sellers off guard by dropping the discount rate from 5.00% to 4.75%. The market had peaked 63 trading days earlier. The S&P 500 was 15.3% off its highs, with the Banking Index (BKX) down 30.8% and the Broker/Dealer Index (XBD) down 46.0%.

January 3, 2001 – In 84 trading days, the Nasdaq 100 (NDX) lost 48.1% while the S&P lost 15.6% of its value. So the Fed, attempting to contain the fallout from a tech bust and stave off any onset of the "deflation" bogeyman, cut the discount rate from 6.00% to 5.75%. The next day it chopped again, to 5.50%.

August 17, 2007 – Although the S&P 500 was only down 9.1% in just 21 trading days before the Fed broke out its fire hose, the financials had been weak most of the year. The BKX peaked in February and was –12.1% and the XBD peaked in early June and was –20.3% prior to Bailout Friday. The Fed’s rate cut came on the morning of an option expiration in order to inflict maximum pain on the shorts.

As it turns out, the Fed faithful were well rewarded in 1998 as the S&P 500 rallied 51.9% in 364 trading days to its March, 2000 climax. 2001 was entirely different, as the Nasdaq 100 went on a tear, up 19% the first day and up a total of 28% over 14 trading days. Sadly for the dip buyers, the credit drug soon wore off, with the NDX plunging as much as 69% over the next 2 1/2 years. All the Fed's pumping and all the Fed's men, could not put the tech bubble back together again. (Though they were wildly successful in fomenting a credit bubble for the ages!)

Which brings us to the current fork in the quagmire: Will Friday's stimulus work, at least long enough for overleveraged speculators, banks, and Wall Street to save their collective skins? Though self-professed "history buff" Jim Cramer is convinced, we demur.

Our monetary addiction is a progressive disease now in an advanced state.

Yes, there were excesses in 1998, but nothing compared to 2000. In December, 1996 Sir Alan Greenspan fretted about "irrational exuberance" with the Dow at 6500; by July, 1998 the Dow broke 9300. Yahoo! and Amazon.com, though still in diapers from their IPOs in 1996 and 1997 respectively, were each up over 11-fold by mid-1998. Yet Amazon.com was set to quadruple and Yahoo! soar another 8 times before hitting the wall. New Economy poster child Cisco Systems sported a modest $100 billion enterprise value in 1998, or 95 times its annual R&D budget. Two years later, Cisco fetched 185 times R&D – $500 billion – and was expected by many to become the first $1 trillion stock. (Today shares trade for a more pedestrian 37 times R&D.) In mid-1998, technology funds made up just 20% of the total sector fund asset pie; by March, 2000 they accounted for 60%.

Clearly, the same patient who responded to the credit drug in 1998–1999 became overly dependent by 2000. Even the massive dose of easy credit applied from 2001 to 2004 could not reflate the old tech/telecom balloon. The new inflation instead created the 2005 housing bubble and 2007 Wall Street bubble, both now bursting in unison.

Regardless of this lesson in monetary impotence, the asset inflation Kool-Aid drinkers are back in the pool:

"Everything’s changed and it's looking a whole lot better. Now we don't have to worry about putting safety first anymore... With the discount rate cut, opportunity has come back to the market."

~ Jim Cramer, CNBC’s Mad Money, August 17, 2007

Although they use slightly different metaphors than the Fed’s detractors:

"I actually applaud them... This was not a shot of adrenaline to the economy. This was more a shot of penicillin to an otherwise disconcerted economy."

~ Dennis Gartman, The Gartman Letter, August 20, 2007

How does today's credit bubble compare to its 1998 and 2000 predecessors? Derivative exposure has more than tripled since 1998. And the balance sheets of the top 5 investment banks have nearly tripled since 2000. Structured finance was in its infancy 9 years ago and the collateralized debt obligation (CDO) market was just being invented. LTCM was a liquidity crisis; the current credit meltdown is a solvency crisis.

Cheap and plentiful credit is what caused the current mess. More of the same can only make it worse. It is only a matter of time before this shot of credit heroin wears off. Sometimes the best medicine is none at all.

August 22, 2007

Kevin Duffy [send him mail] is a principal of Bearing Asset Management.

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