Why the Stock Market Has Not Broken Out

Stock market bears think: “Why does this market fail to fall? What’s holding it up?” Stock market bulls think: “Why does this market fail to rise? What’s holding it down?

Stock market bulls have been saying this ever since last November, when the Dow briefly went above 14,000. The more relevant index is the Standard & Poor’s 500. It briefly went above 1560 in October. That exceeded its peak on March 24, 2000, when it closed at 1527. But since 2000, the consumer price index has risen by 21%. To beak even, the index would have to be at 2124, to pay the 15% capital gain tax and get the investor out at 1847, net. In a tax-deferred IRA, the market would have to be at 1847 to break even.

The bulls pay no attention to this. They seem to assume that the stock market will somehow make up for eight years of negative real returns. As Scarlett O’Hara said, “Tomorrow is another day.”

The bulls are buying today on the assumption that the real estate crisis is over, that the subprime interest rate re-sets will not force more real estate bankruptcies, that the leveraged loans taken out by hedge funds in Fannie Mae and Freddie Mac mortgage portfolios are no longer facing insolvent borrowers, that the smart money remains bullish, and the buy-and-hold strategy will work once again, just as it did from August 13, 1982 (when hardly anyone bought) until March 24, 2000 (when hardly anyone sold).

Why do the bulls remain bullish? Because they believe that the Federal Reserve System can solve the large banks’ insolvency problem. They believe that the FED will ignore the threat of moral hazard and will do whatever is required to keep this stock market from crashing, in order to reinforce investor optimism. The more that Bernanke warns against moral hazard, the more he sounds like Alan Greenspan, whose policies kept the U.S. stock market from collapsing in 2002. He, too, warned against moral hazard. The chronology is worth considering. Bernanke warned on May 13, 2008:

Although central banks should give careful consideration to their criteria for invoking extraordinary liquidity measures, the problem of moral hazard can perhaps be most effectively addressed by prudential supervision and regulation that ensures that financial institutions manage their liquidity risks effectively in advance of the crisis. Recall Bagehot’s advice: “The time for economy and for accumulation is before. A good banker will have accumulated in ordinary times the reserve he is to make use of in extraordinary times” (p. 24).

Greenspan warned on May 7, 1998:

Finally, an important contributor to past crises has been moral hazard, that is, a distortion of incentives that occurs when the party that determines the level of risk receives the gains from, but does not bear the full costs of, the risks taken. Interest rate and currency risk-taking, excess leverage, weak financial systems, and interbank funding have all been encouraged by the existence of a safety net. The expectation that national monetary authorities or international financial institutions will come to the rescue of failing financial systems and unsound investments clearly has engendered a significant element of excessive risk-taking. The dividing line between public and private liabilities, too often, has become blurred.

A decade separated these two speeches. The world’s financial system was in turmoil in 1998. The world’s financial system is in turmoil today. The New York Federal Reserve Bank intervened in August of 1998 to persuade banks to lend more money to Long Term Capital Management, which had borrowed money to buy leveraged financial futures. The New York Federal Reserve Bank has supervised the bailout of Bear Stearns and the biggest U.S. banks in 2008.

If the solution to the problem of moral hazard is more regulation, as Bernanke claims, why was this not done in 1998 and subsequently? Why are we right back in the same debate today? Why has the Federal Reserve had to take extraordinary measures to maintain solvency? The problem of moral hazard has been with us for as long as central banking has been with us: since the Bank of England was set up in 1694. Bernanke quoted Walter Bagehot. Bagehot was writing in the late 19th century about well-established practices in his era. The central bank then, as now, would intervene. It did this then to save the banks. What has changed? The arrangements such as the TAF (Term Auction Facility) program created in December do just this.

Bernanke says things were very different in Bagehot’s era.

How should a central bank respond to a sharp increase in the demand for cash or equivalents by private creditors? Before talking about Bagehot’s answer, I should note that the Bank of England in his time was a hybrid institution — it was privately owned by shareholders, but it also had a public role.

Different? Who owns the Federal Reserve System? Shareholders. Who are these shareholders? Member banks. The FED has a public role. That’s because it answers to Congress. (Stop that giggling. You hear me? I won’t tolerate it. This is a serious discussion.)

The supreme function of the Federal Reserve System, as with every government-licensed central bank, is to save the fractionally reserved commercial banks from bank runs. So far, the FED has done this. The price has been the deterioration of the dollar’s purchasing power.


If you can write the tax code, you can determine which investment markets flourish.

The tax code allows low capital gains taxation for investments help longer than one year: 15%. It taxes gold and silver coins or bullion at up to 28%. Guess which asset class tends to rise fastest.

The tax code allows you to deduct interest payments on mortgages from your gross income when it comes time to estimate your tax burden. It does not allow this for most other debt. Guess which debt has soared. Guess why banks have lent money against home equity, the so-called HELOC loans. Guess why the bubble in real estate took place.

The tax code allows people to avoid capital gains taxation on money invested in IRA programs or other retirement programs. These programs identify specific kinds of investments as qualifying. These are government-regulated investments. They go up even in recessions.

