Never before in America have we witnessed government debt at this level and a monetary expansion so great. How did we arrive at this juncture? Where does this road lead? How has it affected the financial markets? This may well be one of the most challenging investment climates in modern history. To put this into proper perspective, we'll need to go back to the 1930s and The Great Depression.

1934: The Great Depression

After more than a third of all U.S. banks folded between 1929 and 1933, the federal government intervened. You can actually trace the recent housing crisis back to the National Housing Act of 1934, which established the Federal Housing Administration (FHA). Back then, racial discrimination and segregation were common. A year later, in 1935, the Federal Home Loan Bank Board (FHLBB) asked the Homeowners Loan Corporation (HOLC) to survey 239 cities and determine which areas carried a greater risk of loan default. As a result, many minority communities were deemed ineligible to receive loans. This was a significant factor of inner city decay as it caused an exodus of businesses and individuals, leaving buildings abandoned, which eventually became a magnet for illegal activities such as drugs and other practices.

In the 1960s, a sociologist named John McKnight coined the phrase redlining to describe the practice. In essence, a line was drawn around areas deemed to be higher risk for lenders, insurance providers, and other services. But compassion would prevail.

1977: The Federal Government Gets Involved

During the Carter administration, the Community Reinvestment Act of 1977 (CRA) was passed to help alleviate the problem of discrimination and make home ownership more attainable for minorities. However, this was a law without teeth. Then, in the 1990s, during the Clinton administration, the law was amended and for the first time punitive measures were added. Basically, lenders were required to make a certain percentage of their loans in these underprivileged areas. This expanded the number of potential home buyers and set the stage for one of the most catastrophic financial events in modern U.S. history, the housing bubble. The CRA was fully embraced by the Bush administration and by 2006, the peak of U.S. home prices, the ratio of median home prices to median income had risen from its historic norm of approximately 3:1 to almost 5:1. In other words, home prices were growing at a much faster pace than incomes. There were many others who were complicit in the 2008 crisis, including rating agencies, mortgage bankers, brokerage firms, and others. To avoid a more serious crisis, the Fed began its unprecedented expansion of the money supply, first with T.A.R.P. (Dec 2008 to Aug 2010), then QE II (Nov 2010 to June 2011), Operation Twist (Sept 2011), and finally QE III (Sept 2012 to present). Our national debt has almost doubled since 2008, standing at over $17.5 trillion today. To be clear, without T.A.R.P., we may have experienced another depression. However, the real consequences of the Fed's actions have yet to be seen, as it will eventually have to change course and tighten monetary policy (i.e.; raise interest rates and reduce the money supply). Why has the Fed embarked on such an aggressive policy?

The Fed & The Wealth Effect

The Fed is charged by Congress with two primary goals. They are: 1) full employment; and 2) stable prices. To clarify, full employment is an unemployment rate less than 4.0% to 5.0% (approx). Stable prices relate to the Fed's inflation target which is around 2.0%. However, since our economy is measured by its GDP (gross domestic product), and since 67-70% of GDP is based on consumer spending, the consumer is clearly the most important part of the equation. To encourage consumer spending, the Fed has engaged in a type of psychological warfare, which is referred to as the wealth effect. Here's how it works. Consumers have a choice as it pertains to their money; they can spend it or save it. The Fed is hoping they will spend it and is acting accordingly. How? First, the Fed reduced short-term interest rates to near zero, which made savings accounts very unpalatable. However, individuals could still invest in bonds. Bonds are greatly affected by changes in interest rates. For example, when interest rates rise, bond prices fall and bond investors lose principal (at least on paper). In 2013, the rate on the 10 year U.S. Treasury rose about 1.09% in only 65 days! This caused great concern among bond investors. As a result, a large amount of bonds were sold as prices fell. This also made investors wary of bonds as they believed interest rates might continue to rise. That leaves stocks. In short, the Fed has been trying to push investors into stocks for several years. Why? Because if enough investors do this, it will increase demand for stocks, which will help push stock prices higher. This is precisely what has happened. When the stock market rises, investors feel wealthier and tend to spend more (in the aggregate). That's how the wealth effect works. Has it been successful? Well, stocks have certainly risen far beyond the expectations of institutional investors, hedge fund managers, etc. In fact, this prolonged rise, from an historic perspective, has been longer than most bull markets. It's been referred to as "climbing the wall of worry." Why? Because of the belief that the other shoe could drop at any time. The consensus view is that stocks have risen primarily because of Fed policy. In other words, when the Fed changes direction and discontinues its monetary expansion and raises interest rates, stock investors will need a very large parachute as prices are expected to plummet. Contrary to historic norms, stocks continue to rise despite a negative 1.0% GDP during the first quarter of 2014. Although most economists blame the economic contraction on the harsh winter weather, and perhaps that's correct, one more quarter of negative GDP would result in a textbook definition of a recession. And recessions are not good for stocks. However, most do not believe the second quarter GDP will be negative. Whatever the case, cash is out, bonds are risky if rates rise, and stocks are in a potential bubble. We all know what eventually happens to bubbles.


Is this one of the most challenging periods for investors in the modern era? A recent survey of advisors indicated that portfolio management is the most concerning issue today. It's certainly not a time to leave your portfolio unattended, as another precipitous fall in stock prices may be lurking just around the corner. After all, any significant political or social event, a natural disaster, or even a change in Fed policy could easily cause panic and a significant correction. Stay tuned as we continue to watch this story unfold.