Market pricing is influenced by a multitude of factors that can change dramatically over time. What seems clear and consistent one moment can dissipate without warning the next.
The challenge in stock trading often lies in the clarity of buy and sell signals, which become evident only in hindsight. Analyzing a stock’s price chart over several years reveals patterns and trends, showcasing the ideal moments to make transactions. The perceived predictability can be misleading, creating the illusion of certainty.
In reality, the stock market can serve as a harsh teacher, imparting lessons with a dose of humility. Being correct does not guarantee success; in fact, timing can render a right decision more costly than a poor one made at the right time.
A popular misconception that has emerged over the past decade is the belief in the Federal Reserve’s ability to eliminate risk from the market. Many investors hold firm in the idea that careful adjustments to the money supply can maintain a stable, low-volatility market environment. Some even trust that during significant stock market declines, the Federal Reserve’s timely actions will lead to quick recoveries and continued growth.
Advocates of this narrative can reference the last 30 years as evidence of the Federal Reserve’s successful guidance of the stock and bond markets. But what happens if the era of the Fed’s risk-free market manipulation is coming to an end? Let’s delve into this intriguing possibility.
The Greenspan Put
When Alan Greenspan introduced the so-called “Greenspan put” after the 1987 Black Monday crash, the markets were ripe for such intervention. Interest rates had peaked in 1981 but were still relatively high, with the yield on the 10-Year Treasury note around 9 percent, allowing for ample room for rate reductions.
The fundamentals of the Greenspan put are straightforward. When stock prices decline by roughly 20 percent, the Fed steps in to lower the federal funds rate, typically resulting in negative real yields and a surge in cheap credit.
This maneuver creates two significant effects: it provides a safety cushion to prevent further market declines and inflates bond prices, as they rise inversely to interest rates. Wall Street traders quickly adapted to the reassuring nature of the Greenspan put, which alleviated much of the uncertainty surrounding market fluctuations.
Portfolio managers welcomed this arrangement, knowing that stock market downturns would bolster their bond investments. Following these dips, stocks would generally rebound, creating a cycle of opportunity that lasted from 1987 to 2016.
While market downturns like those of 1987, 2001, and 2008 caused considerable anxiety, the Fed consistently intervened with rate cuts to boost bond values and spark stock market recoveries. Few began to question the sustainability of this Fed intervention.
Expect the Unexpected
Over time, investment strategies emerged advocating a balanced approach with a 60/40 allocation between stocks and bonds. With the assurances provided by the Greenspan put, this allocation seemed sound: as stock prices fell, bond values increased.
However, in 2018, this traditional wisdom must be reconsidered: what if the classic “flight to safety” from stocks to bonds has become a flight into peril?
As we approach the next market downturn, it may come as a shock to discover that the historical relationship between stocks and bonds is not immutable. We suspect that what has been observed over the past three decades could be an anomaly of a bygone disinflationary era.
A preliminary examination suggests that before the advent of the Greenspan put, the correlation between stock and bond prices was less certain, and there were instances during the 1970s when both fell simultaneously. Such events could reoccur.
The conditions that allowed the Greenspan put to thrive stand in stark contrast to today’s environment. Interest rates are low and rising, the world is burdened with excessive debt, and extensive monetary debasement has inflated stock and treasury prices to unsustainable levels.
The specter of a significant collapse in both stock and bond markets looms near. Currently, Fed Chair Powell seems intent on ushering in this shift. We commend his determination.
However, when the time comes for the Fed to lower the federal funds rate once more, prepare for surprises. The Greenspan put—once considered a market savior—could be crushed, leaving behind chaotic market conditions that are anything but recognizable.
Sincerely,
MN Gordon
for Economic Prism
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