Category Archives: stock market decline

“Lord, What Fools These Mortals Be!” When Discussing Fed Actions And The US Economy

Many investors spend hours each week watching programs on CNBC that endlessly discuss the state of the US economy and the actions of the Fed. Most of what they say is repetitive foolish banter “signifying nothing”. They talk incessantly about actions the Fed has taken and should take, every tweet of President Trump criticizing the Fed, developments in the trade war with China, negative interest rates in Europe and Japan and recently, the inverted yield curve in the US. They then discuss and ask their guests for an opinion as to what action the Fed should take and whether stocks will go up or down or a recession is coming. Except for the opinion of an occasional guest or reference to a tweet of President Trump which they often mock as inappropriate they make almost no reference to the egregious errors of the Fed which inappropriately raised interest rates and reduced its balance sheet during 2018 and had foolishly projected further interest rate increases and balance sheet reductions in 2019. Such actions by the Fed slowed the forward momentum of the economy resulting from the once in a generation Trump tax cuts and his regulatory changes. Rather than praising President Trump for exposing the Feds errors they foolishly criticize him for interfering with the independence of the Fed and speculate on whether he is seeking political cover for the adverse effects of his trade war with China.

The Fed regulates both government interest rates and banks. Its Congressional mandates are to maximize employment, promote stable prices and moderate long term interest rates. They have become known as the dual mandates because it is assumed that if the first two mandates are met, interest rates will remain moderate. The mandates seem simple, but they are not. The Fed claims it is data dependent when taking actions. It gathers and reviews a broad range of data before making a decision to raise or lower interest rates or to increase or decrease the size of its balance sheet by purchasing or selling bonds. Then it acts in a way to best fulfill its mandate. To act wisely the Fed has to fully understand the data and anticipate future changes in the data including changes that may result from its own actions. Should it be looking at short term or long term unemployment or both? Should it assume that if the rate of expansion of the economy grows, that inflation will inevitably follow? Should it anticipate the risk of recession or stagflation?

During the Great Recession the Fed concluded that its mandates required greatly reduced interest rates and repeated doses of QE to an extent never before tried. Its actions worked spectacularly. But when the economy turned upward it lost its way. Rather than being patient (a word it later discovered) and observing the growth of the economy and its effects on inflation, it mindlessly decided to raise interest rates and rapidly reduce its balance sheet. It failed to recognize that if it could get the US economy out of the Great Recession without going through a depression, it could honor its Congressional mandate by taking actions to promote economic growth and avoid future recessions. It ignored most of the available data. It should have considered the size and rate of change of the National Debt and the GDP. It should have observed the status of and the potential effect on the GDP of the trade negotiations with China, interest rates in other countries, the affect of falling stock prices on consumer confidence and spending, the Amazon effect on the stability of the CPI, government spending, tax revenues and other data that affects the US economy. The Fed has indicated that it considers a rate of inflation of approximately 2% as being consistent with stable prices, but that it will permit rates in excess of 2%. It has recently indicated a major policy change by taking actions to extend the current expansion and avoid a recession instead of letting the expansion run its course and dealing with a recession when it occurs. Yet it has virtually ignored the aggregate interest which will be paid in future years on the swollen National Debt and the impact that its own actions in raising interest rates will have on the interest payments on the National Debt. It also ignored the effect such interest payments will have on future infrastructure spending and on the economy and employment. It acted incompetently by raising interest rates in December 2018  and announcing further expected rate increases and balance sheet sales while the major stock market averages were collapsing. Except for a limited and mostly muted criticism, comments on CNBC have ignored the errors of the Fed.

The Fed does not act in a vacuum. Its actions interact with the actions taken by Congress and the the Executive Branch. It should not be free of criticism. Its independence results from the fact that its actions do not require the prior approval of either Congress or the President. Some people argue that the President should not comment on the actions of the Fed because that interferes with its independence. That is nonsense. What the Fed does affects what the President is elected to accomplish. If it makes mistakes he should let them and the public know it. His criticism is even more important if the leftist press fails to do so. The Feds actions have a profound affect on business and investment decisions and must be considered an important part of the data it is reviewing. The Fed should be in constant contact with the Executive branch and Congress to best gage future changes in fiscal policy.

