What The Fed Can't Do
Since 1871, stocks have – on average – traded for about 12 times their earnings. If a company earned $1,000, the company would have a stock market value of $12,000.
On Wall Street today, however, the average Dow stock with $1,000 of earnings is thought to be worth $24,000 – about twice the average. Has something changed?
As reported in this week’s Barron’s, Jeremy Grantham maintains that no bubble market has ever gone uncorrected forever. Sooner or later, every penny of excess valuation is given up, as every market regresses to the mean.
Grantham has challenged analysts to come up with a single exception. None have come forward.
The way to make money, says George Soros, is to find the trend whose premise is false and bet against it.
The premise of today’s values on Wall Street is that Alan Greenspan, public servant, will be able to do what no one has ever been able to do before – prevent stock prices from regressing to the mean.
Many are the reasons given why this may not be the case today. The ‘productivity miracle’ was popular, until the most recent figures showed productivity growth regressing to the mean… ‘Higher GDP growth rates’ was a winner until the last quarter – when GDP growth also slowed.
‘Information technology’ had a ring to it, but it needed the objective correlative of higher productivity and economic growth to give it substance. How about ‘higher corporate profits?’ Alas, that fell into the gutters of Wall Street as corporate profits slipped up along with everything else…including the myths of the ‘endless expansion’ and the ‘perfect inventory control systems.’ Only one thin reed remains standing – the idea that Alan Greenspan is in control of the U.S. dollar and its economy.
Somehow, it is believed, Greenspan will restore the vigor of the economy and the vitality of its stock markets. It is not for me to predict the future, dear reader. That gift is not given to mortals. Maybe the economy will recover in the 2nd half as advertised. Maybe the stock market will go up. Who knows?
But the premise – that Mr. Greenspan has the power to keep the economy expanding for as long as he lives…and thus prevent a regression to the mean of stock prices – is surely false.
We have already discussed the manner in which the Fed has carried out its primary duty – protecting the value of the dollar. Over an 87-year period, it turned the dollar from a hard currency into something with the consistency of custard pudding. Of course, that doesn’t mean that in the 88th or 89th year Mr. Greenspan will not add a little more corn starch.
Protecting the value of the dollar is one thing. Driving the economy is another, arguably more difficult. You not only need your hands on the wheel, but your eyes on the road ahead. In the autumn of 1999, Mr. Greenspan provided testimony on the Fed’s ability to see around corners: “The fact that our econometric models at the Fed, the best in the world, have been wrong for 14 straight quarters does not mean that they will not be right in the 15th quarter.”
The record shows that Mr. Greenspan neither smiled nor chuckled to himself when delivering the above sentence.
Yet, if the Fed cannot see the on-coming economic traffic…how can it avoid a collision? Perhaps it can’t. If evidence for this were needed, more of it is presented in the latest issue of Grant’s Interest Rate Observer.
Grant’s discusses a new book by Martin Mayer, “The Fed: The Inside Story of How the World’s Most Powerful Financial Institution Drives the Markets.”
“Mayer’s special contribution,” Grant writes, “is to demonstrate that the Fed is incapable of doing what it appears to be doing with the techniques available to it. It can’t control the money supply. It can’t direct the economy. Banking deregulation, coupled with the growth of securitization and the derivatives markets, means that it does not actually control much at all.”
This is not to say that the Fed has no power. It had the power to debase the currency, after all. It has the power to increase liquidity…and to set the rate that member banks pay to borrow money, thus almost offsetting the tendency of bankers to lose money by lending recklessly at the top of the credit cycle.
Beyond that it has another peculiar tool. “It sets the terms of financial discussion and manipulates the expectations of its adoring public,” explains Grant. Last week, for example, Dallas Fed chief, Robert McTeer, urged consumers to go more deeply into debt in order to continue buying. In the name of patriotism, McTeer asks Americans to sacrifice their own financial security to the good of the national economy.
It is hard not to like McTeer. These days, when most public figures are mealy-mouthed blanks, so cautious in their speech that you can’t tell if they are fools or knaves, McTeer is a completely unhedged buffoon.
