In Greenspan We Trust

When last week came to a close, the protagonist of our story, Mr. Alan Greenspan, was widely credited with not merely reversing the bear market on Wall Street, but of saving Life As We Have Known It.

Life, as we have come to enjoy it, has been one long continuous boom. Stocks have been rising since before the Internet was invented – that is, for so long the memory of man runneth not to the contrary. And the economy has enjoyed its longest continuous period of growth in nearly 40 years.

In the few instances – such as the LTCM scare, the Asian Currency crisis, and the Y2K worry – in which growth seemed threatened…Mr. Greenspan and his fellow central bankers provided the necessary grease to keep things rolling along smoothly. And thus, only a cynic or a crank (or a sourpuss) would gainsay Mr. Greenspan’s power of lubrication now. Millions of investors are counting on The Greenspan Put – as traders refer to the Fed chairman’s power to slather liquidity onto the economy’s moving parts. Investment and business strategies…even vacation and retirement plans… rely on Mr. Greenspan to such an extent that he has come to assume a god-like stature. Not long ago, Fortune Magazine ran a cover story called “In Greenspan We Trust.”

So, today, we continue our story…keeping in mind my dictum that people get from the markets not what they expect, but what they deserve.

Will our hero, Alan Greenspan, succeed in keeping the bull market/growth economy alive? Will he manage the `soft- landing’ that he hopes for? Will the Greenspan Put be in- the-money at the crucial hour?

Or, looked at another way – will this story turn out to be a comedy, or a tragedy? In the interest of economizing your time, dear reader, I will flip ahead to the end: Mr. Greenspan will fail. The story will turn out to be neither tragedy nor comedy, but farce.

The mechanism by which the Federal Reserve influences the economy and the markets is complicated, but the concept is simple. The central bank can either make money easier to get or harder to get. An increase in the fed funds rate, for example, makes it – all other things being equal – relatively harder to borrow money.

In a perfect world, prevailing interest rates operate as a kind of speed governor on the economy. At any given time, people contemplate all manner of spending. A concrete merchant imagines adding new mixer trucks to his fleet. A couple dream of a winter cruise in the Caribbean. In both cases, the significant calculation can be reduced to 2 questions: what will it cost…and what will it return?

The return on consumer spending tends to be unquantifiable, so consumers focus mostly on the first question: how much will it cost, which begs the corollary, can I afford it? The higher the interest rate on the borrowed money – the more expensive the vacation becomes.

Businessmen, on the other hand, can look ahead at the likely financial return on borrowed money. If the return exceeds the cost of funds – with a margin for error – it makes sense to borrow and spend. Thus, the lower the rates, the more projects make sense and the faster the economy moves ahead.

Markets, however, have a kind of perverse complexity. What really concerns people is not the nominal rate of return – that is, the rates as persuaded by Greenspan & Co. – but the real rates.

An economist named Pigou once noticed that “people’s spending habits are influenced not only by how much they are earning, but also by how wealthy they feel.” He was describing what is known today as the ‘wealth effect’. The insight may be broadened to the realization that when people decide whether to borrow and spend, they look at the effects in the widest way they can.

The real cost of borrowed money has been phenomenally low. You might have borrowed $100,000 in 1982, put it into Dow stocks – and today, you would have about $1,000,000 in stocks, and owe less than half that amount, including compound interest, on the original loan. For nearly 20 years, the real cost of borrowed funds – when the money was put into stocks – was about minus 8%. It paid to borrow. The more the merrier.

Venture capitalists raised money from investors – and often borrowed money too. But in the hey-day of IPO fever, they earned as much as 1,000% profit. The cost of the borrowed funds was negligible.

Of course, when you give away money – you have to expect people to take it. Consumers mortgaged their homes, spent some of the money on themselves…and invested the rest in stocks. With such low real rates, they could spend up to half the borrowed money on new cars, houses, vacations – whatever they wanted – and still come out even over time.

Publicly traded businesses, too, found that they could borrow obscene amounts of money – the telecoms, for example, took up 40% of all newly issued bonds between ’97 and `99… alone borrowed $2.2 billion, even though it still has no proven business model. For a while, it seemed as though the more they borrowed, the higher their share prices went. Investors seemed to care only about growth and momentum, not about credit quality or balance sheets.

Even speculative junk – at the peak of the Information Age mania – was taken up with coupons as low as 7.5%. Investors were blind to risk – even from the shakiest borrowers and the most absurd business plans.

Bloomberg reports that U.S. investors, for example, just lost $75 million of commercial paper seized from Demirbank – a Turkish bank in the Caymans. The Bank of America, which can’t seem to resist a bad loan, had issued a letter of credit.

Even in the 3rd quarter of this year, debt was still increasing – by $414 billion of ‘total market debt’ compared to an increase of $390 billion in the 2nd quarter.

But eventually, investors stop worrying about the return on their money and begin to fret about the return OF their money. Dodgy stocks and bonds fall. Junk bond yields soar. The cost of credit, for unproven or questionable projects, rises to 20% and more…and then disappears altogether. And for good reason; investors need to be compensated for the risk they run. Moody’s projects that one out of 10 junk bonds will default next year.

