As an asset class, stocks are long overdue for a comeback.

Yes there was a very good five-year run that started in 2002, when the smart money went in after the dot.com bubble bust. But in general terms, the real money was not being made in stocks per-se. The fortunes were made speculating in securitized real estate derivatives.

For the sake of the general public: Securitizing real estate derivatives is a fancy way of saying that mortgage loans are packaged into more liquid, transferable assets, very much like stocks or funds –hedge funds to be more specific– which can be bought and sold at lightning speeds by hedge fund traders, who make their money not in the profits resulting from the trades, but on the commissions generated by these trades. Needless to say, in almost every case commissions greatly outpaced profits. Under normal circumstances, even though a high-risk proposition, securitized derivatives are legitimate financial instruments to create liquidity and cash flow for use in other investments. The problems begin when anything and everything gets securitized without proper oversight or research, just for the sake of generating commissions; an environment in which any dimwit can make money

Again, for the general public: The financial markets did not suffer a major setback due to the 9/11 events of 2001. These events merely provided a dramatic historical backdrop, underscoring the series of market corrections that had been underway for almost two years.

The upward trend of the stock market from 2002 to 2007 was a concerted, technical move to regain lost ground, establishing a value level similar to the one in place prior to the 2000-2002 bust. From this newly gained ground, further, important rational moves can be staged.

We all know now about the rise of residential real estate as a speculative asset class, which in its five-year run –parallel to the stock market– frothed itself into another bubble bust. What happened, just as much as what happened during the dot.com boom, is that everyone and their neighbors were suddenly into real estate investments of all kinds. Some, the more prudent, initially got into actual property trading, buying and –flipping– residential properties for a profit. Soon, the bright lights figured out that the money in flipping was too slow. So they created trusts in which private shares in future developments were sold to partners ≠public and private– creating cash flow which was used to purchase property for multi-family residential projects, or… to speculate in financial instruments.

Again the bright lights turned on. Hey, they said, if we securitize these deals, and if we allow more deals to happen (in collusion with their banking brethren), there will be a ton of money to be made, regardless of the success of the bricks and mortar developments themselves. Knowing that the life span and potential profits of real estate development has its limitations, it was just a matter of time before financial speculation in real estate derivatives became both a means and a goal. And a bust.

I don’t know for a fact that the Federal Reserve is, is not, was, has never been, has always been, a political tool. The dirty work of political economics has traditionally been a job for the Treasury Department’s leadership; the financial policy maker of choice for incumbent administrations, bolstering and furthering the governing party’s agenda.

With all the talk about the new tax stimulus, loan refinancing, cheap inter-bank loans, and spurious money auctions, it is clear that the current administration is bent on deflecting the downward draft of the subprime fallout. It is also clear that some of this administration’s dearest friends, the Saudis, the Japanese, the Euros, etc., have been talked into separating themselves from a few of their reserve dollars, sending them our way in the form of bargain-bin purchases of large chunks of the US economy (for the record, given the opportunities provided by a cheap dollar, I think this is a good thing and is what real globalization is all about).

Yet, all of the above did not matter an inch to the stock markets.

It is with not so detached bemusement that one watches how, in spite of all the utterances and the political policy agitation stemming from the office of the Secretary of the Treasury, it is to the actions of the Federal Reserve that the markets seem to respond. Very literally.

I happen to hold in high esteem what used to be perceived as the technical approach of the current Federal Reserve Board. But there is undoubtedly something political afoot. In fact there seems to be a trampling herd running back and forth, with cowboys and other superheroes trying to avoid a stampede. This unusual untidiness is not the choice approach of technical economists.

Until recently, the attempts at curtailing the effects of the subprime mortgage problem were all focused on helping out the defaulting institutions: banks, hedge funds, and the hedge fund operations of said banks.

That’s when the markets showed their spite and dropped.

Between October of 2007 (the rout really started in August but there was a bounce, much like a last gasp) and January of 2008, the US markets had a combined paper loss of over two trillion dollars. To put this in perspective, the current tally for the subprime defaults is “only” in the lower 100 Billions and, using a living example, has not officially reached the running total of the cost of the Iraq war (for those who think that the war in Iraq was detrimental economically and did not contribute to the business boom from 2003 onward, think again, it did, just not in the right places).

The market’s loss is ten times more (that’s just in the US), give or take a few depending on which set of numbers you use. The difference is that the loss is mostly on paper, not yet redeemed because the markets are now at the bottom of a huge, overdue, necessary correction in its multi-year rise, and the smart money does not sell into a slump (unless you’re into shorts, which is what got us into the subprime financial mess to begin with).

Why did the markets drop? Simple. To protest the Federal Reserve’s playing favorites with the lending institutions at the current administration’s request.

How? Why?

Those who stand to benefit the most from nominal interest rate reductions (overnight, lending and otherwise) are the banks. And the nominal interest rate reductions that were offered up until earlier in January, had no important bearing on the trading markets.

Thanks to the internet, the trading markets, unlike banks and established financial institutions, are open to anyone with a yen and the stomach for trading. It turns out there are a lot of folks with a yen and a stomach for the markets. All these folks, keen on horse sense, know a bum steer when they see one, and we all saw a bum steer in the Federal Reserve’s politically pressured monetary moves late last year.

If the Fed is going to act on political pressure, implementing monetary policy for the benefit of banks and hedge funds, why should it not include the markets as well, we all want to know? And even more to the point, why is the current administration blatantly favoring the bail out of those institutions involved in real estate investments, an industry now known to be a mismanaged bursting bubble?

The markets are suffering ten times the losses. If the government is going to tinker with monetary policy in a self-avowed capitalist system, why not be fair across the board and provide market bail out incentives as well?

I really do not advocate the above. But hey, everyone should get a break if breaks are given.

It is my contention that the Federal Reserve, paying due notice to what the markets were indicating, was pressured to get involved in some serious horse-trading with the current administration, substantially lowering interest rates, to a point where these rates finally become of interest (all puns apply) to the trading markets.

For the benefit of the general public: It seems that you, the general public (US and worldwide) can easily co-exist with about 5% interest, a comfort level tied to economic conditions associated with the best of times. That is: If economic conditions are stable, with inflation in check, and growth proceeding at an easy pace, everyone loves the 5% interest paid to them for their treasuries, money markets, checking accounts, CD’s, etc. But just make the financial environment mix a little more interesting (subprime mortgage defaults for example), and comfort levels go crazy.

The trading markets do not thrive in too stable an environment. There is not a lot of money to be made without the right amount of volatility. Nothing untoward mind you, but enough to make it interesting and worthwhile. We had five years of a relatively stable stock market environment where the people in charge of making money got antsy, creating a new asset class out of home equities which eventually, through mismanagement and overwrought expectations, had a necessary face-to-face with reality.

Now that housing as an asset class has been duly chastised for impersonating tradeable securities, and now that the markets are at very decent value levels, the time is ripe for the general public to return to stocks. All cautionary caveats still apply about market risk, and stocks should still be chosen with care. But truth be told, the current market slump is one of the best stock buying opportunities to come around in a decade.

If only the Federal Reserve would stop horse-trading…

It is all in the making and it is what we make it to be.

Michael Mehl