The Fabulous Destiny of Alan Greenspan
A Daily Reckoning Classique originally broadcast on December 3, 2002, which proves the ol’ French adage: plus ça change, plus c’est la même chose – the more things change, the more they stay the same.
This week marks an important anniversary.
"How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions, as they have in Japan over the past decade?" asked the Fed chairman, when he was still mortal. The occasion was a black-tie dinner at the American Enterprise Institute in December – five years ago.
"We as central bankers," Greenspan continued, "need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. But we should not underestimate or become complacent about the complexity of the interactions of the asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy."
Mortals make mistakes. But Greenspan was right on target in ’96. It was later, after he became a demi-god, the "Maestro," that the Fed chief erred.
In 1996, the bear market of ’73-74 and the crash of ’87 were still functioning as caution signs. Greenspan spoke on the evening of the 5th. On the morning of the 6th, markets reacted. Investors in Tokyo panicked…giving the Nikkei Dow a 3% loss for the day, its biggest drop of the year. Hong Kong fell almost 3%. Frankfurt 4%. London 2%. But by the time the sun rose in New York, where the Fed chairman was better known, investors had decided not to care. After a steep drop in the first half-hour, as overnight sell orders were executed, the market began a rebound and never looked back. By the spring of the year 2,000, the Dow had almost doubled from the level that had so concerned the Fed chairman.
But while the maestro was alarmed at Dow 6,437, he was serene at Dow 11,722. Fatal to Greenspan’s judgment was a combination of bad information, bad theory and a human nature that – though unchanged for many millennia – seems to have avoided the notice of central bankers.
Greenspan’s theory was that by carefully controlling the cost of credit and the money supply he could avoid serious economic downturns. You have suffered enough discussion of this issue here in the Daily Reckoning, dear reader. For today’s purpose, we will just point out that Mr. Greenspan has everything he needs to get the economy back on track, except the essentials. He cannot make telecom debt worth what people paid for it. He can’t restock consumers’ savings accounts. He can’t make Enron a good business. He can’t erase excess capacity, nor make investment losses disappear.
In addition to the bad theory, Mr. Greenspan had bad information. The "information age" brought more information to more people – including to central bankers…but the more information people had, the more opportunity they had to choose the misinformation that suited their purposes.
Since the late ’90s, however, many of the figures used to justify the New Economy have been revised, downward. "The government previously decided that neither corporate profits nor productivity improvements were nearly as good as they appeared to be in 1999 and 2000," reports Floyd Norris in the New York Times. "And now the industrial production numbers have been sharply revised downward."
"The new numbers show industrial production was dramatically overestimated, particularly in the high- technology area," Norris quotes John Vail, the chief strategist of Fuji Futures, a financial futures firm in Chicago.
What was true for the nation’s financial performance was also true for that of individual companies. Companies engineered their financial reports to give investors the information they wanted to hear – that they earned one penny more per share than anticipated. But what they were often doing was exactly what Alan Greenspan worried about – impairing balance sheets in order to produce growth and earnings numbers that delighted Wall Street. Curiously, during what was supposed to be the greatest economic boom in history, the financial condition of many major companies – such as Enron and IBM – actually deteriorated.
But by 1998, Alan Greenspan no longer noticed; he had become irrationally exuberant himself. Markets make opinions, as they say on Wall Street. The Fed chairman’s opinion soon caught up with the bull market in equities. As Benjamin Graham wrote of the ’49-’66 bull market: "It created a natural satisfaction on Wall Street with such fine achievements and a quite illogical and dangerous conviction that equally marvelous results could be expected for common stocks in the future."
Stocks rise, as Buffett put it, first for the right reasons, and then for the wrong ones. Stocks were cheap in ’82…the Dow rose 550% over the next 14 years. Then, by the time Greenspan warned of "irrational exuberance", stocks were no longer cheap. But by then, no one cared. Benjamin Graham’s giant "voting machine" of Wall Street cast its ballots for slick stocks with go-go technology and can-do management. Stocks rose further; and people became more and more sure that they would continue to rise.
