In the period from 1999 to 2003 or so, the Fed lowered rates and created liquidity. That masked some underlying issues -- not the least of which is governmental debts at the local, state, and federal level. Investors seek returns, and money in a low-interest economy moves to either bond price gaming or equities. Stocks and commodities rise as the dollar falls: inflationary, in Austrian/Chicago terms, not the same as consumer inflation (a point I've made several times, since Paul Krugman and others misrepresent the notion of inflationary pressures in Austrian theory).
Basically, the Fed is the "buyer of last resort" for government debt and some securitized loan debt. All of these purchases mask government debt and risks, because the securities purchased are from the housing GSEs and student loans. (With student loan debt at $1T we have a bubble in education, too.)
So, here's why stocks might rise (for now) and mask the structural problems of our economy:
Why This Is 'Best-Looking' GDP Drop You'll Ever See: The darker scenario, in fact, is actually bullish for stocks, which have ridden the wave of $3 trillion in central bank liquidity to eclipse five-year highs and push towards a new record.
Fed Chairman Ben Bernanke "has to keep the economy high as a kite. He has to make sure we don't sober up and realize how screwed up we are," said Peter Schiff, founder and CEO at Euro Pacific Capital in New York. "We don't have a real recovery. It's an illusion, it's a drug-induced high. The minute you take away the drugs we come down. We can't stop easing, ever."
Schiff is concerned that a recession looms that will dwarf the financial crisis woes, a condition he attributes to an overzealous Fed that should stop creating money and generating inflation.When the student loan, new (but smaller) housing, new (and also smaller) tech, and energy bubbles go "pop" it will not be pretty.
Are stock undervalued based on P/E? Absolutely, in historical terms. But, you invest based on the likely forward earnings of companies. What if these bubbles pop in the next two years, accompanied by municipal bankruptcies (Detroit, I'm looking at you), and other stresses?
My guess, and it is only a guess, is that we are still headed for another mild recision. It might be in late 2013 or even as remote as 2014. But, I am convinced something is going to snap before the next four years are up. This will put extreme pressure on Washington to do something to demonstrate fiscal restraint. But, I don't have any faith that our leaders will do the right things.
I am also waiting for California and other states to magically discover higher tax revenue forecasts are incorrect, along with growth forecasts. Anticipated surpluses will be short-lived or never appear.
Let's hope I'm wrong about our elected leaders and the Federal Reserve.
Milton Friedman and others have written that liquidity is needed during a downturn. It isn't only a Keynesian idea. But, there is a major difference between helping consumers and simply shifting government debt from bucket A to bucket B. The Depression was a liquidity crises, but now officials are responding in ways that only help the investor class. That's not surprising, but it is worrisome.
If the "doves" win and we keep cutting rates without significant job growth, we will be emulating Japan.