What imbecile would run down his own balance sheet for the benefit of ‘the economy’? What possible good could possibly come from trying to get the GDP growth rate up a point or two – at the cost of setting yourself up for bankruptcy?
How many people will answer McTeer’s appeal for mass financial suicide? Enough to overcome the business cycle?
We will see, dear reader, we will see.
June 4, 2001
This section of the Daily Reckoning is written by Eric Fry,editor of Grantsinvestor.com.
*** “What recession?” the Fox network’s Neil Cavuto asked optimistically on his weekend business show. The more appropriate question would seem to be, “What recovery?”
*** Early last week, Sun Microsystems slashed its earnings projections for the current quarter due to very soft demand for its products both in Europe and the U.S.
*** Chemical giant DuPont warned of “continuing challenges” and said it would lay off more of its workers than previously expected. Semiconductor manufacturer Altera disclosed a “greater-than-expected” drop in its foreign sales. And according to a filing with the SEC, Cisco reported to that it expects the capital-constrained telecom and technology sector to scale back expansion plans “forthe foreseeable future.”
*** Still, the stock market embarked upon one of its periodic flights of fancy Friday. The Nasdaq bounced 39 points to 2,149, and the Dow tacked on 78 points to finish just below the 11,000 plateau. Still, it was a week most investors would rather forget as the Nasdaq tumbled 6% and the S&P 500 shed 2.5%.
*** SmartMoney.com’s Igor Greenwald described those investors buying tech stocks last week as “codependents.” Greenwald warns, “Like the faithful partners of errant spouses, investors will get more proof next week that the tech companies they love have strayed. And like many a long-suffering wife, they seem likely to consider the alternatives and fall back on that familiar oath: ‘For better or for worse, for richer or for poorer.'”
*** Weekly jobless claims reports continue to rise. Worse, continuing claims for unemployment now total 2.8 million Americans – the highest level since 1993. The Conference Board’s help-wanted index slipped again in April to its lowest reading since 1992. The “jobs-plentiful” index also fell again last month to 39.5 from 53.0 the year before.
*** The trend is your friend – only if the trend is friendly. And the unemployment trend is unmistakably hostile toward investors at the moment.
*** “If we are going to avoid a recession, SOMETHING needs to start showing some signs of a recovery,” writes Fleet Street Letter contributor John Mauldin. “But I ask myself – what reason do I have to think that unemployment won’t increase? How long can consumer spending hold up? When is production going to start back up? Everywhere I look there are far more negatives and questions than positive aspects and answers. So, where do we place our faith? Do we trust in Greenspan or do we believe in History?
*** “It may be time to trade in your T-bills for a Picasso,” says Crain’s New York Business magazine. According to a new study by two New York University professors, art investments produce a higher annual yield than government bonds or Treasury bills. Crain’s reports, “Using 5000 repeat sale prices for paintings sold at Christie’s and Sotheby’s, dating back to 1875, art investments showed an annual return of 5.6%. In that time, government bonds grew only 4% annually and Treasury bills, 4.3%.”
*** Still, for those unable, or perhaps unwilling, to pay $82.5 million for Vincent Van Gogh’s “Portrait of Dr. Gachet,” Treasury bills may offer an adequate substitute. Besides, compared to Picasso, Treasury bills are works of art…
And more notes:
*** It’s a holiday in France today, Pentacost. So, we’re enjoying another spectacular day in the country. Paris empties out on holiday weekends. The streets were so jammed up on Friday night that it was midnight before we reached the toll booths at the entrance to the highway. It was after 2 am before we finally reached Ouzilly. It will be just as bad going back to the city tonight.
*** “When Jesus left the disciples and ascended into heaven,” Pere Marchand explained the meaning of Pentacost in his Sunday sermon, “he promised to send a sign. Well, this marks the day the disciples received the sign. Their hair was set on fire…and their hearts were set on fire too, with the Holy Spirit. And they spoke in tongues. They became one body with Christ. Yes, that is what it is all about, being in solidarity with one another and with Jesus…”
** “Someone is stealing the eggs,” reported our gardener. “I don’t know who…but I have my suspicions.” Elizabeth could not believe the hens laid only a dozen or so eggs last week. She has her suspicions too. Stay tuned for the next exciting development.