The Last Believers: Government Grabs the Bag with Both Hands
The following is a sample from Elliott Wave International's new 40-page report, The State of the Global Markets -- 2013 Edition: The Most Important Investment Report You'll Read This Year. This article was originally published in the October 2012 issue of The Elliott Wave Financial Forecast.
When government gets into the act of speculation, the top is usually way past having occurred. Government is the ultimate crowd, every decision being made by committee. It is always acting on the last trend, the one that is already over. (For example, the Federal government passed securities laws to prevent the 1929 crash...in 1934.)
-- The Elliott Wave Theorist, 1991
In November 1999, The Elliott Wave Financial Forecast demonstrated the usefulness of this socionomic precept when the Glass-Steagall Act -- the post-1929 crash statute the U.S. government adopted to "purportedly protect" the financial industry from itself -- was effectively repealed. Citing the government's role as "the ultimate bag holder," EWFF stated, "The U.S. government may have just provided one of its greatest-ever demonstrations of this principle." That was four months after the all-time high in the Real-Money Dow (Dow/gold), and two months before the all-time high in Dow/PPI. Both indexes have been in a bear market ever since.
On Sept. 1, 2012, the U.S. Federal Reserve upped the ante in the latest test of our "ultimate crowd" theory when it introduced QE3, an "open ended" $40-billion-a-month mortgage-buying program. The U.S. central bank further stated that it intends to keep the Fed Funds rate at effectively zero for the next three years. In time, the Fed's herculean effort to stimulate the financial markets and the economy, with the sanction of government, will illuminate the authorities' role as the last believer in the old trend even more brilliantly than Congress' passage and repeal of Glass-Steagall, at the beginning and end respectively, of a Supercycle-degree bull market. To understand how social mood's long-term positive trend influenced the Fed's actions, we need to travel back to the central bank's creation, which occurred in the wake of a major downside reversal in mood.
The Federal Reserve was established (not at all coincidently near a major bottom in 1914) at least partially as a response to the Panic of 1907. In an effort to prevent financial panic from ever happening again (pipe dream #1), the Fed was mandated to restrain the "undue use" of credit in the "speculative carrying of or trading in securities, real estate or commodities." (Sound like a familiar mix?) When runaway financial speculation burst forth in the late 1920s, the Fed rose to the challenge, or at least tried to. In "The Stock Market Boom and Crash of 1929," economist Eugene White wrote, "The Federal Reserve had always been concerned about excessive credit for speculation. Its founders hoped the new central bank's discounting activities would channel credit away from 'speculative' and towards 'productive' activities. Although there was general agreement on this issue, the stock market boom created a severe split over policy." According to economist Murray Rothbard, Herbert Hoover and Federal Reserve Board Governor Roy Young "wanted to deny bank credit to the stock market." In August 1929, within days of the Dow's ultimate peak, the Fed acted, raising the discount rate to 6%.
As our opening quote from the Theorist notes, government moves by consensus only, so it did not make structural changes deemed capable of preventing another crash until 1934, two years after social mood ended its negative trend and the stock market bottomed. In a bid to strengthen the government's capacity to curtail "overtrading," the Securities Act of 1934 also gave the Fed power over brokerage firms' margin requirements. In the early stages of the bull market, the Fed did not wait long to use its authority. In April 1936, it raised the initial margin requirement on NYSE shares from a range of 25 to 45%, to 55%. Considering that the unemployment rate at the time was 15% -- nearly double its current level -- this act represents an exceptionally conservative stance. Stocks retreated for a time, only to race back to new highs three months later. The Fed responded by "doubling reserve requirements (against deposits) from August 1936 to May 1937," right up to and briefly past the March 1937 Cycle wave I stock peak. Economists Christina and David Romer state that the Fed was "motivated by fear of speculation and inflation."
