Can The Federal Reserve Cause A Stock Market Crash?

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July 11, 2013 3:41pm NYSE:DIA NYSE:SPY

Ben_BernankeTony Daltorio:  A recent article by Paul B. Farrell of MarketWatch said that there is a 98% risk of a stock market crash before the end of 2014.

He said in the article “bubbles are everywhere. . .ready to blow.”

That’s quite a statement. One key reason Farrell expects a crash? Federal Reserve policies.

He believes that the three major bubbles that have blown up in the past two decades were caused in large part by the Fed’s loose monetary policies.

The three bubbles are: the Asian financial bubble that resulted in the Asian Financial Crisis of 1997, the Dot-Com bubble of the late ’90s and early ’00s, and the credit/housing bubble that resulted in the 2008 financial crisis.

For readers unfamiliar with the term bubble, it simply means a financial asset whose price has been driven far beyond any rational analysis of its true worth. And although they look like they will rise forever, since there is little substantial basis for the valuation, these asset prices will eventually pop just like a soap bubble.

The pop results in a substantial drop in price – in other words, a crash.

Farrell quotes SocGen’s global strategist Kit Juckes as saying all these bubbles were “fueled by the Fed keeping policy rates below the nominal growth rate of the economy far too long.” Juckes went on to call current conditions the “bubble with no name.”

He may be on to something. Even members of the Federal Reserve are worried.

In the mid-May meeting of the Fed’s Advisory Council, some members expressed “strong concerns” over the Fed’s low interest rate policies and its bond purchase program, which some members said could result in an “unsustainable bubble” in the stock and bond markets.

Thus, we’ve had the talk in recent weeks about ‘tapering’ the Fed’s purchases of bonds.

The most recent Fed meeting minutes released today (Wednesday) revealed nearly half of the FOMC members were in favor of starting to end QE this year.

But, Farrell could be a bit ahead of schedule. Money Morning Global Investing Strategist Martin Hutchinson thinks the Fed-induced bubble won’t pop until 2014.

But it will pop – and the effect will ripple through the stock market. History tells us that the Federal Reserve can and often does play a role in causing a major stock market pullback, or crash.

How the Fed Causes a Stock Market Crash

Many historians believe that the Fed was a major catalyst in the 1929 stock market crash and subsequent Great Depression.

Too much easy money in the 1920s led to the market reaching unsustainable heights. The stock market then crashed in October 1929. From early September to the end of October that year, the stock market dropped 40%.

It kept right on going, too. The stock market did not bottom until July 1932, down about 90% from its peak in 1929.

The economy followed the market down, not recovering until World War II boosted spending.

The reason for the Depression? Many believe the Fed again was responsible. But this time, the Fed was too ‘tight’ restricting monetary growth and choking any recovery in the economy or the stock market.

The next major stock market crash occurred on Oct. 19, 1987. The market crashed 22.6% in just a day, the biggest one-day percentage drop ever.

There are disagreements about the Fed’s role in the 1987 crash. But the Federal Reserve was raising interest rates the entire year before the crash. The effective Fed funds rate rose from 5.8% a year before the crash to 7.3% when the crash occurred.

Finally, with the other three crises mentioned earlier, very loose Federal Reserve monetary policy was considered a key factor in the crashes.

In the Dot-Com crash, the Nasdaq lost 78% of its value between March 2000 and October 2002. The Housing Bubble crash saw the S&P 500 fall 57% between October 2007 and March 2009.

Excessive Investor Optimism and a Stock Market Crash

Obviously, there are many factors at play besides the Federal Reserve that contribute to market crashes.

Another key part of the equation to a stock market crash has to be the human factor.

People become overly optimistic, or as former Fed chairman Alan Greenspan famously called it in a 1996 speech, “irrational exuberance.”

One signal that investors are becoming overly optimistic is the amount of stock they buy on margin. Margin is the method whereby investors borrow additional money to buy stocks in order to further leverage their positions and potentially add to their gains.

Many of the years that saw great crashes – 1929, 2000, 2007 – also saw sharp rises in margin debt.

Today, we are also seeing a rise in margin debt. In April 2013, margin debt rose to all-time high at more than $384 billion. The prior high was $381 billion in July 2007.

That now puts margin debt at 2.71% of the nation’s GDP (economic output). Historically, every time margin debt has exceeded 2.25% of GDP, a stock market crash has followed in the not-too-distant future.

Money Morning Chief Investment Strategist Keith Fitz-Gerald says that the margin borrowing figures are “very much a danger sign.” Forced margin selling, Fitz-Gerald points out, was a major contributing factor in the 1929 crash.

But, that doesn’t mean investors should run from the markets now.

“Investors need to learn to review the figures just like a big road sign,” explained Fitz-Gerald. “It doesn’t stop you from driving down the road. It just says ‘potential hazard ahead.'”

And while the Fed plans to turn off the spigot, it will do so at a leisurely pace, and the global printing presses will still run full force. So, beware the hazard ahead, but profit as the Fed bubble continues…

Related: Dow Jones Industrial Average (INDEXDJX:.DJI), S&P 500 (INDEXSP:.INX).

Money MorningWritten By Tony Daltorio From Money Morning

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