The Real Crisis For Washington And Wall Street

 |  Includes: BND, DBC, HYG, SPY, VNQ
by: Eric Parnell, CFA

A major crisis is threatening the foundation of our government and financial markets. It is a calamity that has been festering for years and is now presenting itself as an increasingly destructive force. The magnitude of this brewing dilemma extends well beyond the government shutdown, the debt ceiling debate and the potential for another major stock market correction, as these are all merely symptoms of the larger problem. What is this mounting crisis? It is the complete lack of any personal responsibility and accountability among those individuals that direct and influence the major political and financial institutions both in the United States and across the globe. And until these leaders are finally held to task for their actions or lack thereof, the global financial system will find itself increasingly at risk of a potentially major cleansing event.

The Great Fed Enabler

I recently viewed an article entitled Fiscal Flap Vindicates the Fed's Easy Money Call by Michael Santoli of Yahoo Finance that epitomized so much of what is currently ailing the global political and financial system. Mr. Santoli leads his article with the following brash questions:

Who out there still thinks the Federal Reserve blew it last month by leaving its stimulus program unchanged? Where are the vociferous critics of Fed Chairman Ben Bernanke, who loudly blamed him for botching his message and defying market expectations that the Fed would "taper" its monthly pace of bond purchases from the current $85 billion pace?

I would simply respond to these questions by saying that I absolutely still think the Federal Reserve blew it last month by leaving its stimulus program unchanged and remain right here as a constructive critic not only of Fed Chairman Ben Bernanke but the entire Federal Open Market Committee for their recent actions.

My reasons for maintaining these views are the following. Most significantly, the presumption is that the Fed has "saved" the stock market (NYSEARCA:SPY) and bond market (NYSEARCA:BND) from experiencing a considerable correction directly related to the gridlock in Washington that has resulted in a government shutdown and a looming debt-ceiling showdown next week is problematic for the following reasons.

First, where exactly is it in the Fed's mandate that the course of monetary policy should be dictated by its perceptions about the deficiencies of fiscal policy? In fact, by deciding to hold off from scaling back asset purchases, they are effectively acting through monetary policy to greatly reduce the threat of personal responsibility and accountability on the President, his Treasury Secretary and the various members of Congress from both parties that are actively engaged in the debate.

It is not the job of the Federal Reserve to continue to expand its balance sheet and place the integrity of the global reserve currency at risk to provide cover for fiscal policy makers who continue to dither and undermine the confidence of the U.S. government in the global community. Instead, we would all be best served if the Fed would finally stop applying stimulus so that politicians in Washington might be held accountable to make the tough decisions for the future prosperity of our country that are becoming increasingly overdue with each passing year.

Also, the Fed has essentially broken in the U.S. financial markets what was once a critical signaling mechanism for politicians to take action. Historically, a stock market riot or a sharp spike higher in interest rates would rattle politicians to attention that the time had come to stop posturing and instead come to the table in an attempt to negotiate constructive solutions. But thanks to the Fed keeping interest rates pinned at zero percent and stocks elevated on a perpetual stimulus induced high, the markets have been stripped over the last several years of their ability to bring any such call to action for politicians.

In fact, we instead find ourselves now resigned to an unthinkable circumstance where our President and his Treasury Secretary have been perceived to be talking our capital markets lower presumably to help promote their agenda. And the behavior of the opposition party is equally disconcerting, as they remain fractured from an ideological standpoint from within and have taken to shutting down the government without a clearly articulated plan from a policy perspective to justify this action in the first place. Even if all of this is nothing but perception, this behavior from both sides is most troubling to say the least.

In short, the Fed through its actions has permitted fiscal policy makers collectively on both sides of the political aisle to cede any sense of personal responsibility or accountability in even beginning to consider breaking the mindless stalemate that persists in Washington. Instead, they are left to stonewall, posture and dither while the real solutions that have been so badly needed since the outbreak of the financial crisis several years ago are still left unattended.

What Risk?

The troubling lack of personal responsibility and accountability are just as profound if not more so across financial markets. It was not long ago when investment decision making was driven primarily by fundamental factors such as economic growth, corporate earnings and valuation. And investors would eagerly anticipate earnings results from the likes of PepsiCo (NYSE:PEP), Google (NASDAQ:GOOG), General Electric (NYSE:GE) and Johnson & Johnson (NYSE:JNJ) that are set to announce quarterly results next week. But thanks to the endless flow of monetary stimulus from the U.S. Federal Reserve, investors have been lulled into a worrisome sense of complacency that the Fed is paramount and that risk no longer really matters. Stay long the stock market so the thinking goes, for if anything even remotely bad happens along the way, the Fed and the U.S. government will be there on the spot to quickly make everything right. Privatize the gains and socialize the losses.