"Greenspan will never allow the economy to fall into recession," said analysts. "The Fed will always step in to avoid a really bad bear market," said investors. Over the long term, there was no longer any risk from owning shares, they said. And even Alan Greenspan seemed to believe it. If the Fed chairman believed it, who could doubt it was true? And the more true it seemed, the more exuberant people became.
"What happened in the 1990s," says Robert Shiller, author of the book "Irrational Exuberance," is that people really believed that we were going into a new era and were willing to take risks rational people would not take…people did not feel they had to save. They spent heavily because they thought the future was riskless."
But risk – like value – has a way of mounting up, even while it seems to disappear. The more infallible Alan Greenspan appeared…the more "unduly escalated" asset values became. Having warned of a modest "irrational exuberance," the maestro created a greater one.
December 2, 2002
P.S. The most exuberant phase is passed. But neither investors nor consumers could be said to be acting "rationally". Consumers are still spending as if there were no recession. And investors are still buying stocks – as if they were bargains.
"People are habitually guided by the rear-view mirror," explains Warren Buffett, "and, for the most part, by the vistas immediately behind them."
Well, it’s Monday morning and we’re back in business. We’re watching the greatest show on earth – Wall Street’s Fabulous Dream Machine – with a cast of millions…sex, fraud, genius, sorrow, pomp, special effects. You name it; it’s got it. Tragic heros. Good guys and bad guys. Snappy dialogue. Everything.
The market’s purpose, we keep saying, is not financial, but moral. That’s what makes the show so interesting…people get what they’ve got coming, but never without an ironic and unexpected twist or two. Stocks go up and down. Recently, they’ve been going up. They went down so much for so long – with neither a panic to the downside, nor a strong rally to the upside – we began to wonder. Stocks can’t just keep going in one direction all the time, we pointed out…our stroptured minds sliced immediately to the essentials…or we’d be out of business!
We figured something had to give. It did. Back in October, stocks bounced and have been rising ever since. We haven’t read tomorrow’s newspaper, of course, but our guess is that this rally will peter out soon….perhaps leaving the Dow its a trading range for a month or two…before resuming its death march.
We’ve seen this show before. Like the latest James Bond movie, there are sure to be new gadgets and a new woman or two…but we doubt it will turn out any different. Meanwhile, while the old circus on Wall Street continues, a rarer and even more remarkable spectacle is taking place in the world’s money system. Monetary systems come and go. But not very often. Good ones last a long time. Gold coins from Byzantium, for example, remained in circulation, and held their purchasing power, for 800 years. Likewise, the gold coins introduced in the beginning of the 19th century were still serviceable by the century’s end.
What makes currencies hold their value is the obvious thing: they remain in limited supply. If, somehow, the supply of Byzantine gold coins had doubled – other things being equal, the price would have fallen in half. If they became as common as senators, they’d be worthless.
Historically, paper currencies are notoriously short-lived; custodians are rarely able to resist the temptation to print more and more notes. Soon, people catch on; they realize that the supply of currency is not limited…and that, instead, it is growing quickly. They rush to get rid of it. The velocity of money increases. Even if the central bank were not actually printing more currency, the speed with which it changes hands makes it appear that there is more and more of it in circulation. Most often, this ‘hyperinflation’ is only arrested by introducing a new currency.
The illusion of limited supply is critical to a paper currency. People have to believe that the central bank can’t or won’t make their money worthless. Otherwise, they will dump it immediately…and make it worthless!
So imagine our surprise when Fed governor, Ben Bernanke, announced that the Fed would create an almost unlimited supply of new dollars – if it thought necessary – in order to head off deflation. Dennis Gartman said the speech by Bernanke was "the most important speech on Federal Reserve and monetary policy since the explanation emanating for the Plaza Accord a decade and a half ago."
Can the Fed really head off deflation by ‘printing’ more money? Can it do it without destroying the dollar and the economy? The Washington Post: "The broadest measure of prices in the economy shows they rose less than 1% during the 12 months ended September, the smallest increase in 50 years. The U.S. economy is not quite in deflation. But it is getting close enough so that Bernanke will probably get a chance to find out.
