Will the Federal Reserve Bailout Stock Investors in the Next Crash?

 

     Stocks seem to go up too much in part because investors believe in the Greenspan/Bernanke/Yellen Put option. The myth is that the Federal Reserve will try to bailout investors during a crash. But high stock prices are not a necessity unlike keeping giant banks and insurance companies solvent and liquid so stocks won’t get bailed out.
    If another horrible crash came there would be an outcry as people would claim that pension funds, etc. can’t meet obligations because their stocks went down 55%. The best guess about how the Federal Reserve and Congress would respond is that they would tell pension funds and insurance companies to spend their bonds to make their payments and leave the stock portfolio alone for a long time in hopes that it would recover.
   I can imagine the next recession’s bailouts might include the Fed buying bond portfolios at par from distressed investors but not going so far as to bailout stock investors. The Fed could go as far as to buy junk bonds during a crash to help corporations that needed to raise money but they won’t buy equities.
   Since interest rates are already close to zero and actually negative in Europe then the Fed and the EU Central Bank can’t cut rates further. It may be difficult to legislate a fee on deposits to make a zero interest bank account become a negative interest rate account which would be needed for the Fed to lower interest rates even further during the next crash. The Fed has lowered rates in the crash of 1987, then lower in 1990, then lowered them more in the crash of 2002-03, then even more in 2008-09 down to zero, so the trend is for the Fed to give the patient ever increasing doses of medicine during each new crisis. Now that the rate is near zero how can it go any lower during the next crash?
   The principle of Monetarism is that the Federal Reserve allows businesses freedom to let the Invisible Hand of the market use cheap credit to allocate resources that will make the economy operate in the best way. The problem is that the Invisible Hand only seems to work when it is allocating resources in a business environment instead of in an emotionally driven retail stock market. For example, the barriers to entry for establishing a chip foundry result in chip making decisions driven by cautious professionals. By contrast, in the era of dirt cheap commissions for stock trading and day trading of ETF’s, etc. lots of naïve retail investors can participate in the market even if they are not professional and don’t take time to study the market. Thus the Fed’s copious supply of easy money under Monetarism results in the funds being usurped by naïve speculators instead of by wise industrialists.
   The 25 year era of Easy Money from the Fed since the 1987 stock crash has created problems including the great real estate bubble of 1997-2007 resulting in a massive crash of 2008 that Bernanke now says was worse than the Great Depression. Thus Monetarism has been discredited. The implication is that in the future the Fed will be less able to project gravitas and persuade the markets that it can fix a crash. The Fed definitely can succeed in preventing bank runs by rescuing financial institutions the way it rescued AIG and Bear Stearns. But stopping bank runs is not the same as fixing a crashed stock market.
   Thus the next crash in a few years may result in stocks not responding very well to stimulus and not getting as much stimulus as they are used to. Investors need to ask themselves is it possible that the Fed bailout success of the 2002 and 2009 crashes were flukes that won’t be repeated during the next crash? If that happens then investors could spend a long time with their stocks stuck in a trading range at 55% to 40% below today’s prices.
     Investors need independent financial advice about the risks of not getting bailed out during the big crash. I wrote an article “Is the stock market one giant Too Big To Fail Bank?”

 

About the author

Don Martin, CFP®

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