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URL:  http://boards.fool.com/wendy-said-the-risk-is-high-of-a-sudden-crisis-30310198.aspx

Subject:  Re: Catastrophe theory, instability, risk Date:  10/10/2012  1:16 AM
Author:  yodaorange Number:  405654 of 461344

Wendy said: The risk is high of a sudden crisis.

Wendy, I will postulate that things MIGHT be different this time around.

The consensus view back in March 2009 was that the financial outlook was somewhere between bad and hopeless. The SP 500 hit a low of 666. The Dow Jones hit a low of 6516. Both the SP and Dow have more than doubled since then. The US was losing ~800k jobs per month at the time.

So what changed? What turned the SP upward?

I suggest two main contributors to the turning point:

1) Treasury/Fed decided that the largest US banks were Too Big to Fail aka TBTF. Back then, there was widespread debate as to whether Citi and BofA in particular should be "nationalized" or not. Secretary Geithner prevailed in his view that the TBTF should remain independent, but NOT be allowed to fail. Recall also that the first "stress test" results also were released. Yoda's personal opinion is that this helped turn the markets around, but was NOT the main driver.

2) Many investors, including me, believe that the Treasury/Fed directly intervened in the US equity markets by having a “primary dealer” buy SP 500 futures. A few points:

a) Ben Bernanke has widely talked about the importance of positive feedback. Strong and rising equity markets mean more spending and job creation in their mind. Ben wrote an editorial in the Wall Street Journal that talked about this when they did QE1.

b) Ben talked about this in a theoretical context in his famous 2002 “Helicopter Speech.” It was listed as one of the “tools” that the Fed could use to increase job growth.

c) There is near universal agreement that confidence plays a major part in economic growth. If everyone believes the economic outlook is better, their animal spirits will lead them to take more financial risks and buy more things. Conversely, if everyone thinks the financial world is coming to an end, they will NOT spend with reckless abandon.

d) There is also near universal agreement that it IS possible to dictate stock prices in this manner. The only question is how much money it takes. Consider a single stock of say a $10 billion market cap company. If the market price starts falling, a buyer at the margin could purchase all of the additional shares offered and literally set the floor price. This concept gets stretched a little when you talk about the overall US equity market with its multi trillion dollar market cap. Luckily the Fed has a slightly higher credit limit than most of us

e) My OPINION and it is NOT provable one way or the other is that this was the primary mechanism that put a floor under equity prices back in March 2009.

Fast forward to today. If equity markets “fell off a cliff” do you think Ben and the Fed would sit by idly and let that happen? Recall in Ben’s QE to infinity speech he talked about the positive feedback between equity prices and improved job growth. If the equity markets declined precipitously, it would have the potential to undo the literally trillions of dollars of work the Fed has done to boost confidence. Let’s stipulate the SP drops 50% for illustration purposes only. What choices does the Fed have?

a) Sit back. Watch it drop. Watch confidence drop. Watch unemployment rise. Watch companies shut down all hiring. LISTEN TO EVERY TOM, DICK AND HARRY TELL THE FED HOW STUPID THEY ARE for letting this all occur.

Or

b) Direct one or more of their primary dealers to “buy the market” in size. If it keeps falling, up the size. There is literally NO limit on how high the credit card tab can run to. Unemployment will be stable plus or minus a little. Confidence will be stable plus or minus a little. Some companies MIGHT increase their hiring. The Fed will still be criticized, but it will be a lot less than if they allow another equity meltdown.

BOTTOM LINE IMO is “Don’t Fight the Fed”, particularly when they want the equity markets to appear robust. I should point out one other item. Ben and the majority of the FOMC, REALLY, REALLY believe they have the best strategy for increasing job growth. They are "all in" for QE to infinity. They believe in the econometric models they use.


Thanks,

Yodaorange
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