Eric, are you back on the job?
Eric Fry in New York City…
(Eric, by the way, will be a host on CNNfn, Tuesday and Wednesday of this week, that’s tomorrow and the day after, 9:30 to 11:30 am Eastern Time. Catch him if you can)…
– Another week, another gain for the Dow Jones Industrial Average. The blue-chip index chalked up 91 points to 8,896 to log its eighth straight winning week – a feat it had not achieved in more than four years. Hard to believe, isn’t it? Even during the manic, blow-off phase of the late great 1990s bull market, the Dow never registered eight consecutive winning weeks.
– Meanwhile, the Nasdaq has managed to achieve some minor miracles of its own. The tech-fueled index gained a modest 10 points for the week to 1,478 to reach a new five-month high. For those keeping score at home, the Nasdaq Composite has advanced 33% from its Oct. 9th low of 1,114.
– "A glaring feature of the latest rally," observes Alan Abelson of Barron’s, "is the leading role that has been assumed by some of the most insubstantial companies in the market. This group includes largely discredited tech and telecom firms, ghosts of rallies past, with sketchy finances and sliding businesses."
– Nortel Networks, for example, has vaulted 272% from its October lows, and Lucent has rocketed 322%. "In fact," Barron’s observes, "some 50 stocks whose market capitalizations top $1 billion have racked up triple-digit gains as of November 26, according to FactSet Research Systems, Inc. That has brought back another hallmark of the 1990s – ridiculous valuations. Broadcom, Yahoo!, Cymer and eBay are among the stocks now fetching at least 50 times their 2003 earnings estimates and four times their trailing 12-month sales…"
– A new bull market rarely begins with the old bubble leaders. Despite the stunning two-month rally on Wall Street, the stock market still faces a steep uphill climb if it is to finish the year in the plus column. The Dow is about 11% below where it was at the start of the year and the Nasdaq is down 24%. Anything is possible, of course, even the improbable prospect of investors’ continuing to scoop up richly priced tech stocks as if it were still 1999. Which, if you take James Boric’s angle from Friday’s guest essay, might provide you with some decent short-term profits…
– Still, during the times when stocks are climbing to the heavens, it becomes harder and harder to remember that they are also capable of falling. But, as musty history books – the ones that Greenspan says he does not read – tell us, stocks do sometimes fall. It was only one year ago that the Nasdaq climbed 51% from its post-September 11 nadir. Most of the Wall Street soothsayers greeted the advance as "a new bull market" (sound familiar?), but the rally stalled out in January and the Nasdaq eventually tumbled to new bear market lows.
– We are not predicting a repeat, but we don’t rule out the possibility.
– To be fair to the stock market bulls, a few of the recent economic reports hinted of modest improvement. But a wisp of economic strength is not nearly enough to justify the market’s extremely rich valuations. What’s more, the consumer seems to be swooning. One by one, America’s largest retailing operations are reporting disappointing sales trends. Last week, toy retailer FAO Schwarz announced disappointing sales and earnings.
– Apparently, not all consumers have gotten the message that "he who dies with the most toys wins."
Back in Paris…
*** Our Sunday Thanksgiving dinner came close to disaster.
"Where are the keys to the wine cellar," your editor wanted to know. He was looking forward to the turkey, chestnut dressing, buttered leaks, carrots, salade de gesiers, and so forth. But the thought of trying to choke through a big, rich meal without a lavage of alcohol made his mouth dry and his palms sweat. The keys were lost. The search party came back in a quarter of an hour – empty handed.
Five years after the beginning of the information age, and no one seemed to know anything. Who had the keys last? Why were they not on the key board? Was there another set? How gladly your editor would have traded all the benefits of modern telecommunications for a single liquor store that made home deliveries on a Sunday!
And then, at the last minute, the clouds parted…and there was his friend, Pierre, to whom he had given a second set of keys – just in case!
Pierre produced his keys and the party was saved.