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'The markets are rigged' is a complaint that is being increasingly heard across the investment landscape. Such calls are not just coming from the extremist fringe, as even those among the well-respected mainstream investment community have also made periodic rumblings in support of this idea. But are markets actually being managed so as to deliberately produce results that are unfairly advantaging some at the expense of others? While it is easy to toss out such off-the-cuff indictments, particularly when the market is working against you, this is actually a critically important issue that warrants much deeper examination if it is indeed true. For if markets are truly rigged, investors must meaningfully evaluate whether they should continue participating or reallocate their capital elsewhere.

In critically evaluating this question as to whether markets are rigged, it is worthwhile to go through a logical progression to consider the information available to support this point.

Who?

The first question is focused on exactly who has the ability to rig the markets. We operate in a market system where participants are free to act in their own self-interests in pursuit of profit. Ours is not a pure capitalist model, however, as rules and regulations exist to help ensure that market participants are not acting improperly or at the unfair expense of others in realizing profits. While it is the responsibility of market participants to abide by these rules and regulations, it is the government that is charged with the duty to establish and enforce these rules. Thus, it is the government in the end that has the ability to rig the markets.

Looking at this point through an example helps highlight this point. Let's consider college basketball given that it is March Madness time of year with the NCAA College Basketball tournament now underway. The players in the NCAA are all market participants, each with varying skills and abilities. And the referees are effectively the government, as they are assigned to enforce the rules of play during the game. As a result, if teams like Indiana, Louisville, Gonzaga and Kansas go out and dominate their competition on the court due to their superior ability, that's too bad for their competition. And this is true even if these or any other teams happen to achieve their wins through a controversial style of play, as long as it is still within the rules. But if a team is afforded the unfair ability to win a game due to inappropriate calls or actions by the referees, now we have a serious problem.

The same framework applies to capital markets. If selected large financial institutions like Goldman Sachs (GS) or JP Morgan Chase (JPM) perform well, in the end it is at the expense of those that are on the other side of their trades. And as long as they are not found in violation of the rules, that's simply the way it is. But if government regulators become knowingly involved in providing an unfair advantage those on one side of a trade over the other, then we have a rigged market.

What?

This leads to the second question. If government involvement is required to rig the market, exactly what organization within the government actually has the capability and resources to do so?

To begin with, it is not likely fiscal policy makers for two reasons.

The first reason is that there are far to many actors on the fiscal policy side. This includes the President and his cabinet as well as 535 senators and representatives and all of their support staff, many of whom do not get along all that well and are often at odds with one another. In order to effectively rig markets, you would need complicity and secrecy to be maintained among all of these various participants. And given that they can't seem to agree on anything nowadays, it's unlikely they are operating a finely tuned market manipulation scheme behind the scenes.

The second reason is that fiscal policy makers lack both the resources and expertise to pull something like this off anyway. While taxpayer money gets wasted on a lot of things, it requires legislation for it to be allocated, so it is not likely to be leaking into financial markets without somebody knowing about it. And while many very smart people are roaming the halls of the White House and Congress, their area of expertise for the vast majority is politics, not financial markets. One only has to watch a congressional hearing on a timely financial matter to support this conclusion.

The more likely possibility for any potential market rigging comes from the monetary policy side. This is true for three key reasons.

First, the U.S. Federal Reserve enjoys a great deal of autonomy. Board Governors are appointed to 14 year terms and although the Chairman of the Federal Reserve only serves for 4 years at a time, it is a role that comes without term limits and with a great deal of self discretion. Let's face it; if Chairman Bernanke decides in the shower tomorrow morning that he wants to increase the Fed's balance sheet by another $1 trillion, he can have the plan underway by lunchtime. And if President Obama wanted to reappoint him to a third four-year term next January, it is his right to continue on in the job. After all, his predecessor, Alan Greenspan was known as "the Maestro" and held the job over five terms and nearly 20 years before stepping down in 2006.

Second, the U.S. Federal Reserve not only has a keen understanding of how financial markets work, but it is their responsibility to oversee the banking institutions that are the primary players within these markets. As a result, if the Fed wanted to affect an outcome one way or another, they certainly know all of the inroads and have the capability to do so.

Third, the Fed has the resources at their disposal. Unlike fiscal policy makers, the U.S. Federal Reserve is the originator and controller of the money supply. And they can create as much money as they see fit at any moment in time and without prior approval from anyone else.

Thus, if anyone is rigging financial markets, the only clear candidate is the U.S. Federal Reserve.

Why?

This leads us to our third question. Exactly why would the Fed want to rig the markets? Clearly it is not for personal gain, as any such inproprieties would almost certainly been uncovered by someone by now. Nor is it at all likely that Chairman Bernanke and his team have diabolical intentions to destroy the global financial system, as they could have more easily accomplished this task a few years ago by simply letting everything seize and collapse back in October 2008.

