by David Roskoph, MBA, CFP

Did the Federal Reserve Actually Create That Bubble?

In the rearview mirror, trillions of dollars have just evaporated. Gone. I spend the better part of each day in the often frustrating pursuit of understanding financial markets and have been beside myself trying to explain the unusual behavior of US equity markets since late summer of 1998. After exhausting every academic rationale, all that remains is a curious irreverent conclusion. It involves the most respected quasi-public, quasi-private institution on earth, the Federal Reserve Bank (FRB of Fed).

In the fall of 1998 a funny thing happened on the way to the Federal Reserve meetings. Arguably, things were fine in this great union of ours but Asia, the Soviet Union and Brazil were experiencing financial difficulty. As US markets roiled from the potential impact of external factors, the FRB dramatically cut interest rates three times; two separate cuts occurred on the same day! All things being equal, when interest rates get cut, equities go on and sale and US equity markets took off (chart 1), or did they? At that crucial intersection, a divergence emerged as the highflying tech companies powered on to ridiculous valuations (both those with/without earnings) while the average equity began a steady decent. In addition to dramatically cutting interest rates, the Fed pumped up the money supply. although almost everyone considered Y2K a nonevent, the Fed was so unsettle that they kep the printing press on 24/7 to guard against money being stockpiled into mattresses. Equity prices follow the money supply (chart 2) and by early 2000 we were awash in a sea of paper money. It made the Fed seem hopelessly out of touch, but was it? While the bubble inflated, Al Greenspan assured his critics that the "asset bubble" could only be recognized in the rearview mirror." Remember that in addition to affecting interest rates and the money supply, speculative excesses could have easily been tempered by raising margin requirements. Margin borrowing had skyrocketed and was a sure sign of speculation. This was never even seriously considered.

Also in the fall of 1998, a tidal wave of innovation was building worldwide with the potential to dilute the US concentration. No one was sure of how the new technology would alter the economy or who the eventual market leaders would be. Therefore, precise financing was impossible and the global financials were high. In my opinion, the Fed indirectly financed the technological renaissance by finding any excuse to pour money into the economy. The deluge averted a small recession by flooding all companies with financing, tankers and dinghies alike. Alan Greenspan went from repeatedly calling the markets "irrational" to now standing in awe of their "immeasurable" new efficiencies. In the fall of 1998 the Fed went from its historical role as lend-of-last-resort to the opposite end of the spectrum now functioning as investment banker for the United States. Its role reversal exacerbated, if not created this asset bubble.

The bubble is now deflating in time to compound the recession postponed since the fall of 1998. Except now the circumstances point to a much more protracted slowdown of over one year.

Exposing the fragility of financial markets for the last year has not been the most popular position because no one really wants his of her hopes diminished. Most vested interests on Wall Street promote going with the crowd, buying every dip and the certainty of higher valuations, As an independent financial advisor, who has questioned such hype for decades, I feel responsible to expose the efficiency with which such vested interests have separated investors from their hard-earned capital for centuries. Whether a fad involves weight control or an investment scheme, the results are usually unsustainable. Appreciating risk when establishing a plan and sticking to it will always beat chasing the crowd.