What Fed Bailout?

Aug.21.07 | About: SPDR S&P (SPY)

The Fed bailout by cutting interest rates last Friday seems to have calmed the market down so far this week. Whether the market has already bottomed, I don't know, but I wouldn't be surprised to see the market retest bottoms in a few weeks before a good rebound for a few months. However, the crash lasting several weeks has made a damaging picture in the chart from a technical perspective and gives us a loud warning about what is yet to come from a long term perspective.

I feel that this recent financial turmoil is the beginning of a much more serious credit crunch in both the U.S. and globally. Liquidity injections and lender-of-last-resort bailouts by the Fed might make sense and be deemed necessary during a panic like last week on a short term basis, but from a long term perspective, it won't work, it hasn't worked before, and it will only postpone, elongate and exacerbate the eventual bear market.

It is interesting to recall an overpaid speaker and former Fed chairman who has created one bubble after another to declare to bankers and traders at Lehman Brothers on Oct 26 of 2006, "Most of the negatives in housing are probably behind us." Less than a year later, it turns out to be the opposite, that many of the negatives are right in front of us, and the worst is probably yet to come.

The current subprime problem will spill over to other asset backed securities, such as credit cards, auto loans, next levels of home mortgages, commercial real estate, etc. It is just a matter of how deep they will get and how they vary in their asset classes. By the time it ends, the bailout capital involved will be who knows how much larger than LTCM back in 1998 (just the subprime crisis itself is equivalent to LTCM crisis). And even Fed bailed out LTCM successfully in 1998, they still couldn't avoid a bear market 2 years later.

John Hussman of the Hussman Funds in this week's commentary, indicates that the so-call Fed Model has no predictive power to the earnings growth and over- or under-valuation of the general equity market on a long term basis. As he shows, it turns out that 1987 and 2000 are the only two periods in which the Fed Model would ever have been significantly negative, not any period prior to 1987. The so-called predictive power of Fed Model is more an exception than a norm.

On the same token, most of the bullish views about today's equity market are based on one kind or another extrapolation from the last 20 year-long bull market, never reflecting the current situation of overleverage, overvaluation, over bullishness, overbought markets and unsustainable profit margins. If you just expand the time frame back from 1948 to now, the Fed Model becomes irrelevant and we had a long 15 years of bear market which changes the whole picture. As popular historian Barbara Tuchman said it best back in the 1970s:

You can extrapolate any series in which the human element intrudes; history, that is the human narrative, never follows and will always foil the scientific curve.