Although few people realize it, the Fed has done a terrible job of raising and lowering interest rates and justifying its actions during the last couple of years. Interest rates are currently too high and the Fed has reduced its balance sheet much too quickly. The Fed claims it is data dependent, but it pays scant attention to some of the most important available data. It focuses on a limited number of data points and is only beginning to realize that It virtually ignored much of the important data including stock market declines, the China trade negotiations and the spread between US and foreign interest rates. It seems to have totally ignored the affect that raising interest rates will have on future Federal spending if the US debt is rolled over at higher interest rates. It also ignored the adverse affect on the Federal deficit from the slowdown in GDP growth resulting from rising interest rates and the reduction of the Fed balance sheet. As noted above  in December 2018, the Fed committed a major blunder by raising interest rates and predicting three more raises in 2019 while the securities markets were collapsing. It should have looked at the data from the 1920’s when a collapsing stock market caused in large part by margin loan liquidations led to the Great Depression.  It raised interest rates when it should have lowered them. How foolish the mortals at the Fed were. Fortunately the Fed found a reason (called a “mid cycle adjustment” by Chairman Powell”) to reverse the December interest rate increase in July 2019 and stopped reducing its balance sheet, but it never admitted its December errors. It seems to strive for a 2% rate of growth in the GDP when it should not find anything less than 4% acceptable while striving for 5% or 6%. We certainly would have less fear of a coming recession if the economy was growing at a 3% rate or higher. Yet, we hear fool after fool arguing that there was no need for a rate cut. The emerging Democrat socialist left is even more dangerous. It proposes taking from the rich and the upper middle class to further enhance the already substantial welfare benefits for the lower income workers and the unemployed. It ignores the historical record of Socialism. It never works. Despite the failures of local governments, the collapse of the family and an educational system gravely in need of improvement, the rising tide in our economy produced by free market capitalism has lifted the economic well being of almost all Americans. It has offered unprecedented educational and business opportunities for poor children who take advantage of them through their individual efforts. But, we can and must grow or economy at a higher rate.

The Fed is also responsible for regulating the banking industry, a major role because loan defaults often cause a recession. Both Shakespeare and Benjamin Franklin knew about the economies of their day and the risks of debt. Shakespeare wrote “Neither a borrower nor a lender be, For loan oft loses both itself and friend, And borrowing dulls the edge of husbandry.” In those days you went to jail for debt default. Franklin said similarly “He that goes a borrowing goes a sorrowing.” Although neither of them foresaw the great benefits of debt, they warned of its risk because they worried about the affects of default. Today, Fed officials and most economists recognize both the benefits of debt  and the detriments of default on our economic prosperity. The Fed attempts to regulate bank leverage, to insure solvency against loan defaults, but does not prevent banks from making improvident amounts of high risk loans. It did not learn from the defaults that followed excessive mortgage lending on overvalued homes. Excessive margin lending to investors and loans to wildcat oil and gas drillers pose a danger to the stability of banks. The Fed should be taking action to reduce the risks associated therewith, but it is not paying adequate attention to the risks of default highlighted by Shakespeare and Franklin. The Fed should be limiting margin borrowing by reducing the 50% initial margin requirement in rising markets to protect against defaults in falling markets. It should be limiting loans by banks to high risk borrowers who use the loan proceeds in highly speculative endeavors.

We rightfully worry about climate change and the environment . The new socialist left seeks to combat it by mindlessly banning vital energy and food sources that are fundamental to the betterment of mankind. There are better ways. We are reducing detrimental emissions over time. Suppose we used our great industrial complex to build an interstate fresh water pipeline. It would enhance our water supply, let us fill our lakes and aquifers, and help us deal with the wind induced fires and the rise in ocean levels. It could be part of a national program to accelerate economic growth, improve our failing infrastructure,  create new employment opportunities, avoid recessions and reduce reliance on Fed actions.

