The Fed: A Team Player for Wall Street

We’ve all seen the painful results of the Internet bubble. Many of us have experienced it personally.

I won’t recount them here for fear of rubbing salt in wounds that still haven’t healed.

But I do want talk about what I see coming ahead, because I think the results will be similar to that of the Internet bubble: There’s another market disaster coming and this time it might destroy all of the markets.

First, I want to briefly take you through the series of events since the Internet bubble and explain to you where we are today and what to expect in the future of the markets.

A Series of Unfortunate Events

When the Internet Bubble burst in the spring of 2000, investors were still unaware of the disasters ahead.

At that time, the NASDAQ slowly deflated from its high of 5000 eventually down to a low of about 1200 over the next two years. And unfortunately, many investors rode the market all of the way down, not knowing what to do, waiting and hoping for a rebound. And I was there, right in the middle of it all as a successful asset manager in Wall Street’s best trading firm.

The whole situation disgusted me to the point that ultimately caused me to leave the industry.

It was only when many stocks were at multiyear lows did Wall Street start issuing sell signals. But it was too little too late.

Do you remember JDSU, NT, SUNW, RMBS, RHAT, BRCD, INFO, CIEN, NXLK? The list goes on. All were disasters.

But it wasn’t all bad in 2000, as the Dow and S&P 500 continued to do well. But soon, the controversial presidential elections of 2000 caused these markets to drift downward and most people felt they would recover once a clear winner was named.

Wrong.

The markets continued their weakness in 2001, and when 9-11 occurred, all the markets crashed. Despite a reasonable rebound a few weeks later, the economic data continued to get worse.

Then came an avalanche of corporate accounting scandals-Enron, WorldCom, Tyco, Halliburton, America Online, and a host of Internet and telecommunications companies once esteemed by research reports from Wall Street’s top analysts.

The chickens had come home to roost.

By this time, investors finally had it, and the markets plunged to new lows. For traders, this was a sign that a technical bounce was due. It did.

All of these events caused the Fed to issue a series of rate cuts that brought short-term rates down to 40-year lows. And soon, long-term rates followed and were too at multi-decade lows.

After the market lows in late 2003, the economy appeared to show signs of improvement, with strong consumer spending and GDP in 2004. The only problem was that consumers were fueling the economy by increasing their debt, using their houses as virtual ATMs. And this dangerous behavior still continues today.

Low mortgage rates are fueling a real estate boom that has been enhanced by loose restrictions on credit. Meanwhile, home equity loans continue to be as much in vogue as the iPod.

Throughout this time, the Fed has applauded the economic "recovery." It’s a joke wrapped in a Seinfeld plot.

Fiction: The Economy is Improving

The fact is that consumer spending has occurred on borrowed money from home equity loans and record levels of consumer debt. In 2005 alone, Freddie Mac has estimated that Americans will turn $204 billion of inflated real estate into cash by taking out additional home equity loans.

Meanwhile, corporate earnings have not been good overall, and corporate spending has been frozen for nearly five years now.

Remember in the spring of 2005 when earnings were "great"? Why didn’t the market go back up? The fact is that corporations have been focusing on cost-cutting and that has been the main force that has improved the bottom line.

Record consumer bankruptcies continued to rise and peaked in the summer of 2004. As well, record foreclosures have continued and have helped to fuel the real estate bubble.

And while these levels have tapered off, they are still extremely high and not far off from their peak.

With the household savings rate at an all-time low of 0%, consumer debt at an all-time high, record Federal and trade deficits, a prolonged military conflict in Iraq, a weak dollar, record energy prices, a state and corporate pensions under funded, social security a mess, and a healthcare crisis that keeps getting worse, how can anyone claim our economy is even getting better?

In fact, with record energy prices expected to get even higher, interest rates climbing due to the Fed’s wasted efforts to push inflation down, we are on the edge once again and I expect things to get worse over the next few years.

I know, you’re grabbing for the bottle of Prozac, right?

Take two.

Fact: Wall Street is on Their Side, Not Yours

Ladies and gentlemen, unfortunately, the bad times are not over.

As a matter of fact, I believe the market is going to get much worse. But don’t expect Wall Street or the Fed to alert you until it is too late, because they have their own hidden agendas.

Quite simply, the task of Wall Street is to generate business. And during my experience working for Wall Street’s best firms, I have found the vast majority of analysts to be not only useless, but dangerous.

Understand this. Even though we are in bear market, you still hear every talking head on CNBC singing the praises of a renewed bull market.

Ahem, the NASDAQ sits at 2178, roughly 56% below its March 2000 highs.

But let me say this: A year from now, we might be wishing for 2178… as I think the real estate bubble is about to take the markets lower.

The Fed: A Team Player for Wall Street

When it comes to the Fed Chairman, his loyalty lies with the U.S. government, which means his goal is to help the economy remain strong. And when the economy is weak, he will downplay the problems in order to preserve the economic engine-consumer confidence and spending.

You see, because consumer spending makes up over 70% of all economic activity in the U.S., it is important for consumers to remain confident in the economy and to continue to spend.

That is precisely why the Fed cut short-term rates to almost nothing and allowed the consumer finance industry to ease credit restrictions for home equity loans and mortgages.

Greenspan realized that consumers wouldn’t have the cash to keep the economy afloat unless he let them borrow it for close to nothing. What has essentially occurred is that consumers have been fueling the small gains in the economic recovery with borrowed money.

And now that interest rates will soon reach the historic mean of around 5%, (in order to combat the inflation caused by high energy prices) the real estate bubble is ready to burst. And when that happens it is going to devastate the markets.

When interest rates are low, property values increase because the total price required for a residence declines due to lower financing costs. In contrast, when rates head north, property values decline since the total financing cost is higher.

This wouldn’t be much of an issue if people were buying homes for residential use, but estimates are that over 25% of all home purchases in 2004 were by investors.

Normally, real estate is a great hedge against inflation, but not when real estate has been purchased at inflated prices.

We clearly have a major problem at hand.

Next week I’ll tell you how there’s simply no wiggle room in the market for a mistake. If the real estate bubble bursts… if energy prices go higher… your retirement money could get wiped-out in a nanosecond.

Sincerely,

Mike Stathis
Managing Director, Apex Venture Advisors