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Why the Stock Market Has Not
Broken Out
Gary North
Lew Rockwell.com
Wednesday, May 21, 2008
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."
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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).
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.
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INFOWARS:
BECAUSE THERE'S A WAR ON FOR YOUR MIND
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