May 11, 2008
In Part I of this two-part article, “Has Executive Order 12631 Effectively Ended the Era of Free Markets?” I discussed publicly made statements by various officials of the U.S. Federal Reserve that indicated they would resort to free market intervention and manipulation “if necessary”. Since many of those statements have been made, there have been fierce arguments about whether or not the U.S. Federal Reserve takes such actions during periods of crisis. Such behind-the-scene actions, were they to occur, would certainly bring into question numerous legal, moral, and ethical issues. Just because former Board Member of the U.S. Federal Reserve Robert Heller stated that it is quite easy to manipulate stock markets and reverse free-market behavior through the purchase of stock futures, does this mean it happens? Of course not.
But a quick glance at market behavior ever since the Working Group has been formed, especially in the past several months, seems to indicate that some form of behind-the-scenes free-market interference occurs at regular intervals during crises. In past articles on my blog, I reviewed statements of finance ministers from the G7 nations in which they admitted they were undertaking secret actions out of the public eye for fear that public knowledge of their actions would destroy the very effectiveness of their actions. To me, this sounds like an incredible admission of propping up action. Recently, “the SEC said it aims to slash margin requirements for institutions and hedge funds on stocks, options, and futures to as low as 15%, down from a range of 25% to 50%.” At a time when overleveraged funds have collapsed and created great stress in the global financial markets, a decision to allow funds to increase their leveraged positions seems not only foolish but seems to have no purpose but to prop up stock markets.
Furthermore, within past several months, enormous drops in U.S. stock markets that have been triggered by overwhelmingly negative earning news and macroeconomic statistics at market opening have inexplicably experienced miraculous mid-day turnarounds time after time after time despite the absence of any positive news. What possibly can cause investor sentiment to turn on a dime and spur indexes that have plunged by 250 or 300 points at the opening of markets to perform inexplicable rallies in intra-day trading to recover all losses by market close? Additionally, when mid-day recoveries have not occurred in the face of large one-day drops in U.S. stock markets, miraculous rebounds have often followed the next day or within a matter of days numerous times over the past couple of months, almost always triggered by futures reports that have reported inexplicably sharply higher numbers prior to market opening. Again these rebounds in futures markets that are then manifested during actual trading sessions have occurred with little positive news or sentiment that would rationally explain such marked and sharp turnarounds.
For example, just within the past two months, here is an incomplete list of huge down days in the Dow that have been followed by miraculous rallies the following day or just days later. March 6th: – 215 points, March 11th: +417 points; March 13th: -194 points, March 18th: +420 points; March 19th: -293 points, March 20th: +261.37 points; April 11th: -256 points, April 16th: +256.80 points. Furthermore, consider these huge intraday turnarounds just within the past two months. March 3rd: Down 163 points but by day’s end, rallied to close just about even; March 5th: Down 100 points but by day’s end, rallied to close 54 points higher. March 7th: Down 250 points but by day’s end, rallied to close only 150 points down, and so on and so on. Again, though some of these rallies were triggered by specific actions such as the introduction of a $200 billion Term Auction Facility on March 13th that triggered that March 18th rally of 420 points, on multiple other occasions, there were no overt, visible actions that could possibly have explained such turnarounds.
Instead, the negative news that caused the steep plunges were not counter-balanced by the release of any positive economic news, yet the market continued to miraculously right itself just a day or several days later. Of course, the media has explained such rebounds as attributable to bargain hunting investors that seek to take advantage of buying stocks that they perceive to be on sale. I, for one, do not buy this explanation. When fundamentals are positive and a plunging stock markets undeservedly drag good stocks down with them, then yes, bounces make 100% sense. But when bounces happen after company declarations of the worst losses in decades, this is extremely irrational and without logic. Were the accusations that the Exchange Stabilisation Fund, the U.S. Federal Reserve, the Commodities Futures Trading Commission, the U.S. Treasury and other entities meddling in free markets true, detractors of these accusations claim that it would be easy to spot the extra money that is flowing into the system to prop up markets. For example, people claim that were the U.S. Federal Reserve actually executing free-market intervention maneuvers behind the scenes that the various money supply reports released by the Feds would illustrate this.
