< Back to all posts
  • Another Market Head-Fake

    Brian S. Wesbury - Chief Economist 
    Bob Stein, CFA - Deputy Chief Economist
    Date: 2/10/2014

    What happened to stock markets over the past few weeks is nothing new. It’s been happening off and on for the past four years and eleven months.

    Ever since mark-to-market accounting was fixed in March/April 2009, the stock market has been rising along with profits and the economy. But very few investors understand why things turned around so abruptly in 2009.

    As a result, every time the stock market declines, economic data hits a soft patch, or fear is stirred by dour reporting on one issue or another, the “sky is falling” mentality takes hold very rapidly again. All of this happens because conventional wisdom is that the only reason the economy is recovering and stocks are up is because the Federal Reserve has done Quantitative Easing (QE).

    But, as we have written before, the entire narrative of what happened back in 2008/09 is mistaken.

    First of all, the entire subprime crisis was about $400 or $500 billion dollars of bad loans. Yes, those are large numbers, but in an economy that was producing $15 trillion of GDP each year, it’s just not enough to cause a cataclysm.

    Rather, it was an accounting rule – mark-to-market accounting – that created losses for financial institutions well in excess of the true problems in the housing market. This rule forced financial firms to sell mortgage-related assets into a fire sale, markets became illiquid and prices fell to levels well below fundamental value. Without mark-to-market accounting, the crisis would have remained contained.

    We’re not saying firms should never mark assets to market. The rule makes sense when firms are always ready to sell an asset. But the rule makes no sense at all when markets seize up and no sane owner would sell an asset but for the erosion in capital caused by the accounting rule itself. If in the absence of the rule asset owners would just wait out the storm, then the only justification for marking an asset down in value is if it is truly credit impaired, which wasn’t the case when the homeowners backing the assets were still paying their mortgages.

    But instead of focusing on fixing this rule, the US government invented policies – TARP and QE were the big ones – to fill the hole in bank capital caused by mark-to-market losses. Both TARP and QE started in October 2008 and in the five months following the start of these policies, the stock market fell an additional 40%, with financial stocks down significantly more.

    It was not until the Barney Frank and the House Banking Committee leaned on the Financial Accounting Standards Board to fix the excessively rigid rule that things turned around. The hearing was announced on March 9, 2009, the exact day the market hit bottom. The rule wasn’t officially changed until early April 2009, but by then markets had already anticipated a new rule. It was the change in this rule that stopped the crisis, not TARP and QE.

    Our main point is that the crisis was never actually as bad as many thought, and the recovery has not been just a “sugar high” based on QE. As a result, “tapering” is not as dangerous and the odds of a return of the crisis are minimal.

    The economy, profits and stock prices are rising because of “real” economic developments – fracking, new computer software, communication technologies and the impact on energy production and productivity are driving growth. Yes, the economy could be doing even better, but we shouldn’t ignore real improvements either.

    The bottom line is that while so many people view the recovery as fragile and fake, they are missing the important narrative outlined above. Instead, the economy and markets are much more robust than the conventional wisdom believes. When markets fall right now and fear overwhelms so many, opportunity abounds.

    This information contains forward-looking statements about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time and are the opinion of the individual strategist. Data comes from the following sources: Census Bureau, Bureau of Labor Statistics, Bureau of Economic Analysis, the Federal Reserve Board, and Haver Analytics. Data is taken from sources generally believed to be reliable but no guarantee is given to its accuracy.