Freud, the Fed, and a Box of Chocolates

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Includes: DIA, QQQ, SPY
by: Eben Esterhuizen

"Children begin by loving their parents; after a time they judge them; rarely, if ever, do they forgive them" - Oscar Wilde

I was happy that I didn't have to wait too long for the subway to arrive. Two bucks gets you a ticket, garlic gets you a seat. When the doors opened I was welcomed by a screaming boy with a face covered in chocolate ice cream. He was terrorizing his embarrassed mother about something she didn't buy him a few minutes ago. The brat was about five years old, and this was probably not the first time he transformed into a screaming little devil after things didn't go his way.

"Shut up Anthony. I'm going to smack you!" she threatened, wagging her finger in his face, but precious little Anthony kept going. He probably figured out by now that mommy wasn't going to slap him in public. Freud would have had a field day with Anthony's hegemony over his mother. She quickly threw in the towel. "OK, I'll tell you what. If I give you some chocolate will you keep quiet?"

Voila! Problem solved by a box of chocolates (ever wish the world could be that simple?). After gulping down a Mars Bars as if his life depended on it, Anthony took it down a notch and the rest of the subway ride went smoothly. The mother gave a sigh of relief as they got off at Union Square station.

But why should you care about a box of chocolates and a five year old bundle of joy on the New York City subway? Think of the stock market as a spoiled little brat, and the Fed as a nanny trying to keep the rowdy kid under control. If interest rate cuts are like pieces of chocolate, then Freudian psychology offers some scary insights.

Greenspan's Fed, the nanny between 1987 and 2006, was always ready to pull the trigger and cut interest rates to support stock markets. This unofficial policy created the so-called "Greenspan Put", which is just another way of saying that life between 1987 and 2006 was like a box of chocolates. Ben Bernanke's Fed took over in February 2006. Was the new nanny going to be stricter? Or was this going to be the same nanny with a beard?

A few months ago the spoiled brat threw a tantrum when a Bear Stearns hedge fund with sub-prime exposure collapsed and a credit crisis ensued. The brat started testing the limits of the new nanny. Stock markets rallied ahead of the Fed's meeting in August 2007, expecting a 25 basis point cut, and Bernanke surprised markets when he cut interest rates by 50 basis points. The little monster got more chocolate than he bargained for, and it looked like the new nanny was going to be a pushover. During this time the spoiled brat learned an important lesson: keep throwing tantrums, bully the nanny and there will be enough chocolate to sink the Titanic.

Getting back to last week's trading - markets were fully priced for a 25 basis point rate cut, and sold off when the Fed 'only' cut interest rates by 25 basis points. The spoiled brat wanted more more more!

Credit markets have created toxic derivatives that are now threatening the livelihood of the broader economy, which is why the following Freud quote is so relevant in context of our "spoiled little brat" example: "Innately, children seem to have little true realistic anxiety. They will run along the brink of water, climb on the window sill, play with sharp objects and with fire, in short, do everything that is bound to damage them and to worry those in charge of them, that is wholly the result of education; for they cannot be allowed to make the instructive experiences themselves."

A box of chocolates isn't going to solve everything. It took a long time to create this credit market monster, and it will take a long time to sort out the mess. Maybe the Fed should consider incorporating some parent psychology into policy? After all, it's not easy growing up. And why do you want to invest in a market acting like a spoiled little brat that just wants more more more?