Fed and Investment Bankers in Cahoots

09/25/2012 10:45 am EST

Focus: MARKETS

Andy Waldock

Founder, Commodity & Derivative Advisors

It seems that since 2009, the Federal Reserve and investment bankers had struck a deal that works for everyone...except, of course, retail investors, writes Andy Waldock of Commodity & Derivative Advisors.

The anatomy of a market trend is the process of accumulation, public participation, excess, and finally distribution. The recent Federal Reserve meeting assured zero-bound interest rates well into the future. This has provided the fuel for the excess and final upward leg of the stock markets before distribution kicks in.

Based on what I see in the CFTC’s Commitment of Traders reports, it appears that the small traders—the ordinary citizens of this country—are going to be the ones left holding the bag when Rogoff and Reinhart’s “Bang Moment” from This Time It’s Different triggers the fire alarm and the market tumbles.

In some ways, this is simply how free markets work. In other ways, this may be the single biggest fraud ever perpetrated on the average US taxpayer.

The story starts after September 11. The stock market, which was already approaching bear-market territory—down 17% from the May highs of 2001—tumbled. The markets closed for five trading sessions and our country was panicked.

Faced with a nation in shock, the government and the Federal Reserve Board began lowering interest rates to facilitate a rebuilding of US confidence and economic prosperity in the face of one of the darkest events in American history. The elixir of cheap money worked. The S&P 500 rallied nearly 19% by the end of 2001.

The accumulation phase of a trend begins when an already-beaten market has the knockout punch thrown at it. Buyers who understand value and are able to see through the storm that has driven a market to panic levels begin to step in and prop up the market, allowing it to find a bottom.

This clearly fits the 2001 market story: already on the decline (-17%), knockout punch (9/11), panic levels as market closed, buoyed by investment banks and the Plunge Protection Team spending cheap government dollars, the market rebounded.

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The public participation phase is typically seen as see-saw consolidation above the recent lows while individual investors decide whether it’s safe to buy new shares or use the first pop of a rally to bail out of their losing shares. The S&P held fast at 10% to 20% above the lows until the following June, when the market began to make new lows again and unemployment pushed towards 6%.

The markets’ penetration of the September 11 lows brought about further economic stimulus in the form of lower interest rates. Interest rates bottomed in October 2004 around 1%, as unemployment peaked at just over 6% for that business cycle.

Excesses began to build as the mortgage industry picked up steam due to the implementation of looser lending standards trickling through the economy via President Bush’s plan to put home ownership within reach of every American citizen. Lending rates and requirements dropped and the US consumption boom swelled to excess in the form of second houses, new trucks, flatscreens, and Harleys. The S&P 500 rallied 48% between August 2004 and the market top in October 2007.

The fallout from the economic crash of 2009 is where we begin to see collusion within the investment-banking sector at the expense of the retail investor. There is no question that the immediate action by the Federal Reserve was necessary to shore up the markets and the global economy. The Fed stepped in and lowered rates and insisted upon loans being drawn from the TARP facility as a show of force to the world that our markets were not broken.

This bottom is also the beginning of new accumulation. Banks were shoring up the stock markets using federal money. Charles Biderman of Trim Tabs was the primary voice suggesting this. He was severely ridiculed at the time, yet managed to provide enough inexplicable data to prove that something was an unannounced, heavy-handed buyer.

The point is, this was the third trip to a market crash that was averted by the Federal Reserve. Investors are known for their pattern recognition skills, and it became evident to the primary broker-dealers that Bernanke’s third mandate had become protecting the stock market.

2010 tacked on another 12%, as retail investors continued to be frightened and/or too broke to invest. Large broker-dealers held fast, having already booked better than 50% returns from the 2009 lows thanks to the “Bernanke Put.”

Eventually, retail investors came back to the market as Fed speech after Fed speech insisted that they would do anything necessary to instill market liquidity and confidence. This also meant driving down yields to artificially low levels, which has forced retail investors into riskier assets like the stock market.

This led to a flat 2011, as the world decided whether or not Europe would implode one country at a time. Meeting after meeting, press conference after press conference, virtually nothing had been decided...and yet, this is when the retail investors, having missed out on 70%-plus from the 2009 lows, decided it was time to get back in the market.

Quantitative Easing 2 and 3, along with Operation Twist, provided confirmation that the Federal Reserve would indeed do anything it could to ensure faith in the markets. Nothing says faith like a rally, and nothing creates a rally like lack of other investment options. We currently sit within 5% of the 2007 all-time high.

This is clearly the excess phase. Europe has yet to settle their issues, and no matter how you view our economy, it’s simply not healthy. Furthermore, the internals of this rally do not justify the levels we’re trading at. This leads us to the punch line. Commercial traders have been selling stock-index futures with abandon as we’ve approached these highs.

The only major buyers have been the small speculators. The stock positions that the government acquired with our tax dollars at the 2009 lows are now being sold back to the retail investors (taxpayers) on the open market at much higher prices.

When the market tumbles because small specs can’t support higher prices alone, it will be the greatest transfer of public debt to private citizens ever, as the small speculators will be left to absorb the losses in their own accounts.

Read more from Andy Waldock here...

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