Right? Yes, perhaps this may be true for now, but at some point policy makers will finally have to stand down. And when they do, the subsequent pain in the stock market in particular could be pronounced once investors are finally forced to assume personal responsibility and accountability for the risks they have undertaken in recent years, particularly with current valuations so far above historical averages in an already sluggish economy.

Moreover, the fact that so many other highly correlated asset classes to stocks like real estate (NYSEARCA:VNQ), high yield bonds (NYSEARCA:HYG) and commodities (NYSEARCA:DBC) have been increasingly struggling suggests that even the stock market may have limits to its gains resulting from the endless flow of monetary stimulus. It will be interesting to see what fresh bubbles and distortions have been created this time around and the associated pain once they are inevitably unwound.

The Eventual Return of Personal Responsibility And Accountability

Given that we remain in a climate where politicians and investors maintain a warped sense of risk due to the enabling policies of the U.S. Federal Reserve, where can we expect the markets to go from here? Put simply, we likely have one more major market correction ahead of us. It could begin at any time. In fact, it might have already begun with the market peak struck by the Fed's surprise announcement in mid September. Then again, it may still be a few years off in the future. But it remains that we are still likely in the midst of a secular bear market that started thirteen years ago with the bursting of the technology bubble in 2000. And this current long-term cycle requires one more major cleansing before we arrive at the dawn of a new secular bull market.

Reflecting back on past secular bear markets is instructive in determining what we can reasonably expect this time around.

To begin with, secular bear markets since the late 1800s have lasted just over 17 years on average. Given the fact that we are only 13 years into the current episode suggests that we likely have more pain to endure before it is over.

But what if the current secular bear market is actually already over? Perhaps it will be much shorter at just 9 years this time around with the March 2009 lows marking the final bottom? This is unlikely for the following reasons.

First, secular bear markets have historically followed a similar pattern over time. This includes a stock market that undergoes three major corrections along the way before completing a secular bear market. And by the end of third correction, valuations are trading at trough levels with P/Es the mid to high single digits and investor sentiment surrounding stocks is decidedly negative. The now iconic "Death of Equities" BusinessWeek is an example of this latter point. Unfortunately, we have only experienced two major corrections to date in the current secular bear market, which potentially does not bode well for stocks going forward, particularly with investor sentiment generally still positive and elevated P/Es in the high teens to low twenties. As a result, we are likely waiting on the third correction in the current secular phase before it is fully completed.

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Second, the nature of these corrections within secular bear market also follow a typical pattern.

The first correction is usually the bursting of the bubble formed by the cumulative excesses of the previous secular bull market. The technology bubble was simply the latest example in this regard.

The second correction is often the bursting of the bubble that was formed or the correcting of the distortion that was created as a result of the policy action taken to address the first trauma. The housing bubble born as a result of low interest rates and lax lending standards in response to the bursting of the tech bubble and the recession that followed is once again the latest example.

The third and final correction is typically the major cleansing when markets are finally forced to absorb the pain and adjustments required to set the foundation for the next secular bull market. In other words, the final correction has come either through a geopolitical event such as a World War or when policy makers finally turned into the underlying structural problems and fully addressed them head on instead of trying to run away by papering it all over. This head on approach was true in the early 1920s when fiscal policy makers lowered personal income tax rates, slashed government spending and reduced the national debt while monetary policy makers stepped aside. And it was also true in the early 1980s when then Fed Chairman Volcker raised interest rates as high as nearly 20% to completely eradicate the inflation problem at the time. In both past cases, policy makers assumed personal responsibility and accountability for the problems of the day and imposed this on investors in order to cleanse the economy and its markets. And the subsequent outcome was the dawn of the next secular bull market.

While today's Fed was certainly heroic in saving the global financial system from near disaster in late 2008 and early 2009, the system has long since been stabilized and the time has come for policy makers to allow this same cleansing process to finally take place in today's market. Instead of allowing what was once extraordinary policy action in QE to become the norm and with it a muted sense of awareness about risk, Fed policy makers would be well served to finally work toward bringing a sense of personal responsibility and accountability back to the system. This, of course, is likely to result in the potential for some considerable losses along the way, but we as market participants are all adults and should be able to handle this potential pain with the recognition that we are working toward what will eventually be a lean and strong economy and the dawn of a new secular bull market that could last decades into the future. Getting investors reacquainted with the true notion of risk and the potential for loss would also go a long way in returning far more sound and responsible decision making, which is a good thing for the long-term sustainability of markets down the road.

We have waited long enough, and the time for action is now. Although it has been with all of the best intentions, the Fed has been an unhealthy market enabler for far too long. And this has bred an increasingly destructive array of imbalances over the years in the process. It is time for the Fed to finally step aside and allow fiscal policy makers and investors assume greater personal responsibility and accountability for their actions. For if we no longer have anywhere to hide from our misguided choices, we are likely to make far better decisions in the future. This would be a particularly welcome change for those that are tired of the mess that seems to play out with too much regularity in Washington today.

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.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.