This is the point where we find ourselves today. Credit, which was very cheap and very abundant only a few months ago has suddenly become expensive. The average junk bond has fallen 10.85%. A bond buyer, using borrowed funds, would have a real cost of funds exceeding 18%. An investor who mortgaged his home in March of 2000 in order to buy tech stocks paid an effective interest rate – over the last 9 months – of greater than 50%. His stocks probably fell at least 50%…and he probably pays an additional 8% or so on his mortgage.

Ed Yardeni is still confident, though. He believes our hero, Alan Greenspan, has the weapons he needs to defeat a credit crunch. “There are 650 basis points between the fed funds rate and zero,” says he, pointing to Mr. Greenspan’s ammunition belt.

But real rates have gone from minus 8 percent to plus…what…plus 20%…30%…50%?! And there are 900 basis points between Treasuries and Merrill Lynch’s high yield index. Mr. Greenspan will be outgunned.

Your correspondent

Bill Bonner Paris, France December 11, 2000

P.S. Several readers have asked, “Why do you live in France?” Tomorrow: an introduction and an explanation.

*** Now what? The Dow and the Nasdaq both rose substantially on Friday. The Dow was up 82 points by the close of business. And the Nasdaq was up 144. Breadth was unusually solid, too, with 2076 advancing stocks on the NYSE, compared to just 816 declining issues.

*** But then, along came the Florida Supreme court… tipping the balance of the election scales in Mr. Gore’s direction. Investors didn’t seem to like it. Either they didn’t like the idea of a Gore presidency…or they just didn’t wait any longer to see who was going to be Mr. Big in Washington. After hours, futures trading took stocks down the equivalent of about 200 points.

*** But the U.S. Supreme Court also spoke up over the weekend. Advantage: Bush.

*** And here we are…only 12 more shopping days until Christmas…and still no President-elect…and no sign of Santa’s big bottom…

*** But the good times can’t last. The Supreme Court is threatening to end the election uncertainty…and Mr. Bear may have quietly decamped for his holiday retreat over the weekend. His departure would allow investors to fatten themselves up over the holiday…providing even more delicious and delectable targets when he returns.

*** “Sell me everything you have,” invites James Cramer, co-founder of Cramer says he’s given up managing money – and has no operational role at the on-line publisher he helped set up. Cramer does not say if he is buying shares in The stock sold for as much as $60 a share a year ago. Now you can buy it for $2.50.

*** Mr. Cramer, along with most analysts and most investors, still have faith in the Greenspan Put. They believe the Fed chairman will lower rates next year – and that this will set the market on an upwards course again. Why that is unlikely…below…

*** So much is riding on Mr. Greenspan that the U.S. Senate decided it had better keep him happy. By act of Congress, Greenspan’s salary was raised from $141,300 to $157,000.

*** Unemployment increased 0.4% in November – as expected. Hourly wages increased to $13.94, or 4% for the last 12 months.

*** Ollie Curme, a venture capitalist with Battery Ventures, predicts that losses from failed Internet startups could total more than $150 billion – or about as much as the S&L crisis. Both debacles had the same cause…and both will come to the same bad end. Again, more below…

*** The on-line stock site, VTO Report, tracked 215 Internet companies over a year. As of Nov. 30, the average company had fallen by 93%. This makes companies such as and the Internet incu…bator, CMGI, about average. CMGI has fallen 93% over the last year.

*** Analysts’ estimates for profit growth for the 4th quarter average 9.2%. This is the first time in 2 years the number has been below 10%.

*** The dollar went down about 1% last week. Not a spectacular crash – but probably the beginning of something big. Meanwhile, foreign ownership of U.S. assets grew by $207 billion in the 3rd quarter.

*** Maytag announced that it was cutting back on its e- commerce efforts.

*** Gold fell to $275 on Friday…gold stocks fell too.

*** The Rockefeller Center is up for sale…the Chrysler building too. The Rockefeller Center became the focus of Japanese attention at the end of their boom in the 80s. They bought it…and then sold it back after the bubble burst in Tokyo – losing millions in the process.

*** What investment strategy worked over the last 11 months? Value! The Thornburg Value Fund rose 12.2% and has been rated as #1 by Morningstar, for tax-adjusted returns over the last 5 years.

*** “It’s time to plant,” said Mr. Deshais, our gardener and keeper of the local traditions. We were watching a beautiful full moon rise at about 5:30 in the after noon. “But you can’t plant anything now….it’s almost winter,” I protested.

“Oh yes. It was St. Catherine’s day last week,” he replied, adding a little rhyme, which went something like this: “After the day of Ste. Catherine, trees begin to take root.” Well, okay, it doesn’t rhyme in English…but trust me, it rhymed in French.

And so, we dutifully called the local nursery…and soon its owner, a Mr. Robin – a stout man wearing checkered pants – came bob, bob, bobbin’ along. We toured the grounds with him making comments and suggestions, and then Mr. Robin took his leave, promising to send over a proposal. Like everything else about this property, the gardens are now threatening to be a much bigger deal, and much more expensive, than I ever imagined.