Instead, those that serve in leadership roles on the Fed are more of the academic sort that at least to this point have demonstrated that they are applying policy decisions based on their theoretical conclusions of what will work best to promote full employment and price stability. This fact alone does not necessarily mean, however, that they are not either permitting or encouraging activities in the market place that are still resulting in a rigged market. But the notion of the Fed rigging markets is a very serious allegation, so it is one that should be considered not in the context of assumptions but instead based on facts.

Before going any further, it is worthwhile to note that it is not unprecedented for the integrity of the Fed to be called into question. For example, the Fed is under scrutiny for its potential role in the LIBOR rate fixing scandal. It is known that members of the Fed were aware that banks were submitting artificially low rates to convince markets that their balance sheets were in better condition than reality. And there is little evidence that the Fed did much of anything to stop or discourage this activity at the time. But while the Fed has direct responsibility for overseeing three of the U.S. banks that report as part of the LIBOR rate setting process, they are not the British Bankers Association that is directly responsible for managing the LIBOR. If anything, explicit evidence only supports a lack of sufficient action instead of any deliberate moves by the Fed to assist in manipulating LIBOR. Returning to basketball referee parlance, this would be the equivalent of a badly missed call, but not an effort to try and rig the game.

So to better answer this question of why the Fed would want to rig the markets, it is worthwhile to explore exactly what we know about the Fed and what it believes?

First, we know that the Fed wants the stock market to go higher. Fed Chairman Bernanke has explicitly stated that one of the positives associated with monetary stimulus programs such as QE3 is that "higher stock prices will boost consumer wealth and help increase confidence".

Second, we also know that the Fed wants interest rates to remain as low as possible. Chairman Bernanke has also expressed that "lower mortgage rates will make housing more affordable and allow more homeowners to refinance" and that "lower corporate bond rates will encourage investment".

Third, we also know that the Fed is targeting specific segments of the U.S. economy with its policy actions in order to spark more broadly based growth. Chairman Bernanke has explicitly stated as evidenced in the points above that the Fed is targeting the housing market with its policies of low interest rates and direct purchases of mortgage backed securities.

Fourth, we also know that the Fed wants inflationary pressures to remain low, but not so low that we fall into a deflation problem. Low inflation is important because it provides the Fed with the flexibility to continue fighting the high unemployment problem that exists on the other side of its dual mandate. As a result, it wants to see the prices of goods remain steady, including the more volatile food and energy prices that tend to whip up public ire.

Lastly, we also know that the Fed does not like gold. During congressional testimony in 2011, Chairman Bernanke answered "no" to the question about whether gold is money and went on to describe it merely as a "long-term tradition" and something that "people hold as protection against what we call tail risks, really, really bad outcomes". In other words, rising gold prices serve as a direct invalidation of what the Fed is trying to accomplish with its policies.

How?

This leads us to our final question. We explicitly know the outcome the Fed is seeking in financial markets. So how then do they accomplish it? And is there any explicit evidence in these actions that they are effectively rigging markets in the process?

Obviously, the Fed is working to achieve these outcomes through its various monetary policy stimulus programs, the latest of which is QE3 that includes the Agency Mortgage Backed Securities program that was initiated last September 13 and the daily U.S. Treasury purchase program that began on January 4.

Clearly, these programs have a profound impact on capital markets. Stock prices have returned to all-time highs as measured by the Dow Jones Industrial Average (DIA) and the S&P 500 Index (SPY). And interest rates remain at historical lows as measured by the interest rates associated with U.S. Treasuries, corporate bonds and mortgages. Thus, the Fed has explicitly stated its objectives and has implemented programs designed to achieve these objectives. In short, while many market participants certainly may not agree with why they are doing it, the Fed has done nothing more than accomplished what it explicitly stated it was setting out to do with its policies.

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One of the spillover effects associated with these monetary stimulus programs, however, is the associated rise in commodities prices. While the liquidity that flows into the financial system clearly seems to find its way into stock and bond prices (hence lower yields), it also finds its way into the prices of commodity goods such as oil, gasoline, food and other commodities. This, of course, has proven challenging for the Fed, as this spillover effect works in the face of what it is trying to achieve with stock and bond prices. But then if the Fed were rigging the market behind the scenes, we should expect to see stock and bond prices rising while commodity prices were holding generally steady. This has certainly not been the case, however, as the prices for key commodities such as copper, gasoline and food have all ended up in effectively the same place but with far greater volatility as would be expected.

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The strong rise in commodity prices certainly raises some questions about the validity of the inflation data that seemingly continues to suggest that pricing pressures are subdued and under control. But this is not a matter that falls at the feet of the Fed. Instead, measuring inflation is the responsibility of the Bureau of Labor Statistics for the Consumer Price Index and the Bureau of Economic Analysis for the Personal Consumption Expenditure Price Index. So while it is reasonable to openly debate whether the methodology to measure inflation is correct or not, these readings are not likely the result of a cross government market rigging effort.