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PREVENTING STOCK MARKET CRASHES

After every stock market crash we search for the causes and change rules and regulations to prevent future recurrences. Politicians are not well suited for the task. It is unlikely that the current rules and regulations will prevent a future crash because they fail to prevent or adequately limit use of practices which exacerbate market declines such as short selling, stop loss orders, chart theory and excessive margin buying which leads to margin liquidations in declining markets. Managers of many large pools of capital understand the effects of such practices and execute trades timed to further enhance extreme market declines so that they can then become buyers after the precipitous decline.

The talking heads on financial news networks have speculated lately on whether a 20% stock market decline like the one that occurred on October 19,1989 might occur again. They discuss the fact that a 600 point decline in the Dow is currently only about a 2% decline and that a 20% decline would amount to more than 5000 points in the Dow. They often talk about the differences in the US economy between 1989 and now, the possibility of a recession, the strength of corporate earnings and balance sheets, the trade war with China, tariffs, the effects of negative European interest rates, the rate of inflation and the Feds current stance on interest rates and its balance sheet. However, I haven’t heard them talk recently of governmental regulations or controls in place to prevent the recurrence of a 1989 type decline. The safety net value of current regulations and controls in place were about to be tested last year until the Fed reversed its course on interest rates after raising interest rates too fast and projecting ridiculously stupid further interest rate increases and balance sheet reductions. Has the Fed already forgotten the result of its successful policies which enabled our economy to escape from the Great Recession. Does the Fed understand that excessive stock market declines can lead not only to a recession, but as in the 1930’s to a depression? Fed chief Powell stupidly talks of patience when he should have admitted his error in adopting overly restrictive Fed policy decisions. 

Most of us learned from old western movies that a rancher who wishes to avoid a stampede of his horses or cattle builds secure fences or takes precautionary measures when moving his herd. Our current securities regulations and controls which are designed to stem an out of control decline were influenced by investment bankers seeking to maximize their profits by encouraging speculative practices in disregard of stock market stability. Brokers profit from charging high rates of margin interest and charging short sellers for borrowed stock. Speculators often profit in declining markets from short sales at declining prices made possible by the elimination of the uptick rule. A combination of factors acting in concert, including short selling at declining prices,  stop-loss order liquidations, margin calls, tax selling, reaching chart theory sell points and panic, cause stock price declines to be exaggerated.

Now is the time to take action to change the government regulations and controls of the securities markets to greatly reduce the probability of a crash. The Fed and the SEC should work together. Here is what I propose:

  1. The SEC should immediately reinstate the uptick rule and prevent way to avoid it. It was lunacy to remove it.
  2. The SEC should ban all new short selling when  any of the Dow, S&P or the NASDAQ averages (the “leading market averages”) have declined more that 20% from their 6 month highs; and continue the ban until all such averages have recovered at least 10% from their low point after the ban is put in place.
  3. The Fed should limit the risk of margin liquidations by changing margin requirements to provide that aggregate initial margin in an account shall be reduced to 40% during each 30 day period after which any of the leading market averages has hit a 12 month high.
  4. The SEC should change the way stop loss orders operate. Make them become good until canceled limit orders and not market orders when the stop loss point is reached. This will reduce the avalanche aspects of sales at declining market prices and discourage misplaced reliance on the protection of stop loss orders.
  5. Try to reduce dumping of large numbers of shares by active traders by charging a small fee on the dollar amount of all sales of securities held less than 5 years.

The Feds goal of full employment is negatively impacted by stock market declines. A reduction in the wealth of investors negatively impacts their spending. The Fed should stop talking foolishly about “patience” and clarify that it intends to reduce interest rates and engage in QE whenever stock prices decline significantly.

