The Federal Reserve's manipulation of the stock market no more that a ‘Ponzi Scheme’

By Sinclere Lee

The Federal Reserve's manipulation of the stock market that caused stocks to rally last week is just another sign that the game is up for the US economy. As dumb investors cheered the Fed's decision to cut interest rates to helped soften the ongoing credit worries because of subprime loans…. Unfortunately, the result of the Fed’s action for most investors is a classic ‘Ponzi Scheme.’

The Dow Jones industrial average gained about 230 points, or 1.8 percent, after soaring more than 300 points earlier in the session. The blue-chip average snapped a six-session losing streak. We all know that the stock market is over valued, perhaps as much as 30%, and the Fed’s interference is only making things worse.

The broader S&P 500 (up 32.71 to 1,443.98, Charts) climbed nearly 2.5 percent to end higher for the second straight session while the tech-fueled Nasdaq composite index (up 53.09 to 2,504.16, Charts) rose about 2.2 percent to close higher for the first time since last Wednesday.

Just 10 days after reiterating that inflation was its main concern, the U.S. Federal Reserve's policy-setting panel made a 180-degree turn on Friday, laying the groundwork for an interest rate cut as early as next month. For the week, the Dow, S&P and Nasdaq were all down slightly.

A ‘Ponzi Scheme’ is an investment swindle in which some early investors are paid off with money put up by later ones in order to encourage more and bigger risk. The Fed keeps the scheme going by infusing money into a broken system.

In cutting the discount rate charged on direct Fed loans to banks by one-half percentage point in a surprise early-morning move on Friday, the central bank stopped short of a full shift in monetary policy, holding its main interest rate steady.

But the central bank also signaled to panicked markets that it stood ready to act more aggressively, perhaps as early as its next policy meeting on September 18, when financial markets expect the main overnight federal funds rate to be cut.

"In effect, (the Fed) is setting aside its inflation concerns and opening the door to a cut in the target federal funds rate to support growth," Global Insight economists Nigel Gault and Brian Bethune wrote in a note to clients.

Analysts said the move addressed the immediate problem that has been rattling global financial markets in the past week — the free flow of cash. Concerns about who might hold dreaded subprime-related assets in their portfolios left many lenders suspicious and wary of handing over money.

"A sense of calm has come over investors, supported by the actions of the Fed," said Art Hogan, chief market strategist at Jefferies & Co.
But, that’s apart of the scheme to keep you investing and when the bottom falls out of the stock market, and it will, your ass will be up shit’s creek without a paddle. Sell Now!

"Just knowing that the Fed is ready to assist is reassuring," Hogan said. Going forward, however, "we'll have to wait and see how the market reacts to the next piece of negative news," he added, referring to ongoing troubles with risky U.S. mortgages and the credit market.

"Volatility is going to be the norm for a while."

After a tumultuous week, all three major gauges jumped out of the gate on news that the Fed cut the discount rate, which the central bank charges qualified lenders — mainly banks — for temporary loans, by half a point to 5.75 percent, taking Wall Street by surprise.

The move, while largely symbolic, was an attempt by the central bank to "promote the restoration of orderly conditions in financial markets," the Fed said in a statement.

While the Fed did not cut its more closely watched Fed funds rate, the action did calm nervous investors who have been gripped by uncertainty about how hard the subprime mortgage and credit market problems would hit the broader economy.

Overseas, European markets finished sharply higher after the Fed discount rate cut. Mexican and Canadian markets were also higher. But Asian markets tumbled Friday, with Japan's Nikkei index skidding 5 percent, posting its worst day since the Sept. 11 attacks.

Did Wall Street get a break Friday when the Federal Reserve cut the discount rate?

What they're not likely to get a break from anytime soon though is the extreme stock market volatility that's kept them on edge for months.

Stocks jumped Friday after the Fed made the rare move of cutting its largely symbolic discount rate in a bid to help restore faith in the badly shaken credit markets.

The rally followed Thursday's rollercoaster ride, when the Dow bounced back from a 342-point drop to close down just 15 points - but only after the market fell far enough to get near a "correction" of 10 percent from the highs hit just last month.

Although the Fed didn't cut its more closely tracked federal funds rate, which affects consumer loans, the nation's central bank did cut the discount rate - which affects banks and other lenders.

The move was important symbolically, showing that the Fed is aware that the subprime lending crisis has shaken financial market confidence over the summer. It was also significant, analysts said, in that it could egg on banks who were previously too wary to lend money. This in turn could help a variety of financial stocks and by turn, the broader market.

But what the Fed move probably won't do, analysts say, is end the day-to-day seesawing that's been the stock market's MO during this unusually busy summer on Wall Street.

"You've gone from complete despair and pessimism on the part of investors to a calming but still very fluid and volatile period ahead," said Ned Riley, chief investment strategist at Riley Asset Volatility probably won't disappear because the problems with the mortgage and credit markets aren't going to go away, said Ben Halliburton, chief investment officer and founder at Tradition Capital Management.

"You're going to see more hedge fund problems, more funds withdrawing money and hedge funds getting shuttered," Halliburton said. "Stock volatility will likely remain high through year-end."

The Fed's move Friday will a help but a temporary one, the analysts say. In the long run, this shit’s gone crash!

"It's a Band-Aid on a gunshot wound," said Chris Johnson, chief investment officer at Johnson Research Group.

The impact of tightening credit after a period of great liquidity has roiled markets all summer, coming after the housing market collapse and fallout from problems in the subprime mortgage market - loans made to consumers with bad credit.

A variety of mortgage lenders - including Countrywide Financial (Charts, Fortune 500) most recently - have suffered dramatic financial setbacks, while investment banks such as Goldman Sachs (Charts, Fortune 500) and BNP Paribas have had to freeze withdrawals from certain funds because of deteriorating market conditions.

