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Too Much Bullish Stock Market Sentiment?

Stock-Markets / Stock Markets 2010 Oct 15, 2010 - 01:42 PM GMT

By: Sy_Harding


Best Financial Markets Analysis ArticleThe modern Fed has quite a history of blowing bubbles, and doing so even when it seems to be aware of what it’s doing.
Remember the dotcom bubble in 1999, and the stock market bubble in 2000?

In 1998, Fed Chairman Greenspan had already warned of ‘irrational exuberance’ in the stock market a year or two before. But the market had continued to rise into extreme overvalued levels by historical standards of price/earnings ratios and the like.

However, in the summer of 1998 the stock market was finally experiencing a correction, down more than 17%, the exuberance being cooled off.

Unfortunately, Asian countries had run into problems with their currencies, which hammered their economies. The problems spread to Latin American countries. Then giant hedge fund Long Term Capital Management collapsed due to big bets on Asian currencies, causing problems also for the large banks that had financed it. And the Fed seemed to panic. It swiftly initiated two dramatic rate cuts within two weeks of each other. The Fed’s explanation was that it did not think global economies could handle their problems if faced with a further stock market decline in the U.S., and their economic problems could spread to the U.S.

The result was that ‘irrational exuberance’ resumed, on expectations the Fed was going to provide additional economic stimulus via lower interest rates. And indeed, even though global economies and stock markets had recovered, the Fed did not reverse the rate cuts until June, 1999, and by then it was too late.

We know the results. The stock market had spiked up further into its bubble, then burst, and the severe 2000-2002 bear market was upon us.

Then, apparently, not realizing the economy was also about to enter a recession, the Fed continued to raise interest rates until May, 2000, and did not begin cutting rates to try to prevent a recession until January 3, 2001. It was again behind the curve. By then the recession was on us.

To pull the economy out of the 2001 recession, hampered also by the 911 terrorist attacks, the Fed cut interest rates a total of 13 times, not stopping until June of 2003, well after the economy was recovering, and the 2002-2007 bull market was underway.

By then that prolonged easy money policy had the real estate bubble forming. When it burst, the resulting recession of 2007-2009 was the worst since the Great Depression, and the 2007-2009 bear market was the worst since the 1930’s.

And here we are, with the Fed in another bind.

The 2007-2009 recession ended last June. The stock market soared up in an impressive new bull market from its low in March of last year.

The Fed has kept its easy money policy in effect, and yet the economic recovery stalled once other government stimulus programs expired in the spring.

The Fed would no doubt like to now be able to cut interest rates to re-stimulate the economy, but unfortunately has its Fed Funds rate already at zero, where it has been since December, 2008.

So it’s only remaining tool to re-stimulate the economy is to provide another round of so-called quantitative easing, in which it purchases treasury bonds in an effort to lower long-term interest rates, which are already at record lows, to even lower levels.

Economists have concerns about how well that would work to help the economy. The economy’s problems at this point don’t seem to be the level of interest rates, but the lack of jobs, dismal consumer confidence, and the unwillingness of banks to make loans.

However, just the anticipation of additional quantitative easing and still lower long-term interest rates has already potentially begun to pump up the next bubbles, as investors have moved out the risk curve in an effort to find higher rates of return. Money has been flowing at a dramatic pace into high-yield junk bonds, commodities, and gold. And the stock market has surged up 12% just since its August low when talk of another round of quantitative easing began. Meanwhile, the U.S. dollar has been trashed further on expectations that the Fed will be ‘printing’ more dollars to finance another round of quantitative easing. The dollar’s decline threatens a ‘currency war’ with other nations concerned about the negative effect of a weak dollar on their economies.

It’s another tough spot for the Fed to be in.

Exacerbate the new bubbles that will again be problems down the road, and trash the dollar further, or allow the economy to adjust itself with another recession that deflates the prices of assets down to levels that would be self-sustaining.

It’s a no-brainer. Blow another bubble and worry about the consequences down the road.

But yet in his speech Friday morning Fed Chairman Bernanke did not go all in on quantitative easing, stopping short of announcing a new policy, saying only that the Fed contemplates doing more, but “will take into account the potential costs and risks.”

So uncertainty remains for a market that has probably already factored in a substantial new round of stimulus.

Sy Harding is president of Asset Management Research Corp, publishers of the financial website, and the free daily market blog,

© 2010 Copyright Sy Harding- All Rights Reserved

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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