Is the Stock Market One Giant “Too Big To Fail” Bank?

 

The Federal Reserve Central bank and the various regulatory agencies seem to have a policy that any systematically important bank or insurance company is “Too Big To Fail” (TBTF).  The Fed could prop up a failing bank to stop a bank run from happening. So why not extend the analogy to propping up the stock market? If it goes down would the Fed simply start buying stocks as a form of Quantitative Easing? If pension funds and individual 401k’s are dependent on high stock prices would the Fed decide to bail them out by simply printing money and buying shares to support the price?

This is different from QE because QE was done in the hopes of increasing the money supply, lowering interest rates, creating a wealth effect, etc. QE was done by intervening in the bond market which is something more closely related to Central Banking than the stock market.

If stocks crashed there is no guarantee that stimulus from the Fed would help stocks to recover. It would be a huge change for the Fed to decide to re-inflate stocks by buying them. They would need Congressional authorization which would be blocked by some conservatives in the House of Representatives.

The mandated goals of the Fed are price stability and full employment. They are not obligated to support stock prices. If they tried to Congress might object.

If investors woke up and realized that earnings are artificially high and need to revert to the mean and that long run multi-year PE ratios are at cyclical highs then investors would bail out of stocks and a crash would occur. If the economy continued to have full employment and price stability then it is unlikely the Fed would cut interest rates to help stocks.
The 1987 crash of 22% in a day scared the fed and so they cut rates 0.5% right away. But that is the only percent for rate cutting to prop up stocks. Ironically the 1987 crash may have been caused by the end of the Volcker Fed’s era of high “real” rates. Real rates were at times around 6% instead of the typical 2% rate. When rates dropped down to normal levels in 1987 then foreigners decided to invest elsewhere, creating an imbalance of sell orders. Thus cutting rates can actually make foreigners withdraw funds from the U.S. creating deflationary influence.

An investment portfolio should be viewed not as a playground to engage in reckless day trading but as a facility to nurture one’s retirement nest egg, etc. Thus if stocks are overpriced and need to go down to 935 or 1200 for the SP depending on which bearish advisor you ask then repeat of the 55% decline of 2007-09 could occur. If the Federal Reserve is unable to help stocks then investors may be in a for a disappointment. Prevention is the only “solution”. Once a crash has occurred it may not be possible to recoup one’s losses after adjusting for inflation. During the 1929 crash it took almost 30 years for stock prices to break even after adjusting for inflation, although in those days the dividends were very large, thus on a total return basis it wasn’t that bad, except that taxes on dividends were a big problem.

The only proper action is to avoid excessive risk and avoid owning overpriced risk-on assets such as stocks and real estate. Since risk-on assets are too correlated to be much of a diversifier, especially during crashes when correlations rise, then one must simply devote a larger than usual share of assets to investment grade bonds and cash.
Investors need independent financial advice about the risks of a stock crash. I wrote an article “Stocks can crash even if the economy is growing”. If that happened then the Fed couldn’t help stocks because monetary easing during a time of growth and prosperity would trigger inflation and currency devaluation, which would make some politicians seek to restrict the Fed’s actions.

About the author

Don Martin, CFP®

Leave a Reply

Your email address will not be published.

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <s> <strike> <strong>

Copyright 2014 FiGuide.com   About Us   Contact Us   Our Advisors       Login