This claim could only hold up only if numerous other assumptions were made. For example, one would have to assume that no money that would be included in the M3 money supply numbers would be used in market intervention tactics. Why? Because the Feds stopped publicly releasing details of the M3 money supply more than two years ago on March, 2006. Secondly, one would have to assume that whatever entities might be injecting money supply into the system to prop up markets would include these figures in reports released to the public. If concealing money supply sounds like a ludicrous concept, just remember that the U.S. government has systematically and purposefully removed most of the greatest contributors to inflation from their calculation of the CPI over the past two decades. If inflation numbers reported today don’t approximate true rates of inflation then why should we assume that money supply figures are honest as well? Finally, money could theoretically be passed through any of a number of other entities of which the general public is unaware (such as the Exchange Stabilisation Fund) to avoid detection.
After all, even though a Presidential executive order established the Working Group on Financial Markets in 1988, people disputed its very existence for years. Only when government officials began to publicly mention it by name did the argument surrounding its existence finally die. But this isn’t even where all the speculation ends. In recent years, there also have been numerous allegations that the big banking institutions on Wall Street have informal agreements to prop up the stock market with well-timed purchases of certain stocks to boost investor confidence during periods when confidence is faltering. Of course, the only way to ever prove these allegations is to be privy to the innermost circles of these banks, so it can never be done (for one such example of such possible manipulation, consider anomalies that have surrounded GM stock). Again, comments by Fed officials themselves keep these accusations alive. According to the Financial Times, a Fed official who asked to remain anonymous told them that they considered “buying U.S. equities” — not just futures to prop up stock markets after the 9/11 terrorist attacks. The Fed, said the official, could “theoretically buy anything to pump money into the system,” including “state and local debt, real estate and gold mines, any asset.”
However, it is not just words, but circumstantial evidence that gives credence to the notions that free-markets do not exist during times of crisis. Consider the following. In May, 2008, American homebuilder D.R. Horton (DHI) reported a net loss of $1.31 billion, or $4.14 a share, compared with net income of $51.7 million, or 16 cents a share, in the year-earlier period. Analysts polled by Thomson Financial had expected a loss less than 1/10th that amount of only $0.39 a share. Consequently, D.R. Horton halved its quarterly dividend. The rollercoaster in share price for DHI that ensued during the next 24 hours was indeed of an extremely curious nature. During pre-market trading, after DHI announced that losses were 10 times greater than expectations, the price of DHI shares plummeted more than 5%; however, by the time the market closed that day, DHI shares miraculously rallied more than 10% on abnormally high trading volume to close 5.5% higher in share price. Abnormally high trading volume, of course, is almost always indicative of institutional participation.
On that same day, Fannie Mae declared losses of $2.2 billion for the quarter (a loss of $2.57 a share versus earnings of $0.85 per share a year ago). On this terrible news, FNM rallied 17% higher off of its lows (probably a greater swing because I can’t recall what Fannie Mae’s pre-market lows were that day) on extremely abnormal trading volume of over 65 million shares (versus its 3-month daily trading volume of slightly more than 25 million shares). While this certainly provides no proof of collusive behavior among Wall Street firms to prop up markets, only an insane person would not wonder why some of the worst earnings declarations in decades would cause abnormally high buying volume. In addition, one could make similar arguments of extremely curious rallies for most of the major financial stocks such as Citigroup (C), Lehman Brothers (LEH), and many others in recent weeks. In the end, whether the Working Group’s direct intervention in free markets is limited or excessive and whether Wall Street firms collude to drive the price action of individual stocks will always remain a question without any hard answers.
Most recently, on May 7th, the U.S. markets plunged 206 points. The following day in Asia almost every major market also experienced significant losses. If one were to argue that free market intervention were indeed occurring, given that general global sentiment remained negative in the 24-hour span between the close of the U.S. market and its open the next day, one would have predicted that futures for the Dow prior to market open would rally illogically higher. And indeed this happened. If free-market interventions are happening out in the open, is it likely that free-market interventions are occurring behind-the-scenes? Yes. John Maynard Keynes once very wisely stated that “the market can stay irrational longer than you can stay solvent.” The real question that needs answering is this: Do markets behave irrationally longer than investors can stay solvent because of free-market intervention?
