Is the Fed rigging the stock market?

Evidence suggests the central bank is creating another bubble.

By Anthony Mirhaydari Jan 5, 2010 6:56PM

MirhaydariThere is a long list of reasons that home prices reached such fantastic heights in 2006 before collapsing. But most of the blame can go to the Federal Reserve for keeping interest rates too low back in 2003 and 2004. Tech-stock mania, in turn, can also be traced to low interest rates in the late 1990s.

 

There are a number of ways in which one can judge Fed policy. Wall Street practitioners like Tom McClellan of the McClellan Market Report find that the yield on 2-year Treasury notes "has a long history of telling us what's coming" from the Fed. Right now, just as it did back in 1999 and again in 2004, the 2-year T-note suggests the Fed is keeping rates too low. It suggests short-term rates should be more than 1% instead of zero.

 

TrimTabs Investment Research CEO Charles Biderman takes it a step further in a recent report, asking whether the Federal Reserve and the U.S. government have artificially inflated the stock market. For the more conspiratorial among you, here's an excerpt from Bilderman's report:

 

As far as we know, it is not illegal for the Federal Reserve or the U.S. Treasury to buy S&P 500 futures. Moreover, several officials have suggested the government and major banks could support stock prices. For example, former Fed board member Robert Heller opined in the Wall Street Journal in 1989, "Instead of flooding the entire economy with liquidity, and thereby increasing the danger of inflation, the Fed could support the stock market directly by buying market averages in the futures market, thereby stabilizing the market as a whole."
This type of intervention could explain some of the unusual market action in recent months, with stock prices grinding higher on low volume even as companies sold huge amounts of new shares and retail investors stayed on the sidelines. Some market watchers have charted that virtually all of the market’s upside since mid-September has come from after-hours futures activity.

Bilderman's remarks were based on an analysis of the possible sources of the $600 billion in net new cash that was needed to boost the U.S. stock market capitalization by $6 billion since March. The usual sources, such as retail investors and pension funds, could muster only about $100 billion, according to the TrimTabs team. The rest had to come from somewhere.

 

Bilderman's findings are intriguing but mostly conjecture because of the spotty quality of the data available. Also, I think he misses the obvious bubble candidate: long-dated bonds. 

 

The Fed has been openly buying some $1.7 trillion worth of long-term bonds since last March, which is something it hasn't done since the 1950s. Back then, the Fed was forced to buy government debt to keep borrowing rates down during World War II. Today, the Fed is making purchases to support housing by keeping mortgages cheap. In an effort to fight foreclosures, we're using the same tools that helped defeat the Empire of Japan and the Third Reich.

 

As these purchases are phased out over the next few months, long-term interest rates will continue to move higher. This will cause long-term bond prices to fall, causing this new "bond bubble" to deflate. Stock investors will benefit, just as they did in the 1950s and 1960s as capital was moved from falling bonds into rising stocks. See my post from last week for more on this topic.

 

My positions

 

My portfolio at Wall Street Survivor continues to benefit from the new-year rally. I've added to a number of my positions, including Russian steelmaker Mechel (MTL) and the Direxion 3x Financial Bull (FAS). I also started three new positions that will be detailed in future posts: KKR Financial (KFN), Polaris (PII), and Las Vegas Sands (LVS).

 

Overall, my portfolio is up 43% since it was started in September and has gained 3.6% over the past two days versus the 1.5% gain for the S&P 500.

 

Disclosure: The author does not own or control a position in any of the funds or companies mentioned.

 

Anthony Mirhaydari is a researcher for the Strategic Advantage investment newsletter. He can be contacted at anthony.mirhaydari@live.com. Feel free to comment below.

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