The Twitter Stock Price Roller Coaster

In the short time period since the Twitter IPO its stock price has performed as if it was riding a roller coaster.  Various factors have contributed to its meteoric rise to a peak, followed by a rapid decline. Market factors unrelated to the fair market value of Twitter shares have influenced the price movement. Prior to the Twitter offering, IPOs were in a state of great demand (which occurs from time-to-time) with investors of most IPOs being allocated less shares than requested. Many investors were purchasing  the unallocated portion of their subscription as soon as the IPO commenced trading. The Twitter offering was highly glamorized by the financial press. Twitter shares like those of many other IPOs immediately skyrocketed in price. Twitter has many loyal users who were unable to obtain an allotment on the IPO and they and other investors for various reasons elected to buy the shares in the after market. Chart theorists added fuel to the fire as they determined buy points as the Twitter stock price rose and gathered momentum. As the stock price rose far above the IPO price it attracted short sellers. However, as ofter occurs when short sellers sell into a rapidly rising market, they get squeezed and panic, one-at -a-time, and cover their shorts at ever increasing prices, thereby driving the stock price higher. 

When the price of Twitter shares peaked and started to decline, various factors, acting in a manner similar to the way that gravity effects a roller coaster car, precipitated the decline. Some analysts withdrew their support based upon market capitalization and recommended sale . Stop loss orders, which have become fashionable and which were placed at various levels during the share price increase, began to be executed at declining prices, creating selling pressure. Chart theorists interpreted sell signals. Short sellers, who follow the analyst reports, know about the existence of stop loss orders and understand chart theory, exacerbated the decline by selling short at declining prices. As the stock declined, margin calls and tax loss considerations came into play and some unsophisticated stockholders sold in panic. 

Like a roller coaster the ride will stop at the bottom. If Twitter can generate revenues and profitability from its large number of followers, its shares will begin to rise again. If, as I expect, the rise occurs, the SEC should conduct an investigation as to when every short sale took place to try to determine the role of short selling in exaggerating stock market declines.

Short Selling Does Not Promote Pricing Efficiency

Only fools, who do not understand the interplay of short selling with  chart theory, stop-loss orders, margin calls, and panic selling in market downturns, think that short selling is a price discovery mechanism that leads to pricing efficiencies. In fact, it generally exaggerates price swings. Short selling is often used as a manipulative device and it should be banned or carefully regulated. The up-tick rule should be reinstated immediately. In addition, all short selling in a security should be banned when its price has declined substantially from its 52 week high.

You should read the short chapter entitled “Short Selling and Stock Market Manipulation” in my book entitled “Perpetuating American Greatness After The Fiscal Cliff”. My earlier book entitled “Homeland Security And Economic Prosperity” written after 9/11 and the bursting of the .com bubble, but while the up-tick rule was still in effect, proposed strengthening the up-tick rule to prevent bear market raids by short sellers. Subsequently, the SEC ignored the bear raids in 2007 and 2008 and ignorantly eliminated the up-tick rule. My original paper on the subject was written while I was a third year law school student in 1963. Since then SEC regulation of bear raids has gotten worse, not better.

Beware Of The Role Of Short Selling And Stop Loss Orders In The Current Market Decline

For months we listened to investment experts on financial news programs advise investors to protect their positions against a market correction by using stop loss orders. As stock prices rose investors, who heeded the advice of these experts, placed stop loss orders at increasing price levels. As a result an inverse ladder of stop loss orders was created. When international currency issues and other factors set off a moderate market downturn some of the highest stop loss orders were automatically converted into sell orders and the market decline accelerated. Short sellers who have been on the side lines were able to accelerate the decline by selling short on downticks. They know the price on stock charts that chartists interpret as a sell point and begin to sell short on downticks in an attempt to encourage sales by chartists, the execution of stop loss orders and panic by fearful investors. The combination of stop loss orders, chart theory, short selling on downticks and ultimately panic and margin calls may set off a stampede leading to further market declines. Domestic and international economic growth are important to stock market activity, but the above described technical factors have a significant impact during a stock market market decline that may, because of the wealth effect and fear, lead to a downturn in economic activity.