(This post originally appeared at the author's blog)

There has been a lot of chatter over the last year about the government’s involvement in the equity markets. Yesterday’s market action was certainly odd. Several large institutions were active buyers of enormous blocks of the S&P on no news. The volume shot through the roof from out of nowhere. It was not an unusual occurrence. We have seen it repeatedly over the course of the last 12 months (see here for more). Of course, this whole discussion has a very conspiratorial aspect to it, but I think it’s less nefarious than many presume (depending on your definition of nefarious when it come to pseudo-government intervention in markets).

The usual argument with regards to government intervention in the equity markets is pretty simple. The government, or the “President’s Working Group” (aka, the Plunge Protection Team) purchases securities in big blocks and jams prices higher. Jamming, gunning, carpet bombing (whatever you want to call it) is quite simple. In any market there are down times in terms of volume. If you have the firepower (the capital) and the desire you can knock out just about every asking price on the board. Have a look at just about any Russell 2,000 stock at around noon as the volume slows to a drizzle and ask yourself what you could do with $10,000,000? Of course, the same goes for the downside. You can hit the bids and literally knock them off the board in an illiquid market (exactly what we saw in Fall of 2008 with fund redemptions).

Anyone who has ever traded in size has seen this in action. It’s like taking a machine gun to a medieval battle or sending the U.S. Army to Baghdad (not that anyone would ever do such a thing). The point is, you can slice through prices like a hot knife through butter, create a certain sentiment in the market that actually generates attention (liquidity) and then get out on the other side of the trade by selling (or covering) to the crowd you’ve attracted. Of course, if you’re someone who has a longer time horizon than a few minutes you could simply accumulate. If you have a huge amount of firepower you simply protect the position as time goes on (this can be done in any number of ways via the futures market or the options market). The kicker of course, is that someone is holding the bag at the end of each day. The longer you keep the game going the longer you delay the inevitable. If you have a large supplier of capital the game can last for quite a long time. Sounds sort of Keynesian doesn’t it? Well, it is in essence. Let me elaborate.

What’s really going on in the markets now? We all know exactly what is going on. The government, per se, isn’t buying stocks. But someone with close ties to the government is. Remember, the Fed is independent, right? According to the government they are. Except of course when it goes to Congress with its hands out asking for a check worth (roughly) several trillion dollars. This “independent” Fed of ours then goes on its “recapitalization” mission by buying assets from the large banks. Now the banks are flush with cash. What do they do? They do what they believe is prudent and in addition to buying treasuries they buy other assets that diversify their portfolios. The banks aren’t necessarily acting illegally or corruptly. The banks are using their bloated balance sheets to invest in assets that will boost their earnings. Based on their analysis, the assets they have been buying are “good” investments. Much like they believed mortgage backed securities were “good” investments leading up to the credit crisis. Remember, the purpose of the bank bailout was to recapitalize the banks and help them earn their way out of their toxic woes. And the results have been great – at least for the banks. While Main Street flounders the banks have their own little v-shaped profit recovery:

Tyler Durden at ZeroHedge compiled some excellent data on the expansion of positions in SPY over the last few years by several large Wall Street firms. It clearly shows the massive dumping and accumulation of the S&P 500 by the big banks during the financial crisis. We’re now back at record high positions in the S&P thanks in large part to the Fed. Not surprisingly, Morgan Stanley and Goldman Sachs are the largest accumulators (as should be expected):

What’s most important here is the role of the Fed and not the banks. I sincerely believe the banks are doing what their analysts believe is prudent. Remember, in a zero interest rate world, the Fed is herding investors out of cash. It truly is the most expensive asset in the United States. This is one of the primary reasons why you can’t fight the Fed. Bill Gross has personally elaborated on PIMCO’s interactions with the Fed and their use of the Fed’s handout. In an interview with TIME in January he said:

“Just speaking about Pimco’s general portfolio strategy, we’ve sold our agency mortgage securities, Fannie and Freddie, in the billions to the willing check of the Fed. They’re buying a trillion dollars of them, or have over the past nine to 12 months, and so we sold them a lot of ours. Now, what did we do with the money? We bought Treasuries, we bought corporate bonds, and so the bond markets in general have benefited, as have stocks, because this available money effectively flows through the capital markets.”