But what about the precious metals? It has certainly been puzzling to watch the poor performance of gold and silver since the start of QE3. But the fact of the matter is that when viewed over the entirety of the post crisis period, the precious metals have certainly been left to rise without much constraint. If anything, what we are seeing today is a healthy consolidation of what has still been an exceptionally strong advance to this point. And this overall advance is still due to good reason, for if central banks from around the world are printing their fiat currencies like toilet paper, safe haven store of value precious metals should respond accordingly.

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Has there been some unusual trading activity between the hours of 8AM and 9AM in recent weeks? Absolutely, but this does not necessarily mean that the Fed is behind it. Are their certain dubious actors that are key players in the precious metals? Absolutely once again, but these were the same players in place when precious metals prices were skyrocketing higher from mid 2010 to mid 2011. And if anything untoward is going on today in the precious metals market, it remains up to not only the regulators but the independent journalists and researchers that do their own part to help police not only the players but also the referees.

Conclusions and Next Steps

So is the market rigged? And if so, is it rigged by the Fed?

My answer to both of these questions is no.

Is the Fed greatly influencing markets with its actions today?

Absolutely, but the Fed has made no secrets and has been completely explicit all along the way about what its trying to do with its monetary policy actions. In fact, they have bent over so far backwards to inform and please the markets that it warrants criticism in its own right. We may not at all agree with what the Fed is doing - I for one certainly do not - but that's just the way it is and these are the rules of the game investment participants are left to operate under.

Are their market participants that have an unfair advantage in playing the game?

Absolutely, but that's also the way it is and this is something that has been true since the beginning of time for investment markets. Just like Michael Jordan always got an extra step or two to the basket and saw borderline calls often go his way, so too do selected financial institutions have an edge in the market place. But as evidenced by the near implosion of the financial crisis, this does not mean that they are predetermined to win every time. Far from it.

Markets are not rigged, but they do have a far greater number of risks than they did prior to the crisis. And as evidenced by the tumultuous events that continue to unfold around the world including the latest episode in Cyprus, this is likely to continue for a while longer. With this in mind, we are better served to consider the following questions as we look for investment opportunities moving forward.

How much longer can the Fed and other global central banks continue to print money? If and when they either decide or are forced to step down from further stimulus will likely be a major inflection point for the markets.

What truly is the state of the global economy if the façade provided by boundless monetary stimulus were to be removed? While one could look at the path of the stock market over the last four plus years and marvel at its recovery, one could also look back with an entirely different perspective and wonder the following: How is it that we are only back to where we started given all of the massively extraordinary fiscal spending and money printing that has gone on repeatedly over the last several years? After all, given that we have less than 45 cents of total nominal GDP for every dollar of fiscal and monetary stimulus deployed thus far in the post crisis period, how bad are things really under the surface? And at what point do these toxins finally start to bubble over? This question alone is one of the many reasons I haven't slept well at night in years despite the roaring stock market. And given recent events in Europe, it is also the reason I am currently emphasizing quality within stock allocations with names like the S&P 500 Low Volatility ETF (SPLV), McDonald's (MCD) and Verizon (VZ).

What if the Fed actually loses the fight and capital markets begin to fail despite all of its efforts? What then will investor have to motivate them to buy risk assets like stocks? Not fundamentals. This is where things could start to get really ugly.

Focusing on the bond market, what if all of the pundits and experts have things completely backwards? Perhaps U.S. Treasury yields would actually be lower than they are now without the stimulus derived purchase programs by the Fed. Would this help to explain why in the chart above that Treasury yields always cascade lower when the Fed is not stimulating with QE and spike higher once the Fed starts into QE? After all, if the greatest underlying risks for the economy are still biased toward deflation instead of inflation, this would support far lower Treasury yields (and higher Treasury prices). One has to look no further than Japan with their 10-year and 30-year government bonds yielding 0.57% and 1.63%, respectively. These make the yields of their U.S. counterparts currently look lusty in comparison. And such a reality would make investments in intermediate-term (IEF) and long-term Treasuries (TLT) appear most attractive today.

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Lastly, how much longer does the precious metals market need to consolidate before making its next move higher? It has been an enormously frustrating time for gold (GLD) and silver (SLV) investors over the last 18 months, but if you've been long these metals for a half a decade or longer, both your long-term theses and uptrends remain in tact. And both metals are now arriving at multi-year trend lines that may indicate the long consolidation process may finally be drawing to a close. For these reasons among others, I remain long the Central GoldTrust (GTU), the Central Fund of America (CEF), the Sprott Physical Silver Trust (PSLV) and Silver Wheaton (SLW).

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The markets are not rigged, but this does not mean that they are not absolutely unpredictable and maddening for extended periods of time. But opportunities still exist in these markets, no matter how far under the influence they may be. And in many cases, it's just a matter of extra patience and time before the themes that you strongly believe should be correct are likely to finally play themselves out.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Source: Are The Markets Rigged?