The fallout has sent stock markets around the globe falling and spurred central banks worldwide to infuse billions into their banking systems. In light of the ongoing worries, Friday's discount rate cut and a cut in the fed funds rate next month are unlikely to reverse the ongoing problems in the markets.

"The bottom line is the credit situation, the subprime situation, and the confluence of all these items runs a lot deeper through the Street than a Fed move or even a Fed rate cut can fix," Johnson said.

The move soothes some of the nerves in the debt market for the time being, but to think longer-term problems have dissipated would be "naive," said Ryan Atkinson, vice president and market analyst at Balestra Capital.

"By lowering the discount rate, the Fed can target those banks that were too worried to lend money," Atkinson said. "That will settle things in the short-run, but won't help the long-term issue."
The smart money speaks

For stock market participants, the most important takeaway from the Fed move, and especially the statement, is that the bank has changed its emphasis from the last Fed policy meeting Aug. 8, said Riley.

"There was a fear that the Fed was so focused on inflation that it would risk the economy suffering," he said. "So it's encouraging that the bankers acknowledge that the economy is at risk of being undermined by the credit crisis and deterioration in housing."

The acknowledgment gives the bank room to cut rates at the next policy meeting on Sept. 18, something the market would like.

But on the downside, the acknowledgment could also spell bigger problems farther down the road, said Stephen Leeb, president at Leeb Capital Management.

"The statement shows that the Fed doesn't have many tools available to both fight inflation and keep the economy on track and that it's willing to tolerate higher inflation rather than a slowdown in economic growth," Leeb said. "Inflation is going to be a big concern for the markets six or 12 months out."

Leeb said that's because economic growth worldwide continues at a rapid pace, despite recent signs of a U.S. slowdown.
Your best moves in a crazy market

While stocks could rally another day or two, the market is likely to remain volatile through the next Fed meeting and perhaps through the end of the seasonally weak month of September, analysts said. Beyond that, a traditional fourth-quarter rally could follow.

"If there's going to be another wave down, it will happen in the next month or so, but beyond that, it could move higher," said Steven Goldman, market analyst at Weeden & Co. "The seasonal factors come into play in the fourth quarter of the year, which might be a good time for base building."

Leeb said that although stocks may slip back to Thursday's low over the next few months (about 1370 for the S&P 500), stocks likely won't slip much lower.

"I think we saw a bottom yesterday," Leeb said. "You had record volume yesterday and now you have the Fed doing what the market wanted today."

As such, it's reasonable to suggest that the major gauges could end the year at or just above the 2007 highs hit in mid-July, the analysts said.

That's assuming that the Fed follows through on the implications of Friday's cut by cutting the more influential fed funds rate at the September meeting.

Fed funds futures on the Chicago Board of Trade show investors betting the Fed will cut rates by at least a quarter-percentage point in September. The fed funds rate currently stands at 5.25 percent, where the central bank has held it since August 2006, after raising rates 17 times in a row starting in 2004.

But if the Fed doesn't follow through by cutting the fed funds rate at the next meeting, stock markets would probably be very disappointed, analysts said. That could spark another leg down.

"A rate cut at this point seems to be a necessary evil for the stock market," Riley said.

Speculation was a favorite pastime for market watchers trying to divine the Fed's motivation, with a range of theories circulating. Part of the speculation was that the Federal Reserve might have been preparing to act in its role as a lender to a financial institution if one were in trouble. The Fed statement made no such reference.

The message to the financial community seems to be, it is safe to lend as normal, and the central bank will be standing close by, but the current situation does not rise to the level of a special rate cut outside of regularly scheduled meetings.

In an unusual between-meetings statement, the rate-setting Federal Open Market Committee said "downside risks to growth have increased appreciably," and noted that "tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward."

The word "inflation" appears nowhere in the statement.


That was a sharp departure from the message from the Fed after the FOMC's last meeting on August 7, when policy-makers acknowledged tightening credit was hurting some households and businesses, but said the economy seemed likely to maintain its moderate pace of growth, "supported by solid growth in employment and incomes and a robust global economy."

"This, to me, is the functional equivalent of withdrawing the bias toward tightening and replacing it with a bias toward easing," said Lyle Gramley, a former Fed governor and senior economic adviser with the Stanford Group in Washington.

Gramley said the Fed's action would help restore confidence in markets overwrought by a sense of fear and panic that what began as a meltdown in the U.S. subprime mortgage sector was beginning to unravel credit markets.

He said the credit market turmoil had the potential to slow the U.S. economy, adding, "I would say the odds of recession are now 50-50."

Judging from market reaction early on Friday, where stocks rose and safe-haven Treasury bonds gave back some of their recent gains, the Fed succeeded in pacifying rather than spooking anxious investors braced for the next financial disaster.

The Fed was stuck in the uncomfortable position of trying to prevent a credit crunch from derailing economic growth, while avoiding the appearance that it was riding to the rescue of investors who took extreme speculative risks on easy credit.

Some market participants were screaming — literally, in the case of CNBC commentator and hedge fund manager Jim Cramer — for a rate cut as global markets tumbled and banks, hedge funds and companies scrambled for suddenly scarce cash.

While the central bank likely bought itself the luxury of waiting until its next scheduled policy meeting to cut interest rates instead of a more dramatic mid-meeting move, critics pointed out that the Fed did nothing to address the underlying problem of easy credit leading to excess.

"Markets should not be calmed by this tactic. Unlike the Fed funds rate -- which affects all banks' cost of funds — a discount rate cut only lowers the cost of emergency borrowing by institutions in distress," High Frequency Economics wrote in a note to clients.

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