It’s that simple. Toxic assets get exchanged for cash and cash gets exchanged for whatever the banks feel like buying on a particular day. In this case, it’s approximately $1.5T worth of firepower. The results have been “shock and awe” on steroids. $1.5T certainly does wonders for an equity market, bond market or municipal bond market (all of which have rallied substantially in the last year). So, the trick isn’t quite as nefarious as some would have you think. The banks are essentially taking advantage of the Fed’s foolish monetary policy. It’s all part of that wonderful bailout we generated for the banks and what is essentially a fatally flawed monetary approach by a Central Bank that continues to print (or more accurately, “button press”) us into a boom & bust cycle.

For those who still think the government is actually in there buying up shares and selling them I have just two questions for you:

If they are actually doing this then why did they let the market collapse in 2008? Why would they do such a thing when they have banks that can do it for them?

As for the first question – if the government is directly propping up the markets they sure are bad at it. Don’t you think that Dick Cheney, a bona fide market guru would have done everything in his power to prop up the markets using the PPT before the Republicans went down in flames on the back of the economy? We declined 60% in 12 months and remain almost 30% below the all-time highs. By any measure, I would say the so-called PPT is failing at their job.

The answer to the second question is simple as I’ve mentioned above. Of course, there is a very important caveat here. The Fed is not independent in any fashion. This is the fourth branch of the U.S. government whether anyone wants to admit it or not (I personally believe the Fed should be part of Treasury and subject to the same rules and oversight as Congress). The Fed is directly tied to the health of the U.S. economy and acts in ways that they believe best support the U.S. economy. In this case, they think the U.S. economy is best served by a bloated and ever expanding banking system. You know, the 90’s were great in large part due to the explosion in financial services. What if we could just perpetuate that growth? Don’t we all benefit from an industry that makes its money by shuffling money from one pocket to the other and effectively rapes their customers by shaving off fees and increasing the rates they charge on their new and “innovative products”? Not exactly.

By effectively crediting bank accounts with cash the Fed is directly contributing to the boom/bust cycle we have been stuck in for the last 20 years. Your average Keynesian will argue that this sort of government spending is effective in protecting the banking system, keeping bank reserves healthy and helping to encourage lending, but in a world where the private sector remains deeply indebted it simply sews the seeds for mal-investment. Time and time again, the financial sector has proven itself incapable of proper risk management or proper allocation of its own assets. The free market attempted to obliterate this sector of the economy and punish it for its malfeasance but here we are protecting it and providing these banks with money they didn’t earn and in fact should have lost. Why do we allow this to happen? Perhaps more important – if we aren’t going downsize this sector (which I believe the market will take care of over time regardless), why have we not regulated these imprudent institutions more strictly? It’s simply unfathomable that the institutions that caused this crisis have not been downsized and/or regulated more strictly.

What’s the end game here? At some point the Fed will stop buying assets and crediting bank accounts. If, at that point, the private sector is not ready to carry the baton the daily carpet bombings will end and could in fact turn into daily implosions as confidence sinks and the capital isn’t there to bolster a flailing economy. At that point, the party ends and the bagholders look for someone to pass the bag off to. The banks will be looking for the small investor at this point. No one can be certain when this might occur (or if it will assuming no private sector recovery), but Bill Gross explains why he is scared about the potential impact on the market in the coming year:

“So it’s a trillion-and-a-half-dollar check that won’t be there as the Fed withdraws from the market. How that affects the markets, I just don’t know. I’m not eagerly anticipating the answer, but I think it holds some surprises in 2010 — not just in mortgage securities but stocks as well. We could miss the money, put it that way.”

Damn right they’ll miss the money. The question we should be asking ourselves is whether we would miss any of these banks were they to disappear into the abyss of Chapter 11. Let’s be realistic though. In this bailout nation and false capitalist market we all know that won’t happen. The losers don’t lose in this market. At least not until the next big bust. Until then, perhaps the mantra of “don’t fight the Fed” is more relevant now than ever. Just make sure you’re not the guy holding the bag when it all comes crashing down….

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