The Friedman Effect: Is Another Bear Market Around the Corner?
by Dr. Mark Skousen, Advisory Panelist
Tuesday, June 23, 2009: Issue #1024
In 1961, the great free-market economist Milton Friedman wrote a paper called “The Lag in Effect of Monetary Policy,” wherein he discovered a six- to nine-month delay in how long it would take for a change in monetary policy to be felt in the economy and the stock market.
Since then, it has been known as “The Friedman Effect.”
It’s important to understand the Friedman Effect because it can have dramatic impact on your investment decisions and your portfolio…
Milton Friedman and The Friedman Effect
Basically, Milton Friedman found that if the Fed switched from tight money to easy money, or vice versa, it would take about six months before you would see any change in the direction of the economy or Wall Street.
The Friedman Effect worked like clockwork during the financial crisis of 2008. In late 2007 and early 2008, the Fed decided to squeeze the money supply and impose a credit crunch on the financial markets to slow down the real estate boom. The Fed got more than it bargained for. Its tight-money policy had a dramatic impact – the real estate market crashed and took the financial markets with it.
The Fed panicked and in September, 2008, Ben Bernanke & Co. reversed course and injected billions of dollars into the marketplace. The Fed’s balance sheet (see chart below) doubled in a few months as the Fed acted aggressively. Among other bold efforts, the Fed bought Treasuries and mortgage-backed securities directly in an effort to stem the tide of a deflationary collapse.
As you can see from the above chart, the Fed’s bank account (Adjusted Monetary Base) doubled in short order in 2008-09.
The Friedman Effect – Pinpointing The First Signs of Recovery
According to the Friedman Effect, that means the first signs of a recovery and stock market rally would occur six months later. Sure enough, in March, 2009, Wall Street bottomed out and roared ahead in one of the strongest rallies in Wall Street history. The S&P 500 Index has climbed an incredible 34% from its lows of March 8.
Moreover, we’ve seen sure signs of stabilization in the financial markets and the economy. The Libor rate – the interest rate banks charge each other to borrow short term – has fallen sharply, an indicator that the financial crisis is ending.
Many economic indicators have also turned positive. On Thursday, the Labor Department announced that the total number of people filing for unemployment insurance fell by 148,000 to nearly 6.7 million in the week ending June 6. That was the largest drop in more than seven years, and snapped a streak of 19 straight record-highs.
The best overall indicator of a possible recovery is the U.S. Index of Leading Indicators published monthly by the Conference Board, a private research group based in New York. The Ten Leading Indicators are designed to forecast the economy in the next three to six months. Most of the indicators are business related, such as new orders for capital goods, building permits and unemployment claims – and, I might add, the stock market and real money supply growth. The Conference Board also surveys the leading economic indicators for 10 other countries around the world.
The Board reported that the U.S. Leading Indicators fell sharply over the past year, and finally bottomed out – in March of this year! The leading indicators have now risen two months in a row. And on Thursday, the index rose 1.2%, the biggest gain since March 2004.
- In short, the good news is that the U.S. economy is slowly but surely on the road to recovery.
- The bad news is that the Fed has apparently decided to step on the brakes again, reversing course in its monetary policy. The days of quantitative easing are apparently over. As the graph above indicates, the Fed has stopped adding to its balance sheet – the adjusted monetary base has stopped growing.
The broader-based money supply (M2) was growing at double-digit rates until a few months ago. Now’s it’s growing at only 2% or less.
This tight money policy could spell trouble down the road if it continues. The stock market will probably continue to push higher for now, due to the lag time in the Friedman Effect. The Dow might even reach 10,000 by the end of this year. But if the Fed maintains this new tight money policy, we could be in for another rough period and a return of the bear market.
Good investing,
Mark Skousen
Related Investment U Articles:
- Are the Bears Going Back into Hibernation?
- The Catalyst That Could Save Obama’s Job… And Push Stocks Higher
- You Can No Longer Trust This “Leading” Economic Indicator
- China Attempts to Jump-Start Economic Growth
- Forget the “January Effect”… Use The “Siegel Indicator” Instead
8 Responses to “The Friedman Effect: Is Another Bear Market Around the Corner?”
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Isn’t the Fed’s “stepping on the brakes” the action that is necessary in the wake of the Fed’s overactive, interventionist role in the reovery efforts? Isn’t it a subtle move back towards a free market economy.
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Madoff was just the tip of an iceberg that has started a melt down which is not even visible at street level. Wait another 6-9 month and then you’ll see the real market deformity/monstrosity that greed has propagated. Nothing religious just as natural as the Friedman effect!
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Until we see more easily accessible jobs, we are not over this…Obama & Bernake gets some credit for slowing the freefall, but we have yet to do anything to reverse the damage.
We should of been WEANED off the leveraged loans, not had the rug pulled out from underneath us. Most do not realize that the subprime borrowers got a 3% hike OVERNIGHT on their rates – that’s what started this chaos, then they took away subprime loans right after.
Of course that created a catastrophe – who wouldn’t expect that?
The borrowers, mortgage professionals all got blamed – what about the government allowing this to begin with???
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The rally has been noted for its low volume. The reversal this week seems significant. The Fed seems to be confused. The administration wants money pumped into the economy faster. Isn’t this part of a “perfect storm” being created for the continue decline of the dollar and new lows for the market? Wouldn’t this upturn since March 9 be a bear market rally based more on hope than substance?
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Well, call me just plain stupid if you like but I don’t get it. Why are you guys asking us, the readers of your stuff, the questions? Isn’t it supposed to be the other way around? Are we really supposed to pay you for the honor to say that we are headed for another Bear turn around get ready? If you and Friedman are so smart, how come you didn’t tell us to get out of the market when the chart skewed to the upside and excuse me, just too stupid again to see any 6 month lag and even if I did it would be then too late. Thanks anyway I’ll give you an E for effort although I’m still suffering from my last grade of F, for FOOL, not listening to my own understanding but rather leaning on yours (the professional).
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Raging bear market. Raging, I say. Kinda like the 70s. Hey, maybe disco will make a comeback.
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Catherine above is spot on. Until the authorities fully understand the anatomy of the sub-crime crises , from the position of the predatory lenders and their gullible burrowers, then the underbelly of ths whole situation will not be reached. And more costly policy mistakes could be made in the near future.
Sadly it highlights the huge divorce between the government and the true situations of their citizens. If the majority of the sub-prime burrowers were allowed to pay an affordable rate on their mortgages….such as reasonably around the same rates that they initially signed up for in the beginning, maybe we would not be where we are today!!!
Poorly timed monetary policy tightening this time will not affect only sub-prime burrowers …but good burrowers including the commercial property sector who have already seen their collateral values erode.
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I feel sorry for the author and all those who think things have bottomed out. You’ll be punished for your early (very) optimism.
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