The all-important upper line of the Supercycle-degree trend channel that dates back to that 1937 peak is shown on the chart on the next page (download the full report for access to the charts). After the next touchpoint, the Cycle wave III peak in February 1966, a speculative binge accompanied the Dow's double top in 1968-1969. The Fed felt compelled to act again in June 1968 by raising margin requirements to 80%, once again "to curb speculation." The Fed also pushed the discount rate to 6% in April 1969. In 1970, then-Fed Chairman William McChesney Martin famously stated that his job was "to take the punch bowl away when the party is getting good."
By 1974, with the DJIA touching the bottom channel line, the Fed acknowledged the bearish trend of Cycle wave IV by reducing NYSE margin requirements for stock purchases to 50%, where they remain today.
In 1984, a Fed study "cast significant doubt on the need to retain high initial margins to prevent excessive fluctuations of stock prices." When the Great Asset Mania finally pushed the Dow through the top of its Supercycle-degree channel line in 1996, Fed-mandated margin hikes were taken completely off the table. In December 1996, after the Dow made its first decisive break through the top of the channel, then-chairman Alan Greenspan issued his famous "irrational exuberance" comment, citing "unduly escalated asset values." Yet, unlike his predecessors, he did nothing to change margin requirements. A margin debt explosion in early 2000 "prompted some policymakers to debate the idea of changing margin requirements to stem possible speculative excess," but a Federal Reserve paper issued the day after the S&P's March 23, 2000 peak ("Margin Requirements as a Policy Tool") quashed the idea: "The bulk of the research indicates that changes in requirements do not have a significant permanent effect." Ultimately, though, the Fed stayed true to its historical pattern of raising the cost of credit near the end of upside extremes along the trendline, hiking the discount rate to 6% in May 2000.
In 2006, with the Dow once again pushing to new highs above the top of the trendchannel and the real estate mania at peak pitch, the Fed raised the discount rate one notch higher, to 6.25%. In a critical change, however, it did not wait for the Dow to reverse course before easing again. In the first stage of a bear-market prevention effort that continues to this day, the Fed reduced the discount rate to 5.75% in August 2007, two months ahead of the Dow's October peak.
Various government-sanctioned financial bailouts also coincided with the developing stock market reversal. The almost instantaneous impulse to "do something" represented a historic departure from previous behavior. EWFF's November and December 2007 issues noted that government bailouts generally "appear successful because they tend to come at lows," and added that the 2007 bailouts were "too close to the market's peak" to work. The word "appear" is actually the key to that forecast, because it is a reference to the actual cause of the market's reversal: a change in the direction of social mood. This change is far more powerful than any action the Fed might take to induce a desired market outcome. What matters is not the specific action that the Fed may take, but the fact that it feels compelled to act by virtue of the social pressures under which it operates.
In the case at hand, the Fed's long-standing objectives have been reversed. Instead of exercising its original mandate to restrict excessive speculation, the Fed is doing everything in its power to keep buyers' animal spirits alive, even as the Dow is at its 75-year upper trendline.
The open-ended nature of the promise to provide quantitative easing indefinitely and the stated objective of creating a wealth effect in the form of higher stock prices are unprecedented. "Fed Aims to Drive up Stocks," says a September 14 Washington Post headline.
Here's the basic plan in Bernanke's own words: "If people feel that their financial situation is better because their 401(K) looks better, they're more willing to go out and spend, and that's going to provide the demand." Never mind the foolishness of the demand-theory of economic growth.
Just as The Elliott Wave Theorist theorized in 1991, the Fed is getting into the act of speculation with the top long past. It will pay a steep price for goosing the old trend near its end and for fighting the new trend as it begins.
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This article was syndicated by Elliott Wave International and was originally published under the headline The Last Believers: Government Grabs the Bag with Both Hands. EWI is the world's largest market forecasting firm. Its staff of full-time analysts led by Chartered Market Technician Robert Prechter provides 24-hour-a-day market analysis to institutional and private investors around the world.