It is true that people can legally sell stocks and buy bonds for their IRA’s. They can legally sell dollar-denominated investments and buy foreign currencies offered by U.S.-registered companies. But very few employers allow a broad range of investments to their workers. Extremely rare are foreign currencies CD’s or bonds. Occasionally, foreign stocks are on the list. The reality is this: the companies fill their lists of investment options with U.S. stock funds.

There is a bias in favor of stocks in the tax code. There is surely a bias in the major media.

Advertisers want to sell things. Pessimism regarding the economy frightens people. They slow their spending and start saving more. This is why large corporate advertisers generally avoid placing ads in publications that warn subscribers about a looming recession. The bias of editors is toward bullish sentiment for the economy. This favors stocks over bonds.

So, the typical investor does not get exposed to arguments favoring non-stock investments. Today, there is more information on such investments than there was in 2000. The Web has made a big difference. The decline of the dollar and the rise in gold have added to this change of perception. But when did the mainstream media tell readers to liquidate half their stock holdings to buy foreign currencies, gold, and foreign stocks? It has yet to happen.

I don’t think it is going to happen until there is a panic sell-off of the dollar and U.S. stocks. Then, out of desperation, mainstream media will give more recommendations for non-dollar investments. But that may be years away. It will happen only when existing subscribers and viewers have lost a lot of their wealth.


So, the U.S. stock market has not fallen by 50%, as it did in 2002. There is great faith that the Federal Reserve System will intervene to save hard-pressed financial institutions, just as it did for Bear Stearns. There is great faith that really bad news will not again catch the Federal Reserve asleep at the wheel.

Yet this optimism is limited. The various indexes do not reach new highs, adjusted for price inflation. The sellers sell before buyers drive the indexes up to record levels.

The stock market optimists do not call their retirement funds and tell them to move their positions into near-cash assets. They do not move into bonds. They let their monthly payroll deductions pour into stock market mutual funds. This places a floor under the stock market. The buyers’ optimism is muted. Investors are not buying stocks the way they bought homes, 2000—2006. But they have not issued “sell at the market” instructions to their brokers.

We have seen for eight years that investors have been unwilling to commit anything more than marginal funds in the U.S. stock market. They have also been unwilling since 2004 to pull out more than marginal funds.

Look how long it took for the S&P 500 to recover from its 2000—2003 decline.

Discounting for price inflation, it has yet to recover.

Look at the NASDAQ. It has yet to regain more than half its decline.


Here is the argument for stocks promoted by the mainstream financial media when prices are falling.

The economy is heading into recession. The Federal Reserve System will lower interest rates. It’s a good time to buy stocks.

Here is the argument for buying stocks when the fear of recession is weakening.

The economy is no longer heading into recession. The boom will reappear. Corporate profits will rise. It’s a good time to buy stocks.

What about the FED? Won’t it raise rates if the economy is recovering? I have never seen this question asked in any article predicting that the recession is over or that the bull market is back.

What I want to know is this:

What is the case for buying U.S. stocks rather than Asian stocks? Why will the dollar increase over the next ten years? Why will the trade deficit decrease? Why will the Federal deficit decrease? Why will high taxes, compared to Asia, decrease — especially taxes on capital? Why will the regulatory system decrease?

Why is it that Tout TV doesn’t devote at least half its time to Asian stocks and European stocks rather than U.S. stocks?


When the government intervenes into the economy, it creates barriers to the flow of capital. This capital would have flowed to companies that make profits by satisfying consumer demand.

Today’s Keynesians dominate the capital markets and politics. They believe that the government can solve the problem of slow economic growth. Bernanke speaks for them. He said, “the problem of moral hazard can perhaps be most effectively addressed by prudential supervision and regulation. . . .” This is what they teach at the best universities, the second-tier universities, and junior colleges. This is because they do not teach Austrian School economics.

This faith in intervention has led to an economy that is structured in terms of Federal Reserve inflation and Federal intervention.

We are likely to see an increase in regulation in 2009 and thereafter. Politics shows no sign of reversing the march into the Keynesian system of government regulation. The Democrats will not roll back the welfare state. They will not roll back anything that strengthens the state’s control over the economy.

What is the case for a bull market in U.S. stocks?

It escapes me.


The stock market moves up and down in a narrow trading range. It does not break out on the upside. It does not fall back to its 2003 levels. People believe the FED can prevent such a fall.

Yet what are the prospects for greater economic growth in the United States compared to Asia?

If Asia goes into a recession because China’s central bank ceases inflating at 20% per annum, the Asian stock markets will fall. They already have. But in the long run, capital flows to where it is freer. That means Asia. The United States moved into military Keynesianism in 1946. The government got away with this because other nations’ economies were tied down by welfare state Keynesianism.

Today, we are stretched thin militarily. Europe is stretched thin in terms of the welfare State. The engine of growth is Asia. This is not going to change over the next decade. Recession? Yes. A reversal of the policies of freer capital movement? Unlikely.

May 21, 2008

Gary North [send him mail] is the author of Mises on Money. Visit He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

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