FOOL PLATE SPECIAL
An Investment Opinion
Fed Fear is Back... For No Good Reason Louis Corrigan (TMF Seymor)
September 2, 1999
Sometimes it's just clear that the broad stock market is trading on fear. And in the generally thin markets that you typically see going into a Labor Day weekend, stocks can prove especially volatile as the folks not smart enough to be on vacation already decide they are smart enough to act on those fears. Check the market averages today, and you see lots of red with only a handful of meaningful stories like -- big surprise -- Sears (NYSE: S) stumbling some more.
Turn to the skittish bond market, and you get a kind of explanation: the 30-year Treasury down 19/32 to 99 31/32, pumping the yield up to 6.127% from Wednesday's close of 6.079%. The relief the market felt after last Tuesday's quarter point hike in the Fed funds rate has already dissipated. Simply put, the market's afraid that the Federal Reserve may raise interest rates yet again. That's emboldened more eggsperts to go onto CNBC to talk about how the high P/E stocks that have led this bull market have a "valuation problem." It's just so predictable. No one ever asks, well, isn't the price/earnings ratio a rather feeble tool for evaluating those fast-growing high-tech stocks?
Today's renewed Fed fears were triggered partly by comments made to Market News International by Fed governor Edward Kelley. Market participants have generally thought the Fed would be reluctant to raise interest rates going into the new year due to the various Y2K concerns that, to some degree, could lead to a liquidity crunch, albeit a temporary one. Yet Kelley, the Fed's Y2K man, said today that millennium concerns will "not tie the Fed's hands," meaning the Fed could tighten again this year if it thinks that's prudent.
Frankly, I think the average investor can completely discount what everybody except Fed Chair Alan Greenspan is saying. Yes, the governors and other Fed officials may offer some valuable hints on the Fed's thinking, but much of what they tell the press may also be construed as public politicking for certain approaches they would like the Federal Open Market Committee, the Fed's rate-making body, to take. At this point though, Greenspan enjoys such stunning prestige that what he thinks is literally the only thing that matters.
So what's Greenspan thinking? In his speech last Friday, the G-man talked at length about "asset" prices, meaning stocks. Though he's frequently mentioned the rising stock market in his speeches, Friday's talk offered the first extended treatment of the subject in some time. This got the market's attention, and it's been interpreted by many as a sign that Greenspan is worried we're in an asset bubble, and that the ensuing wealth effect (stocks rise so investors feel rich and spend their paper profits) is contributing to excess consumer demand and thus inflationary pressures. In other words, he's supposedly becoming more prepared to act preemptively to slow down the market, which has perversely read each new rate hike as a reason to rally.
If you read the speech, though, you'll find typical Greenspan nuance and intellectual "other handing" that gives the lie to these simplistic interpretations. He noted that while conventions of accounting for employee stock options may have overstated corporate profits by 1% to 2% annually over the last five years, that's been more than offset by equally problematic accounting conventions regarding what gets expensed today versus what gets capitalized, with the cost figured into depreciation expenses over a number of years. So corporate earnings are probably even stronger than they look. On the other hand, even these adjusted earnings alone can't account for "the extraordinary increase in stock prices over the past five years."
For many commentators, that seems to be end of story. Earnings can't justify stock prices, Greenspan says. Not exactly.
Much of the latter half of Greenspan's speech deals with the narrowing of equity risk premiums, the potential structural reasons for this (changes in "just-in-time inventory management appear to have reduced that part of the business cycle that is attributable to inventory fluctuations"), and the tendency for risk premiums to "revert back to historic norms." This latter tendency is potentially negative for stocks.
On the flipside, though, Greenspan flat out says that the Fed needs to think harder about how the wealth effect works. A recent study from the New York Fed suggests that rising stock prices do not translate into anything like proportional increases in consumer spending, which suggest investors may not be convinced those gains are necessarily sustainable. So trying to head off a supposed market bubble in order to cool consumer spending may be completely unnecessary. Indeed, it's probably dangerously counterproductive.
Greenspan's speech dealt extensively with the fragility of markets (as witnessed in last September's liquidity squeeze) and their tendency to trade "discontinuously" and, basically, on fear. "If episodic recurrences of ruptured confidence are integral to the way our economy and our financial markets work now and in the future, it has significant implications for risk management and, by implication, macroeconomic modeling and monetary policy," he noted.
In my view, Greenspan laid out in fairly academic fashion the kinds of issues that economists need to understand better and that the Fed will be trying to get an improved handle on in the years ahead. Yet, in regard to the need for additional rate hikes this year, there was nothing much new to get worried about. Indeed, Greenspan remains particularly cognizant of the novel features of our technology-driven economy and especially alert to how irrational markets can be, particularly on the downside. If anything, that suggests that Greenspan has become even more committed to cautious action regarding changes in monetary policy. If he plans to raise rates again, he will tell us, and he certainly didn't tell us that last Friday.