A Conversation With Fred Sheehan

Fred Sheehan is co-author of Greenspan's Bubbles, with Bill Fleckenstein. A contributor to Marc Faber's Gloom, Boom & Doom Report and a former market strategist with John Hancock, Sheehan told clients eight years ago that U.S. credit markets were at risk. I recently caught up with Sheehan from his Boston office to learn how we got into this mess and what we can do to protect our net worth. An edited transcript of our conversation follows.

Fred, how did you go from studying history at Annapolis to studying the world financial markets?

By way of the Navy, then business school and finally to Hancock. I wrote my eighth-grade term paper on the 1929 stock market crash, so this progression seems to have been foredoomed.

What is the state of the U.S. financial markets now?

The bond market is not functioning. It is priced for a depression. The stock market is volatile -- but at least it trades.

Equities don't seem concerned about a recession, even though the lifeblood of corporate America --commercial paper, junk bonds, bank lending, etc. -- is frozen. Some think the government's recent activities will solve these problems. But money-center banks will stay out of the lending business for at least a year. At this point in the credit cycle, when losses and erosion of reserves are still mysteries, banks are reluctant to lend. A year from now will be too late to prop up the economy that has relied on credit cards and loans. Profit growth is harder to achieve when banks don't lend money.

The Fed has been busy. Are they helping things or hurting?

Four things concern me.

First, the fed funds rate is 2.25%, down from 5.5%. The Fed's goal here is to increase liquidity to the credit markets and to support stocks. But at these low rates, Chairman Bernanke can't cut much further. He doesn't have many more bullets in his gun; soon he'll be shooting blanks.

Second, the Fed's balance sheet is in ruins. It is lending banks and other financial institutions its Treasury portfolio in exchange for all kinds of stuff. Before the credit markets seized, the Fed had about $870 billion in assets, including around $700 billion of Treasury securities. We don't know exactly what securities the Fed is accepting as collateral, but my bet is they're taking the worst paper. It would be rated CCC by an outside auditor.

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Hewitt Heiserman conceived the Earnings Power Chart and the Earnings Power Staircase. A graduate of Kenyon College with distinction in history, Heiserman is a member of the Boston Security Analyst Society and the CFA Institute. He also authored It's Earnings That Count. For additional information, please visit Earnings Power.

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