Greenspan’s Legacy – July 2003

July 21, 2003
Dow Jones Average: 9,188
S&P 500 Index: 992


Greenspan’s Legacy


In testimony before Congress, Federal Reserve Board Chairman Alan Greenspan has frequently warned against government giving investors implied protection from market risks. When investors feel insulated from risk they tend to become far more aggressive. Even as Greenspan worried publicly about “irrational exuberance” in the markets his own actions encouraged speculation. A mystique grew around Alan Greenspan in the late 1980’s and the 1990’s. He was seen as the man who understood how to fine tune the economy, prevent recessions, and use monetary policy to rescue the financial markets from any unpleasant declines. Investors came to believe that they couldn’t lose as long as Greenspan was in charge. It is ironic that his efforts to keep everything in balance, to avoid economic downturns at all cost, have contributed to some of the greatest extremes in the history of financial markets.The cult of Alan Greenspan, revered as the man who would always rescue the financial markets, has led many to take greater risks than they otherwise would have taken.

Greenspan’s legacy is one of dramatic interest rate cuts designed to restore investor confidence in financial markets. While these interest rate cuts stabilized the markets in the short run, they contributed to a cycle of financial excess. As the newly elected Fed Chairman in 1987, Alan Greenspan was greeted by the stunning stock market collapse in October of that year. His reaction was to immediately cut interest rates by several percentage points and issue a statement that the Fed would provide all the liquidity (cash) necessary to stabilize banks, brokerage firms, and the markets. While the lower rates may have prevented further losses on Wall Street, they most certainly helped fuel a speculative real estate boom that crested in 1989-1990. Throughout the 1990’s the same pattern persisted, with Greenspan slashing rates to rescue the market in 1991and 1998. The market’s normal defenses against excessive risk taking were weakened as Greenspan administered his interest rate medicine. Risk taking ran wild producing the greatest stock market bubble in U.S. market history.

In the past few years Dr. Greenspan has cut interest rates thirteen straight times in an effort to revive the markets and economy from a post bubble malaise. With short term interest rates at sixty year lows of one percent and the economy still languishing, it appeared to many that the doctor was out of remedies. But on May 6th of this year Greenspan tried a new tactic, claiming that he was concerned about the possibility of deflation and was prepared to take extraordinary measures to prevent its occurrence. The unusual measures would include active buying of longer term treasury bonds by the Federal Reserve Bank. The Federal Reserve controls only the short-term funds rate that currently hovers around one percent. Longer-term bond rates that are near five percent are the result of buy and sell decisions made by millions of investors worldwide. While the Federal Reserve has no direct control over longer term rates, Greenspan’s comments suggesting possible government intervention in the bond market caused a buying stampede in longer term bonds and a spillover effect that buoyed stock prices as well.

We think that the markets would be better off if they were allowed to find their own level without constant interference by government officials such as Mr. Greenspan. His comments on deflation, repeated on a weekly basis in May and June of this year, were always qualified by his assertion that deflation was a minor, miniscule, remote possibility. We wonder why the highest ranking financial official in the nation found it so necessary to repeatedly discuss a scenario that was so unlikely to occur. The net effect was that investors, already desperate for some yield on their money, overpaid for longer-term bonds on the mistaken assumption that the Fed would support the value of bonds. Once again Alan Greenspan was viewed as the guarantor of aggressive, ill-advised investment decisions.

Current Strategy

Stock prices rose in the latest quarter, as some investors grew more optimistic about economic growth and corporate profitability. Bond prices also moved higher driven by Chairman Greenspan’s comments on deflation. While investors welcomed an up quarter for a change, few seemed concerned that the two scenarios propelling stock and bond prices are totally incompatible. The last time deflation hit the United States the country was mired in the depression of the 1930’s. Deflation may enhance the attractiveness of government bonds, but it would be ruinous to corporate profits and the stock market. When the markets become irrational, as they did in the latest quarter, we either take some gains off the table or stand aside in money funds and short-term treasury bills.

The stocks that gained the most during the past quarter were the sickest companies in weak industries. Companies with stronger businesses and higher stock prices such as Johnson & Johnson, New York Times, IBM, and Microsoft were either down or flat in price over the past few months. The top two performers of the Dow Jones 30 stocks were McDonalds and Altria (the new name for Philip Morris). Both companies had previously been falling due to slow sales, public health issues, and lawsuits. Airlines and companies with asbestos exposure also experienced strong recoveries in the second quarter of the year. It seemed that the closer a company was to bankruptcy the better it did from a percentage standpoint in the latest quarter. We found few stocks that attracted us in this environment. We will be more interested in stocks when higher quality companies with good balance sheets sell for lower prices.

Bonds became ridiculously expensive during the quarter as many investors were panicked into paying high prices by Greenspan’s deflation warnings. We stood clear of the bond market stampede, opting instead for five-month treasury bills that change little in price and come due quickly at full value. Since quarter end, bond prices have fallen sharply and interest rates have risen as Greenspan downplayed his deflation concerns in his July congressional testimony. Investors who acted on his comments last quarter were blindsided by his change of emphasis from deflation to faster economic growth. Now that interest rates have spiked higher we are switching a portion of our client’s capital from treasury bills to bonds with longer maturities.

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