The Federal Reserve’s bailout of Bear Stearns was so unprecedented that it even caused former Federal Reserve Chairman Paul Volcker to criticize the Fed’s decision as “rais[ing] some real questions” about whether their free-market intervention was within the scope of their authority. In fact, Volcker was so troubled by the Fed’s intervention that he declared the Bear Stearns bailout as “absolutely” not “what you want for the longstanding regulatory support system.” Volcker further stated, “To meet the challenge, the Federal Reserve judged it necessary to take actions that extend to the very edge of its lawful and implied powers, transcending certain long-embedded central banking principles and practices.” Perhaps the Federal Reserve has already proceeded beyond the edge of its lawful and implied powers from behind the scenes.
Several weeks ago, I wrote a blog titled “Will Markets Crash Now or Later?” that was primarily inspired by my analysis of current solutions being implemented by the ECB and the U.S. Federal Reserve that continue to neither address nor fix the root causes of this current financial crisis. I think the answer to the debate of whether the U.S. Federal Reserve is interfering in free-market behavior behind-the-scenes will ultimately be revealed by the answer to this question. If the U.S. Federal Reserve is engaging in manipulative behind-the-scenes behavior to prop up stock markets as many claim, then this behavior should ultimately lead to a very steep and painful crash. Remember former Federal Reserve board member Robert Heller’s commented that “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, thus stabilizing the market as a whole.”
Well, we already know that the Federal Reserve has flooded the economy with liquidity because this was done in clear view of everyone. If they are also indeed compounding this problem by intervening in free markets to prop up stock markets, it is almost certain that such meddling in free markets will eventually end in disaster. Of course there are always those that argue that propping up of markets can continue en perpetuity until another bull leg is manufactured. Some say that this is exactly what happened in previous years during times when the market was poised to crash. This time around, however, the crisis is just too big for free-market intervention to succeed on such a stunning level if it is indeed happening.
However, perhaps I am asking the wrong questions in the first place. Instead of asking if the Working Group really intervenes in free markets to prop up stock markets, perhaps the truly relevant question is why the Federal Reserve is not focusing on the drafting and implementation of sound fiscal policy that would make the issues in this article moot? The best policy of all would be to implement sound fiscal policy versus a loose credit, easy monetary policy that creates inflationary environments all over the world (due to the fact that all major markets still peg their currencies to the U.S. dollar).
Perhaps the more pertinent question is what will happen to financial markets if other countries tire of the rising inflation that the U.S. Federal Reserve is creating worldwide and they unpeg their domestic currencies from the U.S. dollar?
Perhaps the more pertinent question to ask is why Central Banks all over the world continue to create stock market and real estate bubbles with loose credit, high monetary growth policies that later require unprecedented emergency rate cuts to prevent market crashes?
Just this past week, an IMF official continued to attribute problematic inflation to rising prices instead of properly explaining that the falling dollar and the debasement of other currencies is the root of rising prices and thus inflation. A focus on honesty instead of deception and sound fiscal policy instead of destructive fiscal policy would be a good start. The best policy of all would be to implement and enforce a strong U.S. dollar policy that would allow free market forces to guide markets all the time so that circumstances that necessitate direct intervention by the U.S. Federal Reserve never arise. Perhaps wise monetary policy would not spark comparisons from the Governor of the Reserve Bank of Zimbabwe to the most recent actions undertaken by the Bank of England and the U.S. Federal Reserve:
“Here in Zimbabwe we had our near-bank failures a few years ago and we responded by providing the affected Banks with the Troubled Bank Fund (TBF) for which we were heavily criticized even by some multi-lateral institutions who today are silent when the Central Banks of UK and USA are going the same way and doing the same thing under very similar circumstances thereby continuing the unfortunate hypocrisy that what’s good for goose is not good for the gander.”
In a country where the unsecured loan interest rate now tops 5,000% and inflation as of April, 2008 just surpassed 164,800% (yes, those figures are not misprints), it would be comforting if such comparisons were laughable instead of warning signals, no matter how politically motivated and self-serving they may be. But perhaps that is just wishful thinking.
[tags]DHI,C,FNM,LEH,GM,Working Group on Financial Markets, Plunge Protection Team, market manipulation, free market interference[/tags]