What do we know?

What if tomorrow’s headline read…
“Interest rates are still at 1% and The Dow is more leveraged than it was in 1929″

I think we must first clarify a few things.

Inflation and Interest Rates.
Banks have the right to print as much money and credit as it deems fit. This may lead to an unhealthy economy. The Federal Reserve controls this expansion of the money supply with short-term interest rates, restricting the amount that must be paid by the Federal Reserve Banks as well as the amount banks must hold on margin.

The Fed has many techniques and factors that show an inflationary monetary system all of which have recently been above their “comfort levels”. The Fed has raised interest rates 18 times over the past few years, from a rate of a meager 1% to the current 5.25%. Although this “tightening” has raised the awareness level of excess consumption, which can be detrimental in a slowing economy, rates are considered to be relatively low by historical levels when rates rose above 15%.

Derivatives.
When industrial buyers wish to hedge or secure themselves from rising or falling prices in a competitive market they can do this by buying a contract on the particular commodity of interest. If a jeweler worries that the price of gold may rise in the future he can buy a contract on the market for the current price of gold and will pay this amount even if the general market price for gold rises. This can be done with financial instruments as well, including interest rates.

The Derivatives market has exploded over recent years with an surge of speculators, especially since the late 90s when many experienced traders, primarily Hedge Funds bought derivatives to hedge themselves against a serious decline in stocks. In addition, these contracts can be bought on extremely low margins. For instance, it is possible for a trader to buy and control over 20 times his initial down payment. Thus the amount of credit or money lent on margin far exceeds the amount of actual materials, be it stocks, interest rates or commodities. It is for this reason that the wise have considered these “Financial weapons of mass destruction”.

A Nasty Combo.
When searching for a medium of success in addition to venturing all the possibilities of the future of that success, we must also consider all the historical reasons for failure.

Looking back at all the times that wrought havoc for investors, we see the same irrational yet consistent behaviors and mindsets.

* Markets reaching new highs with more jumping on board as the trend continues.
* Excess optimism regarding future rises in prices and profits.
* A publishing frenzy of books on investing and trading.
* Smaller allocations of cash due to excess invested capital.
* An insatiable apatite for risk and gains.
* Large sums of leverage and margin.
* More speculators focusing on the technical factors as well as
* More Momentum Investors deliberately riding the trends in the market.
* A lack of following, even an opposition towards the underlying fundamentals.
* Lastly but most importantly, the lack of vision to realize the potential pitfalls and risks.

We could probably go on to check almost every one of the above mentioned. But the reason for concern doesn’t apply as much to the traditional markets as they do the derivatives market in particular. It is with these instruments that many, including large speculators, hedgers, banks and institutions have the capabilities to wager not billions but Trillions of dollars in the market. Originally these conducts were reserved for those with large amounts of capital, but as the gains increased so did the “insatiable apatite” for the small investor become whetted.

I refer not only to the stocks markets, commodities or even credit-default swaps and other exotic contracts that many don’t even have the slightest idea of who holds the opposite promise to fill or fulfill the terms involved. I’m referring primarily to a tool used by the Federal Reserve Bank of the United States that has become apparently unknowingly “manipulated” and de-regulated – Interest Rates.

With modern day derivatives an organization or bank can place contracts on short-term rates to hedge against the possibility of a rise in rates. In 2001 the Fed lowered rates to fend off the severity of a 1929-like recession during the stock market debacle in late 2000 to supply credit to the markets and to free cash flow and loosen tied on monetary availability.

But many caught on. With rates at 1% lows, it seemed like an historical opportunity to lock in rates to benefit when the Fed would inevitable raise in the future. To date these contracts now total in the hundreds of trillions of dollars.

Now with these astronomical numbers there is nothing short of something just as phenomenal that must occur. An increase of rates muscling out many from their positions? A de-regulation in parts of the hedging industry? A collapse in the derivatives market? We don’t know. But such growth is simply unsustainable and caution – one that many probably won’t even consider – is strictly warranted. Remember, we don’t know. The same way investors didn’t know what would come out of all the millions of stocks they bought on margin back in 1929.

For if they had it probably wouldn’t have turned out the way it did. Don’t you think?

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